Maintainng Property Values in Tough Times [Mortgage Banking]

As the recovery in the commercial real estate market continues to be lackluster, reflecting the larger economy, commercial property owners find it increasingly difficult to raise rents and/or increase occupancies - both of which help to preserve, or even increase, the value of buildings. As a result, owners are finding alternate ways to achieve value preservation, which also boost their chances of refinancing. | "This happens every cycle," says Dan Fasulo, managing director of Real Capital Analytics Inc. (RCA), New York. "When values are down, owners get creative. They always cut expenses and scale back on property management costs. And if they are competing in a difficult market, they spend the money necessary to attract tenants." I Despite the severity of the downturn in this cycle, says Fasulo, more and more properties in the United States are owned by large, institutional investors such as real estate investment trusts (REITs) and pension funds, which has a stabilizing effect on commercial real estate. * "Although every market is different, 20 years ago, many more owners were private investors and they didn't have the financial strength to cut rents in a downturn or take other actions to lure tenants, such as offering extended free-rent periods and large tenant-improvement allowances," he says.

Property owners appeal property taxes

There are a variety of ways that commercial property owners can boost their properties' values, but some prefer to raise vaJues by lowering them - which is to say, appeal their property tax assessments. Lower taxes increase net operating income (NOI), thereby raising a building's value, which can be important at resale time or if an owner wants to refinance.

A reduction in taxes, which is the biggest operating line item, goes straight to the NOI and lowers the loanto-value (LTV) ratio, thereby increasing the amount of equity for a loan, says Todd Jones, adjunct professor of real estate valuation at the University of Florida in Gainesville, and former executive managing director of property tax services with Colliers International.

"Mortgage lenders in particular should care about property taxes, because they impact the certainty of their income stream," says Jones. "There could be less money for debt service" if the owner pays high property taxes, he says.

"A borrower may have started with a particular LTV ratio, but a lot of commercial properties got a margin call during the financial crisis," he says, in which case lenders told their borrowers that they needed to contribute more cash or their buildings would be taken back. "One way to avoid this is to appeal property taxes every year," he says.

"More and more property managers are appealing property tax assessments, as property values have dropped from their highs in 2007," says Boyd Zoccola, chair and chief executive officer of the Building Owners and Managers Association International (BOMA), Washington, D.C, and executive vice president at Hokanson Companies Inc., Indianapolis, a real estate investment and property management company.

"In spite of this, assessed values have continued to rise in some places, because many assessors like to leave values unchanged - so there continues to be a high level of tax appeals," he says.

Not all property assessments have continued to rise as property values have plummeted. "Some of the counties in the U.S., including Hillsborough County in Florida, where Tampa is located, have been proactive in recogniz ing the decline in commercial and residential property values," says Ed Williams, managing director at Cushman & Wakefield Inc., New York.

"In other cases, counties have not voluntarily adjusted the values and so properties are assessed at 'full value,'" he says. Although each market is different, property values have corrected by 20 percent to 30 percent from the height of the market, according to Williams.

"Back in the days of the Resolution Trust Corporation [RTC] in the early 1990s, the same thing happened" that is happening today, says William Hughes, senior vice president and managing director at the Newport Beach, California-based Marcus & Millichap Capital Corporation.

"Taxing authorities were deluged with tax appeals from commercial property owners, and tax consultants seemed to come out of the woodwork," he says. The reason for the tax-appeal frenzy, says Hughes, is that "in 2008 and 2009, we saw value reductions at the same time that cap rates went up 50 to 100 basis points."

Saving money on taxes does help the bottom line, but not as much as one might think, says Hughes. "By increasing the NOI, the property may be worth more, but changes in NOI aren't necessarily reflected in a dollarfor-dollar change in value," he says. "If all you are doing is decreasing the taxes that will just go back up once the market improves, that does not increase value as much as higher rents."

Efficient building management boosts NOI

A better way to boost building value, says Hughes, is by reducing operating costs. But because some buildings are run more efficiently than others, that doesn't mean necessarily that their properties are worth more, he says. One property owner could be running so lean and mean that he is deferring maintenance and robbing Peter to pay Paul, says Hughes, "so an appraiser may not give that guy much credit."

He adds, "On the other hand, if you can reduce your electric or gas consumption because the buildings are better insulated, or if you can reduce water usage because you have more efficient appliances, then over time, you will reduce your operating costs" and increase the property's value.

But energy efficiency does not come without a cost. When owners make energy upgrades, they normally demand a payback period of three to five years before they are willing to make large investments in new technologies, says Zoccola. In California, there is a shorter payback period than in most states because energy rates are higher.

"Not every building can receive a LEED [Leadership in Energy and Environmental Design] designation, and saving money isn't just about energy costs," says Zoccola. Being efficient is also about tenant relationships, security and building operations as well as energy management.

The BOMA 360 program, which rewards efficiency, judges office buildings in six major areas of operations and management, including security, emergency preparedness and preventive maintenance, as well as energy usage. It requires participants to use the ENERGY STAR® portfolio manager tool made available by the Environmental Protection Agency (EPA) to benchmark energy costs and level of efficiency.

