Price/Sqft Trends Residential vs Commercial

[nccoastalseller]

I’m puzzled by a few things I am seeing in the commercial market which seem to indicate that price/sqft is going up in many CA markets while residential price/sqft is heading down. This seems counter-intuitive so it’s likely an anecdotal observation.

Is there any historical evidence that indicates one of these markets is a leading indicator for the other or are these two markets independently controlled by separate forces? Has anyone gone to the trouble to track these trends in the last so cal housing downturn?

[Bugs]

That’s easy. For the most part, the commercial and industrial markets lagged being the residential markets when entering into the price appreciation cycle, and they are lagging exiting it, too.

People were watching their homes double and triple in value and were wondering why their commercial properties weren’t doing the same. Over time, many of the commercial market segments have become just as overpriced relative to their rents as the residential markets as a result of those buyers letting their little head do all the thinking.

The difference between the two markets is that no matter what, a residential property does provide a basic necessity of shelter. Commercial properties are all about profitability, so ultimately these prices absolutely will adjust to reflect the realities of the rental markets.

There was a big article in the Union-Trib the other day about spec builders in the office markets. There was a reference to sale prices in the $500/SqFt range and in the same breath a comment about tenant opposition to rents in excess of $3.00/SqFt. If you run the numbers, after taking out the taxes and other expenses, a sales with those numbers wouldn’t even come close to debt servicing their mortgages even if they were completely occupied, which none of them are. These investors are apparently betting on continued increases in pricing and/or increases in rents; and there’s really no reason to think that either of those will occur. A company has options about where they need to be based, more so than a homeowner.

So yeah, some of these commercial buyers have become just as dumb about their commercial properties as they were with their homes. And yeah, some of these commercial markets are destined for the same types of price corrections.

[PerryChase]

Right on bugs. I don’t understand how Blackstone is going to make a killing on their Office Equity purchase.

I think that we should have live/work type spaces in San Diego — kind of like shop houses they have in other countries. Commercial downstairs and apartment upstairs. That would work well for urban areas of San Diego such as Downtown, Hillcrest, North Park, City Heights, etc…

[Anonymous]

Residential and commercial are two very different markets although (obviously) problems in the residential market tend to leak into the commercial market eventually (lower residential prices lead to fewer jobs, particularly here in SoCal).

But the big difference between the two markets, and the reason why commercial tends not to get as totally crazy as residential, is the financing. Residential loans are based on appraisals which follow prices set purely by the forces of supply and demand. We’ve witnessed first-hand over the last several years how crazy such a process can get.

Commercial real estate values are also based on appraisals, BUT such appraisals are based on estimated cashflows (or Net Operating Income, which is rent less non-interest expenses, in simple terms) AND a discount rate (or “cap rate”). Currently cap rates are at historical lows – some properties sport cap rates of 4%-5% – which is crazy in my mind. BUT, even with a low cap rate (which increases the value of the property) the property must have enough NOI to service its debt in order to get a loan. So, even if a commercial building has very low cap rate, there will have to be enough equity in the deal such that the interest coverage ratio is at least 1.1x for just about any bank to finance it. So, put simply, “fundamentals” (that is, cashflow) play a much larger role in how CRE is valued than residential real estate. Now, banks and other lenders can still get hurt on these loans if cashflows decline AND cap rates increase at the same time. But, at least there’s something “real” – in the form of NOI – that supports CRE. With residential real estate there’s just “air and prayer” (although at levels considerably lower than we see today, residential properties are supported by NOI, in the form of rents, as well).

So, what’s happened over the last five years here in CA is that residential real estate has gone berserk due to speculators, easy financing, fraud, etc. while the CRE market has just continued to chug along aided by low vacancies, relativley little new construction (relative to demand, that is), rent increases and declining cap rates.

I think what you’ll see over the next five years is the following: Residential real estate will continue to decline (how low, who knows?). This will increase vacancies a bit on the commercial side, but not to dangerous levels. Cap rates will climb, but slowly. You’ll see some banks take hits on CRE but nothing like the early-90s. For the most part, CRE is going chug along, but the really good times are over – it’ll be much more challenging going forward. We could easily see a bloodbath in residential real estate and a simultaneous stabilization or modest decline in the CRE market. Most California markets are simply not overbuilt on the CRE front, even projecting increased vacancies from the residential fallout.

[Bugs]

Regarding Blackstone’s purchases, I’m not familiar with the details of those properties so I couldn’t comment on that. However, I will say this: A lot of Japanese money got lost here in California during the last RE market downturn because they misread the long term trends and vastly underestimated how high vacancies can go. I think the same thing can happen this time.

When a purchase is based on an income from a building that only barely covers debt service at the peak of the market, then what’s going to happen if the biggest tenant goes BK as a result of not being able to sell enough homes? Further, what happens to rental rates when the vacancies exceed 25%? You can bet that’s not going to result in a soft landing.

The so-called NNN investors are some of the same people who were flipping tract homes in new subdivisions. They have both the same mentality and the same lack of understanding of how markets can fluctuate. Same stupidity, except they’re working with commercial brokers (who absolutely should know better) rather than residential brokers.

Almost half of the “better” jobs created during the last 5 years are related to an industry (RE) that is getting hammered. I guarantee that’s going to have an effect locally on the businesses that were selling non-essential goods and services to all those people. That will trickle down to the RE those businesses are in, too.

[Author]

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