With cap rates having risen 100-300 bps on average, depending on the property in question, some recent deals have a lot of people shaking their heads a bit. It was apparent several months ago that quality core multifamily assets were commanding premium pricing with cap rates in the 6-7% range, with a few deals even trading at sub-6% cap rates. The Class A multifamily market has continued to attract great interest, and now core office deals with strong credit and limited near term rollover are getting priced around 6% caps again as well. What is going on? Are cap rates coming back down? Well, not across the board. The core deals trading at these levels are attracting a lot of interest because there is not much on the market and while everyone waits for the return of the early ’90’s bargain hunting, core deals are attracting interest as the closest to a sure thing as is available today. There is a lot of capital ready to be invested, resulting in upwards of 25-30 credible bids for solid core deals. I have to wonder whether this will hold, though, and whether it might just be a brief mini-bubble that has redeveloped for core assets. It seems like a simple case of supply and demand–not much quality product on the market and a lot of capital chasing the few deals available.
February 10, 2010
October 14, 2009
Cooper Village/Stuyvesant Town Emblematic of the Bubble Era of Real Estate
WSJ reports this morning that the Peter Cooper Village and Stuyvesant Town apartment complex in Manhattan is “in danger of imminent default.” Gee, what a surprise! It was purchased in 2006 at the height of what some CRE pros are affectionately referring to now as the “cocaine era” of commercial real estate. Real Capital reports that the property was purchased at $5.4 billion, which equates to about $481,000/unit or a 3.2% cap rate. On a price per unit basis this is not unheard of for Manhattan. For a project of this size, though, and with so many rent regulated units, the 3.2% cap rate is really a headscratcher, and was even during the bubble days. Granted, Manhattan cap rates trend lower than most markets, and investors there seem to tolerate extremely low cap rates in return for the safety of investing in a market with incredible demand drivers and relative safety of principal. But the low cap rate, combined with aggressive underwriting and high leverage was a recipe for disaster once the recession hit and the owners’ business plan faltered.
Greatly compounding the risk in the deal was a high loan to value and extremely aggressive underwriting of operating performance. The deal was financed with 80% plus leverage, thanks largely to CMBS debt, which has now been transferred to special servicer CW Capital, one of the biggest players in the special servicing world (where CMBS loans go when they have or are about to go bad). The operating projections assumed that many of the rent controlled units could be converted to market rate and that overall operating income would triple (!) in just a few years. Well, needless to say but rents have not kept pace with projections, and a tenants’ lawsuit has largely kept the owners from executing on their plan to convert rent controlled units to market rate.
Most astounding is that some of this risk was in fact foreseen by the lenders. Why else would they have required a $400 million interest reserve? That’s right, the deal included a $400 million interest reserve to cover debt service shortfalls. Obviously the deal had “negative leverage”. The price paid was so high, and the leverage ratio so great, that the deal probably was forecast to run deficits–operating income could not cover the debt service until a few years down the road when operating income would, ahem, triple (allowing the owners to flip the deal at huge profit in theory). Given its size this deal will surely be closely watched as a gauge of how the CMBS system will handle troubled deals such as this and the outcome may affect sentiment, positively or negatively, about the risks which CRE presents to the wider economy.
WSJ link here .
Wikipedia:
Interesting blog about Stuyvesant Town: http://stuytownreport.blogspot.com/
Tenants’ Association: http://www.stpcvta.org/
September 21, 2009
Moody’s/Real Commercial Property Price Indices – still falling
Given the continued fall in values reported by other indices and data sources, today’s Moody’s/CPPI report is not a shock. The National All Property Type Aggregate Index measured a 5.1% drop in July and now stands 38.7% below the peak of October 2007. The Moody’s/CPPI is a same property repeat sales index, and in July it recorded 74 repeat sales totaling $1.2 billion. The safe haven, if we can call it that, was apartments in the Northeast, which registered an annual drop of only 6% while the national apartment index declined by 24.4%. On the other end of the pain spectrum, in Florida the index shows apartments have fallen 40% in value over the last year and 50% from their peak. Unfortunately apartment values in Florida are likely to continue falling given all of the condo projects recently and still being completed, most of which are by necessity being thown into the rental market.
