Closing the “Gap”

In a commercial property offering, there is invariably a difference between what a buyer wants to pay and what a seller wants to receive. That difference is known as the gap or the spread. The size of the gap often changes during a transaction. The negotiation process can be frustrating with both sides feeling the other is out of touch with the market or even behaving badly.

The greatest gaps typically occur when economic and geopolitical factors cause values to fluctuate. That’s when buyers and sellers try to time the market—and almost always miss. Those factors overlay a corporate real estate market, which since early 2008 has experienced a continuing decline in the supply of stable, prime property.

Many pundits claim debt is back and capital is flowing. However, overall commercial real estate sales volumes are only at 55 to 60 percent of 2007 levels and appear to have settled there. The real estate still exists, but most of it is held by second- and third-generation owners who can’t imagine what else to do with their money. These are not serious sellers; quickly making that determination can be a buyer’s best work.

Efficient markets occur when the seller’s representative exposes an asset to a broad range of knowledgeable and capable potential buyers, provides complete and accurate diligence material and has a clearly defined process in place. If any of those three components is missing, the chance of reaching fair market value may be compromised.

The most common reason for a buyer-seller gap is that the seller’s expectations are too high, usually because he has inaccurate or incomplete market data. The next most common reason for the gap is that a seller’s expectations are reasonable to the market, but offers come in considerably lower. This typically occurs when the property isn’t well packaged or when incomplete or inaccurate diligence information hasn’t been provided. Buyers are less likely to value information about a property when they do not clearly understand it.

The most difficult gap to close is the one that occurs when buyer and seller have unrealistic expectations—usually due to incomplete information, compounded by both parties’ evaluation errors that distort understanding of a property’s full market potential. Sellers often ignore replacement reserves and economic vacancy information to make rosy assumptions about the timing and true costs of stabilizing their rent rolls.

To achieve best price, sellers must have an attractive, coherent and informative offering package that not only clearly explains the benefits of the asset, but also addresses issues that would concern most buyers. The property should be exposed to the greatest possible number of qualified buyers with a competent broker. Sellers are best-served by a broker with modern sales tools and with a clear buyer profile for that property—a broker who can tell the difference between serious buyers and tire-kickers. A successful seller is realistic and forthcoming, and considers all the benefits of completing a transaction.

Successful buyers are usually represented by successful brokers. Those agents get to know their clients well enough to help them look beyond the numbers on deals that may appear marginal, but are a strategic fit for their portfolios or accomplish an immediate goal. Those brokers also know how their clients buy and are often better than their clients are at spotting opportunities with inherent advantages.

Ultimately, both parties must be willing to understand the other’s issues and determine whether a win-win solution can be achieved—and then cooperate to achieve it.

Craig Tomlinson is an Director in Stan Johnson Company’s Chicago office. Stan Johnson Company is one of the nation’s leading commercial real estate brokerage and advisory firms that focus on net lease transactions. The net lease group deals exclusively with the acquisition, disposition, and financing of single tenant real estate. Stan Johnson Company has a 25-year history and has completed more than $11.6 billion in transactions nationwide. A dynamic team approach, refined marketing processes, and a foundation of integrity, professionalism and relationships create a winning combination that enables the firm to deliver consistent service and superior results to each client.

The low interest rates and slow
economic growth that have gripped the United States since the onset of the Great Recession have made it difficult for investors to find yield in the capital markets. Returns on corporate and government bonds have plummeted to all-time lows while the equity markets have become a perilous venture characterized by extreme volatility in recent months.

Increasingly, investors are seeking to acquire net-leased real estate as a vehicle to achieve secure long-term returns that provide a yield superior to comparable credit bonds, as well as real advantages that fixed-income assets cannot match.

As demonstrated in the chart above, capitalization rates (the annual rate of return on a real estate investment) for Walgreens leases with 23 years or more of lease term at time of sale have generally mirrored the downward trend of returns on corporate and government bonds since 2009. However, while bonds and treasuries have fallen precipitously since 2011, cap rates have not reacted as quickly. Currently the spread between long-term bonds and cap rates stands at 139 basis points—nearly as wide as it has ever been—offering investors opportunities to outpace investments in other fixed-return asset classes.
As the chart illustrates, cap rates have tended to lag behind movements in the bond markets by roughly six months. Given the rapid decline in bond yields over the past two quarters, it seems likely cap rates will continue to trend lower in the coming months.

Investments in single tenant, net-leased real estate are also significantly more tax-efficient than investments in treasuries or corporate bonds. While interest income from treasuries and corporate bonds is completely taxable, current tax code allows investors to shelter much of their rental income from taxes via property depreciation. That depreciation can often result in as much as 40 percent of a landlord’s annual income sheltered from taxes.

IRS Code 1031 also allows investors to defer capital gains tax following a sale. The code permits a purchase of like-kind property from the proceeds of a sale and exempts the owner from payment of any capital gains or recapture until the real asset is liquidated. As uncertainty grows about future income tax and capital gains rates, those considerations are likely to become more important. Net-leased real estate has another advantage over bonds: its tangible nature. Investors holding a defaulted bond have nothing left, aside from worthless paper. However, even if the tenant of a net-leased building goes bankrupt and defaults on the lease, the investor still owns the physical property and it retains its real value.

Because net-leased assets are fundamentally hard-assets, they give investors long-term protection against inflation. While net-leases are generally long-term in nature, they do eventually allow landlords the opportunity to renegotiate rental rates. The dollar is currently experiencing inflationary pressures which are likely to result in higher rental rates for commercial real estate. Upon renegotiation of a lease, landlords stand to gain by realizing those higher rates and preserving their real rates of return. In addition, net-leased investments stand to become increasingly popular in coming years demographically. As the enormous Baby Boomer population moves toward retirement, the demand for stable-yield investments is certain to grow. The need for consistent annual retirement income will force individuals to move assets from long-term, growth-oriented investments, into long-term, yield-driven vehicles. As corporate bonds continue to offer low yields, more and more equity will flow into net-leased investments as a haven to secure those stable retirement incomes.

Given the relative advantages of net-leased investments over fixed-income assets and growing investor demand for those assets, and a constrained supply of net-leased properties available for purchase, it is difficult to imagine that cap rates won’t stay at current levels or trend lower in the coming months and years.

Bradley Feller is an Associate Director in Stan Johnson Company’s Chicago office. Stan Johnson Company is one of the nation’s leading commercial real estate brokerage and advisory firms that focus on net lease transactions. The net lease group deals exclusively with the acquisition, disposition, and financing of single tenant real estate. Stan Johnson Company has a 25-year history and has completed more than $11.6 billion in transactions nationwide. A dynamic team approach, refined marketing processes, and a foundation of integrity, professionalism and relationships create a winning combination that enables the firm to deliver consistent service and superior results to each client.

 

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