Market Report: December 2006

Dear Friends:

This month's column features some ideas and thoughts of mine about the commercial market. As was true in the housing sector, the sky did not fall in on this market either. Even though price increases have moderated and even retreated, there is still way more cash than properties.

Probably the only sure bet is that rents will increase and owners will get some interest rate relief during the second half of the year. Adjustable mortgages have been chipping away at profits since Mr. Greenspan began his inflation fight a few years ago. On balance, it should be a seller's year.

--Jim

Chasing Numbers

This article I will preview the real estate investment market for 2007 as well as review what happened this year. Investment markets will usually behave differently than the residential sector even though both sectors are affected by the same economic circumstances. For example, residential housing has real utility in that it provides needed shelter. Commercial and sometimes residential tenants behave differently and are much more willing to act on shifts in their economic landscape. You cannot outsource your apartment to New Delhi but you can always close down your factory and build mousetraps in Mexico.

2006

Commercial real estate mimicked the housing market this year. Even though there was a decided cooling of enthusiasm for real estate, prices did not move in any direction in a meaningful manner. Generally speaking, owners of all types of property balked at selling at lesser prices than could have been achieved in 2004 or even 2005.  The inevitable stalemate occurred and market velocity suffered. Losers included outside providers of transaction services, me for instance, and owners who by circumstances needed to sell. There were no clear winners and rarely did a property transfer at a substantial discount--it is not 1994 yet.

The sky did not fall because rents and jobs remained steady. Interest rates crept up over the year but rents kept pace. Residential and commercial rents historically increase although the former are far more steady and less subject to constant over-and-under building cycles.

Residential real estate is safer and probably, when considering all expenses and appreciation, as profitable as commercial. Exceptions exist of course, such as when the price of downtown land skyrocketed. This increase, it should be noted, had nothing to do with demand for office and retail space but for residential (condominium) use.

2007

Short-term interest rates should go lower next year. The recession in the residential housing sector is beginning to affect GDP growth. Reduced demand for goods and services will give the Fed room to lower rates. Tim Quinn, who operates Scott & Quinn Mortgage, told me "long-term rates have been declining for months and short term rates have not. This is a signal the bond market sees less economic growth ahead and therefore lower mortgage rates". Ordinarily, cheap money should make investment property more attractive but I am not sure it will occur next year. The recent surge in the stock market should siphon off more investment dollars and help keep investment real estate in equilibrium. Sellers will harden their positions as operating costs decline as rates usually adjust monthly for most owners of commercial real estate. Buyers will loath purchasing anything with a negative cash flow and will have few options for cash. Still, 2007 will end up a lot like 2006.

What I am Doing

I still like apartments in the county even though the market has been hijacked by condominium converters.  Bent on paying any price, this group swept in and bid up prices to unsustainable levels. These unrealistic prices became the standard and sale prices were at levels far more expensive than the last peak in 1990.

Converters in the first wave were the winners. Converters still holding raw product have been trapped between a market with few buyers and a political backlash against conversions. These condo wannabe buildings, usually saddled with excessive debt reflecting premium purchase prices, have spoiled the party for those of us happy with just a little positive cash flow. If these owners decide to cut their losses there could be some bargains in 2007. If rates go higher, increasing carrying costs of these already overburdened buildings, there will be some deals out there.

My investment group has continued to look outside the county and state for opportunities. We try to chase yield, that is positive cash flow, and that is very hard to find in San Diego unless you are a developer who holds product. Readers of this space know our group has developed projects in Las Vegas, Madrid, Bakersfield and other places not in San Diego. This was not necessarily by choice but by necessity. Only by building a project could we achieve above average cash flows.

Fortunately, my partners have found, fairly close to home, a medical office building that  will give our investors just over a seven percent cash-on-cash return. It is a Denver-area medical office building with an adjacent vacant commercial acre that we will probably develop in the future. The properties are located across the street from a substantial hospital making this a fairly conservative investment. Doctors and dentists are loathe to move their practice and are location sensitive. As a group, they are prized tenants both for their longevity and financial stability. As our population ages there will be even more demand for medical services, making medical office buildings a safe, long term income property to add to your portfolio. We still have some room for a few more investors so call me if you want more information.

Click here to see Jim's past Market Reports. You can also download Jim's 26 page research paper on San Diego County apartments.

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