The Market's Impending Period of Sluggish Deal Flow
The commercial real estate industry, like most markets, has a relatively predictable business cycle of peaks and troughs. Periods of expansion are only temporary and are met with a less severe, shorter period of distress. For the last decade, commercial real estate has enjoyed a prolonged expansionary cycle, abruptly halted by a combination of the coronavirus shutdowns and greatly expanded debt bubble.
The first stage of a commercial real estate distress period is signaled by market dislocation. Lenders evaluate their loan portfolios, sort through the distress in the market, and begin readying their playbook. Concurrently, credit markets start to tighten as both lenders and investors struggle to underwrite at-risk product types. The scarcity of credit and inability of buyers to effectively value properties result in significantly less transactional volume. As the economy slips into a recession and commercial transactions stall, a fundamental disconnect has developed between buyers and sellers.
Before the market can progress through its distress cycle, price discovery must occur, and buyers and sellers must break through the obfuscation currently clouding their expectations. The market is stalled in a quagmire; sellers still believe their property should garner pre-COVID prices, and buyers are already looking for deals on distressed assets that haven't become apparent.
As we wait for the dust to settle and deal flow to ramp back up, a majority of the marketplace plans to bury its head in the proverbial sand for the next 18 months; there are a few, however, who understand that the market must continue to move in some capacity and properties will continue to trade, albeit at a slower rate. So, how will the few continue to close deals over that time? The key to success will be creativity.
How Good Brokers Can Add Value to a Transaction
The market assumes that a commercial broker has an expert handle on the real estate transaction process. Admittedly, deals are frequently complex, and many sellers are too busy running businesses to manage the transaction themselves, but a broker doesn’t simply add value by being present. The profession outlines a broker's fiduciary responsibility to his or her client, and bringing a certain level of competency and expertise to a sale is expected. As we cross the threshold into a marketplace that looks vastly different from three months ago, it will quickly be evident who is adding value to a transaction.
As the divide between buyer and seller expectations grows, dealmakers will need to be creative to bridge that gap. Let's explore a couple of tools brokers should leverage as we navigate the market rift over the next 18 months.1) Seller Financing: As lenders have tightened their grip on new loan origination, particularly for retail and office properties, buyers are having a hard time receiving financing for deals. Sellers have historically scoffed at the prospect, but as the list of sellers continues to grow and the number of non-cash buyers shrinks, it could be an amenable option. Of course, a seller wouldn’t finance for the life of a transaction, but merely over the near term until a buyer would finance through a traditional lender.
2) Guaranteed Rental Income: Receivables insurance is a relatively new product but has generated significant attention over the last few years. Insurers don’t consider rental income a receivable, but the concept is applicable. Most investors are concerned about the risk that certain tenants pose regarding investment properties. Guaranteed rental income, through a seller concession at closing, or rents for risky tenants placed in escrow for a predetermined period, can help to mitigate the short-term risk.
3) Installment Sales: Real estate installment sales are primarily used as a tool for sellers to spread capital gains over several years to reduce their tax bill. These transactions can also be used as an option for buyers to spread principal payments over multiple years as well. As credit is tight, this could be an option for buyers looking to preserve liquidity and hedge against future interest rate fluctuation.
4) Increased Cash Down: Banks lend on a loan to value ratio commensurate to a borrower’s financial well-being and the potential risk of an associated property. As the risk of certain product types has increased over the past three months, lenders are less inclined to lend on these properties. A liquid buyer willing to pay 50% cash down could be the reason for a successful deal.
5) Knowledge of Historical Trends: As the market navigates the recession and establishes new pricing expectations, sellers must be aware that their asset may not appreciate to its pre-COVID value for several years. An owner who had an exit strategy aimed at divesting the property in the next 2-3 years may be better served to sell now. Experience during previous downturns and knowledge of historical trends can help maximize a client's potential value.
There is no one-size-fits-all answer to any transaction; all deals stand alone. Brokerage is as much about taking a cerebral approach to unique problem solving as it is deal-making and transaction management. The deal makers who look at the next 18 months as an opportunity to maximize client value, instead of complaining about the circumstances, will be the few who continue to drive transactional success.