CRE Thought Leadership

The COVID-19 crisis has brought significant stress to the commercial real estate financing market resulting not only from the obvious effects of putting the U.S. economy on hold, but also because commercial real estate and social distancing don’t mix.

The inevitable result will be missed rent, forbearance, and potential defaults by tenants. Landlords will need to accept this and work with tenants or risk sending tenants into bankruptcy. This will create unoccupied spaces in their buildings and destroy relationships with otherwise good tenants.

When crises hit, the biggest challenge in underwriting commercial real estate is in sorting out which issues are brief interruptions, and which will have long-term impacts on value (i.e.  understanding the difference between a suspension of the rules and a changing of the rules). For example:

In Part 1 and Part 2 of this series, we discussed the definitions as well as what factors decrease the useful and physical life of a commercial building.  In this article, we examine a specific property type of commercial real estate that has important deviations from a “typical” older commercial property: residential rental property.  We will explore why residential rental buildings (primarily apartments) have shorter economic useful life expectancies and what the main limiting factors in extending a property’s economic useful life is.

Economic Life of an Apartment is 27.5 Years

When considering the purchase of an older residential rental property (such as an apartment) it is important to understand that the useful economic life of an apartment building is significantly shorter than that of a commercial building.

As a reminder, the IRS allows 27.5 years over which you can depreciate residential rental buildings and 39 years for retail and other commercial structures.  This shorter depreciation schedule was established to encourage construction of new rental housing, however, it also reflects the fact that residential rental structures have a significantly shorter useful lifespan than commercial structures.  The tax code presumes that the useful life of a residential rental building is only 70% of the useful life expectancy of a commercial building.

What factors contribute to a shorter useful life for residential rental housing properties?

In Part 1 of this series, we discussed what the useful and physical life of a commercial building is, as well as the five stages of a building's life.  In this article, we will explore some of the factors that can decrease the physical and useful life of a commercial building. We will also touch on building obsolescence, which can be a major threat to older buildings.

*This is the first in a three-part series on considerations when purchasing older buildings.

Purchasing a building that is 25-years-old or older requires a significant historical investigation and analysis to determine the risks associated with the building.  These articles are intended to aid any investor attempting to answer the following questions:

• How do you identify the risks that come with the ownership of an older building?
• What factors can hurt the future net cash flow of an older building?
• How much more economic life is left in the building
• How many years are left that will produce reliable income from the ownership of the building?
• How do you determine the current value of an asset with a shorter economic life?

A building’s “useful life” depends on its previous ownership, intended use, and prior maintenance regime.

Events such as a downturn in the economy, a dispute among partners, or cash flow problems caused by new market competition, can affect the viability of an income property loan.  These real estate loans may need a “workout” by the lender so that the borrower doesn’t lose its property.  During the loan workout phase, it is critical that the borrower keep in full, open communication with the lender about their cash flow situation and plans to avoid a monetary default.  When a lender is dealing with a responsible, honest borrower, the lender is more likely to work with the borrower to help them get through a rough period. 

With that being said, even if no actual monetary default has occurred, there are a number of events that could precipitate the need for the appointment of an independent receiver.  Some examples of these events are:

We’ve all heard it.  Brick-and-mortar retail as we all knew it is in a death spiral – and the prognosis is grim.  Retail owners, tenants, and investors should find other ways to make a living.  There is no life after death for this product type.  But is this really the case?  Are we sitting front row, witnessing the extinction of brick-and-mortar retail?  The answer, as we discuss in our latest white paper, Understanding & Embracing the Evolution of American Retail, is slightly more complicated than “yes” or “no”.