Plus, a building applying for BOMA 360 designation must also be registered with BOMA's Experience Exchange Report® (EER), which is a compilation of operating expenses for all kinds for buildings in the United States. The EER has data on close to 1 billion square feet of office space, according to Zoccola. These figures are averaged by location and size, so that no information on any one building is available to someone making use of EER, he says.

As for energy savings, Zoccola offers as evidence of the program's success the fact that the 2011 EER1 which is made up of 2010 data, shows a 1.8 percent drop in rental income but a 5.2 percent drop in utility expenses, even as utility costs continue to rise.

At Chicago-based Matanky Realty Group, James Matanky, company president, is also concerned about reducing operating expenses at the company's retail centers. By reducing operating expenses, he is able to lower the cost of common area expenses (CAM), which is often figured separately from the rent, while not reducing the rent, because rent levels affect a center's value. Matanky Realty owns retail centers in the Chicago area and throughout Illinois and Indiana.

Determining values can be tricky

Matanky says that figuring a property's value can be tricky. "With a lack of financing and the amount of equity still chasing trophy properties, it is very hard to price a retail center in this market," he says. "If a class- A, grocery-anchored center trades below a 6 [percent] cap, buyers are not facing up to the risks," so the price is distorted, he says. "There is too much risk of failure for that level of return," says Matanky, "so I would rather invest in some type of bond. "

Matanky says that he is afraid that "we are sitting on the edge of a bubble with properties in certain categories, especially class-? retail centers, still too highly valued, while other centers are being valued lower than they should be by lenders and appraisers who fear liability." This skews the formula for redeveloping properties, he says.

Getting the right tenant mix boosts value

Acknowledging that tenant mix is important in figuring a property's value, Matanky says, "In these difficult times, we have put in more local players than we normally would have." At the same time, he says, when possible, he prefers to have national tenants at his centers.

At the end of October, Matanky was about to replace a regional grocer in one of his centers in Chicago with a national chain, because he thinks that it will stabilize the property at a higher value than if the anchor were a regional chain. The national chain, which signed a lease with Matanky Realty in late October, is a full-service grocery and pharmacy operator, but Matanky says he could not reveal the name, the center's location or its square footage because of a confidentiality agreement.

Reinvention helps

At Columbia, South Carolina-based Edens & Avant, which owns 130 centers - mostly grocery-anchored - the emphasis is on redevelopment, in an effort to attract tenants as well as boost the values of the properties.

Edens & Avant just completed a $26 million redevelopment of the 362,180-square-foot Merchant's Walk shopping center in Marietta, Georgia, "which was underutilized, given the strength of the surrounding neighborhood," says Jason Tompkins, chief financial officer at Edens & Avant. The center, which is not officially grocery-anchored, nonetheless has a new 45,000-square-foot Whole Foods, which opened in July 201 1.

Today, Merchant's Walk is roughly 95 percent occupied, says Tompkins, thanks to the renovation/rebuilding of the center, which includes the addition not only of Whole Foods, but also of other high-quality merchants, all of which are located in a new, approximately 75,000square-foot building.

The new building was built on the site of another structure of about the same size that was torn down, he says. Also a part of the transformation of Merchant's Walk was the renovation and expansion of a movie theater, a reconfiguration of the parking, and new landscaping. Before the renovation, the occupancy rate at Merchant's Walk was about 80 percent.

The total square footage for Merchant's Walk did not materially change as a result of the renovation, says Tompkins. Yet, the center's NOI and value more than doubled compared with before the renovation, he says. This shows that the NOI growth and increased value of the property were driven by the improvements to the center rather than by any increase in size, says Tompkins.

Although it is not unusual for Edens & Avant to redevelop its properties, "We are doing even more of that today as a defensive and offensive strategy," says Tompkins. "We think of our retailers as our business partners. One of our main goals is to increase traffic into our tenants' stores. We've always operated this way," he says.

Creative financing to the rescue

It behooves commercial property owners to spend money on their buildings during a recession, says Fasulo. "They may use incentives, put in new landscaping or anything else that will make their properties attractive to tenants," he says.

"Sometimes if a tenant wants to lease your building and their rental income will increase its value, a landlord can get a bridge loan from a bank" to make the necessary investment, says Fasulo. "Lenders are smarter than they used to be, so usually you can go back to your existing lender" for the loan, he says, because it will help preserve the value of the collateral for the original loan.

In October 2011, the City of New York'sHuman Resources Administration signed a 20-year lease for 400,000 square feet in a 10-story building in the Fort Greene area of Brooklyn. The building, which takes up an entire city block, has been vacant and derelict for years, but with the new lease it will be 85 percent occupied, according to Real Capital Analytics.

"Although the landlord didn't have the money to pay for improvements, they used the credit from the City of New York to get a bank loan to finance the work," says Fasulo. "Normally no one will loan money on a vacant property," but having the city as a tenant made the difference, he says.

Retrofitting can bring a resurgence in value

In the previous example, a building is getting a new lease on life thanks to an owner who found the right tenant and funding to make the necessary changes. But some buildings have to change their usage before they can recover their value.

