Three Rates, One Big Impact

I  was recently at a home improvement store and found myself browsing around the power tool isle.  It’s been a little while since I’ve purchased a drill but I was amazed at all the different varieties now available.  There were drills, drivers, hammer drills, impact drivers, rotary hammers and right-angle drills, not to mention ones that were yellow, red, green and orange.  All these types of drills are related – you pull the trigger and the drill bit spins.  But they are all not exactly the same and perform slightly different functions.   That evening, I was reading about the most recent meeting of the Federal Open Market Committee (FOMC) and their decision to raise the federal funds rate by a quarter of a point, to 4 percent.  The immediate reaction by many people is that commercial mortgage rates would immediately increase as a result.  But similar to drills, different types of interest rates are related but not all the same.  To have a better understanding of why, read on.

Interest rates play a central role in commercial real estate and have a heavy influence on property values, investment returns and sales activity.  The three most common types of interest rates are the federal cost of funds rate, the 10-year US Treasury yield and commercial mortgage rates.  A few years ago, in this very column, we had a discussion on FOMC and the federal funds rate.  In case you missed it (and shame on you if you did), this is the overnight interest rate that banks lend to one another to ensure that reserve balances are maintained.  FOMC is the body that sets this rate, and it is a primary tool used to influence economic growth and inflation.  When FOMC raises this rate, as they did last month, borrowing becomes more expenses, which slows economic activity and reduces pressures from inflation.  Alternatively, if FOMC wants to stimulate the economy, they will reduce rates, which results in borrowing becoming cheaper and encourages investment and economic growth.  Although the federal fund rate impacts short-term borrowing costs, it does not directly set long-term interest rates.  However, it does have a longer-term and more indirect impact because of economic growth and inflation. 

Unlike the federal funds rate, which is established by FOMC, the 10-year Treasury yield is determined by market forces.  As a result, it serves as one of the most important benchmarks for long-term borrowing across our economy.  Investors that are considering investing in this security consider a variety of factors, including inflation expectations, future economic growth, FOMC policy expectations and global demand for safe-haven assets, among others.  Ultimately, the 10-year Treasury yield typically reflects what the bond market believes will unfold over the next decade.  But this yield does not move in lockstep with the federal funds rate.  For example, the Federal funds rate may increase but the 10-year Treasury rate may not change.  But changes in the 10-year Treasury rate does have an immediate impact on the third primary type of interest rate, the cost to borrow money. 

And speaking of the cost to borrow money, a commercial mortgage is a long-term loan that usually has a maturity (sometimes called a balloon or loan term) ranging from five to ten years with amortizations periods ranging from 20 to 30 years.  Because lenders are committing capital over a longer period, they generally price loans relative to long-term bond yields rather than short-term rates.  As a rule of thumb, a commercial mortgage rate starts with the 10-year Treasury yield, which is generally considered to be a risk-free rate.  It then adds a premium that recognizes items that could influence the risk associated with the loan.  These risks can include borrower default, property performance, liquidity, prepayment and market volatility, among a host of others.  For example, if the 10-year Treasury yield is 5 percent and the lender requires a 250-basis point (or 2 ½ percent) premium to compensate for risk, the interest rate associated with the loan would be approximately 7.5 percent. 

Related to the 10-year Treasury rate is something called a ‘yield curve’.  It can be helpful to monitor the shape of the yield curve, as it plots Treasury yields across various maturities.  The most common version plots the yield of the 2-year Treasury to the 10-year Treasury.  A normal yield curve will result in the rates for longer-term Treasuries to be higher than the rates for shorter-term Treasuries.   This generally signals expectations for continued economic growth, and the commercial real estate market will be more bullish.  An inverted yield curve occurs when the rates for longer-term Treasuries are lower than the rates for shorter-term Treasuries.  This indicates an expectation of future economic weakness, and the commercial real estate market will be more bearish.  As I write this, the 2-year Treasury yield is 4.93 percent while the 10-year Treasury yield is 5.25 percent, indicating moderate optimism for the near-term future.

I left the home improvement store that day empty handed.  It wasn’t because I didn’t need a drill, as mine was over 20 years old and one of the first cordless models.  Rather, I didn’t fully understand not just what I needed that drill for now but also how those needs may evolve in the future.  The federal funds rate, the 10-year Treasury yield and commercial mortgage rates form a triangle of influences for commercial mortgage rates.  The federal funds rate represents the FOMC’s short-term policy tool while the 10-year Treasury yield reflects market expectations for inflation, growth and future interest rates.  Commercial mortgage rates are generally priced as a spread above the 10-year Treasury yield, making Treasury movements the most direct driver of borrowing costs.  By understanding not just what these rates look like today but also how they are expected to change in the future, a commercial mortgage borrower will be in a much better position to understand the best time to pull the trigger.

What IC @ PVC – Changing Tide?  Last month, a 12,000 square foot multi-tenant office building on Georgetown Road in Hudson transferred for $1.55 million or $130 per square foot.  The office sector has been much maligned and only time will tell if this was an anomaly or the start of a trend.

Alec J. Pacella, CCIM for November 2026 Properties Magazine

Danger – High Voltage

Every so often, I’ll get a call from my friend Paul.  Although he is a nurse and has good job working in a busy clinic, he always has his eye on the ‘next big thing’.  In the late 1980s, it was tanning salons and then in the late 1990s, it was tech stocks.  Ten years later, in the mid-2000, it was flipping condos, especially in Phoenix and Las Vegas.  Each time that he called to discuss these ideas, I would warn that the bubble may be close to busting.  And each time, he would quickly dismiss this notion using the same rational – everyone wants to jump on board, the growth will continue to skyrocket, and this opportunity is a sure thing.  A few weeks ago, I got a call from my old friend Paul and, just like many of our past conversations, I heard the words ‘skyrocket’, ‘jump on board’ and ‘sure thing’ ringing in my ear.  But the topic of this conversation wasn’t tanning salons or condos, it was data centers.  This month, we are going to take a deeper dive into the current darling of the real estate sector by discussing what they are, what they need and why they could be the next bubble to burst.

Data centers may seem like they just recently showed up on the scene, but they have been around since the 1940s, when the very first electronic computers were born.  As the computer trend accelerated, these mainframe rooms, as they were then called, where characterized by dedicated electrical power, specific cooling systems and restricted access. The term ‘data center’ gained traction in the 1970s, led IBM and the seven dwarfs, which included Burroughs, CDC, GE, NCR, Honeywell, RCA and UNIVAC. The introduction of the internet era in the 1990s, and associated widespread use of the word wide web, email and cloud-based storage, threw more gas on the data center fire.  And while the specific uses evolved, the basics needs of a data center remained consistent; heavy electrical power, specific cooling systems and restricted access.  There are familiar examples across northeast Ohio that many of you may pass all the time; PNC’s facility on W 150^th just north of I-71, KeyBank’s facility on I-480 at Tiedeman Road, several of the Progressive Insurance facilities located along I-271 and, an oldie but a goodie, the NASA Glenn research center on the peripheral of Cleveland Hopkins International Airport.  

The sector really began to ramp up with the advent of artificial intelligent (AI).  While we discussed the latest AI developments in last month’s column, the AI boom really goes back to the introduction of Apple’s groundbreaking application known as Siri, way back in 2010.   This is generally regarded as the first widespread public use of AI.  Although Apple maintained strict control of this technology, others quickly jumped on the voice-activated technology bandwagon.  This led to an increased demand for data centers, as the technology was real time and interactive.  Then, in late 2022, along came ChatGTP and the data center powder keg fuse was lit.  While specific uses continue to evolve, the needs remain constant; heavy electrical power, specific cooling systems and restricted access.  Let’s dive into these needs as a result of AI.

Traditional data center functions such as web site hosting and cloud-based storage can be accomplished using conventional central processing units (CPUs), but AI systems are significantly more robust.  Rather than request and retrieve functionality, AI requires specialized processers known as graphics processing units (GPUs) that can perform thousands of calculations interactively and simultaneously.  Electric consumption is typically defined by a kilowatt (kW).  One kW will power a TV for 20 hours or a household refrigerator for 3 hours.  A traditional CPU server rack consumes between 150 and 250 kW per day but a GPU rack consumes between 1,500 and 2,500 kW per day.  A medium size data center contains 1,000 racks, a large corporate datacenter contains 5,000 racks but a hyperscale facility for companies such as AWS or Meta contains at least 30,000 racks. 

All of these racks of GPUs being powered by a huge volume of electricity not only creates a quick and detailed response to your queries on the best way to lose 10 pounds, but it also creates a significant amount of heat.  Traditional data centers use dedicated cooling systems to circulated air around and under the processing units.  But the heat generated by AI facilities would quickly overwhelm those systems.  As a result, modern data centers use liquid cooling, with chilled water circulated directly around the hottest components, which removes heat much more efficiently.   Access to a significant source of water is just as important as access to a significant amount of electricity.  Finally, a modern data center looks like a big concrete box.  There are no windows, no lights, no landscaping and no signage.   Have you recently driven on I-71 between Columbus and Cincinnati and wondered what those grey bunkers were just north of the outlet mall in Jeffersonville?  The largest online retailer in the world prefers that you don’t. 

The dramatic rise in demand for modern data centers has resulted in a spike in demand for suitable vacant land.  Last year, Microsoft and Amazon made headlines for vacant land purchases in northern Virginia.  The former acquired 124 acres for $465 million or $3.75 million per acre while the latter acquired 189 acres for $700 million or $3.7 million per acre.  SDC Capital partners, a private investment firm focused on digital infrastructure, upped the ante by purchasing 97 acres for $615 million or $6.3 million per acre.  These locations were chosen not as a result of traditional metrics, such as traffic counts, population density or access to rail lines.  Rather, they had the three key attributes that modern data centers covet – proximity to heavy electric power, an ample supply of water and enough acreage to provide securable scale.  While the raw numbers here in Ohio aren’t as eye-popping, a similar spike in prices clearly occurred.  Columbus has emerged as a leader in the state, both in activity and pricing.  In Licking County, Meta acquired a total of over 1,300 acres, with the most recent purchases exceeding $1 million per acre for vacant farmland that ordinarily traded for $10,000 to $15,000 per acre.  Other areas in Ohio that are considered to be data center hotbeds include Hebron, Lancaster, Wilmington and Massillon.    

Despite the bravado, my friend Paul thankfully has never actually acted on his impulses to get involved with tanning salons, tech stocks or condos in Pheonix at their peak.  But there are plenty of people that are rushing in to stake their claim in the current data center gold rush.  As with any booming industry, there will be winners and, then the inevitable bust happens, there will also be losers.  Hopefully, Paul continues to be more focused on IVs than kWs.

Boom and Bust – Last month, the latest chapter was written on a four-building office portfolio in Cleveland’s eastern suburbs.  The three-property office campus known as Landerbrook Corporate Center along with Metropolitan Plaza in Highland Heights sold for $12.2 million or $22 per square foot.  The same portfolio last sold in 2017 for $53.8 million or $99 per square foot. 

Alec J. Pacella, CCIM for September Properties Magazine

The Next Chapter

Since bursting on the scene in late 2022, few topics continue to capture more attention than Artificial Intelligence. I first wrote about AI in this very column in the March 2023 edition, with a follow up in November 2024.  Given the extraordinary pace of evolution, it’s about time for another update. Over the past 18 months, several trends have emerged: more capable reasoning models, autonomous AI agents, multimodal systems, specialized industry models, and growing adoption of private large language models (LLMs). Together, these developments are reshaping not just the commercial real estate industry but also how general businesses operate and how knowledge work is performed.

Give me another reason.  One of the most significant advances in AI has been the shift from simple, prediction-based language models to systems capable of deeper reasoning. Leading AI providers have focused on improving models’ ability to solve complex problems, write software, analyze data, and execute multi-step tasks with greater reliability. OpenAI, who started the AI party with GPT-3+, released GPT-5 in August 2025.  This update introduced a unified architecture that can determine when a task requires deeper reasoning with slower response versus a simpler but faster response. It also includes major improvements in coding, writing, scientific analysis, and instruction-following, while also reducing hallucinations and factual errors.  At the same time, the broader AI industry has increasingly emphasized “reasoning-first” training techniques, including reinforcement learning approaches that reward verifiable outcomes rather than merely predicting likely text. Researchers and industry analysts view these methods as essential for improving performance in high-stakes domains such as law, finance, healthcare, and engineering. Claude ai has become a very popular product in these sectors specifically because of its advanced reasoning models. 

Not so secret agents.  Another major development is the rise of AI agents. Unlike traditional chatbots that simply answer questions, agents can perform tasks, use tools, access data sources, and execute multi-step workflows autonomously, giving rise to a new term – agentic AI.  Enterprise software vendors are rapidly integrating agents into business operations. Microsoft, for example, has expanded its Copilot product with specialized agents such as Researcher and Analyst, while introducing multi-agent coordination that allows multiple AI systems to work together on complex processes under human supervision.  AI agents have become built into specific layers to help weave ai automation within the human structure of the organization.  For example, an AI agent may help organize and summarize the results market research study, which is then handed off to a financial analysis model to help form and validate input assumptions, which then loops in a construction management study to help determine the project’s viability. Rather than replacing employees, these agents are increasingly being positioned as digital coworkers that augment human productivity across a range of tasks.

A picture is worth 1,000 words.  While early AI systems were limited to only recognizing text, modern AI systems have evolved to be able to process and generate information across multiple formats, including images, photographs, audio, documents, and video.  This multimodal capability allows users to upload presentations, analyze diagrams, interpret spreadsheets, generate visual content, and interact naturally through voice. Multimodality is considered one of the defining characteristics of next-generation AI systems because it more closely mirrors how humans gather and process information.  For businesses, multimodal AI dramatically expands practical applications. Employees can ask questions about contracts, analyze photographs from inspections, review technical drawings, summarize meeting recordings, and generate polished reports from diverse information sources with a single system.

Bigger is not necessarily better.  While large, general-purpose models remain important, organizations are increasingly looking to specialized and vertical AI models optimized for specific industries and use cases.  Rather than relying entirely on one universal model, many enterprises are deploying domain-specific LLMs trained on proprietary datasets. Specialized models can offer higher accuracy, lower operating costs, improved compliance, and better performance within narrow domains such as such as a specific type of healthcare, such as cardiovascular or a targeted legal service, such as litigation.  Small Language Models (SLMs) are also gaining popularity. These models require fewer computing resources while delivering strong performance again by focusing on targeted applications. Their lower infrastructure costs make them attractive for organizations seeking scalability without the expense of running frontier-scale models. 

Going private.  Perhaps the most important trend for enterprises is the growing adoption of private LLMs.  A private LLM is a language model used exclusively within an organization’s secure environment rather than accessed solely through a public cloud service. These systems may run onsite, within a private cloud, or inside dedicated enterprise AI platforms, such as Google Notebook LM. Private models allow businesses to retain control over their data, intellectual property, security policies, and compliance requirements.  Several factors are driving this trend.  First, organizations increasingly want assurances that proprietary information will not be used to train public models. Industries such as healthcare, banking, government, defense, and legal services often face strict regulatory requirements around data privacy and sovereignty so a private LLM allows them to harness the power of AI without introducing widespread security concerns.  Second, enterprises are looking to customize AI systems using internal knowledge and business processes. Microsoft’s Copilot Tuning initiative, for example, enables organizations to tailor AI models with company-specific workflows and information while keeping operations within Microsoft’s protected and highly secured enterprise environment. Microsoft also emphasizes that customer data is not used to train foundation models.  Third, advances in model efficiency have made private deployment more practical. Open-weight and smaller models increasingly deliver capabilities that were previously available only through massive cloud-hosted systems. This allows organizations to balance performance, cost, and control more effectively.

The future of artificial intelligence is likely to be defined less by large-scale models and more by smarter, more targeted applications. Organizations are increasingly combining reasoning-capable AI, autonomous agents, multimodal interfaces, and private LLMs into their specific business systems.  The next phase of AI adoption will focus on trust, governance, security, and measurable business outcomes. Private LLMs, in particular, are emerging as a critical component of enterprise AI strategies because they allow companies to harness the power of generative AI while maintaining control over sensitive information.  It all circles back to a phrase that I used in my original article a few years ago – AI is not going take your job, but the person/company that knows how to efficiently use it just might!

What IC @ PVC – Testing the market.  Last month, a pair of familiar Rockside Road office buildings were put up for sale.  Rockside Square One and Two, encompassing a total of 156,000 square feet, has an asking price of $18.35 million or $118 per square foot.  While the complex features a strong location, solid occupancy and is in good condition, the market will be closely eyeing how this sale effort unfolds. 

Alec Pacella, CCIM for August 2026 Properties Magazine

Four Core Sectors of CRE

A few weeks ago, I saw a reference to the ‘four basic food groups’.  This phrase will almost certainly strike a familiar chord to anyone that hung around a grade school cafeteria in the 1960s and 70s.  For those that missed (or forgot) those days, the general idea was that each day, a person should eat at least one food from each of these groups – fruits and vegetables, milk/dairy, breads and cereals and meat/protein.  Doing so helped to ensure a healthy and balanced diet.  However, the reference that I saw had nothing to do with food.  Rather, it was a discussion about commercial real estate.  To see how bananas and yogurt are related to warehouses and community shopping centers, read on!

Commercial real estate covers a wide variety of specific uses and can include golf courses, movie theaters, medical buildings, self-storage and RV parks, amongst a host of others.  However, the vast majority falls into one of four sectors – office, industrial, retail and multi-family.  Each of these has unique terminologies, characteristics and dedicated trade associations, as detailed below.

Industrial properties represent the largest portion in northeast Ohio, with over 500 million square feet in this sector.  There is a wide range of specific types and, dependent on the intended use, can include bulk warehouse, distribution, flex, office/warehouse, manufacturing and freezer/cooler, amongst others.  There are also some specific characteristics in this sector.  Clear height is the vertical distance from the floor to the underside of the ceiling joists and determine how high material can be stored.  Column spacing is the horizontal distance between the structural building columns and help to define the interior flow of material and configuration of equipment and/or racking.  And dock high and grade level doors shape the flow of material into and out of the facility.  National Association of Office and Industrial Parks (NAIOP) is a leading association for this sector.

Office buildings comprise approximately 75 million square feet and include some of the most recognizable silouttes in the region. These structures are sometimes referred to by height.  A ‘high-rise’ is defined to have more than 25 stories and would include Sherwin Williams new headquarters, Key Tower and 200 Public Square, all in downtown Cleveland.  A ‘mid-rise’ has between 7 and 25 stories and would include 76 South Main in Akron, Eaton Corp’s headquarters in Beachwood and Oswald Center in downtown Cleveland.  Finally, a ‘low rise’ is less than 7 stories, with examples throughout suburban Cleveland and Akron.  Office buildings are often described by class.  Class A is generally the newest, most prestigious, has the highest levels of amenities and achieve the highest rents in the market.  Class B are less than new, offering a balance of amenities and value while Class C are the oldest and offer the best value in exchange for a lack of amenities and prestige.  Office buildings also often differentiate in the way square footage is described.  Usable square footage is the premises that the tenant has exclusive use of, while rentable square footage includes the usable area plus a proportional share of the common areas, such as lobbies, hallways, fitness centers and conference facilities.  Building Owners and Managers Association (BOMA) is a leading group in this sector.

Approximately 60 million square feet in northeast Ohio is in the retail sector, which includes locations that are familiar to most of us.  These range from small, neighborhood-oriented centers with a nail salon and cellphone store to power centers anchored by retailers such as Target and Lowes to regional malls such as SouthPark Center to lifestyle centers such as Legacy Village.  Retail properties have some specific terminology.  A tenant’s premises is termed gross leasable area or GLA.  Locations that flank the entry to a larger center and feature visibility and access area called outparcels.  Tenants are typically responsible for their pro rata share of common area maintenance, or CAM, which include the upkeep cost of high-quality, customer-oriented facilities.  In addition to base rent, tenants may also be responsible for paying percentage rent, which is based on the tenant’s annual sales and payable if the sales volume exceeds a pre-established threshold.  The leading trade group in the retail sector is the International Council of Shopping Centers, or ICSC.

The fourth and final primary sector is the multi-family sector, which includes approximately 250,00 units in northeast Ohio.  These properties are generally separated into smaller complexes, such as doubles/duplexes and quads, and larger complexes that are buildings containing 20 units or more.  This sector tends to be very popular with investors due to four specific characteristics.  First, housing is a basic demand that includes a very large pool of potential tenants.  Second, there is a low cost associated with re-tenanting the space.  Third, the risk of vacancy tends to be spread over a broad range of tenants that are similar in size and configuration.  And finally, the leases tend to be short term, with the longest term being annual.  Like the others, this sector also has some specific characteristics.  Because these are residential in nature, there are a host of regulations and disclosures that are designed to protect the occupants, such as lead-based paint disclosures and complying with fair housing laws.  Multi-family properties can also qualify for government-sponsored financing offered through the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).  The National Multi-Family Housing Council is a leading association for this sector.

By the time the 1980s rolled around, the four basic food groups fell out of favor, largely replaced by the food pyramid.  This revamped approach suggests eating more foods situated at the bottom of the pyramid, such as grains, fruits and vegetables, and less situated at the top, such as fats, oils and sweets.  But the idea of the four basic food groups for commercial real estate has endured – so who is ready for another helping of industrial properties?

What IC @ PVC – Blast off.  Last month a 456,000 square foot distribution center known as Westfield Center Commerce Park sold for $48.2 million.  Situated at I-71 / US 224 intersection, the facility is fully leased to B’laster Products.

Alec Pacella, CCIM for August 2026 Properties Magazine

Last month, we discussed the real estate taxation concept of basis.  If you missed that article (and shame on you if you did), we detailed the four primary ways that basis is originally established by the IRS – outright purchase, inheritance, gift and 1031 exchange.  The article concluded by teasing an associated topic for this month’s column, determining the asset’s depreciation schedule.  But before I launch into that, we need to take a step backwards to review what the concept of depreciation is and why an owner of real estate should care. 

Depreciation is a concept used by the IRS to acknowledge wear and tear as well as economic obsolescence associated with a physical asset.  Although it is applicable to all sorts of property, such as machinery, equipment, fixtures and vehicles, the focus of this article is one that is most near and dear to our hearts – real property ie real estate.  As soon as the asset is placed into service (ie the real estate is purchased), the depreciation clock starts ticking and the owner can offset income that the real estate produces by the amount of value the IRS believes the real estate has lost.  This is a true shelter, as deprecation is considered a non-cash expense.  The owner is not writing a check each year for the value that is lost.  This can be a good thing for the owner/taxpayer, The greater the amount of depreciation, the more an owner can shelter, which means that they will owe less in federal income tax which means they will get to keep more money.  The immediate question that comes to mind is likely this; how does the IRS figure out how much depreciation can be take each year?   

There are four basic steps to determine the amount of annual.  And guess what?  It all starts with determining the original basis.  The next step is to allocate this basis between land and improvements.  This is done because, unlike the physical improvements, land is not considered to be subject to wear and tear.  Once the value of the improvements is isolated, the third step is to determine what the IRS calls ‘class life’.  Real estate that is classified as IRS 1231 Trade or Business is considered to be either residential (ie apartments) or non-residential (office, retail, industrial, etc).  Applying the appropriate IRS factor to the improvement portion of the basis is the fourth and final step.  Real estate classified as residential has a 27.5-year class life, which means that the IRS believes the improvements will wear out equally over a 27.5-year period.  Real estate classified as non-residential has a slightly longer class life of 39 years.  With that crash course on depreciation out of the way, it’s time to look at how the depreciation would be impacting, using the same examples discussed in last month’s article.

The first scenario was Mystery Reader buying my shopping center in an arms-length, outright sale for $5 million plus $75,000 in qualifying acquisition costs.  Their original basis would be $5,075,000.  We will assume that the improvements are considered to represent 75% of the overall value.  This results in the allocated value attributable to the improvements to be $3,806,250.  The shopping center is considered by the IRS to be non-residential, which means a factor of 2.564% (or 1/39^th) would be applied to the improvement portion only in each full year of ownership.  This would result in Mystery Reader being able to take $97,592 of deprecation each full year they own the shopping center.

