Wednesday, April 9, 2008

Risk Analysis Update – What’s In Store For Real Estate

More Pains Ahead
Investors, like children in the back seat of a long car trip, keep asking “Are we there yet”. In the case of the investors, the ‘there’ is the bottom of the current down cycle. Unfortunately, the response to the investors is still the same as given to the children: “No, we are not there yet.” With IMF now weighing in on the overall size of the downturn, which it claims will last well into 2009, it would seem that we are still in the middle of the economic maelstrom.

So what are investors to do? In this article, the Practical Risk Manager will outline additional signs of the things to come, which astute investors can use in conjunction with their own due diligence to make their way through the current market. For my list of previous signs of things to come, click here.

More Signs Of Things To Come
Residential Real Estate

  • With the arrival of Spring, hopes of home sellers of being able to finally sell their homes springs eternal. However, their hopes will be dashed. As more mortgages reset off their initial teaser rates, more homeowners, who were already treading water, are going get more desperate. Their desperation will manifest itself in the following ways:
    • Offers of incentives will increase: more home sellers will offer free add-ons, including vacations and willingness to picking up all of the broker and closing costs.
    • Some homeowners will sweeten the incentives further with rent-to-own options. However, this is not the bottom. Once you start seeing more of “take over my mortgage and the house is yours” type of advertisement, then we have hit bottom.

  • Real estate advertisement will dry up substantially to a point of being nearly nonexistent. Number of pages of advertisement will go down to a page or even half a page. Not bottom yet. Shortly thereafter, there will be a flood of advertisement all offering one incentive or another, some even begging you to take over their mortgage and house. I would call this a ‘tsunami’ effect. (In a tsunami, the water will first go out to sea, leaving the beach high and dry and then the water will surge back in a torrent of water, sweeping everything it its path.)
Commercial Real Estate
In any economic down cycle, there is a trend of cause and effect. Commercial real estate is no exception. Here are the causes and effects of the economic slowdown on commercial real estate:
  • For smaller commercial properties: news of economic slow down affects consumers’ sentiment. Their reaction is to slow down on their purchases. This causes retailers and small businesses to suffer and go out of business, due to lack of sufficient business. As these small businesses go out of business, they will vacate their commercial spaces in strip shopping centers, class-B or class-C office spaces, and industrial/flex spaces. This will cause a reduction in the net operation income (NOI) to the commercial property owners. The overall effects of this cycle are increased delinquency and foreclosure of commercial properties, especially the ones that cater to marginal businesses, ‘mom-and-pop’ businesses, and small operations.

  • For large office properties: businesses will trim their workforce in response to lower profit forecasts. Large corporations will begin to reduce their middle management and operation support staffers, the layers that are typically targeted in any downsizing. The effect of the downsizing is the excess space.

    A good rule of thumb for an office space is 200 square feet of space per cubicle dweller and 400 square feet of space for an office dweller. (This accounts for the space needed for aisles, cabinets, pantry, etc.) So, in the case of Citigroup, with their layoff of 25,000 people, one can assume 50% office and 50% cubicle for an average of 300 square feet of space. Multiple this by 25,000 staffers will result in 750,000 square feet of space that Citigroup will no longer require, about the space in a major class-A building, as a result of its downsizing. Do the math. Large companies will consolidate their spaces, resulting in higher vacancy rates; leaving some buildings with large blocks of vacant space.

  • For shopping centers: in response to economic slowdown, retailers will curtail their expansion plans. As the economic slowdown worsens, retailers will start to close their less profitable stores, leading to increased vacancies at shopping centers, including major malls.
Overall, expect commercial real estate to lose their luster as increasing vacancies lead to falling rents. The above lists are just my views of where I think the real estate markets are headed. Therefore, I strongly encourage you to do your own due diligence.

May your investing be profitable!

Ed Kim

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