"A retail building may have a pro forma of $20 per square foot, but if it has no tenants it will be worth more as medical office space than as a vacant retail strip center," says Zoccola.

"Where most retai] centers are located, the highest and best use for those centers is retail. In general, medical office space owners and/or users won't pay top dollar for that location" as a retail owner or user would, because they don't need the visibility of a retail corridor, he says.

A conversion makes the best of a bad situation, according to Zoccola.

Marketing can make the difference

In the case of a going retail center, sometimes a strong marketing program can make the difference, says Enrique Kaufer, vice president of marketing for Woolbright Development, Boca Raton, Florida, an owner and developer of retail properties.

"Our Center & Main program gives support to the merchants in the center to help them grow their business," he says.

Woolbright's Center & Main is a marketing program that serves 55 merchants. It combines traditional marketing methods with online marketing, including the use of websites and social media, as well as "guerrilla" marketing techniques such as handing out coupons in parking lots and bringing in food trucks for special promotional evenings to center parking lots.

Thanks to the Center & Main program, traffic at Woolbright neighborhood centers is enhanced by Facebook pages for the center and websites for specific tenants who don't already have them, as well as email blasts, also for individual tenants, says Kaufer. Woolbright doesn't currently charge tenants for its marketing program.

Enclosed malls have their marketing co-ops, says Kaufer, but at smaller, neighborhood centers - those with 80,000 to 120,000 square feet - marketing hasn't played a big role until now, he says. Woolbright has three full-time marketing people today compared with June 2010, when there were none, says Kaufer.

"We are retaining tenants and improving occupancies at our centers," says Kauf er. Helping tenants with their cash now, which the marketing program is designed to do, has an effect on their ability to pay rent, says Kaufer.

Keeping property insurance costs down

The cost of commercial property insurance is expected to rise, on average, 2.5 percent in 2022 in the United States, according to Robert P. Hartwig, president of the Insurance Information Institute, New York. But some areas of the country will see higher increases because of the catastrophes of the last couple of years, he says.

Premiums for property insurance have actually been flat to down 10 percent in the past few years in non-catastrophic zones, says Atlanta-based Dave Finnis, executive vice president and national property practice leader for New York-based Willis North America, an insurance brokerage firm.

However, rates are going up in catastrophic zones, where hurricanes and earthquakes occur. But in the Midwest, rates are not going up across the board, in spite of the tornadoes of this past spring, because these kinds of storms do not cost as much as other catastrophic events such as hurricanes or earthquakes, Finnis says. Rates are going up for those who experienced losses in non-catastrophic zones, he adds.

Property owners should shop around for insurance, says Finnis. "You don't have a capacity problem with insurance today; the market is still competitive," he says.

Although some companies are trying to raise their rates, a property owner may be able to find lower prices at existing companies that are changing their focus from writing policies on an excess basis to writing the primary policy, he says.

The commercial property insurance market is in a state of transition, observes Boston-based Jeffrey Alpaugh, global real estate practice leader for New York-based Marsh Inc., an insurance broker.

While the amount of premium increase will depend on the risk profile of the insured, for real estate firms with heavy coastal exposure and/or a history of insured losses, premium increases could be up more than 15 percent, he says. For clients with a more favorable risk profile, Alpaugh expects rate changes to range from zero to 10 percent

Hikes in insurance rates are happening for two reasons, says Alpaugh - $70 billion worth of global insurance losses in 2011 and changes to a key U.S. hurricane model developed by Newark, California-based Risk Management Solutions Inc. (RMS). The firm is one of three catastrophic risk-modeling companies used by insurance companies. The new model is referred to as RMS version 1 1.0.

RMS' new hurricane model is a product of lessons learned from past storms, especially 2008's Hurricane Ike, says Alpaugh. What was surprising and costly about Ike, he says, was the amount of damage to properties far inland from where the storm made landfall in Texas - even as far inland as Ohio. Historically, hurricane damage has been confined to the coast, says Alpaugh.

As if all of that were not enough, because the re-insurance market is global, policy holders in the United States are also affected by disasters in other countries - most notably the earthquakes in Japan and New Zealand that occurred earlier this year.

Alpaugh's advice to commercial property owners in the United States today, especially those in the Gulf states, "is to run the RMS model prior to renewal and supply the most up-to-date property-exposure information and data" to their underwriters.

If possible, says Alpaugh, policy holders should stick with the big companies that have specialized real estate underwriting departments, because they are better able to assess potential risk than firms without these departments. Also, he says, it is important to have face-to-face meetings with underwriters. "Relationships are key; they Can't be stressed enough," says Alpaugh.

But as important as relationships are in commercial real estate-in everything from getting the best property insurance rates to negotiating tenant agreements - flexibility is also key, as evidenced in the examples offered here. While it may be that most commercial real estate investors will come out on top in a favorable market, when the chips are down, it takes an extra measure of creativity to survive and thrive.

Commercial property owners are relying on a grab bag of steps to preserve property values. Some efforts include appealing tax assessments and stepping up marketing for retail tenants.

It behooves commercial property owners to spend money oh tneir buildings during a recession, says Fasulo.

Hortense Leon is a freelance writer based in Miami. She can be reached at [email protected].