August 26, 2009
REIS Quarterly and Capital Markets Briefings show continued CRE slide
Highlights from the REIS quarterly and capital markets briefings:
Quarterly briefing:
- Apartment vacancy at 7.6%, highest level since 1987; forecasting peak of 8.1% next year
- -2% rent decline so far this year for apts.; total -2.6% forecast for year
- Office vacancy at 16.9%, expected to peak at 17.9% next year
- Office rents to decline by -8.6% this year and -5.0% next year on REIS forecast
- Retail vacancy at 11.0%, expected to peak at 12.8% in 2011
- Rental declines of -4.1%, -2.5%, -.8% for 2009-11
- Retail shows negative net absorption of over 20 million SF forecast for ’09!
- Industrial vacancy to hit 11.4% in 2009, peak at 11.8% next year
- Industrial rent declines of -3.7% and -1.3% 2009-10
- -65.8 million SF negative net absorption for industrial forecast for 2009
- Recovery is forecast to be tepid for all property types following the negative years
Capital markets briefing:
- Transaction volume slightly lower Q2 vs. Q1, 89% below peak level of Q2 ‘07
- $3.5 trillion CRE debt outstanding, $1.5 trillion of is at banks
- CRE mortgage delinquency rates still spiking up, now approaching 8%, almost on pace with residential
- Construction and development loan delinquency rate at 11%
- REIS counts $18.24 billion of loans in default or delinquent and $47.8 billion in special servicing (this is only for securitized deals; RCA totals up all distressed deals at north of $114 billion– check that…update from today on their site is $145 billion!)
- Overall, REIS views economy as showing some tentative signs of improvement, but no solid footing found yet, so continued deterioration in fundamentals and transaction volume not surprising
August 4, 2009
NCREIF Property Index shows further value declines
The NCREIF Property Index (NPI) declined by 6.7% in the second quarter of 2009, bringing the year to date decline to 14.8% and the year over year decline to 24%. The value of the 6,123 properties included in the index now stands at $254.1 billion. During the quarter, the office portion declined the most at (8%) while the retail portion fared the best but still declined by (4.6%). The total return for the quarter was (5.2%), including the (6.7%) appreciation component and an income return of 1.5%. The one year income return was 5.5%.
June 25, 2009
The debate about appraisals
WSJ has an article this morning summarizing the debate about home appraisals which has recently erupted. New rules adopted under pressure from NY’s AG Andrew Cuomo have the realtors up in arms with Lawrence Yun, the organization’s chief economist, lamenting “poor appraisals” and “faulty valuations” causing deals to fall through. The rules require greater independence for appraisers, who contrary to their long standing professional standards, have been subject to pressure from parties involved in sale and loan transactions. Now “appraisal management companies” are responsible for independently picking appraisers and managing the process.
WSJ article: http://blogs.wsj.com/developments/2009/06/24/whats-with-all-the-moaning-about-home-appraisals/
On the commercial side there are similar concerns which have arisen. Many institutional investors and managers have recently adopted valuation policies and guidelines which include greater independence in valuations. Some have employed appraisal management companies and many are reappraising their entire portfolios in order to “mark everything to market” on a more timely basis to better reflect reality.
Trouble is, on the commercial side, volume is off 80-90%. It’s tough to perform an appraisal with such limited comparable sales data, and appraisers are loath to rely on the “cost method” and the “income capitalization approach” is fraught with peril these days as well. Who is to say what is a proper discount or cap rate in light of the volatility and uncertainty in the marketplace? How far does an appraiser have to stretch geographically these days with limited transactions and what about all those “adjustments” made to the comparable sales to make them comparable to the subject property?
