G. TIMOTHY HAIGHT, DBA
President, Menlo College and Chair of the Board, Board of Commonwealth Business Bank (Los Angeles)
DANIEL D. SINGER, PhD
Professor of Finance, Towson University
Abstract: A wide array of opportunities is available to the potential commercial real estate investor. Such opportunities may be developed by the investor or acquired as existing facilities with a history of costs and revenues. Investment in this area is favored by the presence of tax shields from depreciation, interest rate offsets, and financial leverage. The value of existing commercial properties can be determined by capitalizing the anticipated cash flows associated with that property. The dynamic nature of the commercial real estate market generates a flow of opportunities as apartments, condos, shopping centers, restaurant sites, recreation facilities, motels, self-storage facilities, warehouses, office buildings, and manufacturing sites are continually brought to the market.
Keywords: apartments, condominiums, shopping centers, restaurant, recreation facilities, motels, self-storage facilities, parking facilities, office buildings
Commercial real estate runs the gamut from apartments, condos, shopping centers, restaurant sites, recreation centers, motels, and self-storage facilities to warehouses, office buildings, and manufacturing sites. Such investments tend to be characterized by predictable cash flows and reap the benefits of a tax shield from depreciation as well as interest cost offsets. The result is attractive risk/return opportunities for prospective investors.
As with all real estate investment, location is critical to success. However, the desirability of a particular location for a commercial real estate property will depend on the ability of that property to generate income. This will depend in turn on the type of commercial property under consideration relevant to population density and socio-economic characteristics, the transportation infrastructure, zoning laws and regulations, and the proximity of customers, suppliers, and competitors.
In this chapter we describe the different types of commercial real estate. Table 49.1 provides a summary of the advantages and disadvantages of each type.
Generally, apartment complexes can be classified as one of three types: garden, mid-rise, and high-rise apartments. them. These loans tend to be small in size, generally less than $10 million, but they can be larger. Almost all conduit CMBS deals are fusion deals which consist of a diverse pool of small loans as well as a small number of larger loans. Conduit CMBS deals have historically dominated the CMBS market.
Table 49.1. Advantage and Disadvantage Comparisons by Types of Commercial Real Estate
Type of Property | Financial Leverage | Operational Leverage | Inflation Resistance | Tax Advantage | Own Business | Compounding Properties | Lack of Liquidity | Valuation Difficulty | Management Expertise |
|---|---|---|---|---|---|---|---|---|---|
Single-family | High | Medium | High | High | High | High | Medium | Medium | Medium |
Apartments | High | High | High | High | High | High | Medium | Medium | High |
Condos | High | High | Medium | High | High | Medium | Medium | Medium | Medium |
Time shares | Medium | Medium | Medium | Low | Medium | Low | High | High | Low |
Undeveloped land | Medium | High | Medium | Very low | Medium | High | High | High | Low |
Self-storage | High | High | High | Medium | High | Medium | High | Medium | Medium |
Restaurants | High | High | Medium | High | High | Medium | High | High | High |
Shopping centers | Medium | Medium | Medium | Medium | Medium | Medium | High | Medium | High |
Athletic facilities | Medium | Medium | Medium | High | High | Medium | High | Medium | High |
Office buildings | High | High | High | High | Medium | High | High | Medium | Medium |
Industrial | High | Medium | Medium | Medium | Medium | High | High | Low | Low |
Parking lots | High | High | High | Medium | High | High | High | High | Medium |
Hotels & motels | High | Medium | High | High | High | Medium | Medium | Medium | High |
Garden apartments have from one to three levels and normally contain large balconies or patio areas. Mid-rise apartment complexes range from four levels to six levels. Anything higher than six levels would be classified as high-rise. Typically, zoning laws or the value of the underlying land determines the particular type of apartment to be constructed in a given location. An apartment complex developed downtown adjacent to a central business district is typically going to be a high-rise to amortize the high price of the underlying land. Apartment complexes in suburbia are usually garden apartments, because they are perceived to better fit into their surroundings aesthetically and to make fewer demands on municipal services. This is likely to be forced by zoning laws even where there is an economic incentive to build mid-rise or high-rise complexes. As a general rule, the cost of constructing apartment units rises more than proportionately as height rises.
Physically, condominiums (condos) are individually owned units in an apartment-style building, but condominiums are really about lifestyle choices. This is true in two senses. First, the condo represents an alternative lifestyle choice to a traditional single-family residence. "Residential condos" cost less to build, usually cost less to maintain, often offer an automatic sense of community, and there is no lawn to mow! Second, there is a "destination condo" syndrome that conceptually is related to timeshare properties, but takes the ownership form of a condominium. A condo in Hawaii, Barbados, Orlando, Palm Springs, wherever—like timeshares, this is the stuff from which dreams are made. Own a little bit of paradise—who can resist?
