2011 was a turnaround year in the commercial real estate sector. The mild and uneven economic recovery was enough to motivate industrial space users who are starting to commit to new facilities. Commercial banks responded by providing financing for well conceived industrial projects. The availability of bank financing is a function of the banking industry’s collective capital levels. Banks will start taking smart risks such that limited speculative development financing may become available depending on a project’s position in its submarket. Also, a new accounting regulation, which will affect the duration of lease terms, could make financing more difficult. Debt market conditions have improved greatly in the past 12 months, in line with the improvement in the local economy and industrial real estate markets. And, the outlook is for the market to continue to improve during 2012.
In the last 12 months, Chicago area banks continued to re-capitalize and reposition for recovery. Several banks reduced their troubled assets through bulk loan sales and then raised new capital. The recapitalized banks are now focused on making new loans in order to pay a return on the new capital. A few banks are taking a slow and measured approach to recapitalization and disposition of troubled loans. They sell a few loans, or take discounted repayments, each quarter. Then they reapply their capital and talent to making new loans. Last year, there was an active market for debt financing that was not there in 2010. Continued recapitalization of the banks points to more competition. Increased competition will bring narrower interest rate spreads. Also, banks will have a new willingness to take modest risks including speculative construction.
There has been much discussion about the return of speculative construction. It is already happening in the Southeast Wisconsin submarket where the vacancy rate is below 8%. Just like the economic recovery itself, the return of speculative financing for industrial projects will be mild and uneven. Overall market absorption was profoundly negative in 2009, mildly positive in 2010 and reasonably robust in 2011. Hopefully, the upward trend continues in 2012. However, each submarket has a different pace of recovery. Many submarkets still have historically high vacancy rates. The wide availability of space in these markets does not justify speculative development. The challenge is to know which submarkets are recovering with a sustainable growth trend. Within each submarket, the segmenting of product by size and functionality could lead to shortages of available space. This appears to be the case in the I-55 Corridor. The submarket vacancy rate is more than 12% but there are few choices for a user looking for more than 500,000 square feet. The tightening within a small niche in a submarket could justify a speculative building. The problem is that many developers and bankers could seek to exploit the same opportunity.
A new accounting regulation may make financing single tenant projects more difficult. The Financial Accounting Standards Board (FASB) will require by 2015 that corporations report lease obligations similar to debt obligations – as liabilities on the balance sheet. Current standards only require a summary of lease obligations in the footnotes to the financial statements. The amount of the lease obligation will be established using a discounted cash flow of the lease payments. Thus, the longer the lease term (including renewal options), the larger the liability created. The effect on industrial property will be greater than other property types as the industrial real estate market tends to have a larger number of single tenant buildings.
Chief financial officers will be motivated to keep lease terms as short as possible. The result may be that shorter term leases will become more common in our market. Lenders could respond by requiring more equity and funded monthly reserves for lease rollover costs. Many industrial professionals including bankers, brokers and owners, have expressed concern over this new standard. It may not be as significant as some suggest as there are some mitigating factors. First, most corporate bankers already account for lease obligations in some fashion and the information has always been available in the footnotes. Second, corporate real estate decisions take many economic variables into account. The new accounting standard will rarely be the critical factor in a corporate real estate decision. Finally, the increased lease rollover risk will require greater returns to debt and equity that could be prohibitive. Lenders will require more equity to mitigate risk. This could lead to greater capital costs that can only be offset by higher rents. Corporate financial officers will have to trade off higher rents vs. longer terms in their lease negotiations.
The market for industrial space and the market for bank debt financing are recovering together. Corporate users cautiously invest their cash in new plant and equipment including industrial real estate. The banking system is rebuilding its equity base and seeking industrial real estate opportunities in order to pay a return on the new equity. Bank competition will increase causing interest rate spreads to narrow. As some markets tighten, banks will gain confidence to finance a limited amount of speculative projects. The new FASB regulation for accounting lease obligations should not affect the ability to finance a new project. As the year unfolds, we will have to watch and see what happens. The economy is still tentative and all these positive trends could reverse.
Jerry Rotunno is a Senior Vice President in the Commercial Real Estate group of Associated Bank in Chicago.
