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Commercial real estate pricing dilemma

Brad Elgin

How do you overcome the dilemma that exists when owners want to sell their property, yet understand that current economic conditions limit the ability to identify buyers who are willing, or can afford, to pay the price they deem it to be worth? This is a principal challenge we face in the commercial real estate market of northern Nevada. No one expects to make an investment, see it decrease in value, and then sell for less. While more commonly accepted in the trading of securities, it is not in real estate. Buyers have trepidation committing money if there is a perceived chance it will not be worth what they paid. Is perception reality? The answer in most cases is yes. The number of sale transactions that have occurred over the past two years seems almost non-existent relative to preceding years.

Buyers expect to acquire property for less than what was paid in recent years. This perspective is justified considering the impacts of the recession (layoffs, unemployment, closed businesses, demand for real estate). The media’s attention to the poor state of the real estate market further fuels this perspective. Many articles explain that we have yet to experience the deterioration of the commercial market.

In part, this is where the dilemma begins. Prospective buyers are waiting patiently as they do not want to buy today to find it is worth less tomorrow. For sellers, if the property was purchased within the past few years, it is likely now worth less than what they paid. Owners want to sell for a profit, or at least what they paid, but not a loss. Consider for example a buyer who in 2006 paid $1 million for a property. He put $300,000 down and secured a loan for $700,000. Now he must sell. The likely sales price is in the range of $600,000-$700,000. Assume the seller’s loan amount is now $650,000. The cost to sell is the loan amount ($650,000) plus closing costs ($50,000). The price must be at least $700,000 for the seller to avoid writing a check at closing. If he elects to do so, the down payment of $300,000 is also gone. For both buyers and sellers questions arise.

For the seller:

* Should I wait and hope the value increases as the economy improves?

* When and will the economy improve?

* How many years will it take for the value to increase?

* How long can I afford the financial obligations of the property?

* Should I approach my bank and ask to restructure my loan? If they agree how long can I satisfy the revised financial obligations? Is this revision delaying the inevitable foreclosure?

For the buyer:

* Will prices fall further?

* Should I target only those properties that face foreclosure?

* How many years will it take to see appreciation that meets my goals?

As real estate professionals, our responsibility is to understand and work towards achieving the goals of our clients. It is impossible to foresee with certainty the direction the market will go. What we can do is determine where, when, and at what price actual transactions are occurring. By doing so, we can provide a reasonable estimate of what price and terms are required for a successful sale. The following table provides a sample of actual transactions that occurred in Reno/Sparks in 2008/2009. All of these properties were advertised for a period of no less than six months.

Averaging the percentage reduction in these five properties, buyers paid roughly 35 percent less than the original asking price. This does not mean all properties are worth 65 percent of the asking price. It does show that sellers achieving a successful disposition are adjusting their pricing to current market conditions. What is not provided in this table is the large number of properties advertised for 12-36 months without selling. The majority of these sellers have been reluctant to adjust their pricing.

Buyers should understand that not all sellers have to sell. Many owners are in a solid financial position and are willing to wait to find a buyer who will pay an acceptable price, regardless of the carrying costs (debt, taxes, insurance, expenses). Further, in many cases the lender is the determinant of the minimum sale price. If the loan obligation exceeds the considered sale price, the seller must either write a check at closing or determine if the lender will absolve them of the remaining difference through a short sale.

In commercial property, we have not experienced a significant number of short sales in northern Nevada but have seen properties going to foreclosure and auction. What is not widely discussed, but more common, are work-outs in which the lender restructures the loan to allow the owner to continue making payments. Lenders do not want to take back these troubled assets to avoid the write-down of losses and required increase of their reserves. Will these work-outs allow enough time for the market to rebound and a sale to occur or are they delaying the inevitable foreclosure? Are such fiscal policies artificially supporting the economy and delaying the path to recovery?

Will we see a closing of the gap in 2010? Multiple factors need to improve (employment, lending policies, consumer confidence, etc.). For owners who are unable to cover their debt, lenders may force the closing of the gap through foreclosure. Owners who do not need to sell may want to consider the cost of capital in a stagnant or potentially depreciating asset. Would that capital be better utilized in an alternative investment?

Regardless of the bid-ask gap, the market price is ultimately determined by the price buyers and sellers can agree upon today not the price paid in prior years or the price they hope it will be. The ability to re-establish market pricing and provide a confident opinion on the value of commercial property will be beneficial for all parties directly or indirectly involved and the economy as a whole.

Brad Elgin is a vice president with Stark & Associates Commercial Real Estate in Reno. Contact him at 825-4400 or belgin@starktcn.com.