Are the Big Cs Coming Back?
The big Cs: real estate concessions! Are they coming back? If so, how important is it to understand the economic impact that concessions have on real estate? A look back in time indicates that the most significant causes of real estate disasters have been excessive interest rates, over-paying, over-building, over-leveraging, high unemployment, and concessions.
Unfortunately, although concessions are obvious, they have never been fully understood. Their impact on real estate’s cash flow and value isn’t usually clear. Most asset managers (especially those using other people’s money) believe that concessions are not a big deal and are, in fact, just a necessary cost of doing business (getting lessees). Consequently, concessions have become one of the most insidious problems of real estate. They are deceptive, and they are a principle cause of many real estate investment disasters.
The big Cs: real estate concessions! Are they coming back? If so, how important is it to understand the economic impact that concessions have on real estate? A look back in time indicates that the most significant causes of real estate disasters have been excessive interest rates, over-paying, over-building, over-leveraging, high unemployment, and concessions.
Unfortunately, although concessions are obvious, they have never been fully understood. Their impact on real estate’s cash flow and value isn’t usually clear. Most asset managers (especially those using other people’s money) believe that concessions are not a big deal and are, in fact, just a necessary cost of doing business (getting lessees). Consequently, concessions have become one of the most insidious problems of real estate. They are deceptive, and they are a principle cause of many real estate investment disasters.
What makes concessions “necessary”? Concessions are considered necessary when more space is available (supply) than is needed (demand). When do concessions take effect? They take effect when the owner or owner’s agent is unable to attract or close potential lessees and is anxious to lease space. Following are the signals to look for that indicate concessions are about to start.
- Leasing signs begin to appear.
- Leasing signs stay around for a long time.
- Pennants and flags are pulled out of storage and are used to advertise space.
- Small inducements begin to be offered for leasing space.
- Physical vacancy rates increase.
- Guarantees are used to justify income, expenses, and capitalization rates for properties being sold.
- Replacement costs become a reason to buy.
- Gross rent multipliers are used when cash flow doesn’t work.
- Words such as “discount”, “below”, “turnaround”, “opportunity”, “unusual”, and “once-in-a-lifetime” punctuate investment brochures.
- Ads for personnel for real estate companies begin to decline in the classified sections of newspapers.
- Ads for rental space increase in the classified sections of newspapers.
- Ads for property sales decline in the classified sections of newspapers.
Typically, concessions lower the net operating income of the real estate, which in turn lowers the value. This appears to be a double hit (lower income and lower value). In fact, with income property it is a triple hit. (1) Income goes down. (2) The real estate’s value is lowered. (3) The capitalization rate is raised, and this further reduces the value of the property.
The following is a theoretical example that illustrates the precise risks involved when an owner uses concessions that reduce the income by 10%.
