Lee & Associates
Bruce Norris is joined this week by Erik Hernandez. Erik has been with Lee & Associates in the commercial real estate division since 2000. Prior to that he was in research since 1994. He specializes in industrial real estate, and he has been on the radio show a number of times prior. He is also the Norris Group’s go-to person for the commercial world.
- Which segment of the commercial world does Erik work in?
- What happened with residential real estate in 1995 that was so interesting for the market?
- Which year was considered a peak in the commercial world?
- How much did we have under construction in the industrial industry by the end of 2016?
- What is the difference between a vacancy rate and an availability rate?
- Which countries saw a huge push of foreign investors into the United States?
- Is the industry as a whole concerned about another recession in the next couple years?
There are different segments in the commercial world. This includes hotels and storage units. Erik is basically in the industrial space for the Inland Empire, and this has really been the bread and butter for development. If you drive along the freeway, you will see these big concrete structures being tilted. You will also see new buildings being built, such as the QVC building in Ontario near the airport and many Amazon distribution centers. These are the kinds of things in which Erik specializes. The other segments are called multi-family or apartments, retail, and office. Multi-family is really the first to come back after this recession, and industrial came back like nobody’s business. This has really been the leader out here as far as the commercial and industrial arena goes between industrial, office, and retail. Industrial is the leader by far.
Bruce said what has been interesting about that is residential just got killed. From 2008-2012 it was pretty much a depression. There were a lot of things that felt like they could go really wrong with the commercial world, and for some reason it seemed like they avoided the worst of it. Bruce asked if this is an amateur’s perspective, or is this really what happened. Erik said this was true for most of the owners out here. Something interesting was he remembered sitting with several people who had put together opportunity funds from 2008-2010. A lot of those principals had lived through the late 80s-early 90s to tell about it after the last go-around. At that point in time, the government took back a lot of properties.
They created a resolution trust corporation and the FDIC to save loan crisis. A lot of banks failed, and a lot of assets were taken back. Once this happens, the liquidate, liquidate, liquidate mantra was expected to be avoided at all costs. This was the mission of Sheila Bair, the old head of the FDIC. They had come out very early on and said they wanted to avoid a repeat of the 90s. People like Peter Schiff were critical at the time that it would be “blend and pretend” or “blend and extend.” This is what happened along with a few key sales that were really forced sales because the debt had come due and could not be renewed. Those sales wound up being bottom of the market sales and were a little bit stressed. However, they were not bank take-backs or liquidations. They were forced sales because the debt could not be renewed. There were ready and willing buyers at this point who were willing to take on those assets. For about a good year and a half, there were three active buyers who were ready to make that call to purchase.
Bruce said what is interesting about the residential side is in 1995, there was a rise in defaults but a lowering in trustee sales. The lenders had stopped foreclosing in 1995 on their own, and there was legislation passed that said if people are 100 days late you have to put them in foreclosure. You go forward to 2008-2012, and it was exactly the opposite and they said it was ok if you were behind. Erik said it was different back then than it is today, especially after seeing an advertisement on tv for the “California Save Your Home If You’re in Trouble.” You would have a small business still remaining, and that is really the sentiment. Bruce wondered if going forward whether we have discovered a new way to solve a problem without a lot of damage. This way if this happens again we will have a new playbook and not bring out the one from the 90s. Instead, they will bring out the one they just used.
Out here, the Inland Empire really led the country in coming out of this Great Recession. Erik started as a market research intern, working the numbers back in April of 1994. This was in the middle of a time that was not good. There were people who were still leaving the real estate business from the brokerage. At that time the mantra was “stay alive till ’95.” In hindsight it was probably really 1996. Erik remembered sitting in some early sales meetings in 1994, and some of the top real estate brokers were debating on whether it was a good time to start chasing land listings again. If you had a land listing in 1992 or 1993, almost no one was buying it because it was worthless. So in ’94 the census was that it was time to start going after it.