Condominiums may be described as a hybrid form of real estate ownership. Condo owners hold a deeded title to the specific area occupied by their unit, not to the land beneath. As a result, condos are characteristically built to maximize the value of the land underneath them. Large, multistoried buildings composed of many individual units are commonplace. The owners of the different condo units jointly own the common areas such as the ground, pool, walkways, recreational areas, elevators, and the like. If the condo owner finances the property, the unit will have a separate mortgage, and the owner will pay a property tax on the unit and a pro rata share of the common area costs. A board of directors elected by the condo owners will govern the complex, making a set of rules controlling the usage of the individual units and common areas and will assess each unit a maintenance fee.
Condominiums are sometimes confused with town-houses and cooperatives. These two forms of ownership share the ownership of "commons" as condo owners, but differ in other respects. Townhouses are usually a series of single-story or multistory units that are linked to each other horizontally by common walls. Townhouse owners hold title to their units and the land beneath them, so townhouse units cannot be stacked on top of each other. Individual townhouse owners own any common property in common. Townhouse owners pay property taxes on their individual units. A property owners' association usually manages the townhouse complex and collects fees from all owners in order to maintain common areas. Cooperatives (co-ops) are formed by cooperative arrangement. A corporation holds title to all associated real estate. Buyers purchase stock in the co-op corporation and are considered shareholders, not owners of real property. Each shareholder holds a lease to his unit that runs for the life of the corporation. The corporation pays taxes. Any mortgages are normally held and paid by the corporation. All costs to operate the property are shared by shareholders. An administrative board must usually approve new cooperative shareholders.
Many successful real estate investors started by investing in condominiums. The initial out-of-pocket costs can be relatively low, and the income stream together with the tax benefits may cover substantially all of the cash outflows. Thus, the most significant contributor to return will be the property's appreciation over time. The astute investor will capitalize on this appreciation by increasing his/her leverage and acquiring additional condominiums.
The concept of a timeshare may be represented by the ownership of a particular piece of real estate for a particular time interval. (There are many different variations of this general concept.) The idea is you do not need to buy a condo in Orlando when you plan to use it only a week every spring. Instead of buying the whole condo, you buy that condo for a specific week of the year. This makes "ownership" much more affordable and available to a wider group of people. Quality timeshares (in terms of season and location) at the beginning of 2003 average $4,000 to $8,000 for a week's ownership at even the most desirable resorts.
With ownership you have the right to use that particular property during that particular week. While a given property might cost $240,000 to own entirely, one may be able to buy that particular week for $8,000. (Depending on variations in supply and demand, different weeks will have different prices.) From this perspective, the cost savings are obvious.
Timeshare owners are attracted to this form of vacation primarily by the high standards of quality accommodations and services available at the resorts that they own and exchange. It is felt that these properties are better maintained and staffed than are properties that are merely rented. In addition, the location of these properties is felt to be superior to those available through the rental market. The leading industry association, the American Resort Developers Association (ARDA), asserts that over a third of initial timeshare buyers eventually purchase additional timeshare units.
While timeshares are literally located everywhere, many timeshares are in properties with stunning, highly desired locations. The heart of London, Paris, Tokyo, and New York City all have timeshares. If the beach is your thing, from the pounding surf at Waikiki to the French Riviera, timeshares are there. Practically anywhere one could imagine as a desirable vacation destination will have time-share properties located there. Timeshare resort amenities rival those of other top-rated resort properties and may include swimming pools, tennis, Jacuzzis, golf, bicycles, and exercise facilities. Also featured may be boating, ski lifts, restaurants, and equestrian facilities. Most timeshare resorts offer a full schedule of onsite or nearby sporting, recreational, and social activities for adults and children. The resorts are often staffed with well-trained hospitality professionals. Many timeshare resorts offer concierge services for assistance with visiting area attractions.
The attractions of timeshare ownership have an economic dimension. Timeshares offer individuals the opportunity to purchase fully furnished vacation accommodations for only a percentage of the cost of full ownership. For a one-time purchase price and payment of a yearly maintenance fee, purchasers own their property in perpetuity. The fact that owners share both the use and costs of upkeep of their unit and the common grounds of the resort property ensure that the property will be well maintained over time.
Unlike a hotel room or rental cottage, which requires payment for each use with rates that usually increase each year, ownership at a timeshare property enables vacationers to enjoy a resort, year after year. Timeshare owners may look forward to a lifetime of ownership with minimal exposure to inflation. Costs may be expected to rise by only the increase in maintenance costs.
Undeveloped land can be classified as either raw land or developing land. Each of these has distinguishing characteristics. Raw land tends to be located in rural areas, far from existing patterns of development. Developing land is located in areas that are transitioning from a rural environment to a suburban or urban environment. The two types of undeveloped land have differing investment characteristics, but share the disadvantages of the lack of a depreciation tax shield, little opportunity for leverage, and a negative cash flow.
Considerable difficulties are encountered in trying to determine the value of undeveloped land for reasons discussed below. However, an excellent source of data on current development potential is available from Emerging Trends in Real Estate, an annual study by the Real Estate Research Corporation. This publication examines development potential in different areas from the perspective of existing price trends, existing business locations, demographic projections, and the attitude of local government toward development.
