How to fix the commercial real estate problem: 'Invest local'

Commercial real estate has been hit especially hard by the recent economic downturn. Part of the problem hampering its recovery is the great difficulty in getting funding for local projects. An expert from the W. P. Carey School of Business at Arizona State University explains why this is happening and one way we can make some headway in fixing it.

Professor of Real Estate Practice Mark Stapp is both a real estate developer and executive director of the Master of Real Estate Development (MRED) program at the W. P. Carey School of Business. He says we first got into trouble in the commercial real estate market in recent years because people were overlooking the basics.

“Real estate is location-specific, unique and small, which makes it really hard to trade and value on a significant scale,” explains Stapp. “Still, the financial world took properties with fundamental differences and bundled them together, in order to create a larger scale, offset high transaction costs and trade a bunch of properties together. These pools of mortgage assets were assigned values by rating agencies, so they could be compared and traded as commodities. This overlooked the nuances of the individual properties, which may work well when markets are good, but makes it really difficult to fix problems when the market is bad.”

Stapp says large banks liked the system because they could make money through loans and fees and then package and sell large groups of loans to investors, removing much of the risk. He says this created a disconnect between the banks and the communities where the properties were located. Stapp believes a similar disconnect is the reason for the slow commercial real estate recovery.

“Large financial institutions like large-scale trades because of efficiency and the bigger fees; they don’t want to deal with small loans; they’re too much trouble,” says Stapp. “Big banks also want big, national merchant tenants. They believe those tenants are less risky, but in reality, this can be a false sense of security. Also, local merchants are typically great for the community because they’re very committed and more of the money stays local.”

Stapp says 88 percent of retail firms employ 20 or fewer people, so the great majority of businesses are small businesses. Those are the ones having the toughest time getting a loan now.

“In order to achieve community redevelopment, we need to look at the uniqueness and sense of place involved in different properties,” says Stapp. “We need local lending sources that are willing to help individuals and small businesses, that aren’t dependent on the formulas used by larger banks and decisions made far from the actual real estate locations.”

Stapp teaches his students in the MRED program not to rely only on banks, but also to look at local equity models, including local equity funds and credit unions. He says these models complement and balance out existing banks, with a heavier local focus. He says they include an association with and a stake in the outcomes of community real estate projects. He recommends those wanting to invest in their communities look for the following criteria:

1. An alignment of interests,
2. A balanced approach,
3. A community investment equity fund that is for local, small-scale, area-merchant-focused projects,
4. Local underwriting and decision-making,
5. Federal rules and tax treatment that favor all equity and real estate investment trust (REIT) projects.

For example, Stapp points out a newly announced Phoenix-area transit-oriented development fund (TOD) that might fall into this category. Denver has a similar fund that supports projects in current and future transit corridors. He says big banks might not look so closely at these types of projects, but investors can consider them.

“Real estate is about people, not just about large-scale financial transactions,” says Stapp. “We need to teach people about how these systems work and not treat properties categorically. MRED teaches leaders to establish those processes and projects to advocate for the community, while creating financially feasible projects. We are trying to develop a bridge between community leaders and the real estate industry that helps focus on financing sustainable projects that will endure in and benefit our communities in good times and bad.”

For more information about the MRED program, visit www.wpcarey.asu.edu/master-real-estate.