Erik actually knew one individual who did not chase a land opportunity in 1993 that, in hindsight, would have been a good one to chase. Erik was told to never turn down a land listing again after that. Sometimes it takes a contrarian to make a fortune. In the 90s, Bruce got a call from the city that had a 50 lot subdivision and had to take it back through tax default. They were actually offering to give Bruce’s company the land free. This included 50 buildable lots, but he had to build on them inside of a calendar year. He was able to buy houses in the city for half of his construction cost. Bruce wondered what the point was and said it really did not make sense.
Erik said there was a moment of time in 2009 and 2010 where land was overpriced because the market takes such a hit. Once they got to about the west end around Ontario, they started having a discount of 40-50%. This seemed to be the consensus that this was it. They stayed there for a while, then they clawed their way back. Now they are surpassing the valuations they saw in terms of tank valuations in 2008. On the bigger buildings, the rental numbers have actually surpassed the last records we hit, and the land prices are now about there. However, the lease rates passed before the land prices because they were at a 2-year lag by the time you bought the land to buy real estate. This is because the cap rates compressed compared to where they were at prior. The cap rates have been sub-5 and sub-4% depending on the real estate and when the leases roll over.
Bruce asked if 2008 was considered the peak in the commercial world, which Erik said it was. Bruce asked if at this time it felt like they were in a bubble, and he wondered if it feels like that again. Erik said 2008 definitely felt like one too many drinks had been poured at the after party. When the money shut off, it did so fast and you could see it start to happen in the summer of 2007. Erik said he remembered because his youngest son was born on August 16, 2007, and the day before Kramer went on CNBC screaming for them to open the discount window. This was a full year before the money was completely turned off, but you could see things coming. This time around, it feels very much more driven by supply and demand.
Erik shared some numbers from the Inland Empire West and East that are from 2012. At the end of 2016, we had about 22 million square feet of industrial real estate under construction. If you include that will all the construction completions from 2012 to now, that is 102 million square feet of new industrial real estate that has been built in the last 7 years. This is bigger than some of the smaller metro markets across the country. If you assumed about a 45% coverage building on the land, this means we absorbed about 5,300 acres of land. Bruce asked about the 102 million and wondered what percentage of the whole it represents.
Erik said the entire base between the east and west now is about 540 million square feet. This is really significant adding 20% of your entire stock in 7 years. It is a big percentage of what is out here. When you zoom out and consider the ports of L.A. and Long Beach and how we are only a sub-market of the LA basin, the entire base is really about 1.6 billion square feet now.
Bruce noticed a term on one of Erik’s reports. There is a vacancy rate, and there is an availability rate. They are both different, so Bruce wondered if this means the availability includes what is under construction. Erik said it does and actually includes 3 things besides anything that would be vacant. It includes anything that is physically vacant. It would also include anything on the market that is either occupied or could be on the market for sub-lease. Sometimes you have a big building come on the market for sub-lease, so they would include this as available even though it is technically not vacant with someone still paying rent on the space. It would also include buildings that are under construction.
In a market like we are in right now, depending on the size rents you are looking at on buildings over 300,000 square feet, it could be that 20-30% of the buildings you are looking at are under construction. If you wanted to go look at 10 buildings, 3 or 4 of the buildings in your search would be buildings under construction. You would have to look at those because the market is so active there could be multiple deals working on each of those buildings simultaneously. It is like the rent prices are blocked in and negotiable. The landlords have expectations on the rent. There have been situations where someone is negotiating on a building, and another person comes in and takes it. If you spent 3 months with structural engineers trying to figure out how to make that building work and did not sign a lease on it, you are back to the drawing board.