Undeveloped land frequently exerts an emotional appeal on an investor. "Falling in love with the land" can and does happen. However, purchasing undeveloped land because the beauty of the forest casts a spell on one is a far different behavior than purchasing the land as an investment. The strong emotional appeal of a property can cloud the business sense of an investor. Buying undeveloped land is usually easy; selling undeveloped land is usually hard. More than one investor who has been taken with the attractiveness of undeveloped property has bought high and then, in the absence of buyers, sold low.
The acquisition of raw land for its potential appreciation is also often overlaid with an emotional attraction. The ownership of raw land may yield investors psychic income having to do with "owning" a piece of America, or dreams of an idyllic retirement far removed from the stresses of the urban environment. This appeal is dangerous to an investor. The advertisement may have great emotional appeal to the investor who can almost hear the birds sing and the rustle of squirrels high in the oak trees. However, beauty is in the eye of the beholder. While the supply of raw land in general is quite large, each specific parcel is uniquely defined by its location and particular attributes. Effectively, the supply of that piece of land is perfectly inelastic. Demand for that piece of land may be nonexistent, low, or high.
Unlike raw land, developing land has little amenity value and a much more predictable future. Developing land is in a transitional area, between raw land and developed land. A classic investment in developing land might be 25 acres of farmland, but zoned for residential development, and located just outside the suburban fringe or a three-acre parcel located just off the exit and entry ramps for an interstate highway that is planned to begin building in three years. The future value of such developing land is far more predictable than that of raw land, but still not known with certainty.
Appreciation in the value of developing land results from shifting land use patterns. The trends toward more roads, increasing suburban spread, and economic growth in general are well established in our society. It is certainly conceivable that within a span of 50 years a property could have gone from agricultural cultivation along a dirt road, to residential homes along a paved two-lane road, to a strip shopping center along a four-lane highway. The difficulty of successfully investing in developing lands is that the exact pattern and timing of those shifts is very difficult to predict.
The level of economic activity or the pace of development in a geographic region is subject to the vagaries of unpredictable events. The oil crisis of the 1970s sparked a movement of population out of the Northeast and Midwest to the Sunbelt. Land values crashed in Boston in the early 1980s, and suburban development came to a dead halt. The fall in fuel oil prices in the late 1980s caused a disastrous fall in land values in Colorado and Texas. Boeing shifted its headquarters from Seattle to Chicago. The automotive industry decided to shift its production facilities from Detroit and other traditional northern areas to rural Midwest and southern communities. The Corps of Engineers decided to reverse its policy of draining the Everglades. The impact of the Cuban population on land use in Florida has been profound. Las Vegas redefined itself as a mecca for retirees. All of these events were essentially unpredictable, and all had substantial impact on the pattern of shifting land use in their region.
Whatever the overall trends in a particular region, considerable variation from that trend will be observed in specific localities. Such variation may reflect specific land use regulations, zoning laws, road patterns, the availability of public utilities (water lines, sewer districts, etc.), the availability of public services (parks, hospitals, etc.), and prior land use patterns. Predicting how those patterns will affect a specific parcel of land is difficult.
Even within a narrowly defined locality, considerable variation in land-use patterns may be observed: vacant lots on otherwise fully developed highways, apple orchards in the midst of residential neighborhoods, and apartment buildings abutting industrial sites—vacant land scattered all about with no apparent rhyme or reason, all of which work to make investing in developing land a risky enterprise.
An added danger to investing in developing land is the potential liability associated with land contaminated by hazardous waste. Under the 1980 Superfund Law, a property owner of contaminated lands (or even an ex-property owner) may be liable for clean-up costs, even if they had nothing to do with the contamination. Buying a 20-acre parcel for a shopping center, when it is currently largely undeveloped but does have a few old shacks on it, can be risky! It could turn out that one of those shacks 30 years ago was used as a foundry to make brake shoe moldings and the land is thoroughly contaminated by lead and asbestos. Developing land should always be checked against the Comprehensive Environmental Response Compensation and Liability Information (CERCLIS) list that is maintained by the federal Environmental Protection Agency (www.epa.gov/superfund/sites/query/basinstr.htm.). Each state has its own environmental protection agency that should also be contacted in this matter as they will be most familiar with the environmental issues in a specific locality.
In this contemporary world, property owners may also be beset by all manner of stakeholder claims. A 50-acre site with an old farmhouse on it is purchased to create an office park, but the farmhouse cannot be torn down because it has local historical significance. Or, as the ground is prepared for construction, a human skeleton is unearthed. It is determined that the site contains a hitherto unknown Indian graveyard. Representatives of a local Indian tribe file suit to halt construction. The possibilities are endless, overlaying all development activities with a rich layer of uncertainty.
The underlying economics of investing in developing land are not as favorable as for the other types of real estate discussed in this book. The reason lies in the fact that the vacant land cannot be depreciated. Thus, the tax shield that is available to those purchasing real estate containing depreciable facilities is not available to the purchasers of developing land. In addition, developing land will generally not generate revenue during its holding period. However, the land may well be subject to taxes and necessary expenses (e.g., taxes, preparing a land-use plan,) creating a negative cash flow during the holding period. Leverage is somewhat easier to obtain for developing land because creditors can be more certain of the land's value with actual development a close proximity.
