One of the most difficult tasks for commercial real estate professionals is determining where the market is today. Too few transactions, too much distress, unrealistic sellers, and opportunistic buyers make the demand for property and the proper pricing of property an exercise in futility.

Determining a rate of return commensurate with risk is difficult in these uncertain times.

Three news stories illustrate this point.

Retail Center in Vallejo, CA

GlobeSt.com is reporting that the First Grocery-Anchored Sale Closes, More to Come. The article details the sale of a 66,000 square feet Safeway anchored center in Vallejo, CA.

According to the article the property sold based on a 7.71% cap rate on current NOI. As well, the seller had an assumable loan at below market rates providing an attractive cash-on-cash return for the buyer.

The cash yield seems to be the bigger selling point. Dan Wald of Terranomics said that investors are requiring a 10% cash yield on investments.

While this property gives us an idea of the value, it is not a firm indicator. This center is well located at the entrance to a housing development. A superior location would induce a buyer to pay a higher price for the lower risk.

AIG Headquarters in Manhattan

CPN is reporting that the AIG Headquarters Sale Makes Splash in Quiet Manhattan Investment Market. (HT: David Stejkowski)

Youngwoo & Associates (YWA), a New York-based investment and development firm, together with Kumho Investment Bank (Kumho), entered into an agreement to acquire the AIG building, 70 Pine Street (pictured), and an adjacent office building, 72 Wall Street. The two buildings will total 1.4 million rentable square feet in the heart of Manhattan’s Financial District.

The rumored salesprice is around $100 million. This would value the property at around $100 per square foot.

While this may be the biggest acquisition in New York, the entire property is going to be vacated once AIG is wound down. This again doesn’t establish a firm enough foundation for other investors.

Office Building in Orange County, CA

The WSJ has an article explaing why Maguire Sells Office Site at 40% Off.

Maguire Properties Inc., a struggling Los Angeles-based real-estate investment trust, sold a newly developed office building in Irvine, Calif., for about $160 million, a price representing an estimated 40% discount to its construction cost.

The price of 3161 Michelson Drive, during a lean year for commercial real-estate sales, is the latest sign of the severe drop in values in the commercial real-estate market, which is threatening to become a major anchor around the economy just as it is struggling to come back to life.

This property like the AIG bulding suffers from vacancy issues. As well the seller was under pressure to reduce their debt load and needed to sell the asset.

The Bottom Line

Each of these sales while indicative of the current market demand and supply are not conclusive enough to determine a market pricing strategy.

Until owners begin to sell non-distressed assets, market pricing will be a moving target.

This is a post from Peter Maclennan's blog Peter Pays Paul.

Real estate investors are still interested in purchasing prime real estate in a great location.

This is a post from Peter Maclennan's blog Peter Pays Paul.

Here are some of his thoughts on the length of the current recession:

We think job losses and the recession will end in 2009. We’re expecting that job losses will bottom by the third quarter, perhaps into the fourth quarter. For 2010, if you look historically, we’ve had plenty of instances where sharp declines and severe and sudden recessions have been followed by years of growth spike and better-than-average growth — especially the first year after a recession. But this time around, we still have a significant amount of consumer debt to unwind and we’re still dealing with a lot of headwinds in housing and corporate debt. I don’t think 2010 will bring an economic spike.

Nadji acknowledges that retail is going through some issues and may not recover until 2011 or 2012. He ascribes this to a problem of overbuilding in the retail sector.

On Distressed Property

We also need to know how much distressed inventory is going to appear and move through the market. I believe a lot of buyers with lots of cash are sitting on the sidelines looking for signs of an economic bottoming and waiting to see the scale of distressed property sales. Over the next six months, we’re going to get a better reading on the market because both financial institutions and owners of properties are still having stress and they’re going to have to decide what to do with those assets. I think there will be more motivation to sell at more realistic prices than there was a year ago.

…

One or two high-profile deals are not going to refine the market. Its going to take a little more volume, and a sampling of different asset sales in different places starting to trade, for it to become more of a widespread conviction that it’s time to get back in.

