Value: a fair or proper equivalent in money, commodities, etc.
-- Webster's Dictionary
But in the commercial real estate market the "value" that any building has at any specific time--in terms of what it will sell for, or what it will rent for--has more facets than a Fun House mirror.
There are the obvious ones: the building's location, amenities, general desirability and the local vacancy-occupancy ratio.
But also impacting value are less visible forces: pure and simple human nature; the subtle influence-bordering-on-distortion of foreign investment money; the tremendously active, but literally uncharted, subleasing market; gluts triggered by unforeseeable economic trends not directly related to the real estate market; rent controls and competitive pressures brought to bear from some highly unlikely sources.
And always present under the surface: tax considerations.
"Although," according to William A. Millichap, president and managing director of Palo Alto-based Marcus & Millichap, in an interview, "the impact of the new tax law isn't going to be as great on the commercial real estate market as a lot of people expected.
"While it's causing investors to ask more fundamental questions, prices haven't eroded as much as we thought they would because of a lack of product availability and a reasonable number of buyers coming into the market.
"But if interest rates hadn't come down and if we hadn't had this continuing buyer interest," he continued, "all of the predictions would have been absolutely true."
But don't underestimate human nature, Millichap added. "Especially in Southern California urban areas, it's difficult, if not impossible, to get sellers to sell at a loss. They're just simply not willing to do it--it's almost unheard of unless it's really a distress situation."
With a sales force of 300 and 14 offices extending west from Chicago, Marcus & Millichap bills itself as the largest investment real estate brokerage in the country, handling properties ranging from $1 million to $30 million in size.
And, Millichap continued, while market conditions in Southern California--most notably the high office vacancy ratio--might suggest a logical weakening in prices, the invasion of foreign investment money, primarily from Japan, has been a major factor in preventing this from happening.
"Domestic investors are looking at a cap rate--a free and clear cash flow--of 8% to 9%, or a bit more than that if there's risk involved," he said.
"But look at the Arco Towers sale (to Shuwa Investment Co. for a reported $620 million)--it went down at about 7% and the Japanese have bought four or five other buildings in Orange County with about the same cap. This puts investors like Metropolitan Life, Prudential and others in a real bind. They have to make a decision: Are we going to jump out of the market or do we settle for lower yields, too?"
Drop in Bond Rates
What makes a 7% yield more than acceptable to the Japanese is the plunge in interest rates in Japan on convertible bonds on which so much corporate borrowing hinges.
According to Jiji Press Ltd. in its early March market report, convertible bond coupon rates in Japan were cut five times in 1986--from 3.8% in January to 2.5% in December--"which has made it possible for corporations with high credit standings to raise large amounts of funds at less than 2%," according to the financial news service.
"And there's every indication," Millichap added, "that the extent of foreign investment is even higher than it appears to be on the surface because so much of it is done through trusts.
"They're buying domestic development firms which supply the expertise and the management for an eventual cut of the pie, but Asian investors are putting up the money. They make a real effort not to appear on the title."
While the correlation isn't crystal-clear, broker Millichap added, the foreign investors' willingness to settle for a lower cash return is "probably" impacting rents, too.
Don't Want Risks
"They've gone down, at least in virtually every metropolitan area in California," he said. In San Francisco, for instance, as much as 25% to 30%. And most of our investors simply aren't risk-oriented. They don't want to get into a situation where they're going to lose money.
"If we can say to an investor, 'you're going to get rents in the 8% to 8 1/2% range,' then we can sell those Grade A properties in Grade A locations. But, if they look at the risk factors involved--what's coming on-stream, what the office-absorption rate is, what the job-growth rate is--and if the figures don't work, then they're entitled to ask, 'what's all of this going to do to my rents?' "
Impacting rents even further is another influence--the subleasing market--that never shows up in conventional real estate statistics, Millichap said.
"Officially, the office vacancy rate in Los Angeles is supposed to be about 17%," the president of the 16-year-old brokerage firm added. "But it doesn't take into account the subleasing market which would add probably another 3% to 5% to this figure and is still another downward pressure on rents."
