The devaluation of commercial real estate in 2009
ILLINOIS - At the beginning of 2008 I was sending emails showing that there was twice as much commercial real estate on the market vs. a year earlier and that it was increasing at a rate of 15 percent more properties each month. At that time, the way real estate was trending, I estimated the downward cycle would be a few years. Today, based on the impact of the capital markets, it is likely to be 4 to 7 years just to recover to today's values. Here's why:
Sellers who did not sell in 2007 thought their properties were more valuable than what the market would pay. Let's say they said they would sell for $10 million and it didn't sell. The real value of the property was $9 million but they were holding out believing in the "greater fool theory." Today, that same property is worth 15 percent to 30 percent less. In many cases, that's equal to or less than the debt they owe. In the last four months the feds have asked lenders to re-appraise every property in their portfolio. The borrower's property is now valued at today's value and we are hearing of borrowers handing their retail centers back to their lenders in this scenario.
Our belief is the lenders, who are not in the real estate business, will discount the notes and dump the real estate as quickly as possible. New investors will be buying these discounted notes for 60 percent -70 percent of what all the other competition owns their properties for. This investor can now charge a lower rent, and will fill his property with tenants from other buildings, thus driving the other properties NOI's downward. Historically, this cycle takes 4 to 7 years to stabilize. In the meantime, values of all buildings will fall another 15 percent to 30 percent.
Perceived Value (2007) $10,000,000
The investor who was waiting for the "greater fool"
Real Value (2007)$ 9,000,000
The value an educated investor would have paid when at the peak of the commercial real estate market
Current Value (end of 2008)$7,500,000 (-16.7%)
15-30% Loss of value due to Financial Markets & increased cost and risks (personal guarantees) of borrowing *
Expected Value (end of 2009) $6,375,000 (-15%)
10%-30% Loss of value due to reduced NOI (Tenant defaults and space size reductions)
Expected Value (2010-2011) $5,500,000(-14%)
10%-30% Loss of value due to new competition from new investors who bought defaulted buildings from Lenders and who will now under-bid for Tenants
Expected Value (2012-2015)$7,500,000(36%)
15%-40% Increase in value as defaulted properties reach stable occupancy and are sold
*Real Capital Analytics reports on 12/08/2008 that Chicago area cap rates, on a comparative basis, have risen 18%
As Jack Cohen, CEO of Cohen Financial has said "Asset value on properties today is probably the debt (at best), not the real estate, and, whether or not people default or try to save the deal will be a by-product of how much equity is at risk and whether or not people feel they want to protect it."
So what do you do? I would start by analyzing your current situation closely. Get an estimate of today's market value for your properties. Be realistic and conservative! If you bought your property 2-3 years ago, in most cases, it is worth less today. Look at your rent roll and tenant receivables, tenant renewals will not be 100 percent, and some of your stores won't make it through this recession. Plan for it, as painful as it might be!
Manage your NOI, paying more attention to your expenses. Act as if you will be absorbing all common area maintenance expenses, because you may be paying more than you think in the future. Negotiate the price for every supply and service contract you have. You probably have tenants who are giving notice that they are having trouble paying the full rent and are looking for concessions. If you can compromise, do it. Give them time to get back on their feet. These are the tenants that can leave your center for the lower rent center in a couple of years. Today you have to manage your expenses because it will help your tenants survive, which in turn, keeps you in the game as well.
If you have equity, move slowly. Buying opportunities will increase. Private equity investment groups (and some public equity groups) are buying with cash. They know where the value should be, where they are buyers, and it isn't at 2007 prices, or 2005 or 2006 for that matter. Most believe, as we do, prices will fall further.
However, we have yet to see many properties change hands, from the borrower to the lender. When it begins to happen, it will take more than three years to recover to today's values. An analogy we like to make is comparing commercial real estate to the current stock market crash. We are suggesting you sell when the Dow Jones is at 10,000 (now), or risk it going to 7,600 (2009-2010). Selling now gives you cash at a more favorable capital gains rate than the future will hold, and better buying opportunities are coming soon.
What's Hot, What's Not: Buyers will continue to flock to quality properties, with quality tenancy, with those cap rates slowly increasing. Distressed centers are also in demand, when they are priced appropriately, i.e. higher cap on actual NOI (no more master leasing). Triple net properties below a 7 cap, with flat income are not selling because there are so few exchange buyers. Also, any triple net property with less than 7 years left on the lease will be a difficult sell. That is, unless it is priced accordingly.
Bottom Line: Sell today or prepare to hold through this cycle. If you think the scenario summarized above is accurate and you do not have an interest in waiting for the next cycle which may be 4 to 7 years from now, we should talk about the real current value of your properties today.
Dan Martin and the Martin Retail Team is the top retail investment brokerage team in the National Retail Group for Sperry Van Ness with over $220 million in direct sales in 2008. The office has recently been named to lead the Sperry Van Ness National Self Storage team in the Midwest markets.
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