The real estate market’s effect on businesses, big and small, is undeniable.
When San Diego sees major changes in affordable commercial space, the economic impact is far-reaching.
“Building sale prices are at historic highs,
as are asking rents, but the leases we are
getting done haven’t changed much, materially, from 2005 and 2006,” says David
Marino, principal with Irving Hughes in
San Diego.
Smart Business discussed with Marino
the causes and effects of the spike in local
commercial real estate building sale prices.
What has been driving the record-high sale
prices of commercial real estate?
Fundamentally, there is too much money
chasing a fairly fixed supply of assets. After
the Internet bubble of 2000, institutional
investors allocated more money into real
estate, which is a hard tangible asset. There
has been a flood of capital through pension
funds, private equity groups and REITs
[real estate investment funds] that has driven the supply of capital out of balance with
the asset base’s supply, and institutions
rightly bet that commercial real estate was
undervalued. Fueling the fire, commercial
real estate sellers then reinvest in new
assets at inflated prices through tax-deferred exchanges to defer paying capital
gains taxes.
We have a financial engineering environment in commercial real estate. REITs
have been gobbled up by private equity
groups, whereby the assets are then broken up into smaller asset sales where the
parts are more valuable than the whole.
Most of the buyers of these parts are then
other REITs and institutional buyers. In a
market of high leverage and low cost of
capital, owners are trading on the razor’s
edge of cap rates to generate returns
through flipping assets rather than operating them. Most of the buyers are from out
of town and generally don’t understand the
market. But it turns out they don’t have to,
since they turn around and sell the asset to
someone who understands the market
even less.
Other than the supply of capital, what is the
rationale of these buyers paying such premiums in San Diego?
The argument is that San Diego is running out of developable commercial land,
but I have been hearing that for my entire
18-year career. Someone could say New
York City is running out of land, but that
has been the case for 100 years and there
have been wild swings in asset value over
that time. Also, buyers and their brokers
argue that San Diego has macro-level job
growth and population growth as well as a
diversified economy. But most of that job
growth hasn’t been in industries that occupy office space, so the translation of jobs
and population to the demand for space is
relatively weak. They also argue that rents
are relatively lower in San Diego than in
other major markets around the U.S., and
investors believe there is room to push for
rent increases. However, with the cost of
labor, taxes, gas and living in San Diego,
rents need to be affordable for tenants so
that businesses will continue to start and
grow in San Diego. Shockingly, some of
these investors are putting 10 percent
annual rent inflation in their pro formas.
Do you see the landlords getting these inflated prices?
No, but they have to build a pro forma
that justifies hyped-up purchase prices.
The reality is that virtually none of these landlords is making money on the cash
flows from commercial real estate. They
are buying with huge leverage and low-cost
financing and then selling at a profit a year
or two later. It’s sad to me that many of
these investors really don’t care about the
tenants or the tenants’ businesses or about
putting capital into the buildings to make
them better facilities.
One of the most painful effects of this
buying and selling is that the tax basis
becomes reassessed to the new value, and
that tax increase gets passed right through
to the tenants. Existing tenants have been
hit with unexpected and nonbudgeted tax
increases ranging from 30 cents to 60 cents
per square foot per month. In the short
term, tenants are paying for this buying and
selling game, but in the long term when
those tenants renew with new base years,
or move and get a new base year, the owners are going to have to stomach those former pass-throughs, and landlords aren’t
going to be able to build those higher tax
costs into their new rents.
But wouldn’t overall higher costs of buildings
and taxes for the landlords mean they have to
charge more, and that they would get it?
The capital markets for real estate are
acting independently of the leasing market.
The reality is that there has been virtually
no net absorption in any submarket in San
Diego in over a year, with the exception of
Del Mar Heights, and that the market is
stalled. All of these new buildings you see
being finished are raising vacancy rates,
and supply is beginning to exceed demand.
Aggregate sublease space across all product types has been rising for more than a
year, topping 4,800,000 square feet, which
is the highest level we have seen in three
years, and presents tough competition for
landlords going into 2008. Meanwhile, landlords in lockstep, propped up by the brokerage community, are raising asking rents
all over town. There is no economic supply-and-demand basis in reality for rents
rising in an environment like this, but landlords and their outsourced sales and marketing departments — the brokerage community — are all trying to make it happen.
DAVID MARINO is a principal with Irving Hughes. Reach him at
(619) 238-4393 or [email protected].