Using Cap Rates in Today’s Market

Nadji that cap rates are not as important as they once were in the realm of commercial real estate.

That’s not to say that no one thinks about cap rates anymore — they certainly use it as a metric — but you have to look at return on cash, number one, and using the new underwriting parameters to clear this market for financing, which requires more equity up front and much more realistic rent growth projections and occupancy projections. That would lead you to look at the return on investment for years year one through three in terms of cash flow, which is right now far more important than just a cap rate, which you can come up with in so many different ways.

RTC 2.0?

Nadji doesn’t believe that the current recession and distress in commercial real estate will lead to a second coming of the RTC.

Rather, the forces are working to minimize foreclosures, and therefore this notion of an RTC 2.0 that will bring quality assets to market at huge discounts may not materialize the same way.

He suggests that there are still quality deals available that have cash, can underwrite to today’s rent and occupancy rates, and are seeking to add value to their projects.

This is a post from Peter Maclennan's blog Peter Pays Paul.

The Wilder Project in Orinda, CA is facing legal challenges according to Orinda project stumbles over another legal hurdle – ContraCostaTimes.com.

The lender for a luxury residential subdivision in Orinda’s scenic Gateway Valley has sued the site’s developer, seeking to foreclose on the project, which in February staggered into default on its $180 million mortgage.

The 1,600-acre Wilder project has a murky outlook now that the loan default, the lawsuit and a court’s decision to place Wilder into receivership have coalesced to create a number of fresh financial and legal obstacles for the development, which was first proposed two decades ago.

Merrill Lynch Mortgage Lending Inc. sued OG Property Owner LLC, the developer of the Wilder project, on April 7, Contra Costa County court records show.

OG Property planned to build 245 homes, an arts and garden center, five sports fields, a fitness and pool center, a city corporation yard, and preserve 1,400 acres of open space. The homes were pegged for sale at $3 million to $5 million each.

The Contra Costa Times is reporting that the project has been in the works for over 20 years and has faced many similar obstacles.

To make matters worse,

A dozen contractors, however, have filed liens against the property, claiming that the developer has not paid them for their work. The combined money owed to contractors, court records show, is $17 million.

It appears that a major investor is looking to buy out Merrill Lynch’s note. Barring this the project is likely to be tied up in court for some time.

This is a post from Peter Maclennan's blog Peter Pays Paul.

Lenders filed a record number of mortgage default notices against California homeowners during the first three months of this year, according to the research firm MDA DataQuick.

The company blamed the recession and of lenders playing catch-up after a temporary lull in foreclosure activity. A total of 135,431 default notices were sent out during the January-to-March period, an all time high in the  company’s database which goes back to 1992. That was up 80.0 percent from 75,230 for the prior quarter and up 19.0 percent from 113,809 in first quarter 2008, according.

According to the DQNews.com article Golden State Mortgage Defaults Jump to Record High:

The median origination month for last quarter’s defaulted loans was July 2006. That’s only four months later than the median origination month for defaulted loans a year ago, in first quarter 2008. That suggests a period where underwriting criteria were particularly lax.

Of the 3.7 million home loans made in 2004, less than 1 percent have since resulted in a lender filing a default notice. Of the 3.7 million loans originated in 2005, 4.9 percent have triggered a default notice so far. Of the 3 million in 2006, 8.5 percent have so far resulted in default. A particularly toxic period appears to have been August through November 2006 which had more than a 9 percent default rate. Of the 2.1 million loans made in 2007, it’s 4.6 percent – a percentage that’s likely to rise significantly during the rest of this year.

The lending institutions with the highest default rates for loans originated in August to November 2006 include ResMAE Mortgage (69.9 percent of loans resulting in a default notice), Master Financial (64.6 percent) and Ownit Mortgage Solutions (63.6 percent). Of the major lenders, IndyMac has a default rate on those loans of 18.9 percent, World Savings 8.0 percent, Countrywide 7.7 percent, Washington Mutual 6.3 percent and Wells Fargo 3.4 percent. Less than 1 percent of the home loans originated in late 2006 by Citibank and Bank of America have since gone into default.

