Tuesday, June 24, 2008

Commercial Real Estate Price Crash?

The crash in Residential Housing is an old story by now, and there is no point in beating a dead horse. Our focus now turns toward Commercial Real Estate (CRE). There have been recent media reports on prices starting to decline in CRE in the United States, and battle lines are starting to form on these assets with the main question being - will CRE be the next to crash? If you put aside the hyperbole and emotional rhetoric involved with his question, it should be easier to analyze since CRE should be valued based on cash flows mostly.

Most pundits claim that what happened to Residential Housing won't happen to CRE. They give various reasons for this:

1) There was no overbuilding in CRE.

2) Lending standards were not degraded in CRE.

3) Investors here are more sophisticated (my favorite).

The purpose of this article is not to argue the above points. Let's just say that greed and stupidity, which are what created the lax lending standards that are the root of our current housing problems, are universal concepts that are not restricted to those who didn't go to college or don't know their way around a net present value calculation. (OK, forgive me, I just refuted point 3 above)

This article will focus on the theoretical components that make up the capitalization rate that is used in the CRE market to demonstrate that CRE prices must decline, possibly to a level that might constitute a "crash" to some.

The capitalization rate, for those who don't follow CRE, is defined mathematically as the net operating income (NOI) of a property divided by its value or price. NOI is calculated before debt service. An example should suffice in explaining this concept:

Property A has a NOI of $10,000 a year, and sells for $200,000, then the capitalization rate would be 5%.

This is used as a proxy for the yield or return of a property. It is also used to compare to observable capitalization rates in the market. Current capitalization rates for all classes (office, retail, industrial, multi family) of CRE are very low on a historical basis. In some desirable areas, capitalization rates reached a low of 5%. This was because of low interest rates and the ubiquitous "liquidity" arguments that used to make me nauseous in 2006 and 2007 as I read them. I wasn't blogging during this liquidity tsunami, but if I was, I would have titled my post:

"Field of Dreams Investments - if you create an investment, they will buy it, don't worry."

The capitalization rate has four theoretical components, according to current academic research

1) Expected Inflation - investors in any asset require protection from the ravages of inflation. This is usually expressed as "expected inflation" not actual reported inflation. Surveys show that inflation expectations are rising. This is being fed by media reports about commodity and food inflation. For the purposes of this article, I will not argue whether the commodity boom is real and long lasting. What matters is what expectations are.

2) Real Return - what an investor expects to earn on his capital. We assume that this component is stable.

3) Risk Premium - investors rightly expect to be compensated for the risk they take by investing in Real Estate, as opposed to a risk free asset. There are some who claim that there is little risk in investing in real estate. I remember a sell side REIT analyst marketing back in 2005 who made the extraordinary claim that "REIT's are so safe that trust departments are substituting them in the place of treasuries in customer accounts."

After I finished hyperventilating and coughing extra loud for effect, I interrupted him to tell him that I had worked in a trust department at a bank for four years, and that if I had suggested to the Chief Investment Officer that we swap REIT's for U.S. Treasury notes, I would have been tarred and feathered. He then furiously backpedaled, we all laughed around the table, and began to pick at our food. Sorry for the digression, but the point is that this risk premium will almost certainly increase over the absurdly low levels of the last few years as CRE fundamentals deteriorate.

4) Recapture Premium - this component compensates investors for the physical deterioration of the asset throughout its life. Again, we assume that this remains stable.

Mathematically, therefore, this is how it works:

Our previous example above

Property A has a NOI of $10,000 a year, and sells for $200,000, then the capitalization rate would be 5%.

If the capitalization rate is impacted as I describe:

Property A has a NOI of $10,000 a year, and the Capitalization Rate demanded is 7% - then the market price would be $142,000. This is a drop of 29%.

An even worst case scenario is if NOI falls:

Property A has a NOI of $9,000 a year, and the capitalization rate demanded is 7% - then the market price would be $128,000. This is a drop of 36%.

I know there are those who will scoff at this academically based argument. If you are one of those people, then search on Google for charts on historical capitalization rates for CRE. It wasn't too long ago that these rates were in the high single digits. A two percentage point increase may not be all that unreasonable.

So what you are seeing in CRE currently, in regard to the the slowdown in sales, is not just the result of a lack of financing, or the shutdown of securitization markets, although both these reasons are valid; but the main cause of the slowdown in sales is the fundamental financial canyon, so to speak, between buyers and sellers of CRE, with buyers demanding a higher capitalization rate to be compensated for an increased risk premium and an increased expected inflation premium. Sellers haven't broken down and accepted this yet.

The acceptance of this will be accelerated during the year as cash flows decline in CRE due to increased vacancies, lower rents, and the economic downturn. As more distressed sellers are forced to liquidate at lower prices, capitalization rates will move higher.

1 comment:

Dividends4Life said...

We could be looking at a lot more pain!

Best Wishes,