In the second scenario, which wasn’t my fav, Mystery Reader inherited my shopping center.  We assumed that the adjusted basis was $1 million at the time of my death, and the market value of the center was $5 million.  In this scenario, Mystery Reader would receive a stepped-up basis of $5 million at the time of inheritance, which would then be allocated 75% to the value attributable to the improvements.  The shopping center is considered non-residential, with a class life of 39 years.  Finally, the associated factor of 2.564% is applied to the improvement portion, resulting in them taking $96,150 of depreciation each full year they own the asset, up to 39 more years. 

The third scenario was Mystery Reader being gifted my shopping center.  Again, at the time of gifting, the adjusted basis was $1 million, and the market value of the center was $5 million.  Adding in a bit more information, assume that I’ve owned the asset for 20 years and my current full year deprecation is $34,730.  In this scenario, Mystery Reader would basically step into my same shoes.  Their starting point, called a ‘carry over basis’, would be $1 million and they would continue to take $34,730 of deprecation each full year, up to 19 more years.

The final scenario was selling my shopping center as a part of a 1031 exchange and acquiring an apartment building for $6 million as the replacement property with an additional $100,000 of qualifying acquisition costs.   At this point, I would have a choice between two depreciation options.  I’m only going to discuss the simpler of the two, not coincidentally called the simplified / single schedule election.  In this final scenario, I would have a realized gain of $4 million ($5 million sale price of the shopping center less $1 million adjusted basis at the time of sale).  If I effect a 1031 exchange and use the simplified election, my starting point, now called a ‘substitute basis’ would be the purchase price of the apartment building, $6 million, plus acquisition costs of $100,000 less the unrecognized gain from the sale of shopping center of $4 million.  This would result in a substitute basis of $2,100,000.  Assuming 75% of the basis is attributable to improvements, the allocation to improvements would be $1,575,000.  Apartments have a class life of 27.5 years so a full-year factor of 3.636% would then be applied to the improvement portion of the basis, resulting in $57,267 of depreciation for each full year.

Basis is an important concept to understand, not just for the implications during the ownership period but also for the potential tax consequence at sale.  As Mystery Reader hopefully discovered, a simple question sometimes doesn’t result in a simple answer, especially when I’m involved!

What I C @ PVC – Doubling Down.  James Kassouf followed up his purchase of the Huntington Garage in downtown Cleveland with the purchase of another large downtown garage.  But this one has an office building attached to it.  Kassouf purchased 800 Superior, which includes a 475,000 square foot office tower and attached 325-space garage for $4 million in May.

Alec Pacella, CCIM for June Properties Magazine

Removing Some Mystery

One of the enjoyable parts of writing this column every month is the opportunity to interact with all of you.  Sometimes, it’s running into a reader at a restaurant at lunchtime and other times, chatting with someone at a local real estate event.  But the most common interaction is readers reaching out via email.  If you missed the April ’26 issue (and shame on you if you did), we dove into the topic of cost segregation and specifically pointed out some things to be aware of when using this popular strategy.   I received several emails but one struck me.  A person that I’ll call ‘Mystery Reader’ asked how the overall starting value is determined for real estate.  This is a simple but terrific question, as the starting value, generically known as ‘basis’, not only determines how much depreciation can be taken each year but also plays a key role in determining any potential taxable gain, or loss, when the real estate is sold.  This month, we are going to provide some insight into this topic, as it isn’t a easy answer to Mystery Reader’s seemingly simple question.  Before I dive in, I need to provide my usual disclaimer.  I am not a tax expert and, in an effort to simply the concepts, there may be various details or nuances that are omitted.  It is always best to consult a tax professional for a more complete understanding.

There are four ways that basis can be established for real estate, which is directly dependent on how the real estate was acquired.  The easiest and most straightforward is an outright purchase.  Assuming it is an arms-length transaction between unrelated parties, the original basis is the purchase price plus any associated acquisition costs.  These costs can include items such as title insurance fees, recording and transfer taxes, legal fees, survey costs, certain due diligence costs and closing costs.  Suppose I sell my shopping center to Mystery Reader for $5 million, who also incurs $75,000 in qualifying acquisition costs.  Mystery Reader’s original basis would be $5,075,000.

The second way that the basis can be established is if the property was inherited.  In this instance, the basis is ‘stepped up’ to the fair market value of the property as of the time of the donor’s (the giver’s) death.  The concept of a stepped-up basis can provide a significant tax advantage, as it allows an asset to pass to a donee (the recipient) with no immediate tax obligation.  Suppose that I like Mystery Reader’s question so much that I decide to change my will to name Mystery Reader as the person that will inherit my shopping center.  At the time of death, my current adjusted basis is $1 million, and the shopping center has a fair market value of $5 million.  It would pass to Mystery Reader with a stepped-up basis of $5 million and the recognized gain, the difference between Fair Market Value and current adjusted basis would be the obligation of the donor’s estate, not the donee.   

The scenario changes again if the property is received as a gift as compared to an inheritance.  If the property is gifted, the donee receives what is termed a ‘carryover basis’ instead of a stepped-up basis.  This means the donee takes over the donor’s current adjusted basis.  Suppose that I really like Mystery Reader’s question but I’m not so fond of dying in order for them to get the shopping center, so I decide to gift it instead.  The real estate would pass to Mystery Reader with a carryover basis of $1 million, which is my current adjusted basis.  In this instance, any recognized gain that would result from a future sale of the property would be the obligation of Mystery Reader, the donee.

The fourth and final way that basis can be established is if the property is acquired as a part of a 1031 exchange.  When a taxpayer elects to enter into a 1031 exchange, they are deferring the tax on the property that is being sold.  If the sale price is greater than the adjusted basis at the time of sale, there is a realized gain.  But it is only recognized if the associated taxes are paid.  Since a 1031 exchange allows the taxpayer to defer this tax, the IRS needs a way to keep track of it.  Enter a concept known as ‘substitute basis’.  The replacement property’s basis is the purchase price plus any acquisition costs (which can include fees and costs associated with the exchange) less the realized gain on the relinquished property.  Suppose that I don’t like Mystery Reader enough to change my will or gift my shopping center but I will sell it to them for $5 million.  My adjusted basis at the time of sale is $1 million so I’ll have a realized gain of $4 million.  If I effect a 1031 exchange, I will defer the associated tax on this gain, so I find an apartment building as my replacement property and buy it for $6 million.  My substitute basis in that apartment building would be $6 million plus any associated acquisition costs less the unrecognized gain of $4 million from the shopping center that was relinquished. 

As I said at the start of this article, there are a few reasons why it’s important for a taxpayer to understanding their basis.  First, it establishes a starting point that is used by the IRS when calculating gain on sale.  For each of the first three examples, suppose that Mystery Reader only owns the shopping center for one day and then immediately sells it for $5,075,000.  For the first example, an outright purchase, there would be no gain at sale while the second example, an inheritance, the gain would be minimal.  But in the third example, a gift, there would be a $4 million gain.  I switched things up for the last example so let’s assume that I only own the replacement property, the apartment building, for one day and sell it for the same amount that I bought it for – $6 million.  I’m thinking that I got one over on the IRS, as I’ve only owned it for a day, so there will be no recapture associated with depreciation and I’m selling it for the same amount that I bought it for, so there will be no capital gain associated with appreciation.   However, the IRS will have a much different perspective, as they will compare the sale price to the substitute basis, resulting in a $4 million gain.  There is another important reason, determining the depreciation schedule for the asset.  Sounds like a great topic for next month’s article!

What I C @ PVC – Flying High.  Last month, a 279,000 square foot distribution center in Walton Hills sold for approximately $39 million or $140 per square foot.  The pricing was keyed by a single-tenant, long term net lease with Columbus-based Cardinal Health. 

Alec J. Pacella, CCIM for May 2026 Properties Magazine

Burnt Out

The 1991 BMW 7 series was the first regular production automobile to offer Xenon headlamps.  The automotive press lauded the crystal-clear white light as a revolutionary upgrade and a seed was planted in my mind.  It took a few years to be in a position to afford a car that had these coveted headlamps and even then, it was a stretch.  But once I had that car with those headlamps, it was indeed a significant improvement over the older halogen bulbs.  All was good for several years until one of the headlamps stopped working.  Unable to roll into my local AutoZone to buy a new Xenon bulb, I took it into my friend Tom the mechanic.  I certainly wasn’t prepared for his diagnosis.  He needed to replace the entire housing, as it was a sealed unit that included the Xenon light, the daytime running light, the turn signal light and a motor that turned the lamp slightly whenever the car was steered in a left or right.  The good news – new housings were almost $2,000 but he found a used one for $900.  The bad news – two weeks later, I was right back in Tom’s shop because the other side stopped working.  The IRS introduced the concept of cost segregation in 1997.  Like Xenon headlamps, this concept was a significant improvement over the standard cost recovery deduction as it allowed a taxpayer to significantly accelerate the depreciation schedule on specific categories of property assets.  But also, like Xenon headlamps, there are a few things that can cause a taxpayer to get knocked back on their heels.  To better understand some of these pitfalls, read on.

Passive can be aggressive.  If the real estate investment is considered by the IRS to be a passive activity for the taxpayer, the tax deduction associated with cost recovery is limited to $25,000.  Known as the passive loss limit, it also restricts these losses to only be taken against gains for other real estate held in a passive capacity.  This can be an issue, especially if the cost segregation study creates a significant taxable loss for the investor.  Often, investors can avoid this is by qualifying as a real estate professional, which eliminates the passive activity loss limit.  The IRS considers someone a real estate professional if more than half of their time during the tax year is spent on real estate activities, such as development, redevelopment, construction, acquisition, management, leasing or sales.  By way of an example, suppose a taxpayer works 30 hours each week as a firefighter.  That person would also need to work at least this same 30 hours each week performing the types of real estate activities listed above.  And keep in mind, this requirement is in addition to the fabled ‘7 tests’ to determine being a material participant. 

Red flag.  Nothing sends a shiver down a taxpayer’s spine than the word ‘audit’.   And while performing a cost segregation study is generally not considered to be something that will attract the IRS’s attention, the situation changes if the taxpayer is also a W-2 employee.  As detailed earlier, the primary way for a taxpayer to not be subject to the passive loss limit is to be considered a real estate professional.  And having a W-2 makes this much more challenging.  If you want some excellent bedtime reading on this specific subject, check out an IRS publication titled Passive Activities Loss Audit Techniques Guide.

1245, 1250, give or take.  A cost segregation study will sometimes categorize a portion of the asset as 1245 personal property.  While this will help the taxpayer increase the depreciation shelter because of a shorter class life, it can also create a problem if the taxpayer later elects to sell the property as a part of at 1031 exchange.  The associated gain on any portion of the asset that was classified as 1245 will be immediately taxable, as only Section 1250 property is considered like kind and qualifies for an exchange.

Net sum game.  A cost segregation study allows the useful life on certain components to be shortened.  It does not increase the overall amount of depreciation shelter available but rather just front-loads it.  The result is a significantly lower amount of shelter in later years.  Suppose I own an office building that has $800,000 of value attributable to the improvements. The cost segregation study establishes that $500,000 of this are components that can be accelerated over the first seven years.  But that means that the other $300,000 will be spread over the remaining 32 years – $9,375 each year.  In contrast, I could shelter approximately $20,500 each and every year over the entire 39-year useful life if I didn’t do the cost segregation study.

How good is too good?  Cost segregation is very effective in reducing taxable income.  But as the investor’s taxable income is decreased, the investor’s marginal tax bracket may be reduced as well.  Our taxing system is progressive, with dollars associated with higher income being taxed at a higher rate.  It is spread over seven progressively higher tax brackets.  For example, if filing singly, it starts at 10% for the first $10,000 of income and increases to a maximum of 37% for any dollars in excess of approximately $626,000.  And while the shelter associated with dollars that are in the higher brackets is very desirable, the shine starts to fade if the bracket is the lowered as a result of a decrease in taxable income.  Reducing the taxable income from $1.2 million down to $600,000 in a given year makes a lot more sense than reducing it from $800,000 down to $200,000.  

Any time I have content related to taxation, I always include my presumptive disclaimer; I am not a tax professional, and you should consult a tax professional to fully understand your associated tax implications.  You may remember that I have a tax professional that I consult with, Mark the CPA.  But it was Tom the mechanic who summed it up best.  As I wrote that second $900 check in two weeks, he simply said “a good halogen bulb costs $30 but only you can decide if the difference is really worth it.” 

What I C @ PVC – Burgers to Banks. The Harry Buffalo located at 4824 Great Northern Blvd in North Olmsted recently closed after operating at this location for 26 years.  It was subsequently transferred for $4.4 million to JP Morgan Chase & Co. 

Alec J. Pacella, CCIM for April 2026 Properties Magazine

It’s Magic

A few weeks ago, I was with one of my sons when a song by a
band by the name of The Cars came on. As those who know
me well can attest, this band is one of my all-time favorites, so I
immediately started tapping along to the syncopated rhythm of
“Just What I Needed.” My son took note and wryly commented
“great, another golden oldie.”

While my immediate reaction was to snap back something
snarky about the music that he listens to, he wasn’t far
from the truth. The song was released in 1978, making
it just a couple years shy of being truly golden.
This past week, I was involved in another conversation
about a much different “golden oldie,” a hit known
as the Gordon growth model. To better understand
how classic rock relates to classic financial concepts, read on.

It was way back in 1956 that a professor from the
Massachusetts Institute of Technology by the name
of Myron Gordon, along with Eli Shapiro, published a
model that was originally called the dividend discount
model. This model established the value of a business based
on the sum of future cash flows (known as dividends)
that were discounted back to a present value. If you
google the term, your eyes will likely glaze over, as the
empirical formula is everything that you would expect from
a couple of guys from MIT. Despite the technical nature
of this model, it has set the standard for what we
now call “yield” in modern real estate valuation.

There are four primary components to this model.
The current price is represented by ‘P’. The anticipated
dividend for the next period is represented by ‘D’.
The required rate of return is represented by ‘r’.
And the constant dividend growth rate is represented by ‘g’.
The basic formula solves for P by dividing D by (r minus g).
Putting some numbers to this as an example, let’s assume
that a company intends to pay a dividend of $4 per share
next year and the dividend is anticipated to increase
5% each subsequent year. Finally, the investor has
a minimum required rate of return of 10%. We can
quickly determine the current price; divide $4 by (10% – 5%)
to establish a current price of $80. When Gordon originally
published this work, the goal was to compare the actual price
of a company as compared to what the model is expecting
the current price to be. If the actual price was higher, say
$100 in the example above, than the expected price,
the company was considered to be over-valued
but if the actual price was lower, say $70, it was
considered to be under-valued.

We can use the Gordon growth model in a few different
ways in commercial real estate valuation. Suppose
that we are evaluating a single-tenant net lease property,
like a Walgreens or McDonalds. The tenant just started
a 20-year lease, will pay $25 per square foot in rent
next year with 2% annual increases. And the investor has
a minimum required rate of return, otherwise known
as yield, of 7%. Using the Gordon growth model, we
can quickly establish a current price: $25 divided
by (7% minus 2%) equals $500 per square foot.
But wait, there’s more.

The Gordon growth model can also be used to determine yield.
It is simply the anticipated dividend next year (or D) plus
the constant dividend growth rate (or r). Figure 1 illustrates
a simple yet powerful example of this application. In this example,
we are considering three potential real estate investments.
Investment A has an initial asset price of $100,000 and is anticipated
to pay a dividend of $10,000 next year. I’m going to stop right
here because I just defined a very common investment performance
metric known as “capitalization rate.” This tried-and-true metric is
calculated by dividing the anticipated dividend next year
by the underlying asset price today. When I do the simple math,
I determine that the cap rate for Investment A is 10% – year one
dividend of $10,000 divided by initial asset price of $100,000. Moving
to Investment B, which also has an initial asset price of $100,000.
However, it is anticipated to produce a dividend of only $5,000
so the resulting cap rate for Investment B is 5%. Finally, Investment C
also has an initial asset price of $100,000 but it is expected
to produce a dividend of $15,000. This results in a cap rate of
15% for Investment C. If I assume these assets are all equally
attractive and carry an equal degree of risk, then I would be
a fool not to choose Investment C as the most attractive.
A 15% cap rate is better than the cap rates of either Investment A
or Investment B.

However, look what happens when I widen out my view to include growth.
Investment A is assumed to sold, and thus have a future asset price
of $100,000, which is the same initial asset price. This means it is
anticipated to have no growth. Investment B is assumed to be
sold for $105,000, which means it is anticipated to have growth of 5%.
And Investment C is assumed to be sold for $95,000, which means
it is anticipated to have growth of negative 5%. And when we overlay
the Gordon growth model, something magical happens.
Investment A has a yield of 10% – dividend (or cap rate) of 10%
plus 0% growth. Investment B has a yield of 10% – dividend of
5% plus 5% growth. And Investment C has a yield of 10% –
dividend of 15% plus a negative 5% growth. And while cap rate pointed
to Investment C as the preferred investment, the Gordon
growth model tells us something entirely different. It considers
these all to be equivalent investments once the concept of
yield is established. In the music world, The Cars went on
to produce seven albums and were inducted into the Rock Hall of Fame
in 2018. Meanwhile, in the business finance world,
Myron Gordon went on to write numerous papers and
textbooks as well as receive many accolades in both
academia and business. And, perhaps most importantly, both
of their work continues to influence their respective worlds
to this day. Talk about magical!

Alec J. Pacella, CCIM for March Properties Magazine

Financial Strategies

Life is funny sometimes, especially when considering the concept
of time. There are instances where five minutes seems
like five years but also instances where five years seems like five
minutes. I realized this when having a conversation recently
with several people about the numerous properties that have
fallen into the receivership/special servicing quagmire as a result
of issues with associated CMBS loans. But as the discussion
unfolded, I was greeted with blank stares and realized that the
great financial crises that some of us lived through didn’t happen
a couple years ago but rather many years ago.

This month, I’m going to revisit the
basic structure of a CMBS loan, including
the good, the bad and the ugly. So, if
you need a refresher on this interesting
and dynamic sector, read on.

CMBS is an acronym for a commercial
mortgage-backed security. At its
heart, any mortgage can be considered
an investment and a CMBS loan is no
different. This sector was created by a
financial whiz kid by the name of Ethan
Penner way back in the early 1990s.
During those times, the mortgage market
was still feeling the effects of being
rocked by the savings and loan crises that
began a few years prior, and liquidity was
very tight. Penner, through his company
Capital Company of America-turned-
Nomura Capital, saw an opportunity
to help fill this void of liquidity with a
unique approach. A traditional mortgage
is provided by an investor, usually a bank
but also can be a pension fund, a life
insurance company, even a cash-strong
individual. In exchange for providing a
loan, the investor (the lender) receives
regular repayments from the borrower.
They also generally have a collateralized
interest in the underlying real estate so
in the event the borrower defaults, the
investor is afforded a path of protection.

A CMBS loan has several similarities
but also some key differences. The
biggest difference is the basic structure.
A traditional loan usually has
one borrower, one property and one
investor. But a CMBS loan is part of
a much larger CMBS issuance, which
has many borrowers, many properties
and many investors. The key is a process
called “securitization,” which was
developed by Penner.

Here is a simplistic example of how
this process works. Jim is buying a shopping
center in Cleveland, Mary is buying
an office building in Columbus and
Frank is buying an industrial building
in Cincinnati. Instead of each getting a
separate loan for their specific property,
each is getting a CMBS loan, which
groups all three of these properties into
one big pool, called an issuance. And
instead of having one primary investor
that provides the money for these
three loans, it is sold off to individual
bond holders through the securitization
process. Suppose Jim needs a $5 million
loan, Mary needs a $15 million
loan and Frank needs a $10 million
loan to buy their individual
properties. Penner steps in, takes
that $30 million pool to the public
debt market and slices it into bands,
called “tranches,” which are securities
that are differentiated by risk
and reward.

These securities operate just like
a bond, with a pay rate based on
the associated credit of that specific
security over a defined period of time.
The highest rated tranche, the “AAA”
securities, have the lowest yield but also
have the lowest risk. More on that risk
thing in a minute but let’s assume $2
million of these securities are sold in
the public markets with a pay rate of
3.5%. The next highest tranche, the
“AA” securities, have a little higher
yield as they have a little more risk
and let’s assume another $3 million of
these are sold at a pay rate of 3.75%.
The overall $30 million securitization
issues continue to be divided up in
this manner, with each tranche having
slightly higher risk accompanied with
slightly higher yield; “A” securities, then
“BBB,” then “BBB-,” then “BB,” then
“B” and finally “Unrated,” which say
tops out at 10%.

Once the $30 million of total securities
are sold, that is the money used to
fund the $30 million of debt needed
by Jim, Mary and Frank. Finally, let’s
assume their individual loans have an
associated interest rate of 6.5%.

Frank, Mary and Jim start to make
their loan repayments each month.
These repayments do not go back to pay
the individual mortgages but rather to
fund all of the yields for the individual
associated security tranches. And here
is where the risk steps in. The first in
line to get paid are, you guessed it, the
holders of the AAA securities. The next
in line are the AA securities, followed
by A, BBB, BBB-, etc. And the last in
line are the BB, B and finally Unrated
securities. You may be thinking “where
is the risk?” So long as Frank, Mary and
Jim make their scheduled payments, life
is good. But suppose that Jim loses his
anchor tenant due to bankruptcy. The
corresponding loss in rent causes him
to not have enough income to pay the
mortgage and his loan becomes delinquent.
Frank and Mary are still making
their loan payment so the securities at
the front of the line, the AAA, AA, A,
etc., will be safe. But by the time we get
to the securities near the end, the BB, B
and Unrated, the money runs out.

The losses associated with Jim’s
delinquency are recognized the exact
opposite of the payments; losses are first
charged to the lowest rated securities,
the Unrated, then the next lowest, the
B securities, etc.

And things get even more sticky if
Jim’s delinquency turns into a default
on his $5 million loan. A CMBS loan
carries no personal recourse back to the
borrower. Since there is not one lender
holding Jim’s mortgage but rather a series
of bondholders owning various securities
across the entire CMBS issuance, a
receiver and special servicer will step in.

Last year, total CMBS volume topped $125
billion, which is the highest since 2006.
Those of us who were around back then,
especially in the years that followed, well
remember what the commercial real estate
sector was like when things went south.

The receiver is responsible for maintaining
the condition and operations of the asset
while the special servicer manages
and resolves distressed or defaulted
loans within a CMBS issuance. My
example is simplistic. An actual CMBS
issuance will include 75, 100, even 150
individual properties and total hundreds
of millions of dollars.

Last year, total CMBS volume
topped $125 billion, which is the highest
since 2006. Those of us who were
around back then, especially in the
years that followed, well remember
what the commercial real estate sector
was like when things went south. The
industry learned a lot of tough lessons
and there have been numerous
safeguards subsequently instituted.
But here we are again.

I recently saw an article about Ethan Penner, who is running for
governor of California under an independent
platform. Maybe he’s heard this song before too.

Smart Use of Fiscal Planning & Action

The holiday season is always marked with an endless supply of goodies.
While my favorite used to be the traditional box of mixed chocolates,
over the last few years, a new favorite has emerged.
I call it the “chocolate splatter” – a plate of traditional savory snacks,
such as pretzels, popcorn, potato chips and nuts,
with chocolate randomly drizzled over everything.

As I was working on grazing through this heap of goodness last month, I
noticed that the salt would shine through on certain items, such as the pretzels and
chips, while the sweetness would shine through on other items, such as the nuts
and popcorn. And looking back on 2025, Northeast Ohio’s commercial real estate
market had a lot of similarities to that platter, with some sectors being a little
saltier while others being a little sweeter. To see how things tasted, read on.

Overall economy: a little salty
Last year’s economic performance was a mixed bag. After surging a couple years ago,
inflation was again largely held in check, ending the year around 2.5%.
Interest rates were slowly eased, aided by three well-telegraphed rate cuts of 0.25%
each by the Federal Reserve.
Economic growth, as measured by gross domestic product, was moderate
but uneven, with a mid-year burst after a slow start and surprisingly strong finish
to the year. The resulting annualized growth rate is estimated to be just over
4%, with actual results hampered due to the government shutdown.
But one of the most troubling areas was unemployment. After several consecutive
years of expansion and resiliency, the labor market clearly softened last year, with overall
unemployment climbing to just under 5%.
Job growth slowed and federal employment cuts increased, all creating an increasingly
uneasy environment as the year progressed.

