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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   April 2011

What’s Next for the Industrial Market?

Property prices may have hit bottom, but foreclosures still loom

Like much of commercial real estate, the industrial market is in a state of uncertainty . Although the sector is known for its reliable cash-flowing properties, pricing has hit an all-time low. Moreover, a wave of purchases was made between 2005 and 2008 — which could mean a corresponding wave of foreclosures.

Commercial mortgage brokers working in this segment should be aware of the different factors influencing the market and be ready to advise their clients.

Industrial prices are, in some markets, 50 percent lower than they were at their peak in 2007 and 2008 . With buyers obtaining 75 percent loan-to-value ratios (LTVs) for conventional loans during those times, the equity likely is gone. It’s difficult for prices to stabilize and fundamentals to firm with the bulk of the refinancing yet to come. In addition, properties with no equity often house struggling businesses unable to sink more of their working capital into refinancing their buildings.

It remains unclear whether the industrial market has hit the bottom after three years of declining sales prices and rental rates. Market indicators show that, for now, the pricing decline has stabilized.

Southern California is a good sample market to consider, as it is one of the strongest industrial markets in the country. In 2007, average industrial prices in Southern California reached almost $165 per square foot. In the first quarter of 2010, however, average prices were close to $65 per square foot. Declining prices appear to be leveling out, and there has been slight upward movement in prices since early 2010. Average prices were in the mid $70 range per square foot earlier this year.

The average spread between asking prices and actual sales prices also is starting to decline. The differential peaked at the end of 2010 at almost 20 percent. The most recent differential was 12 percent, indicating a potential firming of the market. This is backed by a bump in prices in the past few quarters.

With the largest volume of purchases occurring in 2007 and 2008, demands to refinance began in early 2010 and will likely extend to 2015. This call for refinancing will be particularly difficult for small-building owners, who will be forced to make a decision about what to do with their buildings. Do they spend capital to satisfy the bank’s new LTV demand, or do they push back on refinancing, causing a new, larger wave of short sales and foreclosures in the process?

These indicators suggest another series of foreclosures will result. The current dilemma is an opportunity for creative and aggressive measures by lenders and mortgage brokers. The mortgage industry will have to find a way to stem the tide.

Will banks perform loan modifications on commercial buildings as they have done with homes? Will they extend existing terms for a finite period of time to forestall the issue until the economy can boost values once again?

Recently, banks have used a series of strategies to combat the issues in the commercial mortgage market. Their two main strategies are:

  1. Reworking the loan: They have aggressively worked with borrowers with good credit to bring down their monthly debt service. This gives borrowers time to allow the market to recover and gives banks some shelter from a full write-down.
  2. Selling the note to investors: Increasingly, banks have sold notes at the first sign of payment struggles. This helps them by taking the write-down upfront and getting the loan off their books quickly. It also helps the commercial-building market in general because it gives the new note holder a revalued position on the building — which creates a more traditional market LTV. Thus, it stabilizes the property value and position.

According to CoStar Group, roughly 20 percent of all industrial sales in 2010 were distressed sales. According to a report from the Congressional Oversight Panel this past February, $1.4 trillion in commercial mortgages are coming due between 2011 and 2014.

When you combine the lack of equity with the pending refinancing requirements, it’s clear these are precarious times for the commercial real estate industry as a whole. The U.S. gross domestic product increased by an anemic 2.6 percent in the third quarter of 2010 and did only slightly better in the fourth quarter, at 3.2 percent, according to the Bureau of Economic Analysis . With this kind of slow growth, a sharp upturn in values in the near future is unlikely, so the market itself won’t bail us out of this situation. Creativity and a proactive approach by borrowers and lenders — not to mention mortgage brokers — represent the recipe for success in this market.

Investors are already taking note of the potential in the industrial market. Sales in this segment increased 61 percent nationally from 2009 to 2010, according to a Cushman & Wakefield report. Capitalization rates have remained stable at 8.3 percent on average, and vacancy rates declined to 10.3 percent, the report says.

Savvy mortgage brokers should follow the industrial market’s shifting economic tide. If property fundamentals and cap rates remain attractive, investors may look for deals. Lenders also may be more willing to be creative on workouts if property fundamentals are good.

Brokers should be ready to help clients rework their existing loans or take advantage of potential investment opportunities. 

Depending on your perspective, now may be a great time to be active in the industrial real estate market.


 


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