Most people hear the word “real estate” and their immediate thoughts turn to the dropping housing prices and the subprime lending woes that have made recent headlines. Yet, as the housing market teeters and the “easy credit” of recent years dries up, many have forgotten that a very different story is unfolding in commercial and investment real estate markets. It seems likely that certain trends will affect both of these distinct marketplaces–and it may be for the better.

Tightening Lending Standards

First and foremost, one fuel increasing the values of all types of real estate has been easy access to credit. Short-term variable interest rates have enabled buyers of all kinds to readily obtain loans for sharply escalating property values–an effective bet for the borrower, and ultimately lender, for continued appreciation.

Lending for investment properties, especially income producing properties, has tended to be more focused on the underlying net revenue with less emphasis on the credit worthiness of the borrower, making the default rate on commercial properties lower than that on residential properties. However, our belief is that the market for commercial mortgages is going to improve once folks stop overacting to the current subprime situation.

The Positive

This tightening of standards may offer some positives in terms of buying commercial real estate. In the multifamily sector, it may point to a continued improvement in occupancy and rental rates. Many markets are seeing their first “up-tick” of rents in years.

Also occurring in the wake of the current market is a reassessment of risk, not only for lenders but property buyers. Up until very recently, a single-purpose, single-tenant property has been selling for nearly the same price as a multi-use, multi-tenant property. The faulty reasoning of this lies in the fact that, in terms of risk premium, these properties are not nearly valued the same. Here’s an illustration:

When a person buys a single-purpose, single-tenant property, such as a Walgreen’s Pharmacy, they are centering their risk on location, with one business model, and one tenant. As opposed to a multi-use/tenant property such as a retail shopping center. So if, for instance, retail pharmacies go out of vogue, the owner is toast because that building can only be used for a single purpose. These single tenant properties (commonly called NNN or “triple net” properties) were sought after for their apparent steady cash flow, however they sold for much less than the superior multi-tenant, multi-use facilities in the same market.

Now that we’re reassessing the market, we’re finally taking a look at risk premiums, which forces buyers to look at purchasing property in a different light. In the past, buyers were not getting rewarded for taking on substantially more risk in a property acquisition, but now the higher the risk, the more likely they’re going to get paid more, and vice versa. If this reassessment of risk premium continues, the market will no longer “carry” the inferior property with a modest price difference; instead, it will trade with a notable discount.

The Forecast: A True Flight to Quality

In light of this risk premium reassessment, many predict there’s going to be a progression to “quality” in the commercial real estate market. Whereas a real estate buyer who was contemplating a 1031 exchange might be willing to accept a single-use, single-tenant taco stand just so they could complete their exchange, will no longer be willing to take such a risk. The value of a single-purpose, single-tenant asset would no longer be comparable to the–now more highly valued–multi-use, multi-tenant asset. .

By yanam49

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