As a case in point, Millichap cites the example of a large San Francisco law firm that was paying $51 a square foot (a year) for space in the Bank of America Building. "We're putting them into a new building that will be completed in about a year at $30 a foot, which will save them $1.3 million a year."
In the Los Angeles International Airport area, he added, is another relatively new office building that is "100% occupied on the books. Actually, a full 50% of it is on the subleasing market. There's just no interchange of information on this."
Fueling the subleasing market is a competitive situation where a tenant leases a substantial percentage of an existing building, but a year later is offered "such a great deal in another building that he can move out, sublease his quarters being vacated at a price well under the market, and still come out dollars ahead," Millichap said.
So, why pay the developer's advertised rent when you can get comparable space at a substantial discount in the subleasing market?
Flight of High-Tech
Where unforeseeable economic events severely impact the commercial real estate market can be seen, Millichap added, in the rosy predictions that developers foresaw for the state in terms of research and development demand.
Although on the cutting edge of the high-technology industry just a few years ago--and with all indicators forecasting a continuation of it--the flight of high-tech overseas was simply not predictable.
("R & D" is broadly defined as the high side of the industrial real estate market as opposed to warehousing at the low end.
("Where a warehouse is commonly just four walls, little, if any, heating and cooling capacity, and about one parking space for every 1,000 feet of space," Millichap continued, "R & D is about 60% to 70% office configuration with drop ceilings, 'clean' rooms, environmental controls and about one parking space for every 200 to 250 square feet of space. All of it is designed for the very labor-intensive, high-tech market.")
A market that has largely flown overseas and of which Santa Clara County is a prime victim.
Impact of Mini-Malls
"There were only 2,000 new net job creations in Santa Clara County in all of last year, and virtually none of them were in R & D. As a result, we've got 27.5 million square feet of vacant R & D space in this one county alone," Millichap added.
Add other, largely invisible factors influencing the commercial real estate market: The impact of mini-malls on the otherwise booming market in shopping centers, and that of rent controls on the apartment market.
"The one really hot market in Southern California," Millichap said, "continues to be the shopping center with one or two good anchor tenants and a reasonable net worth--there's more buyer interest than ever before." But with one big "but."
"It's true, generally, that is, except in those areas where the city or municipality has permitted an inordinate number of strip mini-malls popping up wherever there's an abandoned gas station."
Smaller Tenants Lost
Typically, that is, shopping center developers (and buyers) benefit very little, if any, from the anchor tenants, whose concessions for generating the foot traffic on which the entire center depends generally outweigh their own economic contribution.
"What the mini-malls do," Millichap added, "is drain off the smaller satellite tenants," which are the real bread-and-butter tenants for the owner.
"The bright spot in Los Angeles, though, is that the City Council last November increased the parking requirement (from two parking spaces for every 1,000 square feet of leasable space to three), and this, developers say, has pretty well killed off the mini-mall's feasibility. So I think this problem is about to be resolved."
And while, again, foreign investors are turning their attention to apartment houses in Southern California as well as other commercial real estate, the Palo Alto broker said, rent control strongly impacts the market.
Rent Control Differential
"We ran a study of 14 apartment buildings within a four or five block radius in North Hollywood that included units both under rent control and not under controls--the exceptions being those built after 1978," he said.
"And so we had a nice mix of both in a small area. And it was interesting because--sometimes within 100 yards of each other--those selling in the non-rent control areas commanded prices averaging 12% to 16% higher than those under controls.
Generally, those not under rental controls were selling at seven to 7 1/2 times their gross income. The markdown on those under controls reflected the buyer's demand for at least a full percentage point higher than that--eight to 8 1/2 times income--to offset the risk."
Human nature, differences between "acceptable" yields between domestic and foreign investors, a subterranean secondary market for office leases, high-tech's flight overseas, the proliferation of mini-malls and rent controls . . . all, like the strings on a puppet, pull at commercial real estate values.
And, like the puppet's strings, are all but invisible.