Market conditions are constantly changing and as we move into the recovery cycle our valuation assumptions need to change to reflect current market conditions.
No single factor affects the value of commercial properties more, or has sparked more debate than the issue of rental rates and the timing of rental growth. So let’s start there. Many buildings will see declining cash flow for the next few years as older higher rents from existing leases burn off and are replaced by today’s new below market rents.
Did I say below market rents? Yes. Rental rates are below practically any measure of the level of rent that would be required to support the construction of new commercial space, even in the low interest rate environment and the lower return parameters we are operating in today.
Rents are at the bottom now and will rise over time. But how do we predict when they’ll go up and by how much? Nobody can say for sure and nearly everyone who does this for a living has an opinion. I think rents have the potential to jump by up to 25 percent over the next four years. Why? Because our leasing team thinks so and they’re in the market every day slugging it out with landlords and tenants.
Let’s say the average rent in a first-class building in Waltham, for example, is $22 to $25 per square foot today and you need a $28-square-foot minimum rent to justify new construction in that market. By simple economics, we need rents to grow by $6 per square foot to where the rental rates can support new construction.
The real estate economists at Torto Wheaton and the New England Economic Project are telling us that New England is emerging from recession slower than the rest of the country. Since rents are already firming up in other markets, its seems logical that we can expect another year of flat rent before we start to see increases.
If we used our hypothetical $22 rent in Waltham and assumed zero growth in rents the first year, something like 5 percent in year two, 8 percent in year three, then 10 percent in the fourth year — we’d still be below $28 per square foot and the prospect of new construction in 2008. As the market rebounds, rents will move up to stabilized levels, and historical experience suggests that the growth won’t be linear. It’s hard to imagine right now however, that we’d see anything like the meteoric rental growth that occurred in the dot com era.
Modeling real estate taxes will present new challenges in the rebounding economy as well. In a stable market, thanks to Proposition 2 1/2, it’s easy to model future taxes using the global inflation factor applied to expenses generally. However, in the last several years, owners have sought tax abatements as their rent rolls have fallen victim in the weak market. The result is that recently executed leases with new and renewing tenants have low real estate tax bases reflective of several years of abated taxes. Landlords may wind up eating a large share of the increasing taxes on vacant space in their buildings.
The complexity of predicting when and how much taxes are going up was demonstrated in the city of Boston earlier this year when the fiscal 2004 tax bills were sent out in January with the then current mill rate of $28.83. When the adjusted bills were sent out in April to account for the tax re-allocation they reflected the new higher mill rate of $33.08 for commercial properties. The difference was essentially a 15 percent increase in taxes this year over the preliminary estimate.
If you are a landlord negotiating a new lease today and you expect your taxes to begin to rise, you would probably push new tenants to accept a fiscal 2005 tax base rather than fiscal 2006 in order to push as much of the expected tax increases onto the tenant as possible. Each building owner will need to do an assessment of their own situation to determine what strategy they wish to pursue.
When it comes to return benchmarks throw out the old playbook. The low interest rate environment and dissatisfaction with alternative investments have made real estate the preferred investment vehicle by all types of investors, especially those properties with lease term, occupancy and credit. Reducing unleveraged internal rates of return by 150 basis points from the old playbook and reducing cap rates by 100 points from three years ago is reasonable. If you have an investment grade tenant, cap rates drop to the 6 percent to 7 percent range and internal rates of return will range 150 points higher than cap rates.
If you have an empty building, forget it. Without tenants, buildings are of little interest to investors right now, unless the properties are heavily discounted by motivated sellers.
In summary, we’ve finally experienced positive absorption in the first quarter of 2004 of just over 2 million square feet, all of it occurring in the suburbs. To return to a healthy market with a 10 percent vacancy, we need to absorb half of the 35.6 million square feet currently vacant in Boston and the suburbs. We could get there in three years with 6 million square of net absorption per year, or in four years with 4.5 million square feet of net absorption annually.
We used to do that like “breaking sticks” in the last recovery.
