So You Want to Make a Deal

Buying and selling commercial properties is a lot harder than it used to be. But that doesn't mean it's impossible.

June 1, 2009

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For the first quarter of 2009, commercial sales were "so slow as to be nonexistent," says Glen Esnard, president of capital markets for Grubb & Ellis, based in Newport Beach, Calif. Roughly $133.5 billion of commercial property changed hands in 2008—a 68 percent drop from 2007, according to Real Capital Analytics in New York. The decrease, which became even more dramatic in the first months of 2009, reflects far fewer deals and lower selling prices.

"Sellers are waiting and hoping they can weather the storm," says Britten Shuford, co-managing partner of Pacifica Capital Group, a Los Angeles–based real estate investment company known for buying during market downturns. "Buyers are assuming that rents will drop further as the economy worsens, pulling prices down even lower."

Does that mean that no deals are closing? Of course not. Opportunities do exist, but they’re rarely easy. Successful deals hinge on the property’s current cash flow and buyers’ access to capital. "Capital is the most important thing today; price is almost irrelevant," says Jules Marling, who heads a newly launched distressed asset advisory group at Real Estate Research Corp. in Chicago.

Cynthia Shelton, CCIM, CRE, director of investment sales for Colliers Arnold in Orlando, concurs. "Smaller deals, between $1 million and $3 million, are closing more often because properties of this size are viable for individual investors or small investment groups that can pay cash or get a loan from a local bank," she says.

Sale-leasebacks are another area of activity in today’s market. But while such deals may seem ideal to the buyer, thanks to the built-in tenant, there’s a risk that the owner-turned-renter won’t have the money to fulfill the lease, Shelton warns.

Where else to look for business? At a time when lending is tight, look for transactions that qualify for specialized loans, Marling says. For example, buyers of certain multifamily properties could tap into funds through the HUD 221(d) program, he says.

Business owners who are eligible for the U.S. Small Business Administration’s loan program—which can require as little as 10 percent down—make for promising buyers of retail, warehouse, and office properties, Shelton notes. Another pool of potential clients includes owners seeking to part with one or two properties to provide a much-needed cash infusion to other parts of their portfolio.

When Will the Thaw Come?

Experts say there’s plenty of capital out there, but most investors seem content to cool their heels until the market warms up. Unfortunately, it’s hard to pinpoint when that warm-up will occur. "The market doesn’t come back on a predetermined schedule," Esnard says.

And though there’s much talk of rising commercial loan delinquencies, this has not resulted in distressed properties flooding the market—at least not yet. "Banks have been reluctant to file defaults because they don’t want the bad loans on their balance sheets," says Bernard Haddigan, managing director and senior vice president of real estate investment services at Encino, Calif.–based Marcus & Millichap. Fear of being first in and buying too soon is also holding capital back, says Haddigan. Still, with "thousands of distressed properties out there," says Haddigan, the current market freeze can’t last forever. Sometime this summer, he predicts, people are going to start saying "Let’s just get rid of this stuff," and the market is going to tip.

Making it Work Case Studies

Commercial real estate practitioners are finding ways to close viable deals, even in these tough times. Here’s a look at how three recent transactions evolved and how practitioners helped clients reach their goals despite some serious challenges.

Case Study #1: Buy With Ready Money and Add Value

The property: A large, well-located Class A apartment community in Reno, Nev., that’s not performing up to its potential.

The seller: An institution that wanted to rebalance its portfolio.

The play: Help a buyer realize the property’s potential with some upgrades and a new business plan.

The dealmakers:  Michael Miyagishima, CCIM, and Dewey Struble, CCIM, Sperry Van Ness, San Francisco and Reno, Nev., respectively.

A 450-unit property on 54 acres high above downtown Reno, Nev., would seem like a surefire winner in any market, but uneven maintenance and management had produced rising expenses and contributed to an occupancy rate 6 percent below the area’s average of 93 percent. The owner came close to selling the property in summer 2008, but the deal fell through.

Around the same time, Dewey Struble and Michael Miyagishima were helping a client find an apartment community with the potential for net-income growth. When the Reno property came back on the market, they acted quickly.

"We did an economic analysis of net income and cash flows and determined that the offering price of $72 million would not work," says Miyagishima, a managing director at Sperry Van Ness. So they worked with the owner’s financial adviser to reach a price that was under replacement value and based on actual income and expenses, factoring in an economic vacancy factor of more than 20 percent. The seller wanted to close by the end of 2008, so they sweetened their offer by "making it clear that our client had sufficient cash for a significant down payment and the ability to finance the balance in a short period of time," Miyagishima says. The deal closed, as planned, at the end of 2008.

The new owner immediately modernized and upgraded all the models and vacant units and started other repairs and replacements, including new roofs. These efforts significantly reduced monthly maintenance, allowing for staff reductions. As a result, the owner almost immediately cut operating expenses by $1,200 per unit per year. "Improving the bottom line in such a trophy property made the deal a home run," Miyagishima says.

