Boom Or Bust? What’s Happening In Second Tier Cities

designer2  -  May 24, 2011  -  Comments Off on Boom Or Bust? What’s Happening In Second Tier Cities

The experts all agree: Real estate is a cyclical industry. The experts also agree that some of those cycles are only partially foreseeable and impossible to predict. However, in the commercial office markets in what many analysts call second-tier cities, an established cycle does exist. Each phase of the cycle is signalled by distinct occurrences in the construction or leasing industries. By recognizing each phase, real estate professionals will be able to prepare for these cycles.

For the purposes of this article, second-tier cities include cities with populations of less than 1.5 million and fewer than 30 million square feet of office space, such as Austin, Texas; Tulsa, Oklahoma; Louisville, Kentucky; Wichita, Kansas; and others. Another important characteristic of most second-tier cities is that only one or two major industries drive their economy.

Economic Expansion
The cycle begins with a second-tier city that experiences a spurt of growth in employment due to expansion in one or two sectors of the economy. In Tulsa, for example, the oil industry brought on this type of expansion. In Austin, Texas, MCC, a high tech company that moved its headquarters to the city, instigated the cycle. A good name for the first phase of the cycle is the Economic Expansion Phase.

A corresponding drop in available office space accompanies this sudden expansion of the area economy. Civic and community leaders, euphoric from the employment growth, believe their city will continue this rapid growth rate for an extended period. They fail to perceive that all good things must come to an end. Tulsa believed that oil prices of $30 per barrel and higher would go on forever. Wichita thought that the aircraft industry would continue to grow, and Nashville hopes that additional auto manufacturers will choose to locate in its vicinity.

Construction Growth
Civic euphoria and declining vacancy rates in the city’s office buildings attract local and national developers. Developers, excited by the prospect of growing occupancy rates and prospective commitments from anchor tenants, begin construction at a frenetic pace. The initiation of new construction signals the start of the Construction Growth Phase.

Inflated pro-forma income statements give some developers the false evidence they need to convince bankers and institutions to make unreasonable construction loans even for structures built in secondary locations with less than good-quality construction. Later in the cycle, these bad decisions will haunt lenders and developers.

Responsible real estate professionals profit the most from advising their clients to invest in or construct high-quality, well-located office structures during the early part of this phase. Other real estate professionals may capitalize early in this phase by advising clients to sell their buildings at the artificially high prices that the boom brings with it. Needless to say, developers and brokers profit the most from this phase.

Before the completion of all this construction, leasing rates begin to climb as the office market tightens and the economic expansion begins to fill more space. This adds fuel to the development fire, which is based on a faulty rationale: See, rates are going up, so we need more buildings.

Inventory Expansion Phase
Eventually, all of this construction washes into the office market like a tidal wave. In Austin, office space more than doubled in three years; in Tulsa, office space doubled in five years. Cities like Wichita watched inventory grow by more than 30% in a similiar amount of time. This onslaught of new space, which usually continues for some time, can be called the Inventory Expansion Phase.

At first, most landlords operate on the assumption that it is only a matter of a few months before absorption catches up with inventory, because absorption has been so strong in the wake of the spurt of growth in oil, aerospace, high-tech, or whatever industry has spurred the construction boom.

During this phase of the cycle, real estate professionals should position themselves to take advantage of the upcoming phases by building databases of prospective purchasers, building owners, lenders, and office tenants. The brokers and leasing agents with the most information will be best positioned to benefit in the coming downturn.

Concession Introduction And Growth Phase
With all this excess leasable area, owners begin to offer rent concessions to lure new tenants to occupy their space. This portion of the cycle is probably best labeled the Concession Introduction and Growth Phase. The first concession to creep into the market is short-term free rent. Often leasing agents offer three to six months of free rent on a three to five year lease, with the remainder of the lease at the pro-forma rent rate. The landlords hope that by the time the free rent expires, the market will have firmed up.

Cash-squeezed companies jump at the opportunity to cut their rental expense to zero for a few months. They hope that it will be enough time for them to regain control of their cash needs.

Other firms that just want to cut costs will move into a new building to take advantage of this economic boon. Landlords learn the true meaning of the term net effective rate: what their average rental rate per square foot is after including the free rent.

Many companies that take advantage of these free rent concessions are moving out of their Class B or C buildings into newer, nicer space, leaving their old space vacant. Their move shows no effect on a macro level unless they expand to occupy more space than they did in their previous location. On a micro level, however, one building loses space and another gains. This becomes important a little later.

