We have sole ownership of a couple of office buildings that are performing very well at the moment. We were recently approached by a broker who was encouraging us to sell now while the market is still strong. We have heard all of the talk about rising interest rates and a looming downturn. Is it possible that the market may remain strong throughout the remainder of 2018? What evidence would support such a belief?
We view that there are still opportunities to benefit from in the US markets. If a broker is encouraging you to sell performing assets, usually they are keener on their own commissions and marketing a perfectly performing asset. When we divest from assets it is only for better opportunities and not just to sell a performing asset with stable rent, etc. for a simple reason of a broker encouraging to sell.
Generally speaking, many industry experts and observers believe we are at the tail end of this recovery cycle. People often like to use the baseball analogy, and it’s that we are in the 8th inning of a nine-inning game. However, it's important to remember that while this recovery has been long, it has been slow, implying that people are overly weighting the amount of time that it has been since the 2008, 2009. So, there is likely still a lot of room left, and the economy in general is strong with superficial boosts coming from the recent tax reform. There is strong growth, low unemployment, interesting demographic trends, etc. The biggest risks to the U.S. are probably geopolitical over economic. In commercial real estate nationwide, there is less leverage in the system and spreads have been tightening for some time before a recent rise. LTVs and CMBS rates are at more conservative levels than 2007 highs, implying that we are not near a major blowout in the system. At a more micro level, there are different forces affecting different asset classes and geographies. In fact, New York City prime office prices have already started to decline, and the residential market here has been declining for a while. So in some sense there are price corrections and a “downturn” happening now. Florida in particular is a market experiencing population growth, has a ease of doing business and is benefitting from recent tax changes. I am more bullish on Florida projects (location and product-dependent, of course) than most parts of the country. To answer your question broadly (and without knowing the specifics of the assets, which is crucial), I think a downturn will occur between two to four years from now. I think it will be much more subtle than the 2008 downturn and won’t last longer than 18 to 24 months. Finally, whether or not to consider a sale now depends on your basis and short-term goals. However, prices are inflated at the moment, and if a good price can be achieved that hits exit return goals, I think it can be the right time to sell.
Great response, Mark. Very accurate sense of economy from my prospective as well. I am in South Florida and have already witnessed small corrections in market segments where market corrections were probably needed. However, the overall demand continues to remain strong and consistent for desirable property types in every market I know of. Commercial real estate is all about location and cash flow, in my opinion. If your building is in a good location, you are satisfied with your cash flow and returns (they are meeting or exceeding your goals) and operations are running smoothly, I'd ask, why would you want to sell? Unless you have something else that you think you could benefit more from. I recommend monitoring the business community in which your property is located. If you want to be proactive, make sure that you are properly budgeting and withholding for your capital improvements. Strengthen reserves whenever possible for your commercial holdings, especially if cash flow remains consistently strong. So many factors determine the macroeconomic cycle, but one of my close scholar friends was just discussing with me about how he felt Obama's economic policies have elongated the current economic cycle. From my standpoint things look relatively strong well beyond 2018 in Florida. I can see several more years of most everyone working. I am particularly fond of light industrial and flex space in my market right now. With the push to strengthen manufacturing nationally, I think it's common sense that this particular market segment should remain strong. Additionally, we have seen a re-strengthening of the office space. Working from home is great, but many people need the office setting to focus and expand operations. This segment should continue to do well as long as the general public remains productive.
As a lawyer, I am not sure that my personal opinion on this type of question is reliable. That said, I read a great deal on the U.S. real estate market, speak about it at conferences and listen to true industry experts on their views. Generally speaking, the tremendous runup in real estate valuations over the last 10 years has been very much led by the lower capitalization rates and lower interest rates. Interest rates have seen increases, both short and long term, for the first time in 10 years and I think that there is no longer any room for compression of cap rates, as they have been at all-time highs. This would suggest that there is more room for downside pressure on pricing than upside in the market. But here are countervailing forces at work to mitigate that. There remains an abundance of equity wanting to purchase assets in the marketplace, though the very low cap rates and resulting high valuations are giving investors some pause, and there is still abundant debt. The one factor that can help predict upside or downside in this environment is general market fundamentals. Is the U.S. economy and creation of new jobs still expanding (it is) and is expansion likely to continue for some time? (Most say it will, short of some unforeseen bump in the road of our economy.) How will that likely affect rental rates in various market sectors, such as office, residential and the like? There is some greater risk in multifamily than has existed for a while due to cap rate compression, rising rates and, in some markets, great increases in supply, which makes it more difficult to achieve projected rents and cash flows. But in other areas, new construction has been muted generally for some time. So, this is a complicated and dynamic analysis that can be turned by unforeseen events, but the trend seems to be slow, upward trends in fundamentals that should mitigate any drop in prices in most areas due to higher interest and cap rates. That said, great increases in value of most assets in most markets would be hard to anticipate, short of some great development on a particular property in a value add situation Hope this is helpful and good luck.
I wish I had all the answers. The panels I have attended recently tend to see the industry in a prolonged eighth or ninth inning. Valuations show buildings are losing value, but prices have not fallen yet. My recommendation is to look carefully at each asset. Look at current information. Values are most affected by the dynamics of the market. What is the quality of your tenant base? Does the building need renovations? Are they in primary markets or secondary markets? Depending on the asset class and location, you might test the market. But please don’t jump without carefully considering factors in the locality of your buildings. Is there a long-term mortgage that can be assumed by a buyer? Does it make sense to refinance now? Is your ownership structure optimal for maximizing your after tax return? These questions should be part of your analysis.
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