As the local business community looks to close out 2010 and plan for 2011, there is a lot of information out there that describes the state of commercial real estate and what the future looks like. Some will tell you that commercial real estate is coming back, while others will tell you that the worst is yet to come. What is the answer? Both appear to be true.
The state of the commercial markets, as described by Greg Moyer of Moyer Properties: “Commercial real estate assets are stabilizing to 2007 levels in institutional markets, with lower cap rates in some cases. Lower cap rates mean higher value; because of this, institutional investors are increasing their allocations to institutional grade commercial real estate assets,” such as the large office buildings you see in the Chicago skyline.
What does this mean for Peoria? Private equity will return to secondary and tertiary markets like Peoria as institutional investment will begin to price private equity investors out of institutional real estate markets. The distinction that must be made in that statement is that this is the case for stabilized assets that have little to no vacancy, newer construction, great location and strong credit leases almost certainly corporately backed. It is exactly the opposite for troubled assets. A troubled asset is one that has been neglected, is in need of improvements and has high vacancy.
The opportunity in the coming years lies with those who have cash for bargain buys of troubled assets. Sellers of troubled assets will recognize that there is little to no financing available for troubled assets, lowering the number of prospective buyers and, ultimately, prices. This will drive home the statement that cash is king and create opportunity.
Much of the commercial property in Peoria is somewhere in between the classification of troubled and stabilized. This being said, commercial property sales will slow as financing for commercial property between these classifications will be challenging and, more than likely, stay that way until the economy stabilizes.
Great information, but how should it be used in practice? For the small business owner, you may look at the advantages of leasing. This is a great time to lease; there should be a lot of space for all uses available in the market as landlords will want to fill their buildings and ride out the recovery, which should mirror the term of a three- to five-year lease. A key advantage of leasing is that it frees up capital for investment in the core business. Real estate decisions are made for the benefit of the company, not for the sake of the asset. If you own a business and like real estate as an investment, buy other investment properties, as this will diversify your risk from hinging on the success of your core business. Lease payments are treated as a business expense for tax purposes, and your expenses are fixed in the form of a lease payment, leaving most major building repairs to the landlord.
Some interesting changes regarding the way in which leases are treated from an accounting perspective are on the horizon. The Financial Accounting Standards Board has governed the manner in which leases are accounted for under the statement of financial accounting standards No. 13 (FASB 13). Currently, real estate leases for business operating purposes are considered an operating lease, defined as any lease in which the lessee controls the property for a small portion of its useful life or any lease that is not a capital lease. These leases are considered business expenses and can be spread across the term of the lease on the income statement.
A lease is considered a capital lease if it meets one of four criteria:
- If there is a transfer of title at the end of the lease.
- If the lessee has the right to buy the asset at the end of the lease for less than market price.
- If the lease term is equal to 75 percent of the useful life of the asset.
- If the present value of the lease term equals 90 percent of the value of the asset at the beginning of the term.
All capital leases must be stated on the balance sheet.
The changes proposed to FASB 13 regarding the manner in which leases are classified will force all leases to be considered capital leases. This will create large liabilities on the balance sheets of companies currently leasing. The change could have a significant effect on the length and structure of commercial real estate leases. More importantly, it could require adjustments between lenders and businesses as financial ratios would change, causing technical default in lending terms, though the overall financial health of a company would not change.
The commercial real estate market in Peoria, and the country for that matter, cannot be labelled good or bad. In this day and age, with so much uncertainty—as well as opportunity—the commercial real estate market is much like life. There are great opportunities for the right set of circumstances, which will vary greatly among every tenant, landlord investor and property. Stakeholders need to be sure they match the right circumstances with the right property. With ever-present change, it is now more important than ever to do your homework. I encourage you to utilize the outstanding talent Peoria has within its professional community to build your business and make the decisions today that will create value and shape the future of our city. iBi