Another type of commercial real estate investment requiring a modest cash investment is self-storage facilities. Self-storage facilities represent a burgeoning opportunity in real estate investment. The demand for such facilities is on the rise from both individuals and small businesses. In an increasingly affluent and materialistic society, individuals increasingly have more "stuff" than they can reasonably accommodate in their present residence. In an increasingly mobile society, individuals in transition need places to store their possessions temporarily. Small, and even some large, businesses have found self-storage facilities cost-effective ways to store their records, inventory, extra equipment, and seasonal goods.
There are currently about 30,000 self-storage facilities (SSFs) located throughout the United States. The rapid growth of the industry has resulted in progressive and accelerating change as to the function of such facilities. Self-storage facilities offer the financial leverage, tax advantages, and cash flow characteristics that characterize other commercial real estate properties. The industry began in the 1960s with properties that offered little in the way of location, convenience, and amenities such as air conditioning, heating, and 24-hour secure access. Basically, these were the equivalent of C-type office buildings. Today's self-storage facilities have evolved into centrally located facilities with elaborate amenities, the equivalent of A-type office facilities. In many locations, the demand for facilities of this type appears to be strong and will support a rate structure that makes developing such properties profitable.
SSFs are rented for the exclusive purpose of storing personal property in such a manner that the renter has access to, and control of, the property placed in storage. Self-storage is, therefore, not warehousing and presumes no possession of customers' goods. The fundamental aspect of self-storage is that it is a "self-service" operation and consumers/tenants retain the "care, custody, and control" of their personal property. The definition of "personal property" is vast, and regulations in this country typically focus on prohibited properties that may be stored as opposed to permitted properties. Prohibited properties typically include hazardous materials, perishable foods, and ammunition.
Early SSFs largely consisted of low, flat, one-story buildings typically located in lower-density suburban areas. Such facilities were generally not heated or air conditioned and were of starkly functional design. These units were originally thought of as "mini-warehouses" and often restricted by zoning ordinances to commercial and industrial zones as a result.
Modern SSFs are being built as much larger multisto-ried buildings with heating, air conditioning, and often offering a wide array of complimentary services. These SSFs are often designed to fit into the existing architectural setting. Increasingly, such units are being located in residential areas because they do not generate much traffic, are not noisy, do not create pollution, and place a very light burden on municipal services. These facilities are designed to meet the need for easily accessible, small-scale storage space. A typical SSF covers two to three acres and consists of five to six buildings, each containing approximately 10,000 square feet of storage space. The size of the storage units can range from 25 square feet to 600 square feet. Internal driveways provide access and parking at individual storage units.
Successful SSFs require a location well served by major highways. Well-traveled routes between commercial and residential districts, adjacent to interstate highways, and major thoroughfares abutting commercial and residential areas all show potential for this type of facility. Successful, modern SSFs are typified by a wide assortment of amenities and services that increase their value for their customers. The two absolutely critical elements for a successful SSF are that it provides good security and convenience.
Good security is provided by the sturdy construction of individual storage areas, strong doors, and door casings, locks typically supplied by the renter of the unit (to control access), door alarms, a perimeter fence, controlled access through the perimeter fence, a resident manager, bright lights, and 24/7 video and electronic surveillance of the grounds, an accurate record of individuals entering and leaving the premises.
Convenience involves 24/7 access for renters and their associates; an arrangement of facilities that facilitates access, egress, loading, and unloading; automatic interior lighting where appropriate; available loaner dollies and hand trucks; available packing, moving, mailing, and storage supplies (including tape, bubble wrap, boxes, furniture covers, etc.); outside storage for autos, trucks, recreational vehicles, boats, and equipment to complement the available inside storage; an adequate selection of different-size storage units; and clean rest-room facilities.
Another approach to SSFs gaining popularity involves the conversion of industrial or commercial property to SSFs. Depending on the area, such facilities may be conveniently located for this purpose. The property may be inexpensive because it is no longer being used for its original purpose. Thinking "outside the box" can prove rewarding in this situation. Where the facility already has heating and air conditioning, partitioning the interior can be relatively inexpensive and lead to excellent rental revenues.
An often overlooked commercial real estate opportunity involves purchasing property servicing the restaurant industry. The restaurant industry is huge, accounting for almost 4% of our gross disposable product (GDP). There are approximately 890,000 restaurants operating in the United States with over 12 million employees doing over $800 billion in sales. Future growth is estimated to be between 4% and 7% annually. Americans have not lost their taste for eating out.
Not only is the industry huge, it is dynamic. Old restaurants go out of business and new restaurants spring up. How successful restaurants are depends on a wide variety of factors including broad social issues (the events of 9/11), broad economic issues (the cost of energy), industry-wide issues (mad cow disease), population trends (from the Rust Belt to the South, revitalizing inner cities), as well as the tastes and preferences of individual consumers (high-protein diets, low-carbohydrate diets, low-fat diets, organic foods, ethnic foods). All these factors contribute to a rapidly changing mix for success as a restaurant.