Industrial: moderately sweet
Sure, overall vacancy ticked up to approximately 4.5% and leasing velocity
slowed a bit to just over 2 million square feet of positive net absorption. But this
sector remained strong, as underscored by a couple of significant lease transactions.
On the east side, Piping Rock Health Products leased just over 400,000 square
feet at the new Turnpike Commerce Center in Shalersville, which is the
largest lease deal in the past five years.
And on the west side, B’laster Products leased just over 300,000 square feet
at Westfield Commerce Park in Lodi. Sale activity was also brisk,
highlighted by the portfolio sale from Dalfen Industrial to Plymouth
Industrial REIT that included 10 properties in Northeast Ohio. The
buildings collectively encompass approximately 1 million square feet.
Meanwhile, construction activity slowed, with very little speculative
projects in the development pipeline.
The largest local project is a 750,000-square-foot facility being
built for the HC Companies in Middlefield and there was just under
2 million square feet of total industrial product in the development pipeline at
the end of last year.

Retail: a little sweet
Despite the headwinds associated with ever-growing internet sales,
an unsettled job market and higher interest rates, retail sales continued
to be resilient, ending the year with a growth rate just under 2%. Locally,
the headlines were led by two blockbuster sales. Westgate Shopping Center,
a 311,000-square-foot retail center in Fairview Park, sold for just under $52
million last July. This location was formerly occupied by Westgate Mall
before being redeveloped into an open-air center almost 20 years ago.
A month later, Ridge Park Square, a 387,000-square-foot retail center in
Brooklyn, sold for $55 million. This property had been owned by the original
developer, Cleveland-based Zeisler Morgan Properties, since 1989.
On the tenant front, we said goodbye to familiar names, including Joann
Fabrics and Rite Aid, both ending long runs as a result of bankruptcy.

Economic growth, as measured by gross
domestic product, was moderate but
uneven [in 2025], with a mid-year burst
after a slow start and surprisingly strong
finish to the year. The resulting annualized
growth rate is estimated to be just over
4%, with actual results hampered due to
the government shutdown.

But we also said hello to a few fresh faces, with Columbus-based Bibibop continuing to
expand its presence in the northern part of the state, the opening of three
new Meijer supercenters across Northern Ohio and a resurgence of Qdoba, who
added several new locations.

Office: mostly salty
While the COVID crisis shook the world over half a decade ago, the
office sector continued to struggle in its aftermath. The overall vacancy rate
remained persistently in the low- to mid-20% range, as tenants attempt
to balance their space needs with the evolving workforce dynamics that typically
resulted in tenants needing less space versus more. And, more importantly,
rent growth remains flat. As a result, foreclosure activity had a noticeable
increase last year. In Cleveland’s central business district, Northpoint
Tower was the latest and most significant office complex to fall into
receivership, while in the suburbs, the three-property Landerbrook Corporate
Center office park, Metropolitan Plaza and 3800 Embassy Parkway all found
themselves in the same situation.
And while there have been a few sales, the results have spoken volumes
about investor sentiment in this sector. In downtown Cleveland, 1100 Superior
Ave. was finally sold almost three years after entering receivership. The
sale price was $8.1 million or $14 per square foot (psf). Meanwhile, in downtown
Akron, 76 South Main Street was sold for $900,000 or $2.50 psf.
However, not all the news in the office sector was bad. Jones Day,
one of the largest law firms in the United States, reinforced its commitment
to both Cleveland and the aforementioned Northpointe Tower by extending its lease, which
totals approximately 350,000 square feet, at this complex. Other significant
renewals included Roetzel & Andress and Perez Morris.

I am more optimistic overall than many as we head into the new year.
Although there may be some bumps and bruises in the overall economy, I
don’t think it will be enough to derail the momentum in the industrial sector.
Retail will continue to sort things out, but we are a nation that loves to shop. I
expect the biggest newsmaker to be the office sector, as tenants actually look to
start taking more space, not less, which will lead to a strong year. But, as always,
we’ll just have to wait and see if the commercial real estate “chocolate splatter” is
sweeter or saltier in 2026.

Alec J. Pacella, CCIM for January 2026 Properties Magazine

Six of One

The origin of phrases has always intrigued me. One of the earliest phrases that I can remember comes from my mom, who frequently would say “six of one, half dozen of the other.” It took me
a while to realize that this meant that there was really no difference between two alternatives.

This month, we are going to dig into two hot topics that have recently emerged as a result of the passage of the One Big Beautiful Bill Act (OBBBA) earlier in the year – bonus depreciation
and Section 179 expenses. While it may seem like there is no difference between the two, simple concepts often get very complex when we enter the tax world. To have a deeper understanding of these forms of depreciation, read on.
Before we jump into a complicated discussion,let’s start with a brief review of what the concept of depreciation means. Most of us are familiar with this concept in the context of a car. Suppose I buy a brand-new Honda Accord for $40,000. Six months later, that car will be worth something less than $40,000. And over the following months and years, this loss in value will gradually continue. This isn’t because I’m a bad driver or that I don’t take care of the car. Rather, the car is subject to wear and tear. And suppose five years later, a completely redesigned Honda Accord is introduced. Now, in addition to wear and tear, there is also a loss of value as a result of economic obsolescence – my 2025 Accord barge is no longer state-of-the-art in comparison to this rocket ship 2030 Accord. This is
also how the IRS views depreciation of real estate. The improvements immediately
starts to lose value once the asset is placed into service as a result of wear and tear as well as economic obsolescence. As a result, the IRS allows the owner of that real estate to offset the
income it produces each year against the amount of loss they believe that asset
has incurred. This is a true shelter, as the amount of depreciation really isn’t costing the owner anything. But the income that it generates each year will be reduced by this non-cash expense
come tax time.

Bonus depreciation and Section 179 expenses allow the owner to recognize even greater amounts of depreciation by recognizing certain items not gradually over their useful life but rather at 100%
in the year they are placed into service. The end result of either concept is similar, as the owner can receive a shelter that is dramatically greater if using either of these concepts. But there are
several nuances to be aware of that are specific to each.
Section 179 allows the taxpayer to deduct the cost of certain types of assets as an expense in that tax year. Suppose that I upgrade my building by installing a new roof. Traditionally, this expense
would be capitalized (not recognized as an expense for that particular year) and the cost would be spread over its useful life – 39 years if considered non-residential and 27.5 years if considered
residential. However, this type of improvement would likely fall under Section 179, which would allow me to expense the entire cost in the tax year it was placed into service. This
concept has been applicable for real property since 2010, but the OBBBA increased the maximum annual expense limit from $1.22 million to $2.5 million.
Bonus depreciation allows the taxpayer to deduct a percentage of the cost for qualifying business property. It has been around since 2002 and, under the Affordable Care Act of 2017, was following
a schedule that would have seen 2026 as the final year, with 20% of the asset’s cost subject to being immediately recognized. The OBBBA restored this to the full 100% deduction starting in
the 2025 tax year. Suppose that I bought $500,000 worth of office furniture this year. I would be able to recognize the full amount of depreciation for this tax year. And that 100% is not just for 2025 but rather indefinitely.
You may be thinking that bonus depreciation and Section 179 expenses are six of one, half a dozen of the other. And while both have a similar impact of increasing the amount of shelter for the
taxpayer, there are some key differences, as follows.
Bonus depreciation can reduce your taxable income below zero, but Section 179 cannot. If you want to reduce taxable income to something less than zero, which results in a taxable loss, bonus
depreciation is your only option.

Bonus depreciation can reduce your taxable income below zero, but Section 179 cannot. If you want to reduce taxable income to something less than zero, which results in a taxable loss,
bonus depreciation is your only option.

Section 179 expenses can be more specific, with the taxpayer indicating application to specific assets. Bonus depreciation is much broader and applies to the entire asset classes and not just specific improvements. Also, bonus depreciation is automatically applied to eligible assets. If you do not want it applied, you must opt out and, again, it’s all or nothing as the taxpayer cannot
pick and choose between which specific assets they want to be included and which they want to be excluded. Bonus depreciation can include new as well as used tangible property, so long as its new to the business. It can also now be applied to a new classification of property called a Qualified Production Property (QPP). For a property to qualify as QPP, it has to be nonresidential
located in the U.S.; construction must have begun after January 19, 2025 and before 2029; the original use of the property must begin with the taxpayer; the taxpayer must make the election
to treat this property as QPP; and the property must be used by the taxpayer as an integral part of a qualified production activity, such as manufacturing, production or refining. Portions that are
occupied by office, sales, research, etc. are excluded.
My mom’s favorite phrase is generally credited to a British naval officer, Ralph Clark. Upon crashing and sinking his ship in 1790, he wrote the famous phrase in his journal, comparing the actions of his ship’s sailors to be no better but no worse than the actions of convicts. While the comparison of bonus depreciation and Section 179 expenses is much less dramatic, having a good understanding of the benefits of each can result in much smoother sailing come tax time.

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Apples and Oranges

Last month, we started the first of a two-part conversation on leases.
In case you missed the September issue (and shame on you if you
did), the three primary lease structures of absolute net, absolute gross
and hybrid leases were defined. We also underscored how these various
structures help to balance monetary risks associated with various
expense components, such as real estate taxes, tenant improvements,
repairs, etc.

This month, we will move into a more quantitative phase as the discussion
focuses on building an economic comparison between two or more
leases that are not structured the same way. Sharpen up your pencils, because
there will be a little work involved along the way. Remember, we are back
in school!

Let’s assume that your company, XYZ Inc., has a lease expiring and is exploring
some options. You narrow the search to three alternatives. They can stay
in their current space, the Courtyard, which is a hybrid lease for 12,000 square
feet. Most of the expenses are included in the base rent, which includes a
base year stop but the tenant pays for electricity and janitorial directly.
The second alternative is moving to an 11,500-square-foot unit at the Lakeside.
That lease is also a hybrid lease, with all operating expenses included in base
rent and also has a base year stop. The third alternative, the Parkview, has a
14,000-square-foot unit that is also a hybrid lease, with tenant paying base
rent plus all of their real estate taxes, common area maintenance (CAM) and
insurance plus electric and janitorial.

There is some additional information to be assumed for these scenarios.
At Courtyard and Lakeside, operating expenses are assumed to increase by
4% per year. At Parkview, property taxes are expected to increase by 2%
per year. Common area maintenance (CAM), insurance, janitorial and electricity at all of the buildings are expected to increase by 4% per year. All of the proposals are for a five-year
term and the rental rates proposed are all flat for this time period. Finally,
your company’s cost of capital is 9%. Table 1 lays out the specific terms for
the three locations.

As you can see, the associated economics are all over the board, which
makes it difficult to easily compare them. In order to make an accurate
economic comparison, we need to use a standardized matrix to estimate the
bottom-line cost not just for the first year of the lease but for the entire fiveyear
term for each of the alternatives. Your company will not just be paying
base rent each year but also potentially paying for things like property taxes,
CAM, insurance, tenant improvement (TI) and moving costs. On the flip
side, if there is an expense stop in place, the landlord will be paying for
operating expenses up to the indicated base stop amount. The landlord may
also be paying for electricity, janitorial and a portion of the TI cost. The end
goal is to arrive at a total cost of occupancy for each year of the lease term
for each alternative. There are plenty of standardized forms floating around
out there – or with a little bit of work, you can easily build your own. If you
brought along that sharpened pencil (or clean spreadsheet), give it a whirl. In
doing the math, Table 2 shows how the three alternatives pencil out.

While modeling out the cash flows for each is helpful, there are a handful
of bottom-line measures that really bring this type of analysis home. Total
effective rent is the total aggregate rent that the tenant will pay over the duration
of the lease. Total aggregate rate simply divides the total aggregate rent
by the square footage of the premises. Average annual effective rent is the
total aggregate rent divided by the lease term while average annual effective rate
again divides this by the square footage of the premises. And finally, discounted
effective rate introduces a time value of money element by discounting the
future cash flows back to the present at a discount rate, which is typically the
tenant’s cost of capital. You can again put that pencil or spreadsheet to work
but Table 3 shows the results.

While the process of comparing opportunities associated with different
lease structures is complex and labor-intensive, the end results can be
well worth the effort. Each of these measures provides a different look at
the cost to occupy but when taken collectively, they can provide great
insight in helping to turn everything to apples – and maybe even highlight
a lemon or two!

Alec J. Pacella, CCIM for October 2025 Properties Magazine

Apples to Apples

September traditionally marks a return to the classroom after several months of fun in the sun. And in this column, the September issue traditionally marks a return to more technical topics after a
few months of the Terminator, Tom Cruise and baseball trading cards. We will start our return to the classroom by defining the word “jargon.” According to Merriam-Webster, this word means special terms or expressions that are used in a particular profession or group and are difficult for others to understand. Commercial real estate can be a poster child for this definition and one of the best examples is the jargon used to describe the various types of lease structures.

This month, I’m going to dive straight into this topic and provide a baseline set of definitions. And next month, we’ll continue the discussion by providing a framework to use when comparing lease
economics. If you are ready to go back to school, shine up that apple and read on!
In its most basic form, a lease is simply an agreement that formalizes the possession of property for payment. While much of the agreement is (somewhat) standard and (moderately) easy
to understand, things can start to get unhinged when it comes to the responsibility in paying various expenses associated with the premises. In an attempt to clarify and distinguish the
subtleties associated with various structures, all sorts of monikers have become common. These include terms such as net, triple net, gross, modified gross, double net, full-service gross and a host
of others. The first order of business is to understand that there are truly only three basic lease structures. The first is an absolute net lease. The usual knee-jerk reaction is to use the moniker
“triple net” to describe it and cite a large warehouse occupied by a single tenant or a free-standing fast-food restaurant as examples. And that would be incorrect. In an absolute net lease, not only are all of the operating expenses the responsibility of the tenant (including the three
“nets” of real estate taxes, common area maintenance and insurance) but so are items such as large-scale repair, replacement, refurbishment, rebuilding in the event of destruction, etc. The
best real-world example of this type of lease structure is a ground lease, where all of the responsibilities to occupy and maintain the premises fall on the tenant. The only responsibility that
the landlord has is to safely make it out to the mailbox each month to pick up the ground rent check. Everything else associated with the property is the responsibility of the tenant.

The structure of a lease agreement is primarily concerned with balancing risks. At the extremes, an absolute net structure places all of the operational expense risk on the tenant while an
absolute gross structure places all of the operational expense risk on the landlord.

At the complete opposite extreme is the second basic lease structure, called an absolute gross lease. And again, the usual knee-jerk reaction is to call this a “full-service gross” lease and cite a downtown or suburban multi-tenant office building as an example. And once again, that would be incorrect. In an absolute gross lease, all of the expenses are the responsibility of the landlord, including subtleties such as in-suite electric consumption, in-suite cleaning, future increases in operating expenses, etc. The tenant only makes one scheduled payment each month and
all of the monetary responsibilities are on the landlord. If anyone has ever had the privilege of completing a lease with the United States government, via the U.S. General Services Administration
(or GSA), you know the true meaning of an absolute gross lease. The lease, which resembles a small novel, typically outlines anything and everything that could ever occur during the course of the lease, as well as stipulate the exact rent obligation to be paid for each and every month of the entire term of the lease. The U.S. government has no problem paying what would ordinarily seem to
be an over-market rent but they will not pay a penny more for any month for the duration of the lease.

The third basic lease structure, called a hybrid lease, covers any of the types of leases that fall in between these two extremes, including all of those monikers typically thrown around with
reckless abandon that I mentioned earlier. Relying on a broad-based moniker to describe a specific lease agreement is a recipe for disaster because even with some of the well-used terms there can
be exceptions. For example, a “triple net” lease is assumed to have the tenant be monetarily responsible for real estate taxes, common area maintenance and insurance. But the specific lease agreement may contain additional language that places a monetary limit on certain
items. For example, the tenant is responsible for repairs and maintenance but limited to $2,000 annually for any maintenance and repairs to the HVAC units associated with the leased premises.
The structure of a lease agreement is primarily concerned with balancing risks.

At the extremes, an absolute net structure places all of the operational expense risk on the tenant while an absolute gross structure places all of the operational expense risk on the landlord. With a
hybrid structure, the risk can be balanced between the two parties, which typically
raises two immediate questions. The first question is usually: “How do I know which party is responsible for what?” And the answer is to always read the lease agreement. A well-drafted lease will clearly state who is responsible for what, when and how. A very common second
question is: “Why are there differences in the structure of a lease, sometimes even within the same building?” The “golden rule” is always my response – the party that has the gold makes the rules. If a
landlord has the best building in the best location and the tenant really wants to be there, then the landlord may be able to shift more of the risk to the tenant in the lease agreement. But if the tenant is considered to be creditworthy, will drive traffic or otherwise raise the perceived quality of the building, then the tenant may be able to shift more of the risk to the landlord in the lease agreement.

Understanding exactly what the lease agreement establishes will help cut through the jargon associated with generic terminology and focus on which party is responsible for what specific items. It will also help to form the basis of an accurate economic comparison between different
lease proposals. But the end-of-the-day bell just rang so that will have to wait until class resumes next month.

Alec Pacella, CCIM for September 2025 Properties Magazine

Cleveland Furniture Bank’s Grand Opening

We were honored to attend Cleveland Furniture Bank’s Grand Opening celebration yesterday at their new home at 6282 Pearl Rd, Parma Heights!

Congratulations to our very own Alec Pacella, CCIM, and Mclain O’Donnell, who represented CFB in the transaction as well as Jacob Delk of Anchor Investments, who represented the ownership. Executive Director Tom Gaghan and General Manager Kelly Kortvejesi oversaw the transition to the new location.

This successful lease earned Alec and Mclain their CoStar Powerbroker Quarterly Deals Winner award for top retail leases in Q2!

Attendees celebrated the official ribbon cutting with Tom, Parma Heights Mayor Marie Gallo, and Field Representative Chase Conklin (on behalf of Congressman Max Miller).

We’re proud to have been part of this exciting milestone for Cleveland Furniture Bank and look forward to seeing their continued success in their new home.

A couple of years ago, in this very column, I wrote an article on a new-fangled phenomenon known as ChatGPT. At the time, not many people had heard of it and even fewer were using it. That
article discussed how it worked, along with potential uses, all while using the 1984 hit movie “The Terminator” as a backdrop. A lot has certainly changed since that issue was published and artificial intelligence (AI) is transforming the commercial real estate industry at an accelerating pace. From predictive analytics and virtual property tours to lease automation and intelligent financial modeling, AI is now embedded in every phase of the sector.

This month, I’m going to provide an update and it should be no surprise that I’m again going into the wayback machine, specifically to 1991, and this time dusting off the hit sequel “Terminator 2:
Judgement Day” as my new backdrop. To see how the original Terminator 800 compares
to the more modern Terminator 1000, read on!
While ChatGPT is generally recognized as the catalyst for the current AI explosion, a whole host of new services have burst on the scene, with a dizzying amount of applications. In an attempt to
narrow the field, I’m going to focus on four key areas in commercial real estate
– general applications; property management; financial modeling; and photo and video generation.

General Applications

AI is improving the way CRE professionals approach market analysis, site selection and deal sourcing. One of the most powerful uses of AI in this space is predictive analytics. Machine-learning
algorithms will use historical data, such as transaction history, rental rates, demographics and market statistics, to identify market trends and forecast future property values or demand in specific regions. For example, established platforms like Reonomy, Cherre and Skyline are using massive datasets combined with machine learning to uncover property insights that otherwise would be very difficult to see. AI models can help to predict potential off-market deals, flag undervalued assets and even recommend investment opportunities based on investor and risk profiles.
Natural language processing (NLP) is also becoming more prominent, helping CRE firms extract insights from large amounts of unstructured data like leases, appraisals, emails and zoning
documents. AI chatbots, powered by large language models (LLMs), are now assisting with client interactions and automating customer service tasks on brokerage websites. Just like the original
Terminator, called a T-800, ChatGTP is still a capable and formidable platform. And just like the advent of the advanced Terminator, called a T-1000, the field is now a lot more crowded with competing, more polished offerings such as Microsoft’s Co-Pilot, Claude, Google’s Gemini, Meta’s Llama and xAI’s Grok.

Property Management

One of the things that distinguished the T-1000 from the T-800 was its ability to do superhuman things. From running at highway speeds to having the strength of 1,000 men, the T-1000 did everything better, faster and stronger despite being smaller and more slender. Similarly, AI
is having a major impact on property management, particularly through automation
and optimization. Smart building technologies, which integrate AI with Internet of Things (IoT) sensors, enable real-time monitoring and control of HVAC systems, lighting, energy usage and security. For instance, AI algorithms can analyze historical utility consumption and incorporate weather forecasts to optimize energy usage, reducing costs and carbon footprints. Companies like
BrainBox AI and GridPoint are using AI to automate energy systems in commercial buildings, significantly improving operational efficiency.

Maintenance is another area benefiting from AI. Predictive maintenance models use past performance and maintenance history to model equipment performance and anticipate failures before they occur. This reduces unplanned downtime and extends the lifespan
of critical items, such as elevators, boilers and HVAC units. Tenant experience platforms are also incorporating AI to enhance satisfaction. Virtual concierges, like those offered by companies such as Lane or Equiem, use AI to manage tenant requests, provide building updates and maintain schedules.

Financial Modeling & Investment Analysis

While the T-800 was capable of reasoning, the T-1000 could do it at a higher level. For example, it took the persona of a police officer because it understood that was a trusted figure. Financial modeling is a subject that is near and dear to my heart. Traditionally time-intensive and
prone to human error, AI is streamlining and enhancing these processes. Tools
powered by generative AI can rapidly produce pro formas, discounted cash flow (DCF) analyses and scenario modeling by ingesting raw data and user prompts. This allows the user to think at a much
higher level and not get lost in the “analysis paralysis.” For example, startups like Leverton and Datch are using AI to automatically extract key financial terms from leases, such as rent escalations,
termination clauses and expense reimbursements. Once identified, these terms are then integrated directly into financial models, increasing both speed and accuracy.

AI-powered underwriting platforms, such as Enodo and Rabbet, automate much of the data entry and validation work required for deal evaluation. They analyze comps, market rents and construction costs, allowing investors and lenders to make faster and more informed decisions. Generative AI is now even capable of adjusting entire financial models based on changes to assumptions, such as inflation rates or occupancy levels, and can explain the financial implications
in plain language – offering an unprecedented level of transparency and interpretability.

Photo and Video Generation

Visual presentation is crucial in CRE marketing, and AI is opening new frontiers
in photo and video generation…. AI can now generate photo-realistic property images
from architectural drawings or sketches. This is especially useful for projects in early
development stages, where physical photos are not yet available.

One of the coolest but also most terrifying difference was the T-1000’s ability to morph itself into all sorts of things, including a security guard, a police officer and even part of the floor. Visual presentation is crucial in CRE marketing, and AI is opening new frontiers in photo and
video generation. Generative AI models like OpenAI’s DALL·E, Midjourney and Runway allow users to produce high quality images, virtual renderings and promotional videos, all without ever
leaving their desk. AI can now generate photo-realistic property images from architectural drawings or sketches. This is especially useful for projects in early development stages, where physical photos are not yet available. Interior renderings, landscaping simulations and even animated
fly-throughs can be created in hours, not weeks and changed in minutes, not hours.

AI-based video tools such as Synthesia or Pictory allow owners and agents to create narrated property walkthroughs using virtual avatars or voiceovers. These videos can be personalized for different audiences, localized for different markets and updated dynamically as project
details change. Moreover, image enhancement tools powered by AI can improve existing photos by adjusting lighting, removing clutter or even staging interiors – giving agents and developers a powerful edge in digital marketing campaigns.

Although the T-1000 was smarter, faster, stronger and more cunning than the T-800, both ended up meeting their demise at the hands of the humans. Similarly, while there has been a lot of
speculation and some trepidation about the future of AI, not only is it here to stay but it will continue to be more integrated into our professional as well as personal lives.

I was at a conference recently and one of the speakers summed it up best. He said that AI probably isn’t going to take your job but the person that knows how to use it just might.

Alec Pacella, CCIM for August 2020 Properties Magazine

Risky Business

I’m sure everyone has heard the old adage, “with great risk comes greater reward.” In case you missed last month’s column (and shame on you if you did!), we had a nice discussion on the concept
of diversification as a way to manage potential risk. This month, we are digging a little bit deeper to better understand and categorizing causes of risk, particularly for a real estate investor.

