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

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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