This is great news for commercial real estate investors. The combination of the size of the industry, along with its dynamic character, creates a mosaic of opportunities for commercial real estate investors. Investment in this industry can either be indirect (through holding a lease) or direct (through owning the property and managing the restaurant itself).
There are two basic divisions in the food service industry: (1) fast foods (characterized by both the speed of service and the limited amount of service available) and (2) full-service restaurants. These two sectors in the industry are of roughly equal size. Full-service restaurants may be further broken down into categories based on how expensive they are. These categories are (1) mid-scale (average check below $20), (2) casual dining (average check $20 to $40), and (3) upscale or fine dining (average check above $40). Each segment of the restaurant industry has its individual attributes that make for success and failure. However, a common theme among restaurants of all types is the importance of its location.
When one thinks of commercial real estate, shopping centers are often the first type to come to mind. Indeed, shopping centers cover a broad range of investment opportunities. Shopping centers may be invested in directly or indirectly through a partnership, general partnership, master limited partnership, limited liability corporation, Subchap-ter S corporation, or real estate investment trust (REIT). Rarely are large shopping centers held in the form of a regular corporation because of the problem of double taxation. Most shopping centers are owned indirectly because of the need to raise substantial capital and the advantage of spreading the risk.
Often overlooked for their inherent profitability, shopping centers frequently provide a great opportunity for the small- or medium-sized real estate investor. Shopping centers have desirable real estate investment characteristics. The largest portion of the value of the shopping center is depreciable, generating a substantial tax shield. Shopping centers generate their return through a continuous, relatively predictable cash flow, rather than requiring a one-time windfall in the distant future. Shopping centers usually can be acquired in a manner that provides for substantial leverage. Furthermore, the wide array of available types of shopping centers allows the investor to pick and choose the exact combination of risk and return that he or she prefers.
Shopping centers are defined in terms of the market served. This market can be a few square blocks for a community shopping center or cover the whole metropolitan area for a large regional shopping mall. Location, access, and traffic patterns define a mall's success relative to the market served. Securing aerial photographs that allow the shopping center to be identified within the context of its physical infrastructure can begin the analysis of a shopping center's potential. Such photographs are readily available from local or state government agencies. Traffic counts on key nearby thoroughfares can also be obtained from such agencies. Economic and demographic data by zip codes and census tracts are readily available, making it possible to pinpoint the characteristics of the market to be served.
Strip Shopping Centers
A strip shopping center is 3 to 10 small, independent stores clustered on a heavily traveled road. The businesses are generally dependent on the volume of traffic and their exposure to this traffic. Convenience stores; fast-food restaurants; liquor stores; video stores; specialty produce, meats, or seafood; gas stations; dry cleaners; and so on typically dominate this environment.
Neighborhood Shopping Centers
A neighborhood shopping center is 3 to 10 small, independent stores serving a localized market. Such a shopping center is not necessarily located on a high-volume thoroughfare, although ease of access to the market served is critical. Convenience stores, fast-food restaurants, small restaurants, liquor stores, video stores, drugstores, hardware stores, toy stores, and the like typify this environment. Neighborhood shopping centers frequently may be in close proximity to apartment complexes, office buildings, hospitals, large employers, or in a densely populated urban area.
Community Shopping Centers
A community shopping center is 5 to 25 small stores with a major anchor that is a proven traffic builder. Such a shopping center is typically located at the junction of heavily traveled roads. Stores have sufficient breadth and diversity to generate strong positive externalities. The community shopping center has a mix of tenants that give it a strong destination appeal.
Inner-City Shopping Centers
An inner-city shopping center is 3 to 10 small, independent businesses located on the first floor of a large building. This shopping center serves both a neighborhood and transitional clientele. The shopping center may either be leased from the building's owners or purchased as a condominium from the building's owners.
Regional or Super-Regional Shopping Centers
A regional or super-regional shopping center is a significant concentration of retailers combined to draw shoppers from great distances. Such a shopping center contains 25 to 250 independent stores and may contain several anchors, and it is frequently located beside one or more interstate routes. The 1990s saw an overbuilt market for this type of shopping center. The resultant hypercompetitive environment resulted in the newer, even larger shopping centers doing severe damage to older shopping centers. The competition between these large centers reached such an extent as to draw some business away from community and neighborhood shopping centers in the same metropolitan area, resulting in a more difficult situation for those retailers.
A properly located shopping center with the right tenant mix affords investors excellent risk and return combinations—as long as the retail market served is not oversaturated with competitors. These opportunities are particularly attractive if the investor has the expertise to manage the shopping center itself. However, this management expertise is not absolutely necessary. In any given metropolitan area, the investor will be able to find a number of firms that specialize in managing shopping centers. It is sufficient that investors in shopping centers are entrepreneurs who act as catalysts to bring economic resources together to create something where there was nothing before.
As the Baby Boomers become more and more health conscious, a larger portion of their discretionary income is being directed to recreation activities. Not surprisingly, a wide variety of facilities ranging from single-purpose indoor basketball, soccer, and ice-skating rinks, through bowling alleys, water parks, racquetball courts, weight-training rooms, and indoor and outdoor pools, to multiple-purpose family entertainment centers are being developed to accommodate this market. This provides for an excellent opportunity for individuals interested in a unique commercial real estate opportunity.
