The Drive for Quick Profits Is Fundamental Realty Flaw

The ongoing two-year slump in commercial real estate sales has left most lenders holding the bag.

They find themselves stuck with unprofitable office buildings that they can't sell at a reasonable price. Yet, they haven't figured out why this has happened and what they need to do to make the buildings profitable and -- ultimately -- saleable.

The commercial office building business is fundamentally flawed because it is driven by sale value rather than operational profit.

Commercial property lenders, developers, and managers must stop looking at office buildings as commodities that can be turned for a quick profit. They must start treating them as viable businesses that should be operated on a day-to-day profit.

Businesses, Not Commodities

Back in the early 1970s, real-estate investors and developers adopted this "build, fill, and sell" mentality. The whole focus was on making money by selling an office building quickly, at a profit, to a buyer who increased rents and resold it, again at a profit.

When the demand was there and leases were turning, it was possible to re-lease the space at an increased rent, create a new pro forma value, and sell the property again. This was the case even though, as an ongoing business, it didn't make money operationally.

|Musical Properties' Game

As an oversupply of new buildings, offering low introductory rents, came on the market, tenants began to move more frequently. The result was a big game of musical chairs that shortened the economic life of the older buildings.

The build, fill, and sell cycle was put to a stop by the 1986 Tax Reform Act, which removed many tax advantages, and extensive overbuilding in major metropolitan markets, which sent vacancy rates skyrocketing to 17%.

Once supply outpaced demand and the tax incentives were gone, the pyramid started to collapse.

Vacancies Disconcerting

Although office building construction nationwide has dropped to a more modest 1990 level of $18 billion from a 1986 high of $30 billion, Landauer Associates reports there is still 3.2 billion square feet of existing office space available in the top 100 major American cities.

Vacancy rates in the central business districts of the prime U.S. office markets, which were only 3.8% in March 1981, are now hovering at 16% to 17%, according to the New York-based real estate consulting firm.

Salomon Brothers, New York, has estimated that America's 50 largest cities currently have a 14-year supply of empty office space; suburban markets have a 9.5-year supply. In the early 1980s, even a three-year supply of empty space was enough to send the industry into panic.

Recovery of the office building market may drag on through the end of the decade.

Finale for Free Rent

Steps can be taken right now, however, to aid in the recovery and help ensure that the commercial real-estate industry does not repeat its mistakes.

First, lenders should not fund office development projects that are not likely to be financially viable from day one.

Lenders should also investigate the market to determine the profitability of buildings six to 11 years old. If these buildings are not making money in real terms -- after operation, amortization of capital replacement, and amortization of tenant improvements are taken into account -- lenders should hold off.

Second, vacancy rates should be allowed to fall to between 5% and 10%, nationally, before there is an upturn in construction. This should be combined with economically realistic rents.

Third, rents should be restructured to cover both day-to-day operating expenses and the amortized costs usually overlooked, including repairing or replacing major capital items over the projected economic life of the building.

Reasons to Stay Put

Besides paying rent for their office space, tenants should be charged an additional amount for tenant improvements. These could be amortized with interest over the life of the lease or paid up front, in cash, by the tenant.

Finally, cities should take a proactive role in limiting the issuance of building permits, to control office construction and prevent overbuilding.

There is no guarantee that these measures will reverse the damage or prevent history from repeating itself. Nevertheless, they represent steps that the real estate industry will eventually have to take if it is ever to regain economic vitality.

Mr. Alan Hayman is cofounder of Hayman Co., a national commercial real estate management and leasing firm based in Michigan.

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