The importance of traditional sources and categories of risk will vary with the location and circumstances of a particular investment in real estate. For example, if foreign buyers are the
dominant investors of local real estate, then the exchange rate risk may be important, while in most local markets, such risk may be trivial. Land use regulations, tax laws and interest rates
may be more or less important for a particular property at various points in time. For a residential mortgage investor, prepayment risk may be important, but it is less likely to be an issue for
direct real estate.
The astute analyst must be able to sift through and sort out the trivial issues and focus on those that matter most. The following categories of risk are those that most often apply to real estate.
Business
The business of real estate is renting space to users. The demand for space depends on myriad international, national, regional and local economic conditions. Uncertainty about how economic
conditions will change, such as oil prices, interest rates or inflation rates, will alter the perceived risk of real estate.
Liquidity
Liquidity is the ease with which an asset can be converted to cash without any price discount or loss of principal. Real estate is considered to have low liquidity (high-liquidity risk) because of
the time it takes to sell a property at its current value. Many properties require the buyer to do a lot of due diligence on the property, and they are not likely to agree to a quick sale without a significant
negotiation regarding the price.
Marketability
Marketability is the ease with which an asset can be converted to cash independent
of price. If the market is active for an asset, it may be easy to sell, but there is no guarantee that the seller will get the price they want. With no active market for a property, such properties will
not be liquid, but an active market may be available with low liquidity because sellers
must sell at a discount to sell quickly.
Leverage
Leverage is the use of borrowed funds to finance some of the purchase price of an investment. The ratio of borrowed funds to total purchase price is known as the loan-to-value (LTV) ratio. Higher
LTV ratios mean greater amounts of leverage. Real estate transactions can be more highly leveraged than other types of investments, but increasing leverage also increases risk because the lender has
the first claim on the cash flow and on the value of the property if the investor defaults on the loan. A small change in the NOI can result in a relatively large change in the amount of cash flow to
the investor after making the mortgage payment. For example, if a property has $100,000 in NOI and a mortgage payment of $80,000, the cash flow is $20,000. If the NOI drops 10% to $90,000, the
cash flow drops by 50% to $10,000. One of the reasons investors use leverage is to increase their expected return on equity, but this also increases their risk.
Capital market
As said, real estate must compete with other assets for capital. The willingness of investors to invest in real estate depends on the availability of debt capital and the cost of that capital, as well
as the return on other investments. A shortage of debt capital and high interest rates can reduce the demand for real estate and lower prices significantly. This is one of the risks of investing in
commercial real estate.
Management
Management is the cost of monitoring an investment. Investment management can be categorized into two levels: asset management and property management. Asset management
involves monitoring the investment’s financial performance and making changes as needed. Property management is exclusive to real estate investments. It involves the overall
day-to-day operation of the property and the physical maintenance of the buildings. Management risk stems from how good the property and asset managers are at making the right decisions regarding the operation of the property, such as negotiating leases, maintaining
the property, marketing the property, doing renovations when necessary, etc.

The biggest risk often is one that was unknown as a risk at the time a property was purchased.

Tax impact
Federal income tax laws affect an investment’s income, profits and losses. This includes ordinary income tax during the time a property is held and capital gain taxes when the property is
sold. Risk results from unexpected tax law changes, such as an increase in the
capital gains tax rate or a change in the allowed depreciable life of the asset.
Environmental
Real estate values can be impacted by environmental conditions, including contaminants that may have been caused by a prior owner or an adjacent property owner. This can significantly
reduce the value and the costs of dealing with the problem.

Political + legal risks
A regulatory body can influence operations costs, permits, property size, location on a site, zoning, property taxes, economic incentives, design, the supply of competitive property, or access to critical
resources like water and sewer. These may be local, regional, state, national or international in nature. Exchange rate risks could be considered a political risk or an economic risk depending on how much influence politics have on decisions affecting exchange rates.
As an example of one of these many political risks, consider the ADA (Americans with Disabilities Act, effective in 1992) provisions requiring an owner to accommodate disabled persons
where public access is required. If not anticipated, such a cost will lower returns but add little in revenue. This is why all legislation must be monitored because it is within a political environment that reasonable costs for such accommodations are defined. Other recent regulations
include radon monitoring, asbestos removal and other environmental concerns,
yet most critical land use controls tend to be approvals and variances that fall under the auspices of zoning and building codes, special improvement districts, and TIF (tax increment financing)
possibilities. Research into these controls is as important as market research for demand trends.
Other risks
Many other risks could be identified, such as unobserved physical defects in the property, natural disasters such as earthquakes and hurricanes, and acts of terrorism. The biggest risk often is one
that was unknown as a risk at the time a property was purchased. Risks that can be identified can be planned for to some extent, perhaps with insurance or by diversification and considered in
the price of the investment. However, unknown risks are not priced and can be particularly devastating to investors.
Real estate can indeed be risky business. By having an accurate and thorough understanding of the specific risks associated with a particular investment, an investor is much less likely to
get caught with their pants down. And if they do, they can always turn on some
Bob Seger, put on their Ray-Ban sunglasses and dance the night away!

Alec J. Pacella, CCIM for July 2025 Properties Magazine

WaveMax Laundry opens its first Ohio location in Maple Heights Area

WaveMax Laundry celebrated the grand opening of its first Ohio franchise on June 17 at Southgate USA in Maple Heights. The event was a resounding success, involving residents and city officials, raffles, free food from Barrio, and $20 laundry cards for attendees.

“We are proud of being able to bring WaveMax Laundry to Maple Heights, and, in particular, to Southgate USA – a location perfectly suited for the community’s laundry needs. And we are grateful to the community for their patronage; and to Mayor Blackwell and her team for their support, as well.” said Brian and Angela Simmons, co-owner of the new WaveMax franchise. “We also appreciate our real estate brokers, Ron Midcap at NAI Pleasant Valley and Gary Litvin at NAI Elliott, for their unwavering guidance throughout the process.”

Ronald Midcap, Senior Vice President of NAI Pleasant Valley and Gary Litvin, Director of NAI Elliott in Portland, OR jointly played fundamental roles in bringing WaveMax Laundry to Maple Heights, representing Brian and Angela Simmons.  After more than a year of dedicated effort, they successfully secured the 2,955 SF retail space at 20980 Libby Road.

“Working with Brian and Angela Simmons has been a pleasure. We are proud to be a part of this revolutionary Laundromat format utilizing state-of-the art machines to reduce water and energy consumption creating a lower carbon footprint,” said Ronald Midcap. “WaveMax CEO, Mike Roberts, visited this site when we were prospecting and was excited to get this location for a WaveMax franchise. Maple Heights and Cuyahoga East Chamber of Commerce worked with Brian and Angela to make this the first WaveMax location in OH and we couldn’t have asked for more.”

The Maple Heights WaveMax Laundry is a family-owned laundromat chain offering state-of-the-art, self-serve washing equipment. Known for its commitment to cleanliness, convenience, and customer service, WaveMax aims to redefine the laundry experience for communities across the nation with its range of amenities designed to enhance the customer experience, including free Wi-Fi, security cameras, full-time attendants, text notification on laundry status, and omni UV sanitization. For more information about WaveMax Laundry and its services, visit www.wavemaxlaundry.com/maple-heights-oh/ or contact (216) 392-9979.

Beauty Only Skin Deep

A couple of months ago, in a column called “Lipstick on a Pig” (Properties, April 2024), we discussed several specific items related to due diligence when considering a real estate acquisition. And White each of the items that were identified in that column can be impactful, all are part of a much more comprehensive process.

This month, we are going to dis- cuss how the use of a strategic analysis model brings together a host of factors in helping an investor make a sound and well-thought-out decision. As shown in Figure 1, at the center of this analysis is the investor – specifically their goals, critical objectives and investment alter- natives to help to make a “go/no go” decision. Around this center are four distinct types of analysis – market & competitive; financial; political & legal; and location & site.

Market & competitive analysis

The focus of this analysis is the market that the subject property services. Often defined as a trade area or area of influence, a thorough understanding is needed to ultimately be able to evaluate the property’s characteristics as it relates to the attributes of the market. This would include demographics, psychographics, primary employers, labor trends and sector-specific metrics, such as vacancy, absorption and market rental rates. It also includes a survey of properties that are immediately competitive to the subject property. The goal of this analysis is to understand how the fore- casted supply and demand relationship for the property type and location are expected to impact success.

Location & site anaylsis

The characteristics of the actual property and immediate location are examined in this analysis. A complete overview of the physical attributes of the property area are considered, such as size, construction type and condition, mechanicals, layout, parcel boundaries, building design and age of the original structure, as well as any major improvements and additions. Site characteristics are also examined, which could include visibility, grade and topography, traffic counts and patterns, and ingress/egress. The goal of this analysis is to understand if the existing (or proposed) design of the improvements, along with the attributes of the site and immediate location demand the maximum market income available.

Risk and reward can sometimes be difficult to quantify but an investor has to come to grips with each, as the return they expect to receive is commensurate with the risk they expect to incur.

Political & legal analysis

The impact of politics and municipal regulations are the focus of this analysis. Availability of economic incentives and tools, complexity associated with the development process and general posture associated with the business climate are all items that can be considered. Also included are items related to the local, regional and state government, such as zoning regulations, entitlement process, building codes and real property taxing structure. The goal of this analysis is to understand the political climate and municipal ramifications conducive to a successful project over the foreseeable future.

Financial analysis

The focus of this analysis is to understand the underlying profit or economic benefit associated with the property. Although this analysis can range from very simple to extremely complex, there are several underly- ing components that are necessary. These include historical, current and projected income and expenses for the property, anticipated costs associated with future improvements and terms associated with potential financing of the asset. The goal of this analysis is a projection of the financial picture to quantify the profit or return commen- surate with the risk.

The concept behind the strategic analysis model is that, while all of the individual analyses are independent, they need to be considered in making the overall “go/no go” investment decision by incorporating the impact that each analysis has on the others. For example, if the political & legal analysis discovers that the zoning code in the subject property’s market is very broad and the local municipality has a welcoming posture to new development, this can impact the market & competitive analysis by introducing future competitive properties. This can ultimately impact the future rent and vacancy assumptions that are used in the financial analysis. Nearly all investment decisions will revolve around a solid dose of financial analysis, and with good reason. This analysis illustrates the magnitude of the profit opportunity and we all know that old, familiar adage – with greater risk comes greater reward. Risk and reward can sometimes be difficult to quantify but an investor has to come to grips with each, as the return they expect to receive is commensurate with the risk they expect to incur. And herein lies the beauty of the strategic analysis model.

Lipstick is one way to enhance beauty but there are all sorts of others, such as eyeliner, rouge and mascara. Just as each of these beauty products not only have an individual impact but also can impact the others in forming a collective result, so do the components of the strategic analysis model. Each individual analysis can include a whole host of risks and, while its important to understand these on an individual level, it is critical to understand how these individual risks may impact the other components. Only then can the investor truly get a handle on the true risk associated with the investment. While it’s easy to simply wash away the makeup, it’s a lot more difficult to wash away an investment.

Alec J. Pacella, CCIM for Properties Magazine

Learning Games

As many of you know, one of my “hobbies” is teaching. Whether it’s presenting to a local real estate organization or teaching a CCIM class or holding an impromptu discussion with a couple agents in the office, these types of activities not only allow me to help others grow, but I get to see different parts of the country, meet different people and help keep my skills sharp. And a fringe benefit is having access to the latest delivery techniques and instructional design of content.

There are many different theories related to how we learn and one that has gained a lot of traction recently, especially with the dramatic rise in online learning and presentations, was developed by Howard Gardner. The central part of Gardner’s theory expands the definition of intelligence by identifying eight distinct types of learners.

Gardner believes that everyone has elements of all eight of these types in some combination but one or more will be dominant and shape the way each of us process thoughts, relate to one another and, most important, learn. As a result, interacting and explaining something to others can be more effective if a variety of approaches are used based on the characteristics of these eight types of intelligence.

Musical Intelligence

This type of learner thinks in terms of music by using rhythms and patterns to provide a basis of understanding. Examples of this style of learning are the common cadence when spelling the word “Mississippi” or the familiar song we use to remember how many days are in each month. Professions that are strong in this sector tend to be composers, musicians and conductors. Incorporating things impactful to this style of learner can be as simple as using introductory music to set a theme and using different, more dramatic music to accompany conclusions.

Bodily Kinesthetic Intelligence

Learners that are strong in this type prefer to use body actions to solve a problem, understand or learn. Often referred to as “hands-on” learners, they enjoy using physical props, like the childhood game of Operation. Athletes, surgeons and physical therapists are examples of professions that are strong in this sector. A great way to include this type of learner is to use match cards to emphasize relationships or, if online, using “drag-and-drop” exercises.

Logical-Mathematical Intelligence

This type of learner uses logic and/ or a number sequence to understand information. They think in terms of a flow or diagram to process and learn. The childhood game of Connect Four is a great example. Professions that are strong in this sector will be CPAs, researchers and electricians. Flow charts, Venn diagrams or tables are appealing to this type of learner.

Verbal-Linguistic Intelligence

This learner uses language, either verbal or in written form, to understand. If you are a relentless note-taker and always read the directions first, then you are strong in this sector. Writers, public speakers and translators are examples of professions in this sector. Including crossword puzzles and online discussion boards or chats are great ways to appeal to this type of learner.

Visual-Spatial Intelligence

Learners that are strong in this area have a well-developed sense of space and navigational ability. They can visualize a flat drawing in three dimensions; a great example is the age-old game of Battleship. Professions that are strong in this sector will be architects, pilots and designers. This type of learner may respond well to things such as fishbone diagrams and visuals with embedded text as well as those that use interesting shapes and colors.

Interpersonal Intelligence

This learner prefers interaction with others. They will use this interaction to be able to “read” people and form thoughts on what others may be thinking or feeling. The game of Charades is a classic example of how this person prefers to learn. Salespeople, politicians and teachers/trainers tend to be strong in this sector. Developing group activities, using role play exercises and fostering structured online discussion breakouts are all ways to appeal to this type of learner.

Intrapersonal Intelligence

Learners that are very introspective and have a good grasp of what will work or not work for them are strong in this sector. These learners will prefer assessment-style questions and enjoy games like 20 Questions. Professions that are examples in this sector will be sity professors, philosophers and clergy/ religious ministers. This type of learner will appreciate discussion questions that encourage reflection on the concepts, allowing the learner to select areas of instruction to explore and providing supplemental learning materials to allow the learner to explore concepts further.

Naturalist Intelligence

These learners are closely connected with nature and the outdoors and will enjoy gardening, collecting, hiking and camping. Scavenger hunts would be a preferred game. Biologist, botanist and oceanographer are examples of professions strong in this sector. Having an outdoor classroom/presentation would greatly appeal to this type of learner but if that’s not possible, including activities that involve collecting, organizing and/or categorizing is also effective.

Interacting and explaining something to others can be more effective if a variety of approaches are used based on the characteristics of… eight types of intelligence.

We all have a unique combination of intelligence and prefer to learn in slightly different ways. Creating different learning activities and varying approaches will appeal to a wider variety of learners and ultimately result in a more effective result. Just don’t sink my battleship!

Alec Pacella, CCIM for Properties Magazine

Lipstick on a Pig

I’ve always been a car nut and one of the models that makes my head turn every time is a Chevrolet Corvette. So, many years ago, when I had a chance to buy one as a result of a co-worker looking to sell his, I jumped at the chance. But I was in my early 20s and really didn’t know that much about what I should actually be looking for.

Rather than scratching a check and rolling down the highway, I decided to take it to a friend’s father for a good once-over. He really knew his way around used cars in general and Corvettes specifically. Talk about a buzz-kill; within five minutes, he pointed out several things that I would have never seen. The front gaps on the hood weren’t even and the front fender intake strakes were from the previous year’s model, indicating that the car had probably been involved in an accident. Various pieces of the engine weren’t correct and, in digging further, he discovered the engine was from a Corvette but it wasn’t the original engine. The interior carpet wasn’t original and after pulling it back, he found rust on the floorboards.

My dreams of rolling around in the Sunflower Yellow 1972 Corvette were dashed – but I learned a lesson on the value of due diligence.

This month, we are going to discuss some easy due diligence items that a buyer can do when considering a real estate investment. And, unlike the usual things, like a survey, appraisal and Phase 1, these are easy to perform, often at low to no cost.

FREE LUNCH

Take the maintenance tech and key vendors out for lunch or a cup of coffee. They can offer a wealth of information regarding not only major repairs that have been completed but, more importantly, ones that they believe should be completed but haven’t. Ask them this question: If they get an emergency call at 3 a.m., what is the first thing they think that broke or went wrong?

SWITCH PERSPECTIVES

Visit key tenants as a customer. How does the space look? How are you greeted? If it’s a retail space, is there stock on the shelves, customers in the store and adequate staffing? If it’s an office tenant, is the space actually occupied with employees or are there large portions that are dark? If industrial, is there inventory and activity inside of the space?

GOOGLE IS YOUR FRIEND

Look up the reviews for key tenants using Google reviews, Yelp, Angie’s list, etc. These can offer valuable insight into the business practices and reputation of the companies. Although consumers sometimes will use these review sites as a result of sour grapes, they often provide a good feel for the business practices of the companies. You can also look up social media accounts that the tenants may have established. Are the accounts current or are the entries dated? Do they have a lot of followers? How are the comments?

A-TEAM

Interview the current leasing person/ team. Find out why they were able to make the last few deals completed at the property. And why they were not able to make the last few deals that they lost to competing properties. Ask them for three things they would do if they were to buy the property. Ask to see their current transactions in process.

B-TEAM

Speak to the most active tenant rep agents in the market. Ask them how they feel the property compares to a peer group of competing properties. If they have completed deals at the property, what made the tenant choose this location over the others? If they haven’t completed deals at the property, why not?

MRS. KRAVITZ

Every property has a person that loves to know everything that’s going on at the property. Typically an employee for one of the tenants, a day porter or maintenance person, this individual tends to know everyone and everything – who has already moved out and why, who is planning on moving out and why, what issues have plagued the property, etc. Once you identify that person, a cup of coffee can offer valuable insight.

ROAD LESS TRAVELED

Drive to the property from at least three directions. Often, there is a primary route to the property but by using these less popular routes, you will often be surprised at what you see. Not only will you be able to view the property from different perspectives and angles, but you will also be able to observe changes in the neighborhood, traffic patterns and competition that you may have otherwise missed.

UNPRIME TIME

Visit the property during different times of the day, including early morning and early evening. You will often notice different aspects of the property as a result of how the property is illuminated. And the surroundings can also change, depending on the time of the day. For example, that restaurant across the street that is pretty sleepy during the day may suddenly become very popular, and raucous, in the evening.

Visit the [prospective]property the day, including early morning and early evening. You will often notice different aspects of the property as a result of how the property is illuminated. And the surroundings can also change, depending of the day.

HOT AND COLD

One of the best places to spend money is a thorough inspection of the HVAC units. The interior comfort is largely dependent on the effectiveness of these units and the majority of tenant dissatisfaction is related to space that is either too hot or too cold. Major repairs or replacement of an HVAC unit is not an inexpensive event so the better handle you have on this component, the more likely you are to avoid an unexpected surprise down the road

DEEP DIVE

As part of the financial due diligence, be sure to review the general ledger for the past few years. This report often includes blemishes that aren’t revealed in an aged receivables report or a tenant estoppel. For example, if a tenant is granted forgiveness on past due rent, the only place this will stand out is in the general ledger.

The five minutes spent with my friend’s father not only helped to steer me clear of that specific Corvette but also opened my eyes to what was really important when purchasing a car. By looking past the cool styling and roaring engine, the true character of the car will show through, for better or worse.

The same goes for real estate – investors need to look past the cosmetics and allow the true characteristics to show through. But has anyone seen the ’24 Corvette Stingray?!

WHAT I C @ PVC

TESTING THE MARKET 1100 Superior Ave., formerly known as Oswald Centre, recently hit the market for sale. Plagued by the loss of several key tenants, including Oswald Companies, the asset fell into special serving 18 months ago. It has an asking price of $22.5 million or $39 per square foot.

Alec J. Pacella, CCIM for Properties Magazine, May 2024

(CRE)conomics: The Interest Rate Dilemma – A Rock & A Hard Place

Since early 2021, the topic of interest rates has dominated headlines and conversations in the financial world, especially when it comes to real estate.  Questions like “should the Federal Reserve raise interest rates?” and “should they lower rates or keep rates the same?” are asked almost daily on networks like CNBC and Bloomberg.  This kind of speculation occurs anytime there is economic uncertainty, but there is something unique about the situation we find ourselves in today.  In the past, the raising and lowering of interest rates, which is actually the Overnight Lending rate or “Fed Funds” rate, was seen as a solution to a problem – the Federal Reserve, or “The Fed,” would lower rates to stimulate economic activity and they would raise rates to encourage saving and investment.  Due to some questionable decision-making, we now find ourselves in a much more dangerous scenario – one in which it does not matter if The Fed decides to raise, lower or hold rates the same.  There is going to be severe economic turbulence no matter The Feds decision; in fact, the only decision we really have is whether we would prefer inflation or a recession – a rock or a hard place. 

Inflation – The Rock

The over-arching problem The Fed has been trying to solve since early 2021 has been inflation, and the solution so far has been higher interest rates.  Here is how it works: when The Fed raises rates, it makes it more difficult for consumers to borrow money for big purchases like cars and houses, and more difficult for businesses to borrow to fuel expansion and growth.  The higher rates increase yields from savings accounts, making businesses and consumers more likely to keep their money in the bank, helping reduce asset prices and bring the rate of inflation back on its ideal trajectory of 2% year-over-year.  To this point, the strategy has been moderately successful, with the Consumer Price Index, or CPI, having gone from 9.1% in June of 2022 to 3.2% as of February 2024.  But has the strategy really yielded the intended results?  To answer that, we must dig into the data.

The Data

The first goal of “rate hikes” is to slow consumer spending, but consumer credit card debt is currently at an all-time high of $1.053 TRILLION DOLLARS – over $200 billion dollars higher since January 1^st 2020.  Additionally, household debt reached an all-time high of $17.5 Trillion in Q4 of 2023.  Coupling this information with the jobs data and low unemployment rate reveals a troubling trend of people working more hours, in many cases for multiple jobs, yet spending more money on credit – a clear indication that inflation is still a major problem for the average American, who is struggling to make ends meet and is using credit to bridge the gap.  Inflation is the supply of money AND credit in an economy, not just money.

Consumer Loans: Credit Cards and Other Revolving Plans, All Commercial Banks. (2024, March). FRED Economic Data. https://fred.stlouisfed.org/series/CCLACBW027SBOG

The second goal of rate hikes is to slow corporate spending, but corporate debt is also hovering just below an all-time high at $13.6 trillion dollars, as corporations are continuing to borrow money.  That is a signal that The Fed needs to make monetary policy more restrictive by RAISING rates, not less restrictive by lowering them.  Finally, rate hikes should be increasing the Personal Saving Rate, which sits near it’s all-time low at 3.6% as of February 2024 – a far cry from the 7.2% in January, 2020.  Consumers are spending almost every dollar they earn, yet are still reliant on credit to pay their bills – this is an unsustainable solution.

Personal Saving Rate. (2024, March). FRED Economic Data. ttps://fred.stlouisfed.org/series/PSAVERT

In essence, The Fed has done just enough to bring the headline numbers down significantly, but they have not done enough to fundamentally solve the problem.  If they were to lower rates as currently planned, asset prices would rise significantly in the short term and the CPI would likely exceed the high-water mark of 9.1% it achieved post-pandemic – and could rise much higher from there. 

Recession – The Hard Place

Given the data, one may think The Fed has an easy decision to make: hold or raise rates so as to not experience the wrath of inflation, an economic condition that has destroyed many great civilizations.  Of course, that decision would not be met without consequences of its own – most notably, a recession. 

Easy Money In the aftermath of the Great Financial Crisis in ‘07-’08, The Federal Reserve lowered rates to essentially 0% from December of 2008 to December of 2015, and then again from April of 2020 to January of 2022 as a reaction to the pandemic.  As a result, many businesses and individuals in that period were able to borrow money at a rate they were not necessarily qualified for.

Federal Funds Effective Rate. (2024, March). FRED Economic Data. https://fred.stlouisfed.org/series/FEDFUNDS#

When rates are low, lending institutions are enabled to lend out more money to more speculative borrowers, increasing the likelihood of defaults.  Over time, these institutions and businesses become reliant on this “easy money” – their decisions and business models are developed around the idea that they will be able to borrow money at a particular rate of interest.  Any increase in that interest rate will lead to increased costs, making it less likely for those businesses to succeed and those institutions to get their money back.  That can be an issue when rates have already lowered to 0%. 