The specificity of athletic facility demand has implications for the optimal investment in a facility. The athletic facility must be properly sized. The conventional approach is to project a given-size athletic facility and build it for the least cost or to estimate demand, revenue, and profit and allow the capitalized amount of profit to determine the investment in the facility. Such approaches reflect simplistic thinking. Because the demand for the facility is not generic, but specific to groups with special socioeco-nomic attributes and lifestyles, there is an interaction between the market niche to be served and the investment to be undertaken.
The relationship between the investment made in the facility and the market to be served can be defined very precisely. This is normally done in a formal feasibility study that has three components: (1) a market feasibility study that identifies the viable market niches in a given market area; (2) an economic feasibility study that analyzes all cost associated with the construction of an athletic facility relevant to a given market niche target; and (3) a financial feasibility study that identifies all revenues and costs in a series of pro forma financial statements that allow an investor to judge the risk and return parameters of the facility.
Office buildings provide excellent opportunities for discerning investors to reap excellent returns for the risk involved. Office buildings can be awesome structures with 50 stories and 1 million square feet of rentable space or modest, simple one-story buildings with 4,000 square feet of space. Whatever the size of the office building, the basic elements in the process of successfully investing in this market are the same. Find a location attractive to potential tenants, design a building that conforms to those tenants' needs, secure leases, find construction financing, find permanent financing, construct the building, and then manage the building in accordance with tenants' expectations. This is the simple recipe for success. Of course, the devil is often in the details. It is one thing to have the recipe for success, and another to successfully execute it.
The market for office buildings is highly cyclical but rather predictable. The low point of the cycle would normally constitute an excellent time to either develop an office building or buy one that is already built but in financial trouble. Even outside this office building cycle, a need may exist for an office building that has not been met in a particular location. Such a situation may offer the investor excellent prospects as well. As with other real estate investments, the life cycle of an office building from an investor's perspective goes through an acquisition stage, a holding stage, and a disposal stage.
A variety of other issues must also be considered in the development of an office building:
Design. A community may often have strong feelings about appearance, construction material, and site layout. The requisite approvals from a variety of municipal agencies may be sensitive to the issue of community acceptance of the property design.
Use intensity. This is often expressed by the ratio of floor space to the area of the site. The floor-area ratio is often addressed in zoning standards.
Access and circulation. The intended office building must effectively be integrated into existing traffic flows as well as having a safe and efficient traffic flow of its own.
Traffic generation. The impact of the proposed office building on existing traffic patterns is often a point of contention with the local community. Traffic features such as convenience, ease of access, and quality of roads are often the focus of community concerns about the maintenance of those features.
Parking. Office buildings must have ample parking to satisfy the desires of their prospective tenants, the concerns of local residents, and the requirements of zoning ordinances.
Sewer and water availability. Local sewer and water facilities may be at or close to capacity, requiring costly investments in infrastructure. This issue may be formally addressed by the municipal government through the imposition of "impact" fees, or the developer may have to fund such facilities as are necessary to make the project feasible.
Environmental considerations. Environmental considerations increasingly impinge on land development processes. Environmental considerations would include any relevant natural features of the site (wetlands, flood-plains, endangered species, etc.) as well as the more general impact variables covered by clean air, clean water, and environmental hazard regulation.
Disability accommodations. The Americans with Disabilities Act (ADA) requires that facilities such as office buildings be accessible and usable by persons with disabilities. This means public entrances (such as sidewalks), parking, and meeting places must not have barriers to disabled individuals.
A single tenant, willing to pay more for a unique shape and floor plans, unusual building design, and an outstanding location, is typically attracted to "trophy buildings." Such buildings are characterized by the best quality of materials and workmanship and enjoy top-quality maintenance and management. Examples of such buildings include the PPG headquarters building in Pittsburgh and the Bank of America headquarters in San Francisco. Such buildings are always considered Class A.
Character Buildings
Character buildings are typically smaller office buildings (less than 10 floors) that are created by an investor or developer to display a sense of personal accomplishment. Such buildings are typically named after that investor or developer and are intended to stand as a monument to his or her accomplishments. Such buildings are normally well constructed, well located, and well maintained, but are not constructed on as lavish a scale as trophy buildings. Character buildings may be either Class A or Class B.
Class A Buildings
Class A buildings generally constitute the best buildings available in a given market. Such buildings are well located, attractive, and well maintained, and considered highly desirable by prospective tenants. They feature excellent elevators, mechanical systems and air-control systems. Class A office buildings are frequently occupied by high-quality, prestigious tenants.
Class B Buildings
Class B buildings are constructed along utilitarian lines using standard construction techniques to create as much rentable space as possible for a given cost. The design and layout of such buildings would be considered adequate, but is primarily functional in nature. These buildings also feature adequate elevators, mechanical systems, and air-control systems. Maintenance services and building management are average.
Class C Buildings
Class C office buildings are typically unrefurbished older buildings or older buildings with limited refurbishment. Their location may be inferior. Building maintenance may be substandard. Mechanical, heating, and air-conditioning systems may have problems. The building tenants are noticeably inferior to those found in higher-class buildings and in less desirable areas.