Less than a year later, the property’s net operating income has improved enough to allow for a loan refinance at a favorable fixed rate. The new owners expect to recover the renovation and modernization expenses along with some of the original cash equity from the new long-term loan. "The owners intend to hold the property for a long time, and with its great location and good management, it should continue to perform well," Miyagishima says.

Case Study #2: Tax Credits Keep It Affordable

The property:  A well-performing affordable apartment community in Sioux Falls, S.D.

The seller: Owners who had reached the end of the affordable compliance period required for previously issued tax Credits and wanted to cash out.

The play: Rather than convert the property to market-rate housing, keep it affordable by using new low-income housing tax Credits.

The dealmakers: Bob Dean, Seldin Co., Omaha, and Kevin Keating, Urban Housing Partners, Omaha.

The Country Meadows apartment community in Sioux Falls, S.D., could have been repositioned as a market-rate development. But research by Seldin Co. and Urban Housing Partners, which were interested in teaming up to buy and renovate the property, found that it would be better left as affordable housing. "The large size of many units and a lot of green space made the property well-suited to families," says Bob Dean, executive vice president of Seldin. "In addition, several nearby multifamily properties had been developed as market-rate apartments or condos, so the moderate-rate apartment market was underserved."

Low-income housing tax credits are a time-tested way to finance the purchase and renovation of affordable apartment properties, and that’s what Dean’s team planned to do. They convinced the South Dakota Housing Development Authority to issue both LIHTCs and multifamily housing revenue bonds to cover most of the property’s $4 million purchase price, as well as $1.7 million for renovation.

But in order for the plan to be complete, Dean would need to find investors to purchase the tax credits. In a normal market, this wouldn’t be a challenge. But recently, LIHTC investors, like many other sources of financing, have dried up. Who needs write-offs when you’re not making a profit?

"Even though the deal was strong, turmoil in the financial markets meant there was a limited number of investors in the market that matched up to our timing," Dean says. "In addition, we wanted to be able to provide a good return on the credits to the investors in a strong rental submarket."

To get the deal done, the development team tapped a group of fellow real estate professionals who saw opportunity in the transaction and were in a position to use the credits. The group formed a partnership and purchased the credits privately.

In the first quarter of 2009, after more than a year of negotiation, the new general partners, including Urban Housing Partners and Seldin and its investors, closed on the property and kicked off a 14-month renovation project. New Low-E windows and Energy Star appliances, along with other new green technologies, improved the property’s environmental profile.

"Understanding the community and the state where the property is located are key to developing a tax-credit deal," Dean says. "Each state has a slightly different allocation plan. We worked closely with the South Dakota Housing Developments Authority and other stakeholders to make the deal successful."

Case Study #3: Take the Risk and Ride It Out

The property: A specialty furniture mall in Costa Mesa, Calif., that got caught on the wrong end of the housing slowdown.

The seller: The mall’s lender. A distressed owner had walked away from the property.

The play: Buy it low, fill the space creatively, and hang on until the market improves.

The dealmaker; Dixie Walker, Grubb & Ellis, Newport Beach, Calif.

It seemed like such a good deal in mid-2006 when a private investor made the commitment: a brand-new 300,000-square-foot specialty mall on a major expressway in Costa Mesa, Calif., fully leased by the developer to housewares tenants and anchored by a Wickes Furniture store.

Yet, within two months after the deal closed in September 2007, "tenants just began to melt away," says Dixie Walker, a senior vice president of institutional capital markets for Grubb & Ellis. Even though Wickes’ store at that location had been performing well, the chain was suffering and eventually closed all its stores. After Wickes vacated the center, smaller stores followed, dropping occupancy to 66 percent. Many tenants that remained struggled and asked for rent reductions of up to 25 percent. The owner stuck it out for a year and then walked away. Walker and his group were called in first as a court-appointed receiver to oversee the property and then as a broker to help the lender sell the center.

Initially, Walker says, buyer interest was high, with 16 offers in early fall 2008. But as the economy worsened, the mall’s income deteriorated, and many of the lenders began to back out. The buyers who ultimately purchased the property had already done business with Bank of America, which held the note, and were able to reach an attractive price that factored in the property’s current operating income.

"Buyers of distressed properties like this one have to base their prices on supporting income, not on an internal rate of return focusing on the future. Otherwise, they’re not pricing realistically and could end up eliminating themselves from the running," Walker says.

For now, the new owners are trying to increase income and hang on. They’ve moved the remaining furniture retailers to prime mall locations that front the freeway. The back half of the property is being repositioned for office and other flexible space. The owners are trying to lease space to companies that complement the furniture focus—for example, a window and door distributor, Walker says.

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