Detroit Bankruptcy Rattles Investors

When a large municipality such as Detroit files for bankruptcy it tends to give institutional investors pause when it comes to assessing potential buys. Detroit is not alone …

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When a large municipality such as Detroit files for bankruptcy it tends to give institutional investors pause when it comes to assessing potential buys. Detroit is not alone in its financial woes, but it is a high-profile example of the instability faced by some municipalities during the recession and the fallout has many reevaluating real estate investment in areas that suffer from low employment, stagnating growth and a fleeing population. Detroit is caught in a downward spiral in that it can’t offer inducements for businesses to move there, which forces people to leave and in turn causes the cycle to get worse, which leaves investors little to entice them. For more on this continue reading the following article from National Real Estate Investor.

Detroit’s recent bankruptcy bid pushes an issue to the forefront that has increasingly been on the table for institutional investment committees—the financial health of municipalities.

A city’s economic strength is one of the major fundamentals that institutional investors look at when evaluating potential acquisitions. If a city doesn’t pass the “litmus test” investors won’t even look at a particular asset, notes Donald J. MacLellan, a senior managing partner at Faris Lee Investments in Irvine, Calif. “Investors are not going to go into an area that is declining and has no employment drivers,” he says.

After struggling for years, Detroit officially filed for Chapter 9 bankruptcy protection on July 18th—citing $18 billion in liabilities. Although Detroit is an extreme example of a large municipal financial crisis, it is certainly not alone. The recession has generated other casualties across the country with bankruptcy filings in the past two years from cities such as Harrisburg, Pa. and San Bernardino and Stockton in Calif.

The question is how much, if at all, high-profile bankruptcies have affected investor underwriting. The financial strengths and economic outlooks for geographic markets or regions have always been key parts of institutional investors’ underwriting practices. “That attention gets people asking questions about how is this going to impact the value of my real estate, whether it is my house or a huge office building,” says Kevin Smith, a senior managing director and head of U.S. business at Prudential Real Estate Investors in Madison, N.J.  

More scrutiny for cities

The financial health of a municipality has a real impact on the local business climate and a city’s ability to attract business and job growth—a key driver for demand for commercial real estate. Cities often use incentives such as tax increment financing programs and grants to offset development costs on build-to-suit projects. “If a municipality is in duress, it really can’t offer inducements, because it just doesn’t have the money to do that,” says Bruce Westwood-Booth, managing director, capital markets at Jones Lang LaSalle in Chicago        

That financial health is critical to a city’s ability to attract people and companies. Cities need to have the money to support necessary infrastructure improvements and other basic services. The fiscal health also can impact the tax burden placed on residents and businesses.

For many investors, a city’s financial woes present an automatic red flag for new acquisitions. Other investors may see the herd moving away from a place like Detroit and see that as an opportunity. “We certainly don’t redline any markets, but the impact of those financial struggles on job growth is something that we pay a lot of attention to,” says Smith.

In the wake of the recession, risk-averse investors have gravitated towards the safety of major metros. Buyers are targeting markets where there is current and projected healthy job growth. PREI, for example, is concentrating on strong tech markets such as Seattle, Austin, Boston and Raleigh, as well as areas of Florida, Atlanta and Phoenix that are starting to benefit from the recovery in the single family housing sector. Following that strategy, PREI acquired the Sabadell Financial Center in Miami earlier this spring. The 30-story, class-A office tower is located in Miami’s Brickell Financial District.

Lessons learned from Detroit

Clearly, the Detroit bankruptcy is going to create some fallout. Investors also are going to study what’s going on in Detroit and relate that back to other areas of the country that might be experiencing some financial struggles.

One concern is that tenants, particular large corporate tenants, will be reluctant to lease space in the city, particularly when they have better options in other cities or stronger suburbs such as Southfield or Troy. Two, the bankruptcy is expected to translate into reduced city services. Although the city will not fall below certain standards for fire and safety services, they might not offer the same level of service that other cities do. “That is a concern for companies,” says Woodson-Booth. It will also be more difficult for Detroit to provide incentives to companies to locate or expand in the city.

When Jones Lang LaSalle evaluates markets on behalf of clients, whether that is an investor, developer or corporate client, the firm looks at factors such as the bond ratings, as well as the overall business climate and economic environment of a city or region.

Even before Detroit’s bankruptcy filings, many investors were wary of investing in Detroit, as well as the broader state of Michigan. “The problem with Michigan is some investors see that spiraling down as a whole state. They saw an exit from that area. They saw uncompetitive business practices in that area, and it just steered a lot of investors away from it,” says Woodson-Booth.

On the flip side, investors once held much the same sentiment about Pittsburgh, and now that situation is the opposite with new investment capital flowing into Pittsburgh rather than out of that market. A few years ago, people also were very concerned about the financial viability of the state of California and the extreme taxation and high business costs driving businesses out of the state. Although some cities and regions within California continue to struggle, much of the state has proved to be resilient and has continued to attract new investment dollars.

Ultimately, investors remain keenly focused on one of the basics to underwriting commercial real estate investment properties – the demand for space. Certainly, demographics, economic growth and business diversity are common factors that institutions evaluate in determining the strength of the market. One of the things that has changed is that the tools and the data available to make those decisions have gotten more sophisticated, adds Smith. “Our ability to make reliable projections has gotten better,” he adds.

This article was republished with permission from National Real Estate Investor.

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