Norton on Real Estate

Last month this column was titled “An upbeat outlook for 2005, with some key caveats.” It concluded that office job formation, jobs which will fill up vacant office buildings, would be the keystone for successful investment in the office sector.

To recap, the economy for 2005 will likely:

• Be very similar to 2004, with slightly rising interest rates.

• Unemployment will not move much.

• Corporations will start to increase capital spending.

• The same corporations will look to squeeze more out of existing workers.

• The dollar may stabilize relative to the euro, yen and yuan.

The caveats were:

• The war in Iraq will not heat up or boil over.

• That the price of oil will settle somewhere between $40-$50 per barrel.

• That there are no significant terrorist acts in the United States.

• That the new Bush administration reduces spending, puts the breaks on annual deficits and quickly mends fences with our trading partners around the globe.

If things play out, commercial real estate offers an attractive sector in which to invest. Existing properties leased with secure tenants for four to 10 years will yield 8 to 10 percent on average. Capital for financing is readily available and still quite competitive. Many prospective tenants are trading up, not to taking more space but getting better space at the same rate and committing to longer terms through options. A five-year term is typical for a well-established company.

Often they will negotiate the right to extend the lease term for two, three or five years, or multiples thereof. Newer companies will seek the right to extend but at the same time negotiate the right to terminate early upon written notice of three, six or 12 months, or the right to give back some portion of their space.

We completed a lease negotiation for a tenant that runs seven years, with three three-year rights to extend, while allowing them to terminate at the end of year 4, 5 or 6 upon one year’s written notice.

For the landlord, this translates into a four-year lease, as that is all that can be counted on until the fourth year actually begins.

Two key elements come into play in this transaction. The building is good and solid, well located with amenities, signage opportunities and curb appeal. It will be as popular and sought after in four years as it is now.

Second, the tenant is stable, has been around for quite some time and is likely (70/30 perhaps 80/20) to be in the building for the full seven years, and perhaps longer. This lease transaction was a fair deal for both parties.

During 2004, we saw some impressive office buildings in our market sell below replacement cost. These were empty or nearly empty. If the office market heats up, they will be good investments over the next 10 years. Initially there will be additional costs to hold them, market and then fit them up. If the tenants have good credit, the properties will start yielding a positive return to the investors in a year or two.

For such properties, we use a 10-year investor cash flow model to determine the value of the building when advising both a seller and a buyer.

Our model assumes the investor will hold on to the property for 10 years and sell it in the 11th year. We pro-forma income (total available space times probable rental rate less vacancy). From this, we subtract annual operating costs. We factor in vacancy, tenant turnover, releasing costs and ongoing maintenance. We calculate the net operating income for each of the 10 years. We then estimate a sale of the building in the 11th year.

We net present value each year’s income (essentially discount those sums to reflect inflation or alternative uses if the initial capital was not invested in real estate). We take the annual sums plus the net sale amount in the 11th year, discount those amounts and come up with a dollar figure which reflects what a rational investor would be willing to pay today to earn those annual amounts over the next 10 years.

Our model is dynamic. We can adjust many factors or assumptions to reflect the level of risk, cost of funds as well as rising expenses. Most often we generate four to 12 iterations of the model before buyers feel comfortable with all of the assumptions and parameters. Only then do we advise them to move forward.

It is not a pure scientific equation. There is plenty of art in the process, but a knowledgeable real estate broker and adviser will be able to educate you to a point where you are either willing to proceed or not.

Bill Norton is president of Norton Asset Management. In addition to his active brokerage work, he is a Counselor of Real Estate. He can be reached at

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