I had been through numerous cycles in my 40 years in the commercial real estate business. All of the cycles had vastly different consequences. The current cycle is very long and producing the lowest interest rates that I had ever witnessed. Consequently, low returns from normal investment vehicles for example; stocks, bonds, money markets, and mutual funds are causing many Americans to look elsewhere for a higher return on investment and potentially more risk.
In the past apartments on the West Side of Los Angeles sold for 3-4 caps which I always thought was ludicrous! Now, commercial real estate is selling for 3-5 caps providing there is a value add component in the property. It is a better bet to buy commercial real estate compared to apartments on the West Side, since it is not subject to rent control and there is very little management compared to apartments.
It is a seller's market indeed, and it will continue to be so until interest rates rise. This seller’s market trend should continue to the next general election at least, since the Federal Reserve announced interest rates will remain fairly stable for the next few years.
My big concerns are two fold in commercial real estate:
1. There is a big debate in Washington, D.C. to extinguish or cap the 1031 deferred tax exchange to $1,000,000. It is my opinion this will cause investors to hold rather than sell their assets. As a result, there will be substantially less sellers which may cause inflation.
2. There are more discussions in California to do a split tax roll and separate commercial real estate from residential real estate. If Sacramento implements this modification to Proposition 13, it will cause a much larger burden on commercial real estate for higher taxes and create lower values.
The safe investment and good liquidity in commercial real estate at this time will continue to cause prices to rise. This is an incredible opportunity for sellers to take their cash off of the table, before the next cycle begins.
An attorney who represents an owner of a commercial building with a long term lease should always question the client to find out when they visited the property. If the tenant pays the rent on time and does not cause any obvious problems, most landlords do not take the time to visit the building.
In a high speed technological world, commercial tenants must constantly change to keep up with the competition. Therefore, the business changes and the use that the building was originally intended also changes. It may happen quietly and the tenant will not bother to call the owner.
SEC is the acronym that I use for the potential change of tenant's use. Does the new use conform to the Sprinklers, Environmental requirements and Codes?
Fire sprinkler requirements change when the use changes. The new materials that the tenant works with may be more hazardous, the stacking height of the products may be reduced due to their flammability and even the distance to the fire station may be in question.
The question of environmental issues may come into play if the tenant utilizes different materials in their business. Again, it is the responsibility of the tenant to verify if the materials are hazardous and are safe. Certain materials that are hazardous should be disclosed to the owner of the property. Hazardous materials can cause irreparable damage to the property, employees, and adjacent properties.
Building codes are constantly changing and the zoning may not be appropriate for the new use. I recently was involved in a case where the tenant was in violation of not maintaining the fire sprinklers. This issue caused me to visit the building department at City Hall and uncover the tenant's use did not conform to the zoning. They moved out of the building and down the street. Most leases place the responsibility on the tenant to verify the suitability of the property and comply with the ordinance. A vigilant owner of a building might consider a double check with the City and a visit to the building.