The Bubble

The above scenario has created an “asset bubble,” an environment in which prices for goods like real estate, stocks, cars, etc., become much greater than their fundamental values would support, which is a byproduct of the “easy money” policies over the past 20 years.  That bubble was pricked when The Fed began raising rates in early 2022, but they have been able to avoid any capitulation to this point.  However, the higher interest rates go and the longer they are held, the more likely we are to start seeing major cost-saving efforts in the form of layoffs, “rightsizing,” and bankruptcies.   Already this year, Google, UPS, Sony, Nike, Ford and Meta have all announced significant layoffs, just to name a few.  These companies were encouraged to expand their businesses and hire new employees because of the low borrowing costs.  As those costs have risen dramatically, these companies have been forced to pull-back on their plans for growth and are now focused on consolidation in order to reduce costs.  The growing list of companies is also an indication that these problems are not limited to one sector; rather, it is a broad-based problem across all industries.

If interest rates are held at their current range longer than markets anticipate, or in the event rates are raised higher, more air is going to come out of the asset bubble, leading to more layoffs and defaults, pushing our economy into recession.  With interest rates now in a range that is normal by historical standards, a recession may be considered a necessary evil.

Wrap Up

It may not be a decision we want to be faced with, but the choices are certainly clear: The Federal Reserve can lower rates to reignite a struggling economy, or they can hold or raise rates to extinguish the inflation fire once and for all.  As a commercial real estate investor, all you can do is prepare yourself with information and react accordingly.  While these headwinds present problems in the short term, they will also create major opportunities in the CRE market for many years to come. If you’re interested in learning more or would like to discuss your commercial real estate investment, contact me at (440)-708-8578 or Noah.Broadbent@naipvc.com.

Women’s History Month – Celebrating Marissa Rufe

As we continue to honor Women’s History Month, we take pride in spotlighting the women who contribute to the success of NAI Pleasant Valley. Sales Associate Marissa Rufe, embodies the spirit of persistence and continuous improvement in the world of commercial real estate.

Just over a year ago, Rufe joined NAI Pleasant Valley with her team from Pickard Commercial Group (PCG). When asked how she navigated that transition, Rufe said “I was unsure at the beginning what would change with this new environment, but quickly learned that the opportunities for growth, education, and success were abundant. All of the agents here have taught me something, whether they meant to or not, and I am very excited for what the future holds. I can truly say I love what I do and look forward to it each day.”

Rufe also expressed her positive feelings about working with NAI Pleasant Valley as a woman in a historically male dominated industry, “We have wonderful leaders, including two very impressive women I look up to, Barb Faciana and Stacy Tramonte.”

Rufe has received insightful mentorship from industry professionals like NAI Pleasant Valley Executive Vice President, Jim Pickard, and Executive Director, Geoff Coyle. Regarding her mentors she said, “They’re just wonderful. Jim Pickard was my mentor for over three years and taught me the ropes of CRE as well as the importance of relationships. Geoff Coyle has been my mentor now for about a year and I learn something new from him every single day. He challenges me to ask the right questions and seek the truth behind the answers.”

Embracing the fast-paced nature of the industry, Rufe finds fulfillment in the entrepreneurial spirit that drives commercial real estate. “I have always been drawn to fast-paced work environments. I enjoy the entrepreneurial aspects and that each day brings new experiences and exposure to different industries.”

Beyond her professional career, Rufe is involved in her community as a member of the Rotary Club of Akron, OH, allowing her to impact lives locally. Reflecting on her experiences, Rufe offers invaluable advice to aspiring women in the industry. “Be confident in your abilities, strive to make meaningful connections in the industry and your community, and seek out mentors who challenge you to find perspectives that you cannot see on your own.”

As we celebrate Women’s History Month, Marissa Rufe’s journey serves as inspiration for young women in commercial real estate. We take pride in working with women like Rufe, who thrive in their element and strive to pave the way for generations to come.

Women’s History Month – Celebrating Stacy Tramonte

As we continue to commemorate Women’s History Month, it is a fitting time to celebrate the remarkable contributions of the women of Pleasant Valley Corporation / NAI Pleasant Valley. Stacy Tramonte, President of Property Management and daughter of co-CEOs Barbara and Gino Faciana, exemplifies the boundless potential of women in business and leadership.

Stacy’s professional journey began at Baldwin Wallace College, where she earned her Bachelor’s degree in Business Management with a minor in Human Resources. In 1996, she joined the Pleasant Valley Corporation team, starting as the manager of the Accounts Payable Department, becoming the first second-generation leader in the family business.

Over time, Stacy’s dedication and commitment propelled her to new heights, including obtaining her State of Ohio Real Estate License and working alongside her mother, Barbara, in various capacities within the real estate division. Despite her skills and determination, Stacy encountered skepticism due to being a young woman.

“The toughest challenge I faced entering the industry was my age and being a woman,” Stacy said. “I got my real estate license when I was 18, so it was hard for people to take me seriously.”

However, she refused to let these barriers deter her. Stacy’s perseverance in the face of adversity serves as a testament to her resilience and determination to succeed in an industry where age and experience are often considered paramount.

“I feel like I had to work twice as hard to gain the respect of colleagues and clients,” Stacy said.

In 2019, NAI Pleasant Valley partnered with the globally recognized brokerage, NAI Global, to expand its services to include property management. With her expertise and experience, Stacy took the role of President of Property Management.

Stacy’s journey is not just one of personal achievement but also of familial collaboration and support. As a proud mother, she cherishes the opportunity to balance her professional career with the joys of motherhood.

“My mom has taught me you can be a full-time hands-on mom and have a career as well without sacrificing either one,” Stacy said. “It is definitely hard to juggle at times but extremely rewarding.”

She also finds fulfillment in working alongside her parents and husband, Joe Tramonte, who serves as the President of Construction at Pleasant Valley Corporation.

As we honor Women’s History Month, Stacy Tramonte’s story stands as a testament to the limitless possibilities available to women in commercial real estate and property management. Her journey underscores the resilience, determination, and unwavering commitment to excellence that define women leaders across industries.

Women’s History Month – Celebrating Barbara Faciana

As we celebrate Women’s History Month, we at NAI Pleasant Valley want to recognize the contributions of the women within our company. In Northeast Ohio, Barbara Faciana is a beacon of empowerment and achievement. As the co-CEO of Pleasant Valley Corporation (PVC) and NAI Pleasant Valley, Barbara’s journey embodies resilience, entrepreneurship, and a commitment to excellence.

With roots in small beginnings, Barbara obtained a degree in Business Management from Cuyahoga County College. Then, beginning in 1976, with $500 in hand and a hunger to build something great, Barbara and her husband, Gino, started an electrical contracting business. Motivated to continue her education, Barbara earned her degree from Tri-C in Real Estate and her State of Ohio Real Estate License in 1987, opening doors to new opportunities. Today, Pleasant Valley Corporation is a testament to their dedication, emerging as a leading family-owned and women-owned commercial real estate and facilities management company in Northeast Ohio.

Throughout her career, Barbara’s leadership has been instrumental in shaping PVC’s development into an international powerhouse, offering a comprehensive suite of services in facilities management, construction, property management, and real estate. With over 45 years of dedication, PVC employs over 200 associates locally and impacts thousands nationwide.

However, Barbara’s impact extends beyond business success. Her commitment to family values and community engagement emphasizes her profound sense of purpose. As a second-generation family business, PVC embodies the spirit of legacy. Barbara’s vision is to bring in, teach, and guide the third generation, ensuring that the values she holds dear endure for years to come.

Outside her career, Barbara remains deeply invested in philanthropy and community service. She sits on the Huntington Bank, Medina County Economic Development Committee, and Summa Health boards. Barbara also founded and continues to operate several food pantries.

As we honor Women’s History Month, Barbara Faciana’s story serves as a testament to the limitless potential of women in business and leadership. Her journey embodies the spirit of resilience, determination, and the transformative power of vision. In celebrating Barbara’s achievements, we acknowledge the countless women who continue to break barriers and shape the future of industries worldwide.

Giddy Up

Alec J. Pacella, CCIM

If you’ve spent any time around the legal world, you know that the outcome of many cases revolves around a concept known as “legal precedent.” Cases are made, argued, won and lost based on the results of decisions that had been made on similar cases in the past. Oftentimes, these precedents go unnoticed, as they usually have a narrow potential impact. But every so often, there will be a case that gains widespread attention because of a much broader potential impact. And this was the situation last fall, in a case known as Sitzer/Burnett.

Before I get into the details and potential ramifications, I need to make a disclaimer. The focus on this article is on the primary components of this case, the initial decision and how it may ultimately impact the commercial real estate industry. I am going to deliberately not address specific commission rates. Although this was a part of the original case, I consider it out of bounds for purposes of this discussion as it may be construed as price fixing. And I have no desire to have my broker’s license suspended. With that out of the way, off we go.

The plaintiffs in Sitzer/Burnett are over 500,000 homeowners in Missouri. They collectively alleged that the four national brokerage firms unfairly inflated the commission rate charged to this group in conjunction with the sale of their homes. Also named in the suit was the National Association of Realtors (NAR), as all of these firms are members (known as Realtors) of this trade group. Two of the national brokerage firms chose to settle outside of court but the other two and NAR elected to go to trial.

To fully understand the plaintiff’s position, we need to dig a little deeper. There is a code of ethics associated with being a Realtor and one of these is known as the Participation Rule. This includes an obligation to share a portion of the commission that is received by the seller’s agent with an agent that is representing the interests of the buyer. The amount of the fee available to the buyer’s agent must be disclosed if the property is listed by the seller’s agent on their local multiple listing service (MLS). There are approximately 500 MLSs nationwide, with each typically maintained and administrated by a local or regional board of Realtors that ultimately roll up to the NAR.

The homeowners argued that the commissions charged were unfairly inflated as a result of the seller’s brokerage firm being associated with NAR, who mandate that a portion of the fee be shared with the buyer’s agent in order for the property to be listed on the local MLS. If you are hearing about this for the first time, you may be scratching your head a bit. But it didn’t take long for the judicial system to scratch their heads, as the jury not only quickly found for the plaintiff but granted an initial award of $1.78 billion. And, pending the judge’s decision, not only could this amount triple but the current practice related to commission sharing could either be modified or completely banished. Hundreds of similar cases were immediately filed in courtrooms across the country within days of this decision, with associated alleged damages spiraling into the hundreds of billions of dollars.

Many of you reading this may be thinking that this could have a long-term impact on the residential sector but think the commercial sector is insulated because it’s different. There are several key factors that make me say “not so fast.” First, while the nuances, motivations and drivers of the residential and commercial sectors have many differences, there is but one type of real estate license in most states, including Ohio. It doesn’t matter if an agent only sells houses or only leases office buildings – everyone holds the same real estate license. Second, membership in the NAR is much less widespread amongst firms that focus on the commercial sector. But the two leading trade associations in the commercial real estate sector, the Society of Office and Industrial Realtors (SIOR) and the Certified Commercial Investment Member (CCIM) Institute are both affiliated organizations of the NAR. And third, participation in the local MLS is also much less widespread among firms focused on the commercial sector. But the practice of the seller’s agent sharing their fee with the buyer’s agent is just as common in the commercial sector as it is in the residential sector. If you think that lease transactions are different, think again as it too follows this same practice, with the landlord’s agent sharing the fee with the tenant’s agent. Remember, this was a primary allegation of the plaintiffs in the Sitzer/Burnett case – the amount of the fee that was paid by the seller was unnecessarily increased as a direct result of the seller’s agent sharing it with the buyer’s agent.

The defendants in the Sitzer/Burnett case are in the process of appealing the decision and it will take months if not years for the full impact of the Sitzer/ Barnett case to play out. But to my thinking, the quick and decisive initial verdict speaks volumes of the public sentiment and ultimately where the current fee-sharing arrangement may be heading. And it’s not going to just be isolated to the residential sector. Years ago, one of my real estate Yodas characterized the real estate brokerage industry as “the last of the wild west.” Only time will tell if these real estate cowboys are riding into the sunset.

For Properties Magazine, February2024

(CRE)conomics: The Economics of Commercial Real Estate

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Lease Vs. Own – What is Right for You?

In my last post, we discussed the most important factors to consider when leasing space in an office building, specifically a downtown office building.  This week, we will take a step backward to review what leads a business owner to the decision to lease or purchase.  When considering a change, many owners will need to contemplate the following – does it make more sense to purchase or to lease my business’ future home?  To make an informed decision that best serves your objectives, consider the following: 

• Flexibility and Growth Potential

Leasing offers greater flexibility for businesses that anticipate changes in size or location in the short term. Startups or rapidly growing businesses may initially prefer to lease in order to accommodate future expansion without the commitment of owning a property.

• Capital Preservation

Leasing requires less upfront capital compared to purchasing a property. This allows businesses to preserve capital for other essential operations such as inventory, marketing, or hiring employees.

• Fixed Costs and Budgeting

Leasing provides predictable monthly expenses since lease agreements outline the rent and any additional costs. This stability aids in budgeting and financial planning for businesses, especially those in volatile industries.

• Maintenance and Repairs

One of the greatest advantages of leasing is that the responsibility for property maintenance and repairs typically falls on the landlord. This relieves tenants from unexpected expenses and the hassle of managing a property, making it attractive for businesses with limited resources or experience in property maintenance.

• Location and Market Dynamics

Leasing allows businesses to access prime locations that may be financially unattainable for purchasing. This is particularly advantageous for retail or service-oriented businesses that rely on foot traffic and visibility.

• Tax Considerations

Owning a property offers potential tax advantages, such as deducting mortgage interest and property taxes. However, leasing may provide tax benefits in the form of deductible lease payments and the ability to avoid property tax liabilities.

• Investment Diversification

For some businesses, especially those with surplus capital or seeking diversification, purchasing commercial real estate can serve as a long-term investment strategy. Building equity in an appreciating asset can provide a source of wealth accumulation.

• Business Strategy and Long-Term Goals

The decision to lease or buy should align with your business’s objectives and long-term vision. Factors such as industry stability, market conditions, and growth projections play a critical role in determining what the most suitable option is when acquiring commercial space.

Ultimately, the decision to lease or purchase your will depend on an array of factors, including your business sector, financial resources, prospective growth and strategic priorities.  Understanding how this decision impacts your employees and your future business is imperative in achieving future goals.

Is your business facing an upcoming decision to relocate? Contact me at 440-708-8578 or noah.broadbent@naipvc.com.

Partly Cloudy or Partly Sunny?

Alex J. Pacella, CCIM

I’ve always been a fan of watching the weather forecast. I love seeing maps that show weather fronts, high- and low-pressure areas, storm systems and don’t even get me started on long-term forecasts. But one thing that I always felt is a “free pass” is the famous “partly cloudy / partly sunny” forecast. This seems to be a catch-all, as the optimistic interpretation is just a few wispy clouds, the pessimistic interpretation is an intermittent drizzle, and the actual result can be anywhere in between.

If there ever was a textbook example of “partly cloudy,” it would be the commercial real estate market in 2023. While everyone will agree that the market was not as strong as the past few years, few will share the exact same perception of the cloudiness. This month, I’m going to discuss some of the highlights from last year, including my armchair opinion, as well as a quick forecast for 2024.

Interesting times

Nothing can drag down a party faster than rising interest rates. After a long stretch of historically low rates, the Federal Reserve started an unprecedented run of 11 consecutive rate hikes. The primary intent was to damper inflation by gradually cooling the U.S. economy, but it came with a side effect of spiking mortgage rates. In an 18-month period, rates went from the low- to mid-3% range to the mid-to high-7% range. The impact has been widespread and particularly acute with regards to drastically curtailed sales volume and construction activity in the commercial real estate market. But the forecast is partly sunny. Last December, Fed Chairman Powell not only announced that rates would be unchanged for a third consecutive time but also intimated that rates could be cut up to three times this year.

Some were winners

While the office sector has been surrounded with uncertainty in the years following the pandemic, several area companies either made or announced significant moves last year. CBIZ moved to 58,000 square feet in the southern suburb of Independence and Ernst & Young relocated to 44,000 square feet in downtown Cleveland. Meanwhile, Oswald Companies announced plans to relocate to 100,000 square feet in downtown Cleveland and Park Place Technologies announced plans to acquire several buildings totaling 230,000 square feet in the eastern suburb of Mayfield Village. Finally, work continues on the one-million-square-foot headquarters for Sherwin-Williams in downtown Cleveland, with the project expected to be completed later this year.

The forecast for this year is partly cloudy, as there will be more moves announced, with most involving existing companies taking the opportunity to right-size – i.e., reduce their occupancy.

Some were losers

The broader office sector saw a steady number of properties fall victim to financial distress last year, with the downtown areas of Cleveland and Akron being particularly hard hit. The year started with Oswald Centre (625,000 square feet) being taken over by a special servicer and Fifth Third Center (570,000 square feet) met the same fate later in the year. Several other buildings either wrestled with ownership issues or were openly put on the market for sale. The story was even bleaker in downtown Akron, where five buildings totaling just over one million square feet all face uncertain futures. Huntington National Bank Tower (240,000 square feet) and the First Energy Building (335,000 square feet) are both owned by their respective namesakes, but each physically occupies only a fraction of the square footage. 1 Cascade Plaza (195,000 square feet) fell into receivership last fall while Akron Centre Plaza (195,000 square feet) is on the market for sale. Finally, the former Akron Beacon Journal building (230,000 square feet) has been vacant since the newspaper publisher moved out in 2019. The forecast for this year is decidedly partly cloudy, as there are no easy or obvious answers for stumbling office towers.

While the increasing vacancy rate has spelled big trouble for the office sector, it has been a boon to the industrial sector. Thanks to solid gross domestic product statistics throughout the year, manufacturing remained strong, resulting in continued demand for industrial space.

Loosen up

While the increasing vacancy rate has spelled big trouble for the office sector, it has been a boon to the industrial sector. Thanks to solid gross domestic product statistics through- out the year, manufacturing remained strong, resulting in continued demand for industrial space. But unlike past years, when virtually no space was available, the loosening of inventory created more opportunities for expanding companies to consider. Rental rates remained solid and most of the recently completed projects have been successful in finding new occupants. Great examples of this include the 434,000-square-foot lease completed at Gateway Commerce Center in Streetsboro with FNS and the 220,000-square-foot lease completed at Forward Innovation Center West with Victory Packaging.

The forecast for this year is partly sunny, as demand is expected to again be strong and new construction will continue to wind down.

Shopping and dropping

The retail sector continued to be a paradox. It’s been a couple decades since the rise of online shopping was predicted to spell the doom of traditional “bricks and mortar” retail. And for some companies, that proved to be true last year. Rite Aid finally filed for bankruptcy and was joined by Bed Bath & Beyond, Party City, David’s Bridal and Tuesday Morning. Meanwhile, other companies have not only survived but continued to thrive. Most have been in the fast-food category, such as Chic-Fil-A, Chipotle, Starbucks and Raising Cane’s. But several other categories flexed their muscles, including grocery, such as Aldi; value retail, such as Dollar General; and car washes, such as Sgt. Clean.

The forecast for this year is partly sunny; inflation is expected to remain in check, allowing for consumers to spend more of their dollars on retail goods and services.

People always like to say that if you don’t like the weather in Northeast Ohio, simply wait a day or two and it will change. Overall, 2023 had a similar theme; not many of us liked how things were going in a particular sector and during a specific stretch of time but if we were a little patient, things often changed. We should keep that in mind as we head into 2024 – there will be times when we think things are partly cloudy but if we can just be a little patient, things will certainly change.

Alec J. Pacella for Properties Magazine

Building on Spec

By: Joe Hauman

This blog will cover the basics of building on spec and the current spec market forecast in my home market of Cleveland, Ohio.

 What is the Definition of Building on Spec?

Spec means speculative; in its most basic form, spec is when a developer constructs a structure without a tenant in mind to use the space. When a developer builds on spec, they have no specific tenant in mind and rely on their broker to find one to occupy the property while it is under construction.

Why Would a Developer Build on Spec instead of Build-to-Suit?

Almost all developers will “build to suit,” meaning they will be approached by a company that needs a building suited to its specific needs. The developer will agree to build the building in accordance with the business’s specifications, and a lease will be signed so that the developer may secure bank financing to construct the space.

Due to a scarcity of industrial-spec buildings, numerous spec buildings have been constructed in Cleveland. Developers will rarely build on spec if there is insufficient market demand for the space. Since 2020, the industrial market has grown at unprecedented rates. A gap in the market emerged as demand for distribution space increased faster than supply could keep up. As a result of high demand and little supply, an industrial developer and lending institution were willing to take the risk of developing without a tenant in place since they knew that a tenant would most likely come along and sign a lease while the facility was under development.

What are the Risks of Building on Spec?

The most significant risk for a developer building on spec is not finding a tenant to inhabit the space they just completed. Banks lend to developers on a draw basis, which means the developer must achieve certain requirements while building the project before the bank will continue to lend them money. The bank does this to limit their risk and ensure that the property is developed in a timely manner. After the project is completed, the developer must convert the construction financing to permanent financing. This could be a major issue if the developer has no tenants in the building and no income to demonstrate to the bank that the property is profitable. If the property is not performing well, the bank may decide to foreclose on it. One significant project gone wrong could be disastrous for a whole development firm.

 What am I Seeing in Spec Construction?

Newly built spec buildings are some of the most interesting and high-quality buildings currently on the market. As building practices continue to accelerate, almost every new construction has a feature that the last new construction in that market lacked. Cleveland is no different. With over 2 million sqft of industrial space under construction, there is a large amount of spec industrial buildings coming to market in the next 12-18 months. As I stated before, the supply of distribution space in Cleveland was well below demand, and the events of 2020 only amplified that need. Many industrial developers are still building on spec. Many of these buildings are 32-foot-high, tilt-up construction warehouses that can be occupied by a small amount of buildout. Building spec office buildings can be extremely difficult, especially because many banks believe that building spec office towers is not worth the risk. It can be difficult to find solid tenants that are willing to pay above-market rates for brand new office space.

 What is Next for Spec?

I think supply and demand are beginning to reach equilibrium, and increased interest rates have quelled the fire of developers. I think speed to market of the under-construction buildings will be key for many current developers. Many developers are already beginning to dial back their once-ambitious plans of 6-7 building industrial complexes to a more reasonable 3-4 building complex with land for future expansion. Like most things in the real estate industry, only time will tell when it comes to predicting the growth or downfall of spec buildings.

Have a question about spec buildings or want to give me your opinion? Reach out to me at joe.hauman@naipvc.com. I want to hear what you have to say.

(CRE)conomics – The Economics of Commercial Real Estate

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Factors to consider when leasing downtown office space

by Noah Broadbent

As a tenant and business owner, one of the most important decisions you will make is determining where to locate your business. Juggling factors such as where your employees live, access to public transit and rental rates can prove to be a more challenging decision than many anticipate. Whether you’re thinking about leasing office space in a downtown like Cleveland’s Central Business District (CBD) or a suburb, consider these factors as you make your decision:

1. Amenities & Services

The amenities and services a downtown can offer simply cannot be matched by a suburban office building. The variety of food and entertainment options within walking distance in a CBD can make employee attraction and retention much easier. Many buildings in a downtown will boast Class A amenities like full-service restaurants, state-of-the-art gyms, and even something as unique as a golf simulator – a suburban office building cannot compete.

• Higher Rental Rates

Rental rates will always ultimately be determined by the building itself, but the same building will have a higher rental rate in a downtown than it would in a suburban market. The majority of that difference in cost is simply due to the added expenses associated with operating a building downtown; because the cost of property taxes, insurance and common area maintenance are higher, the rental rates must be as well.

• Proximity & Accessibility

For many, an office downtown means short commute times. A denser population downtown makes it more likely your employees will be living downtown.  Much of your office would be able to walk, bike or take public transit to your building – an idea that is much less feasible in a suburban office building.

• Commuting Challenges

For those employees that do not live downtown, the commute to the office could turn out to be a major negative, especially for those in a building that does not have on-site parking. Commuting downtown from a suburb is costly and time-consuming for many employees, and can limit your potential employment base in many instances. It is important to consider where your employees will be coming from. 

• Brand Image 

Maintaining a high-quality brand image is very important for many types of businesses, and the building you choose to call home has a major impact on how you are perceived by clients. Working in a downtown office building, especially a Class-A tower with high-level finishes, projects an image of power and importance.  A suburban office building will not have the same visual effect for those visiting. 