Among the commercial real estate plays that are often overlooked is investing in parking lots. However, this type of commercial real estate opportunity deserves a closer look. Parking lots are cash-generating machines. Parking lots can be low-cost, low-technology facilities that are simple to operate. Parking lots can also be high-cost, high-technology facilities requiring a sizable staff and sophisticated management controls. The hallmark characteristic of parking lots is their high ratio of fixed to variable expenses. This means that the key to successfully developing (or purchasing) a parking lot is revenue estimation.
The potential revenue of a given parking lot is driven by location and constrained by competition. Location is always of great importance in determining the value of property, never more so than in the case of parking lots. In any suburban or urban area, there is always plenty of free parking—but it is just not in the right place. The demand for parking lots is very location specific. You are either next to the convention center or three miles away. One of these locations will not substitute for the other.
Parking lots generate heavy externalities (benefits that do not accrue to the parking lot itself). Urban hotels, stadiums, shopping mall, hospitals, and large office complexes cannot exist without parking facilities. As a result, parking lots are frequently integrated into the development of such population-intense facilities. Often times, the integrated parking facility will be an important revenue generator in its own right. Municipal governments may see the need to provide parking facilities as part of an infrastructure to support its commercial, industrial, and residential population. We are a nation on wheels. To live in our culture is to be on the go. The large bulk of the population finds the automobile a necessity, and as they go from here to there, they need to park that automobile.
Short-Term/Transient Parkers
Short-term/transient parkers may need parking for a fraction of an hour or several hours. On an individual basis, their demand for parking may be only occasional or sporadic. As a group, their demand may by quite predictable and regular. Generally, these parkers pay by the hour and the revenue schedule is set up to "front load" the cost to the patrons. That is, the first fraction of an hour, or the first few hours, is priced much higher than successive hours. Since short-term and transient parkers by definition have only a limited need for the consumption of a parking space, this pricing structure will have a favorable impact on the revenues of the parking facility. Where the demand for this type of parking is predictable, this is the most profitable type of service the parking facility can provide.
Demand from this source tends to have the smallest physical drawing area. The patron demand for parking is a direct and immediate function of the patron's destination. Therefore, this demand will be limited to arising from destinations in the immediate vicinity of the parking facility.
Where demand permits, the goal of the revenue structure is normally to capture 25% of the maximum daily rate (MDR) in the first hour and 50% of the MDR in the first three hours. It may thus be possible to get three or four patrons in a given spot during a 24-hour period, potentially doubling the MDR revenues for that spot.
Early-Bird Parkers
The demand from early-bird parkers arises from the desire of the parking facility to fully utilize its available capacity. Early-bird parkers are price-sensitive shoppers who are able to exercise discretion in determining where they park. If there are competitors nearby in the effective market area, then these parkers must be attracted by offering price discounts. Early-bird parkers have more elastic demand curves than short-term/transient parkers. This market is served by specifying a specific time slot for their parking (e.g., in by 8:00 A.M. out by 5:00 P.M.) and offering these parkers a 40% to 60% discount off the MDR.
Special-Event Parkers
Examples of special-event parking might include a sporting event, a parade, a circus, a concert, and the like. Such time-and-destination-specific parking tends to be highly inelastic. If the parking facility and the site of the event are in close physical proximity, this often means a flat fee can be charged equivalent to the MDR for the event because parking is event dependent rather than time dependent. Where the parking facility is located on the outer edge of the effective market area, price concessions may be warranted to attract parkers.
Saturday and Sunday
In most urban settings, parking demand is weakest on the weekend. Offices and business are closed, and the need for short-term and transient parking declines. If the effective marketing area of the parking facility includes attractive retail destinations, price concessions may stimulate the use of the facility. If the local retail destinations are large, they might even be interested in subsidizing parking fees to encourage their business. Downtown retail shopping districts are often at a severe disadvantage to suburban shopping malls on the weekends. Many parking facilities use low flat rates to entice weekend parkers.
Holidays
The demand for holiday parking shares many of the same attributes as the demand for parking on weekends. Offices and business are closed, and the need for short-term and transient parking declines. An exception to this may occur over the Christmas holiday season, where the demand for retail shopping is so great that parking demand will approach or exceed normal weekday demand. Under these circumstances, the normal rate schedule would apply.
Monthly-Contract Users
The demand for this market segment arises from potential patrons with employment in the effective marketing area. Depending on the degree of competition, such demand tends to be inelastic. Because the cost is large and planned to the parker, price shopping will occur if at all possible. This situation results in a wide dispersion of rates whose ultimate determination will depend on the particular circumstances of a specific facility. Monthly-contract parking rates vary between 10 and 20 times the maximum daily rate. At 21.7 times the MDR, the entire work year of 260 parking days is covered. Providing amenities such as desirable locations within the parking facility, special entrances, special exits, and expedited ticketing often mitigates the expense to monthly contract users.