Tenants generally receive rent concessions for one-and-a-half to three years. For example, in Tulsa, concessions were offered from 1983 to 1986. Following the free rent period, landlords begin to experiment with another form of concession: consistent, but substantially reduced, rental rates through the term of the lease. The rates quoted by the leasing agents as the pro-forma, which supposedly are the income of the property, begin to fall. The landlords determine that it is better to have consistent cash flow over the entire term of the lease, rather than to pay a tenant’s expenses with absolutely no renumeration during the term of the free rent.

Many landlords are hesitant to introduce this concession, so it takes some time to catch on. The national developers are the first to offer these lower rates, then the large institutional investors follow. Eventually, the smaller landlords are forced to follow the lead of the deep-pocketed landlords, because if they don’t they will lose potential tenants to buildings with lower overall rates.

At this point, the economic growth spurt has stopped and, unfortunately, it didn’t fulfill the great expectations of the civic leaders. More important, those developers who made space available by constructing more buildings to house this anticipated growth have new properties that are nearly empty.

Tenant Lateral Movement
As tenant awareness of the office space oversupply increases, tenants will move from a lower-class building to a higher-class building. Leasing activity is at a pitched level from tenants leaving lower-quality space and moving into higher-quality space for the same lease rate. The moving tenant may actually require less space through more efficient planning. Since the growth spurt is no longer supplying new business, absorption is weak, even negative. Tenants occupying space in Class C and D buildings can now afford space in Class A and B buildings. These reduced rates and higher-quality amenities in the newer buildings have now created the Tenant Lateral Movement Phase.

In this phase, there are two very profitable real estate businesses: representing tenants to landlords in lease negotiations, and serving as a leasing agent for the Class A buildings that have the deep pockets to close competitive deals. Real estate agents who represent tenants to landlords can expect rising commissions due to the competition among office buildings to get tenants. Class A building leasing agents can expect to find tenants knocking on their door daily looking for nicer space at better rates.

Well-located new buildings that offer competitive deals finally begin to fill up, but at inexpensive rates that cause the landlord to bleed. To attract tenants, finishes have to be nicer, parking cheaper, and rates lower. Older Class C and D buildings don’t have the finances to compete. The poorly located newer buildings are unable to compete because of the abundance of well-located space.

Office space is a classic supply-and-demand item, almost a direct function of employment. Both the supply and demand for space are relatively inelastic in the short run. This means that although there is a much greater supply of space, when the growth spurt ceases, the total use of space won’t increase proportionally even if it is less expensive.

In addition to demand inelasticity, landlords face both price and quality competition. This means that tenants tend to move out of lower-quality, more expensive space and into higher-quality, less expensive space. The end result is that landlords are forced to offer both more amenities and lower prices as concessions, in order to compete in the overbuilt market.

Late in the cycle, older buildings are now going back to the lenders because the landlord cannot afford to maintain the debt service on the rates the market will give him. After two years or so, all the tenants that will move because of reduced rates will have done so, and leasing activity will slow.

In the face of the lateral movement of tenants from Class C and D buildings to Class A and B buildings, the Class C and D building owners are against a wall with no one to fill their space. Lack of income and funding by lenders causes many of these buildings to become white elephants: Sometimes it costs more to tear one down than the building is actually worth. These buildings either close their doors and gather dust or have minimal occupancy until the economy improves. Either way, the owner or lender loses a lot of money.

The length of the Tenant Lateral Movement Phase depends upon the downward movement of rental rates. For example, if the rates drop from $17 to $11 and plateau, there will most likely be only one segment of lateral movement. If, however, rates drop again from $11 to $9, lateral movement probably will surge again; new tenants will be induced to move because of the lower rates, thereby creating two segments. The number of segments largely depends on drops in rental rates.

Post-Activity Equilibrium
A Post-Activity Equilibrium Phase then sets in. This is the office market’s equivalent of rigor mortis. Leasing activity drops off and tenant expansion stagnates. This phase continues until the next cycle of new economic activity and growth begins.

Waiting It Out
There is no easy solution to the problems that a real estate cycle creates. Many times the only option is to wait and see what happens. However, informed real estate professionals can take advantage of the cycle and make a profit for their clients.

Informed professionals also have a responsibility to the real estate community at large to improve information dissemination among themselves. Many of the local lenders that finance construction have a clearer understanding of what is occurring in the local market than out-of-state lenders who are not as well-informed about the local economy. Major institutional lenders, on the other hand, have a tendency to make a loan where a feasibility study produced by a developer shows a positive cash flow, although the feasibility study may be biased in favor of the developer. Maybe it’s time that lenders start obtaining more of their information from sources closer to the planned development, such as local real estate professionals.

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