• Security Concerns

Major urban areas have long been struggling with higher rates of crime, and it is no different in today’s environment. Every major downtown will have its share of bad actors – awareness and education are the best ways to prepare yourself and your employees. 

Where you choose to call home for your business is an incredibly nuanced decision, and it is one of the most important you will make as a business owner. Hiring an experienced broker to advise you during your decision-making process will ensure you’re making the right choices.

Are you a business owner looking to acquire space in Cleveland? Contact me at noah.boardbent@naipvc.com.

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At Risk

Alec J. Pacella, CCIM

One of the most popular things in our office is a large white board. It is primarily used to post announcements and track progress on critical projects. But one day, someone wrote a question, specifically “what is your dream vacation?” From that simple question, a star was born.

Each morning, everyone looks forward to the question of the day. Recently, the question “what is your fav board game?” generated the usual scores of answers but one caught my eye. The game of Risk. As a kid, I would spend hours playing this game with friends – drinking way too much RC Cola and eating way too many Doritos in the process. I thought back on the various strategies (I loved loading up in Ural and Siberia) and the friends with whom I could (and could not) strike an alliance. But ultimately, it all came down to a roll of the dice – red if attacking and white if defending.

This month, we are going to discuss another way to roll the dice, not in the world of board games but in the world of commercial real estate investment. So, if you’re feeling lucky, read on.

When considering the acquisition of a real estate investment, investors

will usually develop a scenario that they think will unfold during their ownership period. This scenario, often called a proforma or projection, is based on various assumptions, include items such as rental rate projections, vacancy assumptions, anticipated expense growth and a future disposition price, amongst a myriad of other items. These assumptions are used in building a performance measure, which can be as simple as a gross rent multiplier or as complicated as a leveraged internal rate of return (IRR). But regardless of the measure, the projection is based on forward-looking variables that may or may not reflect what actually will happen.

There are a few ways to acknowledge and compensate for this underlying risk. One is to develop multiple scenarios. Rather than just base the performance measure on one scenario, an investor can use multiple scenarios. The most common approach is to develop three. The first is considered the most likely scenario and all of the variables reflect what the investor believes will occur.

When considering the acquisition of a real estate investment, investors will usually develop a scenario that they think will unfold during their ownership period. This scenario, often called a proforma or projection, is based on various assumptions… which are used in build a performance measure.

For example, an investor is evaluating a multi-tenant industrial property, and, over the next five years, they believe that net operating income (NOI) will be flat. The projection they build, and resulting IRR calculated, uses this assumption to establish NOIs in the future. The second scenario is considered the worst case and all of the variables reflect the most pessimistic reasonable outcome. This scenario forms the floor. Using the same example above, the investor believes that, if things go worse than anticipated, NOI will actually fall at an annual rate of 2%. The model is adjusted to reflect this and a worst-case IRR is developed. The third scenario is considered the best case and all of the variables reflect the most optimistic reasonable outcome. This scenario forms the ceiling. Again, going back to our example, the investor believes that, if things go better than expected, NOI will increase at a 4% annual rate, The model is rerun a third time, using an NOI growth rate of 4%, to calculate the best-case IRR. This approach is very effective in compensating for risk, as it not only illustrates the anticipated performance associated with the most likely scenario but also forms a floor if things go worse than expected and a ceiling if things go better than expected.

Using multiple scenarios is good, but if you really want to dig into risk-adjusted returns, Monte Carlo simulations up the ante. Before we get into how it can be used, let’s talk about what it actually does. And the fact that it shares the same name as a famous casino should be your first clue. Just like a famed roulette wheel, a Monte Carlo simulation will run an analysis literally thousands of times. When spinning a roulette wheel, where the ball lands on any individual spin will be a unique event. But the greater the number of spins, the greater the probability of a uniform outcome occurring. The more times the wheel is spun, the closer we get to a 46.37% probability that the ball will land on red. With a roulette wheel, the odds are known in advance but with a real estate investment, there is much less certainty when it comes to future events.

There are a variety of ways that an investor can utilize a Monte Carlo simulation to address risk and one way incorporates multiple scenarios to form the basis of the simulation. In the example above, each of the scenarios for NOI growth had a 33.3% probability of occurring. While we could weight each of these scenarios by applying a more specific probability, introducing Monte Carlo is the equivalent of spinning the wheel a thousand times. The three scenarios form what is known as a tri-angular distribution – worst case is the low end, most likely case is the middle and best case is the high end. Each of the three scenarios result in a specific associated IRR but, as the expected NOI growth rate is adjusted between the established limits, the IRR will change. A Monte Carlo simulation will run this calculation a thousand times by randomly choosing a NOI growth rate and then calculating the associated IRR. The more the proverbial wheel is spun, the more well-developed the range of returns becomes.

Figure 1 illustrates an example of this process while Figure 2 illustrates a summary of the resulting range of returns. There are many other ways to use a Monte Carlo simulation, as the analysis can incorporate multiple variables. And if you think you’ll need a degree in computer programming,

think again. Software such as Crystal Ball and @Risk make the simulation calculations a snap. Most of the marathon games of Risk from my childhood never had a definitive end. Rather, it became obvious that one player controlled too much territory and had too large of an army and, one by one, the other players would drift away. A Monte Carlo simulation is similar; rather than provide a definitive answer, it relies on statistics to illustrate a likely winner. And no pop and chips are needed!

Alec Pacella, CCIM, president at NAI Pleasant Valley, can be reached by phone at 216-455- 0925 or by email at apacella@naipvc.com. You can connect with him at www.linkedin.com/in/ alecpacellaccim or subscribe to his youtube chan- nel; What I C at PVC.

For October Properties Magazine

Halfway Home

Alec J. Pacella, CCIM

As hard as it may be to believe, half of 2023 is in the review mirror. And what a first half it’s been! It seems as if everyone in the real estate biz has had eyes on the Fed, the banking system, the stock market, and inflation. Throw in that pesky debt ceiling and it’s been enough to make a person crazy.

A common question on everyone’s mind is “where are things heading” and while there is no flux capacitor to help us out, one of the next best things is Dr. Glenn Mueller. He produces a quarterly publication called the “Real Estate Market Forecast,” which is widely followed and has historically been uncannily accurate. I last profiled Mueller’s thoughts in the early days of the pandemic and, given the current uncertainty surrounding the commercial real estate market, figured it was a pretty good time to revisit.

The crux of Mueller’s analysis is based on a 16-point real estate cycle. As illustrated in Figure 1, the cycle is broken up into four distinct phases. Phase 1, classified as “Recovery” can be considered the bottom of the market, characterized by negative rent growth and supply drastically outweighing demand. As conditions improve and the market crosses over the long-term occupancy average, it enters Phase 2. In this “Expansion” phase, rent growth turns positive, demand begins to out-pace supply and, in the later phases, new construction occurs in earnest. At point 11, the market is considered to be in equilibrium, with supply and demand in balance. After this point, the market slides into the “Hypersupply” phase. New construction continues but demand begins to fall off, which results in slowing rent growth in the early states followed by flat rents in the later phases. Once point 14 is hit, which again represents the long-term occupancy average, the market slips into the last phase, “Recession.” This phase is characterized by negative rent growth, curtailed new construction and supply met with little to no demand.

Each quarter, Mueller surveys the office, industrial, retail, multifamily, and hotel sectors for 57 metropolitan areas, including Cleveland, Cincinnati, and Columbus. His most recent report is as of the first quarter 2023, so if you want to know what the soothsayer thinks, read on.

Office

If any sector can be defined as a complete wildcard, it’s the office sector. Initially battered by COVID and very slow to recover, this sector continues to be a topic of which everyone has an opinion. And Mueller is no different – as of the Q1, he has metropolitan areas spread across nearly every point of the cycle. Austin, Charlotte and San Francisco are bottomed out at point 1 while New Orleans, Palm Beach, Richmond, and Riverside are in equilibrium at point 11. Ohio is also a coin-flip, with Cleveland in the Expansion phase point 7 while Columbus and Cincinnati are both in the Recession phase at point 15.

Industrial

And if any sector can be considered surprise-free, it’s the industrial sector. Four distribution powerhouses in Atlanta, Memphis, Nashville, and Salt Lake City are sitting at point 10. The remaining 53, including Cleveland, Columbus, and Cincinnati, are at point 11, which Mueller considers market equilibrium. I’ve been following Mueller’s reports for a couple decades and while it’s not uncommon to see so many markets tightly clustered, I can’t remember a time seeing such a vast dichotomy between two real estate sectors as there currently is between the office and industrial sectors.

Apartment

There is a little more diversity in the apartment sector. The majority of metropolitan areas are at point 11, which is equilibrium. These include Cleveland, Columbus, and Cincinnati. However, several markets have slipped into points 12 and 13 of Hypersupply, including Austin, Las Vegas, Nashville, Phoenix and Tampa. Mueller includes broad-based commentary to accompany the charts and one of his thoughts for the apartment sector was this: “The national apartment asking rental rate may increase by 2/3% in 1Q23 and be up 15.9% year-over-year.

Retail

The profile of this sector is unique in that all 57 metropolitan areas are situated at the exact same point 11, which is considered equilibrium. Mueller’s general comments include this: “We expect demand for space to continue to grow at 15 million square feet per quarter through 2023, with supply growth being slightly lower, thus keeping occupancies high.” But there is a lot brewing in this sector that is just below the surface. Mueller also produces supporting cycles, including one that profiles subsectors. And while neighborhood/community center subsector is at point 11, first-tier regional malls and power centers are one click back at point 10 while second-tier regional malls are back in the Recovery phase.

I had the opportunity to meet Mueller last summer and spent about an hour discussing the actual analytics involved in developing his quarterly analysis. And it is impressive to see exactly how the sausage is made. He maintains multiple databases, many of which have auto-mated data “scrapers” to collect the raw information. Data sources range from municipal building departments to commercial brokerage firms to national subscription-based vendors. This information is then rolled up and run through various algorithms based on his 16-point cycle. And out the other side pops the end result – an estimation of where each of the 57 metropolitan areas are expected to be as of that quarter. It’s quite the operation and requires several people, mostly graduate students at the University of Denver’s real estate pro- gram, to make sure the hamster keeps the wheel spinning.

I know what you are thinking right now – how much does the information cost to subscribe? Brace yourself, because it’s absolutely free. There are a variety of places that it can be retrieved – just Google ‘Mueller real estate cycle 2023.’ For those who want to take a deeper dive, Mueller does offer subscription-based analytics, which he performs for a variety of clients. Again, while nothing is a completely accurate predictor, the breadth of data sources, sophistication of modeling and over 30 years of continual improvement results in a pretty good resource. The proof is always in the pudding, so bring on the second half of the year!

What I C @ PVC  

TURN OUT THE LIGHTS Last month, Sokolowski’s University Inn was sold. The well-known restaurant was shuttered and put on the market in October 2020 in the wake of the pandemic. The new owners, an affiliate of WXZ Development, paid $1.5 million for the property, which is expected to be redeveloped. –AP

Alec J. Pacella for July Properties Magazine

The Deal Dance

Alec J. Pacella, CCIM

The last eight months have been spent in school, not literally but figuratively. Each month in this very column, we had a “class” or period. Subjects have included some weighty topics such as capital accumulation, discretionary capital expenditures and risk mitigation strategies. We even took time for a lunch period, drawing parallels between current real estate trends and fabled grade school lunch choices. The final bell has rung but we have one more extra-curricular activity: debate club.

Many of us debate and negotiate on a regular basis as a part of our job. And everyone has countless more instances during the course of a normal day. Maybe it’s a discussion with one of our children about driving the car to school or a decision amongst co-workers on where to go for lunch. But make no mistake, debate and negotiation is a big part of our lives. There are all sorts of theories, material and education on the topic and this month, I’m going to talk about three key components. Collectively, these three concepts are the foundation of any debate and negotiation. And having a thorough understanding of each will increase the likelihood of a successful outcome.

Anchoring

The first concept is known as “anchor- ing” and sets the initial expectation. If you are a seller, the anchor will be your asking price. There can be a significant amount of insight drawn from an asking price; how will a buyer react to an asking price that is higher, or lower, than anticipated? Even in instances where the anchor represents a retail price, the anchor sets an initial tone. Think about your reaction to a bottle of wine that has a retail price of $20 as compared to one with a price of $100. And anchoring isn’t just about price. For example, if my wife and I are discussing potential dinner plans and she suggests Pier W, she has clearly established an initial expectation. The concept extends to the other party’s initial expectation. Suppose a seller is asking $500,000 for a property. A buyer’s initial offer of $400,000 sets a very differ- ent expectation as compared to an offer of $480,000. Same goes for my potential response to my wife of Chipotle as an alternative dinner destination. There is significant research and material that has been devoted to this concept, including a wide range of philosophies. Regardless of the approach, a negotiation is a dance and the impact of this initial step should not be underestimated.

Reservation point

The second concept is known as the “reservation point” and represents a bot- tom-line position. It is the minimum set of conditions needed in order to move forward. The reservation point is usually different than the anchor. For example, the seller sets an asking price, or anchor, of $500,000 but the minimum they are willing to accept is $470,000. A reservation point has several interesting aspects. First, it can work in conjunction with the anchor. Using the example above, a seller can use a strategy of a lower anchor but a higher reservation point, establishing an asking price of $475,000 with a reservation point of $470,000. Or they can use a higher anchor of $525,000 with the same reservation price of $470,000. Each of these strategies will have a unique interpretation and the negotiation processes will likely be very different as the dance unfolds. Second, a person can have multiple reservation points. Again, using the previous example, perhaps the seller’s reservation point for a normal deal, with various contingencies that need to be waived, is $470,000. But if a buyer is willing to waive all contingencies and close quickly, perhaps the reservation point would be only $460,000.

There can be a significant amount of insight drawn from an asking price; how will a buyer react to an asking price that is higher, or lower, than anticipated?

BATNA

The third concept is known as BATNA, which stands for “best alternative to a negotiated agreement.” This is arguably the most important part of a negotiation, as it establishes the “fall back” alternative. Ironically, BATNA is typically given very little thought prior and only becomes a focus when the primary negotiation begins to fall apart. However, you will be in a much better position by having a good understanding of BATNA before engaging in the primary negotiation. A quick example, using the classic negotiation of buying a new car. Most of us have done our homework prior to ever stepping foot in a dealership. We know the model and trim level we are interested in, the options we want and probably even a preferred color. We know the dealership’s anchor, which, in normal times, is the sticker price of the car. And we at least have a solid idea of our anchor, the initial offer, as well as our reservation point, which is the most we are willing to pay. But the critical piece that is missing is our BATNA; if we are not able to reach an acceptable agreement, what is the best alternative? Not only will having a solid grasp of our BATNA help to establish our reservation point but it will also be a strong guide in the negotiation process. A few things to keep in mind regarding BATNA. First, it is not the ideal outcome but rather the best alternative. Second, we can, and often will, have multiple BATNAs but there is usually one that stands above the others. And third, we must continually monitor and be confident in our BATNA.

As I said prior, there is a lot of material available on the topic of debate and negotiation. Harvard’s Program on Negotiation (PON) and Cambridge University Press both offer a substantial amount of information, much of it for free. Thousands of books that have been written, with “Never Split the Difference” and “Getting to Yes” standing out. I googled BATNA and received literally 10 million responses. And considering the number of dinners I’ve had at Pier W, you would think I’d practice what I preached!

May Properties Magazine

History Repeats Itself

We have all heard the saying “history repeats itself”, but does it really? The world works in cycles. We see it most in the financial world, but it’s everywhere. Life has a funny way of coming back around, but never in the same exact way as before. The astute are able to recognize trends before they happen, even when the cycles come in different forms. This post is all about the recognition of a new cycle within the industrial sector of real estate and how the past can help us make better decisions in the coming years.

Our industrial inventory in Cleveland, OH, is dated and aging due to the manufacturing backbone that Cleveland was built on. Two and three story industrial facilities make little sense for the needs of modern users. Likewise, not many of those users even exist in the U.S. any more. The large-scale exportation of manufacturing jobs to places like China and India made many of our facilities obsolete. This is where the cycle began. The loss of jobs in the US during this time was a big fear for the country. Our businesses began to shift to service-based needs instead of manufacturing-based needs. Accelerated by the recession in 2008, our country lost jobs and lost them in thousands as companies moved to countries with less expensive labor. The decade between the recession in the late 2000s and current times was a transition period. For industrial real estate, this period was marked by developers purchasing property for cheap and attempting to redevelop it or offer low rental rates to get occupants in the space. This was not a bad strategy, but due to the economic downturn, the users of the space were significantly reduced, so many spaces sat vacant and falling apart.

The 2010s ushered in a new era of technology, and online shopping boomed. Manufacturing jobs were beginning to be replaced by distribution jobs. Large manufacturing facilities were not required, but warehouses were. Developers began building to satisfy the needs of their clients, this mostly entailed building 36-foot-clear multi-dock facilities to help companies transport goods more effectively. It is often said that the last mile of the distribution process is the most challenging and expensive portion. Many companies combated this by placing smaller facilities closer to their customer bases. This meant they could also fill many jobs that were lost as manufacturing left these communities. I identify this time as the beginning of the new cycle. Business began to recover; the country’s economy was strong, and consumer desires shifted as the online shopping brands grew.

Much like the great recession fueled job loss and a move away from manufacturing, the global pandemic fueled job creation and a move toward distribution space. COVID-19 accelerated the cycle. Thousands of local jobs were created as people stayed home and ordered from companies like Amazon. Third-party resellers stressed the resources of FedEx, UPS, and USPS as internet shopping increased significantly more than the country anticipated. This strain was felt on the industrial real estate market as vacancy rates reached a historic low in the Cleveland area. Companies were willing to fully lease buildings before developers had even put up walls. As demand grew and supply diminished, asking rates hit all-time highs.

It would be easy to look back now and see the lack of bulk distribution as an issue for Cleveland, but the truth is that before COVID-19, the lack of this space was not felt by the market. Now, however, we have multiple major spec distribution centers being built in all areas of northeast Ohio, most of which will be leased before these buildings are completed. This is good for the market because more space will be available for those companies that require it; however, as more bulk space becomes available, market velocity may begin to slow. Tenants who require the advantages of these large facilities will pay market rates for brand new high-end space. Smaller users who were pinched during COVID-19 may have an easier time finding flex and B-C space that meets their needs. The labor market grew as the economy grew. Jobs lost in 2008 were now being replaced in abundance in new distribution centers.

My question now is, when is it enough? What does the next cycle look like? We lost jobs in 2008 due to cheaper labor in other areas of the world. Is the rise of technology going to be the next thing that takes jobs away? According to a leaked Amazon memo, the company expects to run out of labor in many of its major metropolitan areas by 2024. I believe many distribution jobs within these facilities will slowly be replaced by machines that make the jobs of the employees in the physical building easier, but is that really going to take jobs away if large companies are already expecting labor issues in the coming years?

With the collapse and bailout of SVB and many other banks seemingly on the ropes, is this another 2008? It seems as if the cycle has come back around and rested where we began almost 15 years ago. We may have clues as to how the market might be impacted, but as I said earlier, every cycle is just a bit different. How and when the pieces will fall is still a question that is unknown. I take comfort in the fact that our world works in cycles because it allows us to be confident that perseverance through bad times will pay off.

China Reopening Set to Boost Asia-Pacific Multifamily; Hospitality Sectors

With the news that China has lifted travel bans, travelers from across the globe are gearing up to visit the country and provide a welcome cash injection for the Chinese tourism industry. At the same time, the greater Asia-Pacific (APAC) area is getting ready to receive an influx of Chinese nationals as they flock to neighboring countries for business and leisure.

While that’s good news on a number of economic levels, it’s also a tailwind for the APAC commercial real estate (CRE) industry. And, according to recent reports across the region, the two sectors that are anticipating the biggest benefits are multifamily and hospitality.

Apartment sales are on the up

Multifamily sales in Singapore, for example, are expected to improve, with some analysts anticipating a “more than 10% increase in the number of homes purchased by Chinese this year” in the city-state.

A recent article in the Australian Financial Review (AFR) adds that another possible effect of China’s reopening is an uptick in Australian apartment sales. AFR says: “At a time of little new apartment supply, Australia’s residential developers will benefit from returning demand from returning foreign migrants.”

AFR notes that luxury apartments in particular are likely to see elevated sales but states that overall Australia is “lower down the list of countries to directly benefit from China’s reopening.”

Tourism and hospitality boost

Countries like South Korea and Japan are expecting a bigger boost, especially from the tourism and hospitality sectors. Likewise in Thailand, hospitality is gearing up for a major influx of Chinese tourists, with Thai Deputy Prime Minister, Anutin Charnvirakul, stating:

“The arrival of tourists from China, as well as from countries around the world to Thailand is expected to increase continually. This is a good sign for Thailand’s tourism sector,” adding “…it will accelerate the economic recovery after our suffering from the Covid-19 pandemic for three years.”

The reopening is also a positive signal for the hospitality sector in many other South-East Asian countries, which have battled low hotel occupancy and slow revenue recovery over the last three years.

Worth noting, however, is that some APAC countries have introduced restrictive new travel policies regarding Chinese nationals, including Covid testing requirements, which could act as a headwind to recovery.

Economic ‘silver lining’

At the start of a year where murmurings of recession have kept economic prospects largely subdued, China’s reopening is a strong positive signal for the global economy.

As a recent Bloomberg article quoted in the Japan Times puts it:

“China’s sudden reopening is set to offer a boost to a flagging world economy. The growth impulse will be felt through services sectors such as aviation, tourism, and education as Chinese people pack their bags for international travel for the first time since the pandemic.”

Capital Markets FinCEN scrutiny CRE transactions

FinCEN Alert Could Mean Greater Scrutiny for CRE Markets 

A new alert issued by the U.S. Treasury’s Financial Crimes Enforcement Network (FinCEN) is warning banks and other financiers to be on the lookout for potentially suspicious investments into US commercial real estate (CRE). FinCEN says some of these investments may be an attempt by Russian oligarchs to use CRE to move or hide funds and avoid international sanctions. 

What this means for CRE firms is that there may be greater regulatory pressure, and greater scrutiny, in the cards.

Shoring up ‘vulnerabilities’

FinCEN points out that there are “several vulnerabilities in the CRE market” that could be exploited to avoid sanctions, including the fact that CRE markets and transactions: “involve highly complex financing methods and opaque ownership structures that can make it relatively easy for bad actors to hide illicit funds in CRE investments.”

Part of the challenge lies in the fact that CRE transactions often involve trusts, private companies, and other legal entities as buyers and sellers, making it tricky to pin down ownership. 

Risks and regulations 

While it’s not yet clear what specific requirements may be incoming, in a recent CoStar article on the matter, bank regulatory attorney, Dan Stipano noted that: “FinCEN has started a rulemaking process that would impose requirements to prevent money laundering on the commercial real estate industry.”

He added that the process is still in the early stages, however, and that we don’t know which aspects of the industry new regulations will target. 

Ongoing developments

The move to take a closer look at US CRE investments is part of a bigger trend of scrutinizing property markets across the globe. Back in December 2022, a FinCEN Financial Trend Analysis noted that CRE markets in Turkey and the United Arab Emirates had “become a safe haven” for this kind of illicit activity, and the UK National Crime Agency issued a broader “Red Alert” on sanction evasions in July.

Taken together, these moves add up to a global environment where CRE investments (and investors) may have a tougher time finding financing and completing the required diligence processes needed by increasingly cautious lenders.

That said, the good news is that the Commercial Real Estate Finance Council (CREFC) is also keeping a close eye on the situation and have noted that they are: “working with policymakers to educate them on the CRE finance markets, including how the industry works to prevent, detect, and report illicit activity.”

OPM – Part II

Alec J. Pacella, CCIM

Last month, we had the first part of our “double period” and discussed various types of loan structures that can be utilized by a real estate investor. This month, we are going to roll into the second part of this discussion and highlight various key terms associated with loans.

There are two specific documents. The first is the mortgage, which pledges the real estate as collateral for the loan. Equally important is the promissory note (usually called the note), which is the document that contains the terms and conditions between the borrower and the lender. It memorializes the deal that both sides need to live with, so it’s important to understand some key components.

Loan amount

This is the amount of money the lender has provided. If funds are going to be held back from the full amount, the note will specify when and how the borrower will receive these additional funds.

