Estimating Values in Today’s Market
While everyone understands the commercial real estate markets are in trouble, few comprehend the problem’s full magnitude. Values have dropped in most markets, but the amount of adjustment is difficult to ascertain due to the lack of transactions.
Earlier this year, Green Street Advisors, a real estate investment trust advisory firm, described the economy’s impact on commercial real estate as a one-two punch. Green Street predicts that capitalization rates will return to pre run-up levels due to more-expensive debt and increased return requirements. It's called the “969” phenomenon, which is a pattern of cap rates, not an area code. In other words, cap rates were close to 9 percent for many sectors early in the decade, dropped to 6 percent in the easy-credit environment, and will return to the 9 percent level when the market stabilizes.
A simple calculation explains the impact of this likelihood. A property with $100,000 in net income capped at 6 percent results in a value of $1.67 million. At a 9 percent cap rate, the same property would sell for $1.11 million, which represents a one-third value decline, assuming the income is stable. If rental rates decline or vacancy increases, the decline in value is even greater.
FMV Opinions has performed research on median cap rates for investment-grade office and industrial buildings nationally since the early 1990s. Generally, cap rates have ranged between 9 percent and 10 percent from 1993 to 2002. After that, cap rates for both asset classes dropped to the low 7 percent range from 2005 to 2008 for industrial investments and about 6 percent to 7 percent for office products during the same period. Through the first half of 2009, median cap rates have reached more than 9 percent for industrial and more than 8 percent for office. The commercial investment market has seen an increase of about 200 basis points, or 25 percent to 30 percent. This at least partially explains the downward adjustment in prices currently being registered in the commercial real estate market.
Green Street suggests these cap rate fluctuations will result in a value decline of 35 percent to 40 percent. While trades are few, Green Street says this is where the market is now and property owners should prepare for the impact on their financial statements, loan covenants, and other issues related to property ownership and operation.
Richard Parkus, head of commercial mortgage-backed securities research at Deutsche Bank, corroborates these findings in the company’s commercial real estate outlook. He predicts property prices will decline 35 percent to 45 percent or more overall during this recession.
FMV’s research shows that industrial prices peaked in 2005 and remained relatively level at near $47 per square foot. Since then, prices have dropped to about $40 psf, a 15 percent decline. Office investment prices peaked near $230 psf in 2008 and have dropped to about $200 psf in the first half of 2009, a decline of 13 percent. Based on our research, the annualized decline for 2009 could approach 25 percent to 30 percent. Taking into consideration cap rate movement and statements from major investment advisers, the probable minimum decline will be approximately 30 percent or more for 2009.
Clearly, the commercial real estate market is in a very serious correction. Actual sales data for the first half of 2009 show declines of 25 percent to 30 percent. With continued softness in employment, price declines will continue to occur in 2010, but at a slower rate.
The interesting wild card in the recovery is the capital markets. If Green Street Advisors is correct and cap rates adjust up to long-term averages approaching 9 percent, values will not adjust to levels reached at the peak in 2005 to 2008. Instead, capital return requirements coupled with more-stringent underwriting demands will result in higher cap rates and lower long-term values.
— by Robert E. Dietrich, CCIM, MAI, managing director of FMV Opinions in Irvine, Calif., and head of the firm’s real estate division. Contact him at rdietrich@fmv.com.
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