The reality today is that there are really three potential values for a commercial real estate asset to think about:
1) Fire sale today: Given the lack of transactions and limited appetite for risk, owners will generally sell today only if they have to, i.e., the property is in trouble, has tripped loan covenants, etc., or the owner is in distress. This is the low end of value and represents a market clearing price today.
2) Market stabilized value: By market stabilized here I am referring to the stabilization/normalization of the investment sales market. We may never reach the peak activity seen in 2006-2007, but a return to 1/4 or 1/3 that volume could be viewed as a normalized market which would improve pricing for owners/sellers. The capitalization rate for this value is likely 200-300 basis points below that of the “fire sale” cap rate available today. But one cannot sell at this price today; think of this as the medium to long term “intrinsic value”. Owners might think about projecting out when this value may be achievable and then discounting that value back at an appropriate rate to determine the value today.
3) Orderly dissolution value: This is the value of a property assuming temporary impairments such as owner distress have been resolved but the market has not yet fully stabilized. Think of orderly dissolution as a value somewhere between the fire sale and the market stabilized value. This seems to be something like what the Financial Accounting Standards Board was getting at with FASB 157. See the rule here: http://www.fasb.org/summary/stsum157.shtml
All of this discussion points out that an appraisal is an educated guess. The most solid real value at any given point in time is what an unrelated party will pay for an asset today. Until the property is marketed and sold, the appraisal and valuation process is just an educated guess, and today that guess is more uncertain than ever for residential and commercial real estate.
June 24, 2009
June 18, 2009
Effect of income and cap rate changes on value? Potentially huge.
While there is great debate about where CRE cap rates and values are headed, often lost in the discussion is the double hit to values which occurs when cap rates creep up and net operating incomes (NOI) fall. In order to better understand this dual effect on values, I have constructed the following simple matrix which crosses potential reductions in NOI with cap rate increases. The assumed starting cap rate is 6%, so think of this as the archetypal deal completed for virtually any property type of reasonable institutional quality purchased between 2005-2007. For example, a 100 basis point rise in cap rates and a 10% drop in NOI would together result in a 23% loss in property value. For many properties purchased at peak pricing, this is what has already occurred. Should cap rates march up to, say 8% and NOI fall by 20%, this would result in a 40% value reduction from peak pricing. Needless to say the potential for further distress in the CRE markets will linger for some time to come as assets are revalued, loan covenants are tested, and owners see equity dwindling. The upside is that these dynamics will create buying opportunities for well capitalized firms.
May 29, 2009
Where are cap rates headed?
Cap rates (for non CRE practitioners think inverse P/E ratio) have been trending up over the last year and half or so, meaning values are declining. There was a time in 2006-2007 when “everything was a 6% cap” (at most!). Quite a few seasoned real estate practitioners were scratching their heads wondering how this came to be and when it would end. With the onset of the credit crisis in the late summer/fall of 2007 it became clear that the 6% cap era may be threatened. As the recession has worn on, cap rates, as measured by the National Council of Real Estate Investment Fiduciaries and Real Capital Analytics, have generally risen by 75-100 basis points. Now everyone is talking about the return of 8% and even 9% cap rates, which were the norm only a few years ago. For perspective, the long term average for institutional quality real estate investment has been about 8.25%. The consensus seems to be that we are headed back to that level, but we are clearly not there yet.
The lack of recent transactions may be holding the cap rate uptick somewhat in check. Aside from investment property supply/demand and investor sentiment/expectations, the primary driver of capitalization rates is the cost of debt, i.e., interest rate levels (and other debt terms which have a material effect on leveraged returns such as loan to value ratios). The expectation is that interest rates will rise, and cap rates will follow. Interest rates are up a bit, but we have yet to see a significant increase in borrowing costs. This is probably the primary reason that cap rates have not gone up as much as everyone thinks they have or will (yet, anyway).
It’s worth noting that if a property’s cap rate started at 6% at purchase and now stands at 7%, that’s a 17% drop in value based purely on cap rate movement and not considering any potentially lower net operating income, which has been common with the recessionary environment we are in.