Method of repayment

As discussed last month, there are all types of loans, including fully amortizing, partially amortizing, interest-only, participating, etc. This section of the note will detail exactly how, when and under what conditions the loan will be repaid.

Interest rate

The contract interest rate will be clearly stated in the note, along with a description of any future adjustments to this rate. For example, if the loan is tied to an index, this section will clearly state the index, the specific timing associated with future adjustments and any margin or spread that will be applied over the specified index.

Term

The note will include the initial date of the loan and the maturity date, or when the outstanding loan balance must be repaid to the lender. Some loans have a term that matches the amortization period. For example, loans originated by a pension fund will often have a 15-year term that matches up with a 15-year amortization period. However, most loans will have a term that is shorter than the amortization period. It may be amortized over 20 years but have a term, when the loan balance must be repaid, of five years.

Acceleration clause

This clause is always included in a note, as it gives the lender a strong position to force repayment. Under an acceleration clause, the lender has the right to declare the entire loan balance due in the event of default, which can be defined to include missing one or more mortgage payments, failing to keep the property maintained to building codes, failing to pay insurance premiums or property taxes, having a key loan metric such as debt service coverage ratio fall below a specified threshold, etc.

Because lenders have a direct interest in a property’s ability to generate income, they may use various mortgage covenants to specifically outline various controls. For example, a lender may have to approve leases that exceed a certain size threshold or consent to various repairs that exceed a certain dollar amount.

Most loans will have a grace period that allows the borrower the opportunity to cure some of these defaults.

Prepayment provisions

A lender may want to protect the yield received on a specific loan by specifying a time period which the loan cannot be prepaid, often called a lockout period. Or the loan may be allowed to be repaid with an associated pre-payment penalty. Certain loan products, most notably CMBS loans, will include a variation such as defeasance and yield maintenance, which allows the borrower to repay the loan according to a fairly sophisticated formula that again results in the yield being protected.

Due on sale

This clause will require full repayment of the loan upon the sale of the underlying real estate collateral.

Escrow/reserve accounts

A lender may establish various accounts that are used to withhold funds that are earmarked for specific events. The most common examples are escrow accounts for real estate taxes and property insurance premiums, as the lender will want to ensure that sufficient funds are available to pay these obligations when they become due. Reserve accounts go one step further and will withhold funds associated with a significant future expenditure. For example, if the roof on a large warehouse is anticipated to need replacement in a few years, the lender may require that the owner establish a reserve specifically to hold funds associated with this future replacement.

Property management & operation

Because lenders have a direct interest in a property’s ability to generate income, they may use various mortgage covenants to specifically outline various controls. For example, a lender may have to approve leases that exceed a certain size threshold or consent to various repairs that exceed a certain dollar amount.

Loan guarantees

Lenders may require additional security for the loan, beyond the value of the property, and a personal guarantee from the borrower is a common way to accomplish this. In the event a loan is personally guaranteed, the lender can require the borrower to pay any shortfall in the event of default or foreclosure. As a result, the security of the loan is beyond just the immediate real estate collateral and is extended to include other assets controlled by the borrower. A related concept is joint and several liability. If two or more borrowers are a party to a recourse loan, a joint and sev- eral loan guarantees the lender a right to recover the full amount of the deficiency from any of the borrowers, regardless of their ownership interest in the property.

Carveouts

Although not all loans contain guarantees/recourse, even non-resource loans will have some personal liability. These are commonly called carveouts and include full personal liability in certain events or circumstances. These circumstances include acts of fraud, misrepresentation, omission of facts or causing environmental damage to the property. Now that we have discussed the various forms a loan can take as well as the common terms and conditions they will contain, it’s time to get to some numbers. But that will have to wait until next month, when we head to the eighth and
final period of the school day.

Properties Magazine March 2023

CRE “By the Numbers”: Internal Rate of Return (IRR)

In our first installment of “By the Numbers”, we looked at a common metric for return on investment: a property’s capitalization rate or “cap rate.” As we saw there, many factors can influence a property’s cap rate and determining what makes for a “good” rate is often a lot more complicated than just looking for the higher number.

In addition to cap rates, however, there are several other metrics investors and commercial real estate (CRE) professionals can use to determine returns. Another common return metric that can tell you a lot about a property’s investment potential is the Internal Rate of Return or IRR.

IRR defined

Investopedia defines IRR as: A financial metric, used to measure the profitability of an investment, that takes into account the time value of money.

In other words, the IRR metric accounts for the fact that money received earlier is more valuable (given inflation and the potential to generate interest). This also means that, to calculate IRR, you need to have some idea of the cash flows a property will produce each year over the period of investment.

For example, an IRR calculation would include what you initially paid for the property, the amount you expect it to generate in rent each year (which would vary), and the amount you expect to be able to sell the property for later.

The actual equation to calculate IRR is fairly complicated (the Corporate Finance Institute gives an excellent breakdown here) and you’d typically use software or an online calculator to determine it. For the purposes of understanding the importance of this metric to CRE investing, however, it’s more useful to break things down in terms of what IRR tells us about an investment.

IRR essentials

Because IRR considers cash flows on a yearly basis over multiple years, it allows investors to see when they could expect a full return on investment, and how much profit they would make each year thereafter.

Comparing the IRR of two properties can therefore give investors a more nuanced understanding of how each will perform over time, and which is likely to be the better investment. All else being equal, a property investment that generates the same earnings sooner will have a higher IRR.

A “good” IRR?

Importantly, like cap rate, IRR is another metric where simply having a “higher value” doesn’t tell you whether a specific property is a better investment. For example, two properties might have the exact same IRR, but one generates a lot more profit over time than the other. The catch is that those profits are paid out later.

Real estate investment platform ArborCrowd gives a useful example:

(Source: ArborCrowd)

As the above scenarios show, with the same initial investment, but different cashflow horizons, the IRR is the same. The difference between the scenarios lies entirely in when returns are provided, and how much those returns are.

The value of the investment therefore really depends on what the investor’s expectations are. Would they rather wait longer for a bigger payoff, or could short-term gains be put to use in a way that generates more money elsewhere?

As with all things CRE, the exact value that constitutes a good IRR also depends on the sector, and the risk, involved in the investment.

IRR and other metrics

Like many return metrics, IRR can help investors understand specific information about a potential deal. IRR is useful in that it takes into account cash flows generated over multiple years and gives a view of returns on an annualized basis. Worth keeping in mind, however, is that IRR relies on forecasting cash flows (and a potential exit sale price), and many risk factors can affect those valuations in the long run.

By comparison, cap rates provide a “snapshot” of the income a property generates in a year in relation to its current value. It’s a less nuanced metric, but one that can also tell investors something about immediate risk versus reward.

In addition to these two, there are several other metrics the savvy investor should consider. We’ll be examining those in detail in future installments, so be sure to check back for more insight into CRE “By the Numbers.”

OPM

Alec J. Pacella, CCIM

With lunchbreak now behind us, the school day moves on as we head to fifth period. We lingered a little too long at the lunchroom table and our next class is a double period so there is no time to waste!

It’s very popular for a real estate investment to include capital from sources in addition to the investor’s equity. The most common form is a mortgage, sometimes called a permanent loan, and many think that a loan is a loan is a loan. But that is not always the case. While a traditional mortgage is a very common tool used by investors, it’s not the only way to use other people’s money (OPM). To learn more about some alternatives, read on.

Construction loan

A construction loan is specifically used to finance a construction project. These are typically negotiated between a developer and a lender, with the loan being used to fund construction costs. But it is very different in its structure and characteristics. Construction loans have relatively short terms, usually one to three years, while permanent loans are much longer. A construction loan is disbursed from the lender to the borrower/developer gradually as the project progresses. These usually take the form of “draws,” with the borrower making a request to fund a specific amount. During the time, the only repayment obligation is the interest associated with the outstanding loan balance for a given time period and the interest is based on a short-term variable or floating rate. Once the project is completed, the entire outstanding balance is due in full. This is usually accomplished by using a permanent mortgage.

Bridge loan

A loan is sometimes used to cover the time period between the construction loan ending and the permanent loan commencing. A common scenario is the development of a speculative project, where the building is completed without sufficient tenant commitments in place that would be necessary to qualify for a permanent loan. The construction lender will want to have their loan retired when the project is physically completed but the permanent lender may not be willing to disburse funds until the building is substantially occupied. A short-term loan, sometimes called a “mini-perm,” is a common way to fill this gap.

Second Mortgage

Mortgages are ranked in terms of priority and any type of mortgage that is subordinated to the first mortgage is called a second mortgage. Second mortgages carry greater risk than first mortgages because of the potential to be eliminated should there be a foreclosure of the first mortgage. This is particularly true if the value of the property has decreased since the loan(s) were originated. Therefore, second mort- gages usually carry a higher interest rate and have a shorter outstanding term. The second mortgage holder typically gives notice of this encumbrance to the first mortgage holder and the first mortgage holder usually must consent to allow the creation of a second.

It’s very popular for a real estate investment to include capital from sources in addition to the investor’s equity. The most common form is a mortgage, sometimes called a permanent loan, and many think that a loan is a loan is a loan. But that is not always the case.

Mezzanine loan

An alternative to using a second mortgage to obtain additional financing is to use a mezzanine or “mezz” loan. It is different than a second mortgage because it is secured by the investor’s equity in the property instead of being collateralized against the real estate. As a result, if there is a default on repayment of the mezz loan, the lender would engage in legal proceedings that would give them an equity interest in the property. The mezz lender usually will enter into an agreement with the first mortgage holder to have a right to take over the mortgage should there be a default by the borrower. Mezz debt typically has an associated interest rate that is several percentage points higher as compared to the first mortgage and the repayment of the mezz loan ranks ahead of any cash distributions made to the equity investor but obviously behind any loans that have priority.

Convertible loan

This type of loan is similar to a mezz loan in that it is provided to the borrower and collateralized against the borrower’s equity interest. But in this instance, the loan holder has the right to convert the debt into a share of the equity rather than have the obligation repaid or retired. The timing, terms and result of a conversation will vary and be clearly spelled out in the loan document.

Participation loan

This is a mortgage secured against the real estate that typically has an associated interest rate lower than that of a traditional loan. In exchange for achieving a favorable rate, the borrower agrees to allow the lender to share in the upside of the investment. This sharing can come from various sources. The lender could receive a percentage of gross income, net operating income or cash flow after debt service and/or can share in the gain achieved because of the property being sold or refinanced. The agreement related to a participation loan is highly negotiable and there is no standard structure.

Joint venture

While not a loan in a traditional sense, a joint venture has several characteristics of an encumbrance in exchange for a stake in the real estate. In a joint venture, or JV, two or more parties share in the ownership of a real estate venture. This can be an effective way to pool equity from more than one source, as well as include parties with different expertise, capacity or access to capital. As with a participating loan, there are all sorts of arrangements and structures for a JV.As you can see, a loan is not always a loan, at least not in the way we traditionally think. Next month, we will roll into the second part of this class as we will dig a little deeper into some ways to analyze a few of these alternative approaches, as using OPM sometimes is a result of thinking outside of the box.

Alec Pacella, CCIM, president at NAIPleasant Valley, can be reached by phone at 216-455-925 or by email at apacella@naipvc.com.

Properties Magazine, February 2023

New Construction off to a Shaky Start in 2023

According to a recent GlobeSt article, the US construction industry should prepare for a 3% drop-off in construction starts (i.e. new construction projects) in 2023. This follows on from a complicated couple of years for the industry in 2021-2022, as soaring materials prices and supply chain disruptions kept developers guessing about their next steps. 

GlobeSt was reporting on data from the Dodge Construction Outlook Conference which took place in November 2022. The Dodge Construction Network provides data analytics and insights to construction executives and industry leaders across the US, and the annual conference is cited as: “the leading economic forecast event for commercial construction.”

Multifamily set to slow

As is often the case, the expected decline will affect specific real estate sectors in different ways. GlobeSt notes, for example, that the value of multifamily construction may see a large decline (around 7% when adjusted for inflation).

In their own report on the data, industry news site Engineering News Record (ENR) adds: “In the multi-family sector, starts are expected to finish the year [2022] up 16%, but will drop 9% next year.”

Mixed bag for Retail, Office and Industrial

ENR also notes that the increases in retail and manufacturing starts seen in 2022 are likely to taper off, though it’s worth pointing out that the manufacturing industry saw gains of 196% over the year.

Quoted in the article, Dodge Chief Economist, Richard Branch, noted that despite an anticipated 43% drop for manufacturing construction, “that is still historically a very strong record level of activity.”

Meanwhile the dollar value of office construction is in for a “slight decline” of 1% in 2023, as remote work trends and the tight labor market continue to put pressure on the sector.

Niche sectors still offer respite

Despite these generally downhill trends, other predictions made during the conference include ongoing strong performance from some of the niche CRE sectors we’ve seen rise to prominence in recent years. As Archinect reports:

“While traditional school construction is set to fall, life science buildings and healthcare projects, including outpatient clinics and hospitals, continue to rise.”

These are assets we’ve seen big things from over the past year, and it seems they’re set to continue attracting investors in the year to come.

Recession effects

As the above predictions show, there are still many factors in play that will influence how things shake out for the construction sector in 2023. Arguably the biggest determinant is the likelihood and severity of a potential recession.

In Branch’s words: “We’re walking the razor’s edge here. In our estimation, there is a very, very, very narrow path to avoiding a technical recession in 2023.”

Lunch Break

Alec J. Pacella

During my school days, lunchtime was always an interesting experience. In addition to providing a nice break and opportunity to socialize, there was the actual main event – food. And with this came great variety, sometimes in a good way and other times in a bad way. I have similar thoughts when looking back at the commercial real estate investment market in 2022.

To see how our real estate market relates to school lunches, read on.

PIZZA

Nothing made me happier heading down the lunch line than seeing a huge sheet of pizza, cut into squares, of course. And nothing made investors happier last year than seeing a new, net leased industrial warehouse offering. This sector continued to be red hot, both on the leasing and the sale side. Occupancy was at an all-time high and increasing rental rates coupled with falling cap rates led to record activity and pricing. Facilities leased to Amazon led the pack and routinely traded at cap rates in the upper 4% range with pricing eclipsing the $300 per square foot (psf) mark. But even more routine deals were greeted with cap rates around 6% and pricing of $75 to $85 per square foot. These include the JB Hudco facility in Bedford ($83 psf at a 6.25% cap rate), the ID Images facility in Brunswick ($77 per square foot at a 5.8% cap rate) and the True Value facility in Westlake ($75 per square foot at a 6.75% cap rate).

CHICKEN NUGGETS WITH CRINKLE FRIES

Nuggets and fries along with some packets of BBQ sauce was a close second in my book, similar to investor interest in apartment properties being right on the heels of industrial warehouses. And while glitzy complexes such as the 401 Lofts in Akron made headlines with equally glitzy per unit pricing that exceeded the six-figure mark, it was the solid activity amongst the Class B product that carried this sector last year. Examples include Clifton Plaza Apartments in Cleveland (108 units sold for $57,000 per unit), Oak Hill Village in Willoughby (182 units sold for $77,000 per unit), State Hill Manor in Parma (110 units sold for $75,000 per unit) and 200 West in Fairview Park (173 units sold for $65,000 per unit).

SPAGETTI AND MEATBALLS

This lunch choice was always polarizing, with some loving a heaping platter of pasta while others hating it. It reminds me of the appetite for retail properties last year. A favorite type was well-located, smaller footprint centers occupied by credit tenants. Examples include Great Lakes Plaza, a 7,200-square-foot center occupied by Condoda Taco and Sleep Number, which traded for $5 million, and Parma Outlet Center, an 8,000-square- foot center anchored by Bank of America and Verizon, which sold for $1.8 million. Meanwhile, a clear unfavorite was tradi- tional, larger centers in mature locations. Examples include Stow Falls Center, a 95,000-square-foot center occupied by Planet Fitness and Litehouse Pools, which traded for $6.1 million, and Pheasants Run, a 30,000-square-foot center in North Olmsted, which sold for $1.7 million.

SLICED HAM WITH GREEN BEANS

When this showed up on the menu, most students opted to pack their lunch, which is similar to the activity in the office sector last year. When an office building showed up for sale, most investors headed in the opposite direction. The sector continues to struggle with weak fundamentals, including static occupancy, flat rent but rising expenses, all against a backdrop of uncertainty of the future of office space. As a result, pricing has languished. Examples of this softness include Westgate Plaza, a 92,500-square-foot building in Fairview Park that sold for $25 per square foot. Springside Place, a 97,000 square-foot property in Montrose that sold for $37 per square foot; the PDC Building, a 70,000 square-foot property in Beachwood that sold for $50 per square foot; and One Independence Place, a 100,000 square-foot building in Independence that sold for $50 per square foot.

ICE CREAM SANDWICHES

No matter how good or bad the lunch choices were, there was always a line when the ice cream freezer opened. This is very similar to investment activity in the single-tenant, net leased sector. Regardless of what may be going on in the broader real estate market, investors always seem to be able to make room for a good net leased offering. There were plenty of examples last year. A newly constructed Jiffy Lube in Avon traded for just over $700 per square foot, at a 7.2% cap rate. A Citizens Bank in Bainbridge sold for $1,400 per square foot, at a 5% cap rate. A Starbucks in Aurora sold for $1,100 per square foot, at a 5.75% cap rate. And a Wendy’s in Cleveland sold for $1,450 per square foot, at a 4.5% cap rate.

While the full effect [of the Fed rate hike] on the commercial real estate market isn’t readily apparent, the activity level clearly slowed over the last part of the year. More importantly, this sluggishness is anticipated to continue into the first part of 2023.

NEW MENU COMING

One of the most interesting days in the cafeteria was when the new menu for the upcoming month was posted on the bulletin board. Everyone would gather around to figure out what days they would packing their lunches and what days they would be buying them. Last year, the bulletin board was replaced by our phones or computers. But we weren’t looking for a menu but rather a news release on the results of the most recent Federal Reserve Board meeting. The Fed met eight times last year and raised the fund rate at seven of these meetings. As a result, the rate went from 0.75% to 4.5% and has obviously had a dramatic impact on the cost of borrowing. While the full effect on the commercial real estate market isn’t readily apparent, the activity level clearly slowed over the last part of the year. More importantly, this sluggishness is anticipated to continue into the first part of 2023.

But I’m starting to get into 5th period so for now, let’s just kick back and enjoy the rest of our lunch!

What I C @PVC

PAINTING A PRETTY PICTURE Last year ended with a bang when it was announced that Sherwin- Williams was entering into a sale/leaseback for the new 1 million-square-foot corporate headquarters. Benderson Realty Development is paying $210 million for a 90% interest in the property, which is currently under construction and scheduled to be completed in early 2025. –AP

For February 2023 Properties Magazine

Conflicting Signals: What do Layoffs Mean for the Labor Shortage?

In recent news from the Washington post, tech giant Meta is cutting around 11 000 jobs, representing 13% of the company’s workforce. Twitter is also continuing with layoffs, after already slashing jobs drastically earlier in November.

Meanwhile Forbes reports large-scale layoffs at Amazon, adding that multiple other major companies – from Disney to Barclays, Salesforce, and Lyft have all already cut jobs or have announced cutbacks and hiring freezes.

With all of these changes incoming, the question that’s top of mind is: How will this affect the labor shortage we’ve seen since 2021?

In larger context

The names above are some of the biggest players (and employers) in the market, so it’s natural to assume that these cuts mean the labor shortage is inevitably reversing. Before making that deliberation, however, it’s worth taking a look at some of the figures from the U.S. Chamber of Commerce (USCC) to get a sense of the bigger picture.

In October, Stephanie Ferguson, the USCC Director of Global Employment Policy & Special Initiatives outlined the magnitude of the shortage, stating: “We have a lot of jobs, but not enough workers to fill them. If every unemployed person in the country found a job, we would still have 4 million open jobs.”

State and sector

The shortage stems, Ferguson says, from the unprecedented number of jobs added in 2021 – approximately 3.8 million. At the same time, the labor force has shrunk, with many workers retiring early, and workers quitting their jobs in unprecedented numbers as part of the Great Resignation.

USCC data shows that these shortfalls are  largest in Northern and Eastern States, and that certain industries, like hospitality and healthcare, have disproportionately high levels of job openings.

All of which is to say, that while the big moves happening in the tech sector right now are certainly concerning, they still form part of a much larger, and more nuanced, picture.

CRE concerns?

For the commercial real estate (CRE) industry, the effects are likely to be similarly varied, depending on where and what type of business we look at. We have already seen some sharp downturns for specific Proptech companies. Redfin, for example, has cut a further 13% of its staff, following on from an earlier round of layoffs in June.

Other Proptech outfits are facing similar difficulties, as 2022 shapes up to be a tough year for CRE startups.

Labor market outlook

What these cuts ultimately mean for the labor market, and CRE operations in the Bay Area where many tech companies are concentrated, is still unclear.

For now, it seems that worker availability, even in tech, is still falling short of demand from employers. Amid the current economic uncertainty, however, that situation might well change as we head into 2023. As always, we’ll be keeping a sharp on the trends, and potential impacts in CRE markets.

Thought Leader Cybersecurity

Risky Business: Why Cybersecurity Should be Top of Mind for CRE Professionals

Over the past year, it’s sometimes felt like the number of factors that we, as commercial real estate (CRE) professionals, need to keep track of have grown exponentially. Especially in the face of challenging market conditions. 

At the same time, there’s an ever-increasing need to be conversant with new technology and tech tools that help boost productivity and add value for clients. The tools available  span the spectrum from social media to drone technology, climate-savvy building tech, and even augmented or virtual reality software.

For brokers, building managers, and developers incorporating these game-changing technologies, the possibilities are nearly endless.

There is, however, a flip side to this coin. And, like many things tech-related, it’s an area where CRE professionals have often been slow on the uptake: Implementing the right cybersecurity protocols.

A growing threat

Part of the problem is the idea that cybersecurity is something that’s handled exclusively by a dedicated team, or automatically built into the software being used. While that’s true to some extent, the fact remains that the tactics cyber criminals use, and the number of incidents each year, are continually growing.

Sophisticated “phishing” attacks, which aim to get staff to unwittingly compromise system security, and ransomware are the order of the day, and, as a recent incident in Australia shows, the real estate sector is far from exempt from these threats.

Given the amounts of sensitive data passing through or stored by the CRE industry, the question we need to ask is: Are we truly prepared in the event of a breach?

New risk vectors

The first thing all CRE businesses should consider is whether all possible systems, and avenues of access to those systems, have been identified and are properly protected. 

In an excellent recent interview on cyber threats in CRE, security consultant Coleman Wolf points out that many possible avenues of attack go unnoticed. These may be linked to building control systems (think temperature or lighting management) and other smart tech, or even to the specialized Internet-of-Things (IoT) systems being used in industrial operations.

If these systems are connected to the internet, but not adequately protected, they may act as a springboard for access to other systems or data. Hackers may then be able to tap into sensitive information, including financial and personal data stored elsewhere. Alternately, simply taking control of building systems can be used as a tactic in ransomware attacks.

As the CRE industry begins to adopt new smart building technologies, and we increasingly repurpose buildings for niche markets, like the booming medical office sector, the potential for sensitive information to form part of breaches also grows exponentially.

Other trends, like the Bring-Your-Own-Device (BYOD) movement where employees use personal devices in the office, create additional avenues of attack if those devices aren’t properly secured.

Best principles

While all the above may make it sound like it’s impossible to keep track of potential threats to a building or CRE enterprise, the good news is that there are certain essential principles that can be followed to mitigate the risk.

In a recent article on cybersecurity best practices in CRE, J.P. Morgan advises that:

• CRE companies should ensure all employees, beyond just the IT team, are aware of potential risks from phishing or ransomware and have been trained in how to minimize those risks.
• Companies ensure there’s appropriate access control. For example, implementing multifactor authorization (MFA) and other safeguards.
• Employees are aware of the risks of oversharing on social media (e.g., detailed information on job responsibilities and the type of data they have access to, which could make them phishing targets).

Of course, these recommendations are only starting points, and the exact requirements and level of detail needed will vary based on each firm’s unique context. There’s certainly no “one-size-fits-all” solution for CRE cybersecurity.

That said, an excellent resource to familiarize yourself with upcoming benchmarks and strategies for cyber-security can be found in PwC’s “C-suite united on cyber-ready futures” guide (you can register for free to download the report).