The DQNews.com article also reported:

Foreclosure resales have emerged as a significant market factor, accounting for 58.1 percent of all California resale activity last quarter. A year ago it was 33.1 percent. Foreclosure resales varied significantly by area, from 13.0 percent in San Francisco County to 80.8 percent in Merced County.

Real estate values have not settled in California. This new “wave” of foreclosure notices is going to cause uncertainty in the markets for a while. This combined with the “shadow inventory” of as many as 80,000 homes reported by SFGate.com will keep prices depressed and may drive them lower.

This is a post from Peter Maclennan's blog Peter Pays Paul.

Owners of several small commercial buildings in San Francisco already are behind on payments, and local industry observers are laying odds on which large property could be the first to be seized by a lender.

…

“Real estate fundamentals are softening dramatically,” said Richard Parkus, research analyst at the German bank. “Over the next 12 to 18 months, we expect to see pretty significant deterioration.”

Of particular concern for San Francisco is the fact that nearly 75 percent of the Class A – premier – office buildings downtown traded hands in the past four years, according to Tove Nilsen, director of market research at Colliers International. The flurry of activity propelled sales prices to record highs and drove the ratio of rental income to cost to all-time lows.

According the article vacancy in San Francisco has risen by 32% from the 1st Quarter of 2008 to the 1st Quarter of 2009.

Marcus & Millichap predicted in their 2009 National Office Report a rise in vacancy of 400 bps to 15.1% in 2009 for San Francisco. As well, they predict that effective rents could drop as much as 10.7%.

Falling rents and rising vacancies will drive the value on a leased office property lower. Lower values make it more difficult to obtain financing.

Another factor that is hurting owners’ ability to refinance is rising cap rates. Investors are acknowleding the greater risks inherent in real estate and are expecting a greater return. This desire for a greater return is driving cap rates higher.

It may be a while before we see the end of the commercial real estate cycle. Properties that provide a strong cash flow now may still be a good buy. Don’t expect to find financing in today’s market for a property that cannot service the debt at a ratio of $1.10 of income to $1.00 of debt service. More institutional lenders are requiring even hire debt service coverage ratios of 1.3 or greater.

This is a post from Peter Maclennan's blog Peter Pays Paul.

• The WSJ covers the Treasuries new plan in: Treasury Releases Details on Program to Buy Troubled Assets
• Calculated risk writes CRE: Cap Rate Expansion
• Retail News Blog explains: The Role Of An Appraiser
• CoStar warns of: The Return of the Miserly Lender
• Square Feet informs us that Moody’s Commercial Property Price Index Posts Large Declines
• Bloomberg. com is reporting that Defaulting Commercial Properties Hit Banks on Vacancy-Rate Rise

This is a post from Peter Maclennan's blog Peter Pays Paul.

In a groundbreaking ruling as well as a rare victory for common sense and the overall good of taxpayers, Bankruptcy Judge Rules Calif. City Can Void Union Contracts.

In the first ruling of its kind, a bankruptcy judge held the city of Vallejo, Calif. has the authority to void its existing union contracts in its effort to reorganize, holding public workers do not enjoy the same protections Congress gave union workers at private companies.

If you recall, the city of Vallejo, CA filed bankruptcy over the high costs that it was having to pay for public services. I wrote more about the problems facing California’s cities here and here.

This is a post from Peter Maclennan's blog Peter Pays Paul.

According to the report there are currently 19,600 office buildings with vacancy ranging from 60-100% of the office space. According to the chart compiled by CoStar San Francisco has 125 buildings in this category and the Oakland/East Bay has 208 buildings.

The article also reports few if any sales of these distressed assets.

The reasons for the dearth of deals appear to come down to three primary factors: the pricing disconnect that exists due to rapidly declining market fundamentals, tightened credit conditions, and a lack of appetite for risk on the part of [both] lenders and investors.

A Matter of Perspective

The answer CoStar provides is exactly correct and comes down to a matter of perspective.

Sellers tend to be optimistic about the future value of assets and buyers tend to be pessimistic or at least realistic. Sellers foresee rental rates rising and demand picking up for commercial office properties. This perspective motivates sellers to hang on to the property until a buyer who recognizes the “true value” of their property or they are forced to sell through foreclosure.

