The Counterintuitive Commercial Real Estate Market

Falling real estate prices don't automatically produce a traditional buyer's market.

Unexpectedly, the current downward drift in commercial real estate prices isn’t translating directly into cheaper rents for corporations. Faced with the sudden uptick in inflation, landlords are finding ways to collect more money from lessees.

To be sure, the Moody’s/REAL Commercial Property Index reported a 9.6 percent decrease in prices in June, compared with the same period last year, and a decrease of 11.8 percent from the October 2007 peak. The report, which was released in August, measures the change in transaction prices for commercial real estate assets based on the repeat sales of the same assets at different points and time.

The June index is the fourth consecutive month of negative returns, and shows a negative return over a two-year period. And while the 10 largest cities in each property type — industrial, office, and retail — are performing better than the national average, the aggregate numbers continue to drop. For instance, nationally the price of industrial space declined 9.3 percent from the previous quarter, and 7.8 percent from a year earlier. The price of office space sunk too, by 5.9 percent since the second quarter, and 7.8 since 2007. Meanwhile, retail space declined 4.6 percent from the previous quarter, and 7.7 percent over the past year.

On the leasing side, a similar trend is playing out. The commercial real-estate market is showing signs of “negative absorption,” says Marisa Manley, president of Commercial Tenant Real Estate Representation, a New York City-based broker that advises corporate tenants. That means that more space is becoming available than is being leased or bought. As a result, the law of supply and demand is helping to cut rental rates and creating incentives for building owners to offer tenants additional concessions.

But that doesn’t always translate into lower rents. Indeed, landlords are tightening up lease structures, and there’s an escalation in the number of clauses finding their way into contracts. In fact, come renewal time, landlords will be working to extract as much as they can from tenants in terms of passing along rising operating costs. Meanwhile, CFOs and corporate real estate managers will be looking for their opportunity to lock-in better long, and short-term deals.

In the recent past, when inflation was in check, landlords became comfortable with billing tenants a simple fixed increase to cover building operating expenses. Landlords preferred to avoid billing tenants directly for operating expenses because it was costly and time consuming to itemize and disclose all the charges to the tenants, says Manley.

Now, however, as the economy moves toward an inflationary environment, tenants can expect landlords to seek more aggressive formulas to recover costs rather than a simple fixed rent increase. Corporate managers should expect to see new leases that include variable rent increases based on such external metrics, as the consumer price index which reflects the national inflation rate, or the porters’ wage increase, which is a local union contract staple that raises the pay scale of building maintenance workers.

Such increases can raise rent by nearly 20 percent, posits Manley. The hikes are a mechanism for landlords to preserve their return now, and will act as a profit center in the future when inflation wanes, she adds. That’s what what happened in the 1970s and early 1980s.

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