Chasing Income Why Land is Worthless Without Occupiers

When I was a lad I had a job mowing yards and my meager earnings went into a passbook savings account that paid 5% interest. It wasn’t much, but it would be a welcome rate to anyone with savings on a fixed income today. All investors today are trying to balance the need for higher returns on their capital with the risk of not getting the return of their capital.
Chasing Income Why Land is Worthless Without Occupiers
The control of our economy’s growth has transitioned from the developers, speculators and lenders to the rent payers and the occupiers.

The year 2008 is still fresh in the minds of both Wall Street and Main Street investors. And new laws designed to prevent a repeat of that meltdown of both real estate values and stock equities are making borrowing more difficult for speculative ventures. In the eyes of the banking community, few ventures are more speculative or more risky than acquiring and developing land. Prior to 2008 it was not unusual for developers to borrow against their land holdings to meet the equity requirements of the proposed development. So a parcel appraised at $500,000 and held free and clear by the borrower could be sufficient collateral for a loan of $2, 3 and even $5 million! That is, until the failure of Bear Stearns, AIG and Lehman Brothers and the simultaneous demise of the collateralized mortgage-backed securities market (CMBS), which had provided much of the capital for the real estate development world.

Suddenly lenders saw a tsunami of non-performing loans being put back to them by borrowers unable to meet the demands of the debt service. And the lenders sadly discovered the formal appraisal report that they used to conservatively underwrite the loan was insufficient to address the re-pricing that occurred when borrowers stop borrowing and lenders stop lending. As Warren Buffet so vividly pointed out,

“When the tide goes out you discover who has been swimming naked.”

In an effort to guarantee the banks don’t repeat the mistakes of the past, borrowers and lenders alike have shown a special preference for income producing real estate and a disdain for speculative development. While this is completely understandable, it does explain the lack of growth in the overall economy. Real estate development is and always been filled with outsized risk and outsized rewards. However, when both parties to risk and reward choose to largely be risk averse, we will see and have seen a flight to quality which is to say a flight to income. For investment real estate this explains historically low cap rates for properties producing income, such as net leased retail buildings, single tenant big box warehouse buildings leased to public companies like Amazon, and surprise, surprise, apartment properties that provide immediate shelter for young people unable to afford to purchase a home, and to their parents, who haven’t been able to replace the income they lost through layoffs or wiped out savings or both.

This flight to income is placing tremendous value on “occupiers,” those wonderful tenants of retail, office, industrial and apartment properties. It is also placing tremendous challenges on developers of lots appropriate for affordable single family homes, (those priced below the $200,000 median home price for central Indiana).

Don’t feel too sorry for your friendly land broker. We have had several busy years, (who do you think helped the banks clear out their excess land inventory?!) And we have been adjusting to the new metrics for land demand. So where is the action in land brokerage? A considerable amount of our team’s activities have been associated with selling 15-30 acre parcels zoned for medium and higher density rental housing. Throughout central Indiana the developers of apartment communities have maintained a steady appetite for such sites since 2008. We expect this to slow going forward for several fairly obvious reasons.

  1. There is evidence the supply is starting to outpace demand. Thousands of tenants flocking to new projects downtown came out of existing projects elsewhere in the city and some of these older projects will struggle to maintain high rents and high occupancies without new capital investments (which will further push out the least among us).
  2. New construction is expensive and the rents required to justify new construction may be pushing a larger percentage of renters into their pain threshold.
  3. Municipalities are expressing concerns about the burdens renters place on the educational infrastructure of the community.

The strongest area for land brokerage is land suitable for a single occupier to acquire for its own business requirements. Many commercial land sales in 2015 and 2016 are in the 1-5 acre variety, a size typically required to meet the occupier’s current and future space needs but providing no land for speculative development not required by the occupier. Speculative development, or oversizing projects today in the belief that they will be leased within a reasonable period of time following completion, was historically the way everything was constructed.

In 1993 my 14th floor office window faced east from the corner of Illinois Street and Ohio Street in downtown Indianapolis. I could see steel for 4 new office buildings, each in excess of 250,000 square feet, including buildings that today are still the bulk of downtown’s class A office properties. I asked my colleague, a leading office broker, who would occupy all that space. He said,

“Each of those buildings is chasing the same two law firms.”

And he was right. Of course neither law firm occupied more than 35-40% of the building’s total square footage and that left two other buildings dancing alone.

Our country’s growth was fueled for many years by developers and bankers taking tremendous risk, until they became risk averse and chose simply to chase income. The control of our economy’s growth has transitioned from the developers, speculators and lenders to the rent payers and the occupiers and this has placed the brakes on deal velocity. Land is still a significant component of the real estate deal for developers supplying the product required by the rent payers. Our land brokerage team will continue to chase them and facilitate their needs. Fortunately for us, our site brokerage expertise and market knowledge increase in value as fewer brokers can afford to be in our field full time.

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