Buyers realize that though the seller may expect rents to increase, there is no guarantee that this will actually happen. Buyers want to pay a price based on actual rents, if not decreased rental rates due to the over abundance of office space. Buyers with this perspective will hold out until they can buy a property that meets their criteria.

Leverage Has Left the Building

A lot of the value attributed to office buildings in the past five years was a product of the ability of buyers to leverage the properties to such a degree that even a slight increase in rents or occupancy gave a nice bump to their rates of return.

With 80-90% loan to value leverage, unavailable buyers need to have a greater upside in relation to the purchase price to get a compensating return commensurate to the risk they are taking on.

A Staring Match

It has become a staring match of sorts. Neither side wants to show weakness and neither side is ready to admit defeat.

Until one side concedes defeat, the staring will continue and properties will remain unsold.

Who will blink first? Will it be they buyers or the sellers?

This is a post from Peter Maclennan's blog Peter Pays Paul.

Your response to this question may play a role in how “lucky” you are according to What It Takes To Survive from Newsweek. (HT: Get Rich Slowly)

Only 10% of Life is Chance

“Luck is not a magical ability or a gift from the gods,” Wiseman writes. “Instead, it is a state of mind—a way of thinking and behaving.” Above all, he insists that we have far more control over our lives—and our luck—than we realize. Going back to the Italian Renaissance philosopher Niccolò Machiavelli, great thinkers and writers have argued that 50 percent or more of what happens in life is determined entirely by chance (or Fortuna, the Roman goddess of fortune). Wiseman says no way. He believes that only 10 percent of life is purely random. The remaining 90 percent is “actually defined by the way you think.” In other words, your attitude and behavior determine nine tenths of what happens in your life. Wiseman has concluded that there are four reasons why good things happen to certain people. [Emphasis mine.]

If only 10% of life is purely random, it removes a lot of excuses.

Sure we can’t change the family we were born into, but we can choose how to live with them. We can’t choose the boss we work under, but we can choose how we respond to them.

We didn’t choose to get into this economic mess, but we can choose how we will act in spite of it.

Characteristics of the “Lucky”

Prof. Wiseman says the four reasons good thing happen to certain people are:

1. First, lucky people frequently happen upon chance opportunities.
2. Second, lucky people listen to their hunches and make good decisions without really knowing why.
3. Third, lucky people persevere in the face of failure and have an uncanny knack for making their wishes come true.
4. Fourth, lucky people have a special ability to turn bad luck into good fortune.

One of the key factors detailed in the article is that survivors and “lucky” people tend to have a great awareness of what is happening around them.

I can attest to the truth of this statement. I found a $100 bill in the parking lot of a major theme park. Other people had obviously walked past it. However, I reached down and picked it up.

Was I “luckier” than these other people? Probably not, I just had my eyes open.

Making Your Own Luck

Based on Prof. Wiseman’s observations here are a few suggestions for making your own luck.

1. Keep your eyes up and your ears open. Notice what is going on in the world around you. When you walk down the street do you notice differences in the buildings? Would you be likely to spot a friend on the street or would you walk past them?
   Listen to what is being said around you. Ignore the gossip and useless banter of fools. Listen for ideas and opportunities. Listen to learn about new markets or ideas you may have previously missed.
2. Learn to make good decisions. Wisdom does not happen on accident. People are not born wise, they become wise.
   Pick up a book or take a class that will help you to make wise decisions. (The Biblical book of Proverbs is full of wisdom.) Learning from your own mistakes and the mistakes of others plays a major part in wisdom.
3. Don’t let adversity or failure discourage you. Thomas Edison had 10,000 “failures” before he found the right filament to make the light bulb work.
4. Look for opportunities instead of obstacles. If our responses determine 90% of what life is, we have greater control over our lives than we know.

In the words of Dirty Harry, “You’ve got to ask yourself one question: Do I feel lucky? Well, do ya, punk?”

This is a post from Peter Maclennan's blog Peter Pays Paul.