Bruce said one thing he noticed that surprised him was when you looked at the share of sales that were occupants versus investors. Bruce would have thought the occupant would have been the dominant player, and it is not even close. It is the investors by far, and Bruce wondered why, especially with the cap rate. Erik said if you lift up the curtain and look at the wizard behind the curtain. The wizard operating the levers are often big institutional money people. Some of the biggest investors are teacher retirement funds, pension funds, CalPERS, CalSTERS. A lot of teachers like to buy in California, Washington, Ohio, and New York. Along with that, you have your life insurance companies like New York Life, Principal, and Prudential. Those firms have billions of dollars allocated to invest. They take a percentage of what they put out and put it into real estate.
Bruce next asked about foreign investors since they are pretty concise participants in that space. Erik said in the last few years there was a big push out of Australia and that there were some major funds and institutions that came from there. They have continued to grow, and a couple of them decided to sell some substantial portfolios. Sometimes those are exchange-driven, depending on where the money is going. One of the stories Erik heard was that back in the late 70s and early 80s a lot of real estate developers were based out of Canada. This country has added a rule with residential real estate where if you are a Chinese investor, you have to pay a 15% premium to buy real estate. Bruce asked if this caused more people to want to buy in the United States. Erik said this could be a factor, but he is not sure since he does not know the details on it. Like Bruce, Erik is a numbers guy and likes to have the data right in front of him.
Erik said the hard things he has seen in terms of actual transactions and deal flow is Japanese banks have really cheap money. They have partnered with other institutions to place that money into California and U.S. real estate. This is because the cost of funds is so low, even negative. Two years ago Erik had to have someone explain to him what a negative interest rate was. Essentially, they get charged for keeping too much money in the bank, and they have to send it out. Bruce said one of the hottest selling items in Japan is a home safe; so instead of losing money with their savings in the bank, they just keep it at home. Americans have had this for quite some time, and people are finally realizing it. When you put your money in the bank, CPI is to the 3% a year, and your money is getting 0, your money is losing its purchasing power over time by sitting in the bank.
What is interesting about things like CalPERS is they are supposed to be clipping along at 7 ½% yield, and they are buying industrial buildings at a good size premium in price. Bruce asked what happens with cap rates when interest rates change. Erik said it is typically spread between the metric and tenure Treasury. For example, when Ben Bernanke had his temper tantrum in 2013, the tenure was around 1.67%. On December 1, there was about 3%. This means it went up almost 140 basis points in 9 months. In only 8 months, it was massive and the market could not take it anymore. When they finally relented, the tenure in January of 2017 was back at 1.67%.
Bruce asked about the industry in general and if it is concerned about a recession in the next couple years. He also asked how this impacts commercial real estate. Erik said recessions are always hard to predict. There was a saying that economists predicted 9 out of the last 5 recessions. It has been humming along so well and for so long now that there is a feeling there may be a pause that refreshes. There is so much money chasing real estate, and the buildings that get built seem to get absorbed often before completion. There is a technology happening that is driving a lot of these big buildings. If you build a 1 million square foot building, you are taking down a lot of land at a given time. 50 acres here and 50 acres there adds up pretty quickly.
There is a huge e-commerce thing that has completely changed the way the world buys things, especially on Amazon. Erik said he loves Amazon. On one hand, a lot of retail is winding up in houses and being delivered by truck to your front door. This means these old line retailers and malls will have to re-think how they exist going forward. One of the craziest examples of that was a mall that was closes, graffiti everywhere. What they had done was converted to a drone race track. This massive mall in Minnesota was now the world stage for drone racing. Erik had heard about this on ESPN. Has this became the new highest and best use for closed malls?
There is a report typically put out every year for projecting and going forward. It talked about financing, and they had a track record of what the sentiment was for the next year, 2012, 2013, and all the way into now. 2017 was way higher than any of the years, and the term they used was “more rigorous qualifying” for the entire segment of commercial real estate. He thought this was a little scary since it was way higher than 2012 and 2013.
Tune in next week as Bruce continues his discussion with Erik Hernandez. If you would like more information, you can contact him at (909) 373-2707.
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