Securing the future

As we head into 2023 and beyond, some of the most exciting aspects of the CRE industry come in the form of new technology. There’s an ever-expanding array of Proptech tools on hand to help us close deals. Smarter building technologies ensure we meet environmental and climate imperatives while also offering something new and different for tenants and investors alike.

As CRE professionals, we’re right to be excited by the possibilities on offer. But we also need to make sure we keep security top of mind as we begin to integrate these tools.

As PwC summarizes: “Digitization makes security everyone’s business. The future promises more connected systems and exponentially more data — and more organized adversaries. With ever expanding cyber risks, business leaders have much more work to do.”

The Winner’s Circle

Alec J. Pacella, CCIM

Last month, we continued our “back to school” theme and started a discussion regarding capital accumulation. And equally important, we took a walk down memory lane, discussing slot car racing sets that were a part of my childhood in the 1960s and ’70s.

If you read last month’s column, you may recall that although Internal Rate of Return (IRR) is a well-established measure of an investment, it has some deficiencies. This is particularly true related to what I called the investor’s total pile of cash. IRR only cares about money in the deal and gives no consideration to money that comes out of the deal – even though an investor can reinvest these cash flows. Interwoven in that discussion was the story of AFX, a leader in the slot car racing scene of the ‘60s and ‘70s, and upstart Tyco, which proved to be a worthy alternative. This month, we are going to continue this discussion as AFX vs. Tyco isn’t the only battleline being drawn. This is the last period before our lunch break so let’s go! Modified Internal Rate of Return (MIRR) was initially developed in the 1960s and primarily used by businesses to make a more accurate comparison between investment alternatives. It addressed one of IRR’s main limitations of ignoring cash flows produced from a primary investment by introducing a couple concepts. If you recall, last month I used the analogy of putting money produced by an investment in a mason jar and burying it in the back yard. This would equate to a reinvest- ment rate of zero, as the money in that jar would be earning nothing. But we can do something more productive with those cash flows – like redeploy them at a realistic reinvestment rate, usually a rate comparable to the firm’s cost of capital. Also, any additional outlays that would be needed to cover anticipated shortfalls (i.e., negative cash flows) over the holding period are assumed to be funded upfront at the firm’s cost of debt. Figure 1 illustrates the MIRR process, using an 8% cost of capital and 4% financing cost. As you can see, the $10,000 negative cash flow anticipated to occur in year three is acknowledged at the beginning of the investment by dis- counting the shortfall back to time period 0 at 4% and adding this to the initial investment. Meanwhile, all of the positive cash flows are reinvested at 8% to end of the fifth year. As a result, the $108,890 initially invested is anticipated to produce $201,501, which equates to a MIRR of 13.10%.

Figure 1

Capital accumulation is newer, developed in the 1980s. While the basic premise is the same as MIRR, the concept is more specific to a real estate investor and introduces a few twists. A primary difference is the treatment of negative cash flows. MIRR eliminates future anticipated deficits by setting aside the additional capital necessary upfront, at time period 0. Capital accumulation discounts negative cash flows back one year at a time, offsetting it against any positive cash flows produced in the preceding year(s) until the deficit is eliminated. This is done at a “safe rate,” which represents the rate of a secondary investment that can confidently be achieved. After eliminating any negative cash flows, the remaining positive cash flows produced by the primary investment are assumed to be reinvested at rate representative of an investment alter- native readily available to the investor. But rather than compounding the positive cash flows produced each year to a corresponding future value at the end of the time horizon, capital accumulation only compounds each annual cash flow forward to the following year. This is added to any cash flow expected to be released in that following year and then the entire sum is again compounded forward one year. A second, related nuance is that capital accumulation can have multiple, or tiered, reinvestment rates. A higher reinvestment rate may be available as specific dollar thresholds are met. This acknowledges a premium in return as a result of the aggregate amount being reinvested. This kicker is a concept similar to “jumbo CDs” of years past. By compounding cash flows one year at a time, the opportunity to exceed any established thresholds can be realized. This acknowledges a premium in return as a result of the aggregate amount being reinvested. This kicker is a concept similar to “jumbo CDs” of years past. By compounding cash flows one year at a time, the opportunity to exceed any established thresholds can be realized.

Figure 2 illustrates an investment with the same series of cash flows but utilizing the capital accumulation approach, with a tiered reinvestment assumption of 8% for positive cash flows up to $50,000 and 9% thereafter as well as 4% safe rate for negative cash flows. Note the differences in handling of both positive and negative cash flows as compared to Figure 1. Capital accumulation uses periodic positive cash flow in year two to offset the discounted shortfall from year three. It then compounds the remaining positive cash flows one year at a time, which allows it to take advantage of the higher 9% return as a result of exceeding the $50,000 threshold in year four.

These subtle nuances have a significant cumulative impact on the results; the $100,000 initially invested is anticipated to produce $190,077 by the end of year five, resulting in a capital growth rate (CGR) of 13.71%.

AFX slot car racing has several similarities to MIRR. Both are more established and set a standard in their respective worlds. Both have a wide following. And both take a more conservative approach. Tyco and capital accumulation also have several similarities. Both are upstarts and offer some twists to their more established counterparts. Both have a niche following. And both take a more unconventional approach. By understanding these nuances and choosing the path that best fits your needs, you will be in a better position to end up in the winner’s circle.

What I C @ PVC                

STILL HOT Investment sales, particularly industrial warehouse product, continues to achieve record pricing. Last month, a 125,000-square- foot facility in Middleburg Heights sold for $13.7 million or $109 per square foot. This is the 12th industrial investment sale to break the $100 per square foot mark this year. –AP

From December 2022, Properties Magazine

Thought Leadership Women in CRE

Investing in Gender Equity is an Investment in CRE’s Future

When it comes to parity, commercial real estate (CRE) still has some ways to go in leveling the playing field for women in our industry. That’s the central message of the latest report from the Commercial Real Estate Women Network (CREW), a national organization with a focus on diversity, equity and inclusion in CRE.

Hidden figures

One of the biggest pain points for women in the industry according to the report is the culture of secrecy around salaries. Of the 1228 CRE professionals interviewed, 68% indicated they’d change jobs to work at a company with greater salary transparency (even with a similar salary offer on the table as what they currently earn). Around 82% said they wanted job listings to include wage and benefits information, with many adding this would give them more confidence in salary negotiations.

In an industry with a proven record of pay disparity, those numbers are especially telling and highlight an important point. Part of creating equity is building transparency into the recruiting and salary negotiation process.

Another concern raised was the disparity faced by women of color specifically, who, according to PayScale’s 2022 Gender Pay Gap data, typically earn far less (across a variety of industries) than white men or even their white women counterparts. CREW also noted in a previous report, that women of color were less likely to have a sponsor or mentor in CRE, blocking their opportunities for advancement in the industry.

Building better businesses

Besides the obvious social imperative to address these issues, investing in gender and racial equity is an increasingly important part of building business resilience.

As, Lily Trager, Head of Investing with Impact for Morgan Stanley Wealth Management, recently pointed out: “When our quantitative team analyzed global companies based on their percentage of female employees and other metrics of gender diversity, companies that have taken a holistic approach toward equal representation have outperformed their less diverse peers by 3.1% per year.”

Trager added that a growing requirement from Morgan Stanley’s “high-net-worth investors” is that Diversity, Equity, and Inclusion (DEI) be a priority for the companies they invest in.

Promoting equity

For us in CRE, the challenge is to address the historically low numbers of women both in our industry, and especially in C-suite positions. And while that process should be driven by everyone, it’s especially important that the policy decisions and changes we make to promote equity are guided by the experience and expertise of women in the space.

The CREW Network’s recommendations in this regard include:

• Committing to pay transparent practices – In other words ensuring that both salaries and the processes for earning pay increases are clear and accessible.
• Supporting professional development – Encouraging women in your organization to pursue professional development opportunities (and join women’s forums) and financing those opportunities.
• Formal mentorship and sponsorship programs for women – We all know that in the real estate industry, mentorships are invaluable in shaping the trajectory of an individual’s career. For women, and especially women of color, we should incorporate and encourage mentorship as a central part of our business.

A commitment to gender equity

The legacy of gender, and other, inequities won’t be undone overnight. What’s vital to accelerate the process is that, as business leaders, we commit to creating workplaces that make Diversity, Equity, and Inclusion a reality. In doing so, we can build a CRE future that enables the best in our people and our business.

For more information about NAI’s own commitment to Diversity, Equity, and Inclusion,  please visit our page here, or find more information about the NAI Global Women’s Alliance here.   Or join us in becoming signatories to the CREW Network’s Pledge for Action![SR2] 

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DEAD IN THE WATER

Joseph Hauman

Do you know where the saying dead in the water comes from? It was originally used to refer to a boat that was stuck out at sea with no wind. No wind means no movement and as you could imagine, no movement is not good for a boat in a large body of water. Over the last 2 years, people have been telling me that the office market in Cleveland is “dead in the water” as everyone from your nephew’s Lemonade stand to Google decide if they need more space or if they even want any space. To be honest with you I believed it for a little bit too. I thought there is no wind in the sails of the office market in Cleveland, but then I allowed myself to take a real look at the industry.

Sailboats are great but they need something to push them. A tide, current, or wind is needed to make a boat with no motor move. I believe that office rents in the Cleveland Market have stayed stagnant because they have been the tide, current, or wind in the sails of our largely vacant office market.  What do I mean by that? Owners in Cleveland often think that they are in competition with each other. They attract tenants to their buildings by offering a low price, free rent, and higher tenant improvement allowances than what they view are their competitor’s. That, in turn, makes other owners lower their prices and it becomes a price war at its most basic level. For years, that has been the reason why the office market continued to truck along with very few new buildings and stagnated rent growth. Lower prices and increasing free rent packages were the slow wind that was pushing the sails of a fundamentally broken office market.

Why are low prices so bad in an office market? The answer is they aren’t when they can be controlled and used to attract quality businesses that will help the area grow. That, however, is not the situation that the Cleveland office market is in. We are in a vicious cycle of rent reduction to attract businesses that don’t choose Cleveland because of the lack of amenities, in both buildings and the city, and because they don’t choose Cleveland both the owner and city miss out on valuable tax and rental income that could be used to pay for new amenities to attract new businesses. This is the reason why the Cleveland office market is “Dead in the water”.

Nobody cared about this issue until the past two years when work from home skyrocketed and tenants didn’t care how much you reduced their rent; they just wanted out. It was no longer a price war because price mattered very little anymore. It became an agent’s job to keep tenants from bull rushing out of a building. Any wind that was ever present, was lost. No hope, right? Wrong.    

Going back to what I had said earlier when technology advanced we learned that we could put an engine on a boat and we had no more need for the wind to propel us. The wind and the sail didn’t matter anymore because the fundamental idea of a boat changed. It was no longer difficult to maneuver, slow, or relied on something totally out of one’s control. Instead, a boat became fun, attractive, and a sign of success for most. Office buildings need a motor. The entire idea of an office building needs to be changed. Low rent and new paint aren’t enough anymore. You need a space that makes people want to come to work. If your building doesn’t do that, then you need to take a hard look at the future success and viability of that building. If you are a landlord you must know your effective vacancy on any building you own. I don’t mean how many people you are getting checks from every month or the number of available square feet you tell your broker to put on the flyer. I mean how many people are coming in and using your space on a DAILY basis? If you have amazing tenants that don’t want that stuff then, congratulations, you have won the jackpot. If you have large amounts of vacant space and are wondering how to change it, then hold on because I’m going to tell you.

ASK AND YOU SHALL RECEIVE

I know most office buildings or parks are purchased as a semi-passive investment which is great and I fully support it, but if you have a high vacancy you need to get a broker, or property manager or go yourself to each tenant and ask what they are looking for. Ask what your building lacks and where it could be improved. If you have current amenities in the building ask if they use them and how often. If you have someone that works in an amenity like a dry cleaner, food service, or gym, ask them how often people come through and what sort of mood they are in when they come in. If you have services in the building you need to find out if people are using them because the service is good or if it’s convenient. If tenants are using it out of convenience then that’s great, but it’s not enough to keep them there at your building. The true testament to the amenities that you provide should be if a tenant leaves and still comes back to your building to use your amenities. Obviously, not all amenities are offered to people that are not tenants, but ones that are, such as an open cafeteria or dry-cleaning service should be good tests. If you ask tenants for their opinion make sure they are valued and listened to. Asking them questions only to do nothing in hopes that they will stay is going to do you no good. If you want to have a low vacancy you need to get things in the building that people want. Let the ideas flow. Everything from a VR gaming setup, driving simulator, or golf simulator might be options that are relatively inexpensive in comparison to renovating a cafeteria or building out a new gym. Take the answers to the questions that you get from your tenants and mix them with your ideas and see if it’s possible. Maybe call me and let me come take a look and allow me to give you my opinion.

If your building represents a sailboat that is quickly or slowly losing wind then pull it out of the water and put an engine on that sucker because if you don’t make a change soon your boat will be dead in the office market water. 

Have something to say? Great, I would love to hear it. Shoot me an email at Joe.Hauman@NAIPVC.com or give me a call 440-591-3723.

SIOR report shows sentiment waning in Office, Industrial

Despite a red-hot streak that’s outperformed other commercial real estate (CRE) asset classes, it seems that bullish sentiment on the industrial sector is finally cooling off. A recent report from the Society of Industrial and Office Realtors (SIOR) indicates that realtor confidence in the market dropped to 5.5 (out of 10), compared to 7.7 in Q1. Office sentiment fared poorly as well, with a 32% drop in confidence from 6.5 in Q1 to 4.4 in Q2.

Declining activity  

While general factors, such as prevailing economic conditions, played a role in the flagging sentiment, SIOR reported specific indicators of a downturn between Q1 and Q2 as well.

For industrial, these included:

• Only 31% of members reporting an active leasing market (down from 61%)
• An increase in “on-hold” transactions (from 10 to 14%) and canceled transactions (from 7 to 11%)
• 69% of members reporting “booming” or “average” development conditions (down from 81%)

Meanwhile, office realtors reported a similar shakeup, with SIOR noting that:

• 37% reported “little” or higher leasing activity in Q2 (down from 58%)
• Canceled transactions jumped from 7% to 11%, and
• There was a 61% reduction in the number of members reporting a “booming” or “average” development environment in their area.

SIOR adds that uncertainty around inflation and potential “economic turmoil” were the main drivers of the downturn. Or, as one of the survey respondents put it:

“Consistent commentary among clients is that the future is very uncertain and a recession likely coming.”

Concerns in context

Sentiment analysis across the broader US market indicates that the general consumer outlook continues to drop as we progress into Q3. This makes July the third consecutive month that consumer confidence has taken a knock.

Economic sentiment indicators in Europe show similar retractions, with confidence in the industrial sector declining by 3.5% in the region. Challenges such as the high cost of energy and gas shortages are hitting Europe particularly hard. In July this year, Reuters reported that Germany, the region’s industrial powerhouse, could be on the verge of recession.

For sectors like office and industrial, these reports indicate that there may be strong headwinds incoming.

SOCIAL: How have the industrial and office sectors performed in your region in recent months?

Second Period

Alec J. Pacella

Last month, we went back to school and discussed some useful financial calculations incorporated within Microsoft Excel formulas. This month, we are going to continue the school day and, along the way, weave in the theme of renovation being covered throughout this issue of Properties. Both fit perfectly for me; I teach a course at the University of Denver and just finished writing a question for the midterm exam, as follows:

An investor is contemplating installing an automated ticketing system in their parking garage. If continued to be operated with a manned attendant, the garage is expected to produce $100,000 next year and anticipated to grow $2,500 annually in subsequent years as a result of planned increases in the parking rate. The reversion value at the end of five years is expected to be $1,200,000.

The automated system is anticipated to cost $250,000 but income will increase to $125,000 in the first year, as a result of no longer needing an attendant and thus realizing lower expenses. Annual increases are projected to remain the same, $2,500 per year, and the reversion value at the end of five years is expected to be $1,500,000, based on the higher income level.

Using a discount rate of 10%, which alternative should the investor choose?

This is a classic renovation analysis – should the investor keep on keeping on, as-is, and not incur the upfront expense which will result in lower annual cash flows and lower reversion. Or should the renovation be completed, which will result in a significant upfront expense but higher annual cash flow and higher reversion. Who’s ready to go back to school?

We are going to use a three-step approach to solve this problem, dragging in our old friend the CCIM T-bar to help. The first step is to model the cash flows associated with doing nothing. The present value (PV) component would be zero, as no initial money is being spent. The payment (PMT) component would start at $100,000 in the first year and increase $2,500 each subsequent year of the holding period. And the future value (FV) would be $1,200,000. Figure 1 represents the T-bar for these cash flows. The second step is to model the cash flows associated with making the renovation. The PV component would be ($250,000), reflecting the cost of installing the automation system. The PMT component would start at $125,000 in the first year and increase $2,500 each subsequent year of the holding period.

And the FV would be $1,500,000, which is the anticipated value of the garage at the end of the holding period. Figure 2 represents the T-bar for these cash flows.

The third step is to calculate the net present value (NPV) of each T-bar, using the 10% target rate. You’ll need a financial calculator to perform this function (unless you were paying attention to last month’s column). Once completed, you will discover the “as-is” scenario has a NPV of $1,141,339 while the “renovate” scenario has a NPV of $1,172,385. At this point, the decision is simple; based on the assumptions provided, it is worth it to pursue the renovation.

We are not done yet – the university students also have a related bonus question, so why shouldn’t you? We can take this analysis one step further by using a concept known as “IRR of the differential.” Calculating it is straightforward and is the IRR of the difference between the renovated series of cash flows less the as-is series of cash flows. As you can see in Figure 3, the PV of ($250,000) is found by subtracting the PV of the renovated T-bar (Figure 2) minus the as-is T-bar (Figure 1). The PMT in year one in Figure 3 is found by subtracting the year one PMT of the renovated T-bar minus the as-is T-bar. Lather, rinse, repeat for the cash flows in years two through five and the reversions. Plug these into a financial calculator (unless, again, you were paying attention to last month’s column) and we come up with an IRR of the differential of 13.08%.

But the bonus question on this insidious mid-term exam doesn’t ask for the IRR of the differential. C’mon, these are graduate students! It asks what this concept means – because to me, this is the most important number on the board. And I’ll save you the grief. From a purely mathematical perspective, 13.08% is the exact rate at which the NPV of the as-is scenario and the NPV of the renovate $1,500,000, which is the anticipated value of the garage at the end of the holding period. Figure 2 represents the T-bar for these cash flows.

scenario are equal. You are welcome to try it but, trust me, you will come up with an NPV of $1,015,465-ish for either scenario if you use a discount rate of 13.08%. But mathematics doesn’t pay the bills, understanding the practical application is what’s important. The 13.08% discount rate is considered the point of indifference or cross-over point. At that exact rate, there is no difference between the as-is and the renovate scenario. They are equivalent decisions. But at any rate less than 13.08%, the decision swings to the renovate scenario and the lower the rate, the more pronounced the renovate decision becomes. Conversely, at any discount rate greater than 13.08%, the decision swings to the as-is scenario and the higher the rate, the more pronounced the as-is decision becomes.

Gang, our business is all about under- standing and quantifying risk, and the concept of IRR of the differential is a hallmark example. The break-even risk versus return for this proposed renovation is 13.08%. If you believe the risk associated with this proposed renovation demands a return greater than this point of indifference, you are better off to not spend the money and keep on keeping on. But if you perceive a low degree of risk associated with the renovation, and are good earning a return at some rate less than this break-even rate, you are better off to spend the money. And if you liked second period, just wait to see what we have in store for third period!

by Alec Pacella for Properties Magazine, November 2022

Top Tech partner: Harken

Staying on top of new developments and technologies is a necessary, but demanding, part of being a savvy commercial real estate (CRE) professional. With the Top Tech series of blogs, we aim to highlight some of the ones that have caught our attention while also showcasing the work of NAI partners that we feel are changing the CRE game.

Worth keeping in mind is that these blogs aren’t “partner content” or sponsored; rather they’re an opportunity for us to share tools that we think really add value for real estate professionals, from across our diverse partner-base.

That said, we are proud to add that the company featured today is the brainchild of NAI’s own Ethan Kanning. Ethan is a co-founder of valuation software company Harken, which through their “Bankable Real Estate Data” approach, has found a home with some top brokers and brokerages in the NAI Global network.

What do Harken do?

Harken’s software combines automated analytics with a built-in comps (comparables) database to simplify the process of estimating a specific property’s value. This approach allows brokers to complete a Broker Opinion of Value (BOV) in record time, which of course translates into quicker turnaround for clients and more business for brokerages and firms.

The platform’s reports are also white labeled to the broker’s company, allowing them to build their brand and establish expertise in the market.  Meanwhile, for those that need to be Dodd Frank compliant, the process is simplified by having all relevant fields already included in the BOV form. With these functionalities built-in, you can see why Harken is one of our top picks as a tool that streamlines real estate workflow.

A company with a conscience

Another thing worth noting about these up-and-coming entrepreneurs, is that Harken doesn’t draw the line at “just business.” In addition to making top-notch software, they are also committed to keeping DEI (Diversity, Equity, and Inclusion) top of mind. As one of the sponsors for the Women’s Alliance initiative  at the NAI 2022 Global Convention, they had this to say:

“We believe the healthiest, most vibrant, and sustainable company is one that focuses on DEI initiatives… A diverse team with a focus on self and other’s awareness, helps us recognize both our personal and company biases. Once these biases are understood, we can begin working together to create a more inclusive and sustainable business environment for everyone.”

With their genuine desire to make the workplace both easier to navigate and more inclusive, it’s not hard to see why we consider Harken a Top Tech partner!

Deconstructing the cost of building materials in 2022

Throughout 2021, the cost of building materials was a constant pain point for the construction industry. In an analysis by the Associated General Contractors of America (AGC) earlier this year, prices were found to have jumped over 20% between January 2021 and January 2022. The cost of specific materials like steel and plastic sky-rocketed, leaving construction firms caught between shrinking profit margins and a sharp decrease in available labor.

As we head into the second half of 2022, the question that’s top of mind for building contractors and many Commercial Real Estate (CRE) professionals is: Has the situation improved?

Well, the cost reports from the first and second quarter this year are in. Here’s how it’s looking.

Prices climbed in Q1

Overall, the first quarter was still rough for price increases, with the National Association of Homebuilders (NAHB) indicating that the cost of residential construction materials jumped 8%. One of the biggest price hikes was softwood lumber, which increased 36.7% over the period.

Meanwhile, a Q1 report from construction consultancy Linesight showed increasingly high costs for resources like copper (3.3% estimated increase from Q4) and steel (4.7 and 8.9% for rebar and flat steel respectively), accompanied by moderate hikes in cement, asphalt and limestone. Bear in mind that these increases are on top of the price surges many of these materials already saw last year.

Materials costs still (mostly) soaring in Q2

Any hopes of price relief in Q2 were also met with resistance, as costs for many materials continued a steady climb. In an analysis of recent Producer Price Index (PPI) data, AGC showed that the overall cost of inputs for new non-residential construction had jumped 1.1% between May and June alone.

The report also noted that the cost of supplies like concrete products, insulation material and some plastics had increased over the same period. In terms of other materials, however, there were bright spots, with lumber and plywood costs dropping 14.7%, while steel saw a more moderate 1.8 % retraction.

Lumber prices continue to tumble

Lumber has proved an interesting case overall, hitting record highs in 2021 that carried through into 2022. And while in March 2022 the lumber market was still showing a massive price spike, by July it had experienced a 50% decrease. At the time of writing, prices have dropped even further, adding an extra layer of complexity to forecasting and planning for new construction.

Outlook uncertain

Overall, the market remains in flux, with some prices still increasing rapidly. In a recent article covering AGC’s July Price Index analysis, Ken Simonson, Chief Economist for AGC stated:

“Since these prices were collected, producers of gypsum, concrete and other products have announced or implemented new increases. In addition, the supply chain remains fragile and persistent difficulties filling job openings mean construction costs are likely to remain elevated despite declines in some prices.”

In a separate post, Simonson pointed out that the Construction Industry Confidence Index (CICI) also dropped 17 points to a value of 44 in Q2 2022. The index, which measures sentiment amongst industry executives, only indicates a “growing market” if the value is over 50.

Heading into the rest of 2022 the situation remains uncertain, but some experts have predicted a drop-off in materials prices. Whether this translates into gains for the construction industry amid other pressures, only time will tell.

SOCIAL: How have fluctuating materials prices affected new development in your area?