Hotels and motels provide wonderful opportunities for passive investors looking for excellent risk-return opportunities, or for active investors short on cash but long on a desire to work hard to build sweat equity in a business. Despite some unevenness in demand, opportunities for successful hotels and motels are likely to increase in the future. Travel and guest lodging are luxury goods in an ever more affluent society. Our increasingly mobile lifestyle assures a constant increase in the demand for lodging services.
Overall, the "hospitality" business (which offers lodging and food) has tended to the strong secular growth characterizing an affluent society one might expect. Americans will travel on just about any excuse, including trips to resorts, the ocean, or national and local parks; visiting relatives; class reunions; weddings and funerals, or just to sight-see. However, the industry is prone to shocks affecting the confidence of travelers or the cost of travel. The events of 9/11 had a significant impact on travel throughout the nation, as well as New York City itself. In the spring of 2003, sniper killings in the Washington, D.C., and northern Virginia area resulted in a dramatic fall in lodging occupancy in that region. The problems with the cost and availability of gasoline in the 1970s also had a significant impact on the demand for away-from-home lodging. While the supply of gasoline does not appear to be the problem that it was in the 1970s, the price will likely have a significant effect on the prospects of this investment class.
The industry is characterized by a large number of segments providing more or less good substitutes for each other in a given lodging market. Hotels may be huge skyscrapers, costing hundreds of millions of dollars, capable of hosting thousands of guests located in the center of the city next to a convention center or sports arena. At the other end of the spectrum, lies the 10-unit, "ma and pa" guest cottage on the side of a stream in a rural area adjacent to a state forest. It is important to note that there are at least a dozen market segments between these two extremes, which cater to a wide variety of tastes, preferences, and expectations.
Industrial sites are seen to offer a potentially good risk and return combination for investors. When the industrial firm is unable or unwilling to finance its own properties, their alternative is to have an investor supply that capital in the form of a build-to-suit leasing arrangement. There is little doubt that this arrangement favors the industrial firm, especially where it is subject to a high tax rate. However, it is often advantageous to the commercial real estate investor as well.
Risks exist for the real estate investor in this situation, but it can be controlled for with foresight. The first risk to be encountered by the investor is that of nonrenewal of the lease. Because the taxing circumstances will normally dictate the use of an operating lease, the lease cannot be fully amortized over the property's life. The investor can address this issue by designing the building so that it has use in a wide number of applications and that it is located in an area that would be attractive to other industrial firms.
A second risk could be default by the lessee. This risk can be addressed by assessing the financial solvency of the lessee prior to committing funds. In the event of default, the risk to the lessor is minimized by the fact that the property is retained and the industrial firm's creditors cannot attach the property.
All in all, commercial real estate has performed very well historically. Further, commercial real estate opportunities include the obvious plays such as hotels, shopping centers, and office buildings. However, the less obvious categories such as parking lots, self-storage facilities, and recreational facilities may also fit well into one's investment portfolio. Other types of commercial real estate not discussed in this chapter are timberlands (see Wilson, 2000) and agricultural real estate (see Wilson, 2000).
Beyard, M. D., and O'Mara, W P. (1999). Shopping Center Development Handbook. Washington, DC: Urban Land Institute.
Coyle, S. M. (2000). The U.S. office market. In S. Hudson-Wilson (ed.), Modern Real Estate Portfolio Management (pp. 75-84). Hoboken, NJ: John Wiley & Sons.
Fenker, R. M. (1996). The Site Booh A Field Guide to Commercial Real Estate Evaluation. Ft. Worth, TX: Mesa House Publishing.
Geltner, D. M. (2007). Commercial Real Estate Analysis and Investments, 2nd edition. New York: Southwestern Publishing Co.
Haight, G. T., and Singer, D. D. (2005). The Real Estate Handbook. Hoboken, NJ: John Wiley & Sons.
Parking Consultants Council. (2000). The Dimensions of Parking. Washington, DC: Urban Land Institute.
Real Estate Brokerage Managers Council. (1996). Real Estate Office Management. Chicago: Dearborn Financial Publishing.
Rutes, W A., Penner, R. H., and Adams, L. A. (2001). Hotel Design, Planning, and Development. New York: W W Norton & Co.
Senn, M. (ed). (2005). Commercial Real Estate Transactions Handbook, 3rd edition. New York: Aspen Law and Business.
Schmitz, A., and Brett, D. (2001). Real Estate Market Analysis: A Case Study Approach. Washington, DC: Urban Land Institute.
White, J. R., and Gray, K. D. (eds). (1996). Shopping Centers and Other Retail Properties: Investment, Development, Financing, and Management. New York: John Wiley & Sons.
Wilson, J. D. (2000). Agricultural real estate. In S. Hudson-Wilson (ed). Modern Real Estate Portfolio Management (pp. 165-17'4). Hoboken, NJ: John Wiley & Sons.
Wilson, J. D. (2000). Timberland investments. In S. Hudson-Wilson (ed). Modern Real Estate Portfolio Management (pp. 149-164). Hoboken, NJ: John Wiley & Sons.
Zankel, M/L. (2000). Negotiating Commercial Real Estate Leases. Ft. Worth, TX: Mesa House Publishing.