FEATURE ARTICLE, JUNE 2007

AUCTIONS ARE A FAST OPTION FOR SELLERS
When the commercial real estate market faces leaner times, auctions provide for a quick sale.
Julian E. (Jeb) Howell III

Howell

The real estate boom of the past several years has definitely entered murky waters on the residential side. The recent woes of the subprime market are an early indicator of a period of shakeup in the securitization industry as years of risky underwriting, fuelled by an aggressive capital market, are finally surfacing. Delinquencies in the more vulnerable subprime sector of the residential mortgage market have hit 13 percent on adjustable rate mortgages, and the Center for Responsible Lending recently published a study that estimated that 2.2 million overextended subprime mortgage borrowers will lose their homes to foreclosure. New home sales have been severely impacted around the United States, as homebuilders turn to increasingly desperate measures to generate sales and to stave off hungry subcontractors.

Meanwhile, the commercial real estate market seems to be in boom times, with REITs and foreign investment fueling high levels of investment and funding of projects and acquisitions. According to the National Association of Real Estate Investment Trusts, or NAREIT, the primary U.S. REIT index delivered a total return of 34.35 percent for 2006, outperforming all other major U.S. equity market benchmarks for the seventh straight year. Top-performing REIT industry sectors and their total returns for 2006 included the office segment at 45.22 percent, health care at 44.55 percent, self-storage at 40.95 percent and apartments at 39.95 percent.

A massive amount of liquidity has flooded world markets due to the rapid monetization of hard assets through REITs, pension plans and other instruments of securitization. This is largely because the aging of the affluent developed world has increased the demand for income and lowered the cost of capital, thus reducing expectations on equity. This strong upsurge in commercial development and lending activity appears to be entirely driven by the capital market, rather than by product demand.

Demographic and Business Trends

There are several factors on a national and global level which suggest that this current period of growth in the commercial real estate sector is not based on product demand, and that present growth levels are not sustainable. In fact, there are reasons to believe that the commercial real estate slowdown could become much more severe as the realities of demographic factors combine with present business trends. These factors include our declining birth rate to just below the level required for replacement. The void is being filled by primarily Hispanic labor. Even so, the Hispanic birth rate of 2.6 added to the native birth rate of 1.6 results in a 2.0 birth rate, just below the replacement rate of 2.1.

Secondly, the same aging phenomenon that has increased the demand for passive income is also resulting in a society with a much higher dependency ratio. In other words, the proportion of working adults relative to those who depend upon them for support (children and the elderly) is declining. 

Third, thanks largely to the Internet, even the smallest of companies or business entities can compete in the business environment today. 

In response to the Internet, retail space needs will diminish as online sales increase. According to the U.S. Department of Commerce, total e-commerce sales increased by 24.6 percent totaling $108.7 billion in 2006. Total retail sales only increased 4.5 percent during the same period. E-commerce sales accounted for 2.8 percent of total sales in 2006 and 2.4 percent of total sales in 2005. All indications are that this trend will continue.

Finally, job functions which tend to require large numbers of people have migrated steadily to other parts of the world, where labor and the space to accommodate it are cheaper. Thus, less space is required to be built here, not just for call centers and manufacturing, but also many elements of the service industry, even such services as legal and accounting.

These factors all point to decreased demand for new commercial space. The present commercial boom, due to high costs at every level of production (land, labor, and materials), is resulting in space that is much more expensive than what we have seen in the past. Only much higher rents can justify these costs.

This market disparity suggests that there is going to be an increasingly greater level of inventory in the coming months. When this happens, many owners of commercial real estate will face the difficult decision of whether to continue to hold and rent with revenue levels below debt service and operating expenses. When faced with a lengthy period of operating losses, alternatives such as auctions can be attractive because they assure a quick sale and a fair current market price. 

Commercial Real Estate Auctions

Commercial real estate auctions typically occur when a seller either chooses or is forced by outside circumstances to dispose of an asset quickly, rather than over an extended period of time. Auctions are attractive in such situations because sellers can compress the marketing period into a brief (typically 30 days) but intensive campaign, on “as is” terms they can require of all bidders, with quick, noncontingent closings. Whereas auctions occur throughout real estate cycles, in good times and bad, they can become particularly attractive when supply exceeds demand, and sellers require a more expedient way to market assets. We typically find that the discounted rate of return to a seller from an auction sale can be equivalent or superior to returns from a lengthier, ordinary marketing approach, when operating losses and holding costs are factored in.

The capital-driven oversupply of commercial real estate in what is really a period of falling, rather than rising, demand will result in longer marketing periods using ordinary marketing approaches. In a period of slow or no price growth and increasing expenses, the opportunity cost of not being able to sell today can be steep, since capital is tied up in non-productive or poorly performing assets.

Commercial real estate auctions are a cost-effective way to sell assets quickly, rather than allowing them to languish over the course of the months or years typically required for commercial assets. The marketing period is reduced to a matter of a few weeks. Auctions are either conducted on a “no-reserve” basis where the high bidder is automatically the buyer, or on a “confirmation” basis where the seller reserves the right to accept, reject, or counter the winning bid. In such cases, minimum bids may or may not be published. Typical auction terms are substantial (i.e., 10 percent) earnest money deposit, 30 day noncontingent closing, and acceptance of title in “as is” condition.

A well-marketed and promoted auction assures the seller that all market attention is focused on his asset during the auction marketing period, and if the right selling psychology is employed, bidders must take the auction seriously, thus ensuring that the highest possible price is paid at the auction. We have often seen cases where the price paid at our auctions exceeded the highest asking price of previous listings, only because we were able to establish a level of credibility which ensured that bidders took the offering seriously, since they knew they would not have another chance to buy the asset.

Although we do a lot of auctions in strong markets, we see even more auctions in periods where supply exceeds demand, where sellers do not want to be tied to non-performing assets for extended periods of time. We feel that a significant correction will soon occur in the commercial real estate market, and that now would be a good time for prudent real estate investors, commercial brokers and lenders to incorporate auction marketing as an effective exit strategy for excess assets in the coming months.

Julian E. (Jeb) Howell III is president of Atlanta-based Auction Management Corporation, a commercial and residential auction firm with offices nationwide.


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