Commercial Real Estate

This is the first time I've tried posting something only on the website, not in the weekly email, let me know what you think. In response to a number of inquiries about my commercial real estate comments last week, a number of readers responded with information and opinions on the marketplace. Since this is not my area of expertise,I have shown their comments below, without attribution to protect their privacy.

If you ever want to post anything to this site and don't mind people knowing it was you, just click on the "comments" link below. If you want to stay anonymous, just send your thoughts in an email and I will either include them in the weekly note or post them ala these notes.

First note:

Ned,

As long as you are writing, how about some prognostications regarding commercial real estate. My biggest question right now is where are CAP rates going to go? I am seeing a little movement for retail triple net properties, but not much. I have heard some people say that we may see 9 Caps on investment property, I am saying BS.

Second note:

In regards to cap rates...I can give you more details and specific numbers in a couple weeks when I get caught up at the office, but here is a quick my quick take.

Capitalization Rates vary based on a wide array of items including but not limited to Property Location, Property Type, Tenant Quality, Projected Cash Flows (Lease Terms), etc. With this being said cap rates will continue to edge upwards during the majority of 2009 and probably pick up pace in 2010 and 2011 and start to max out at that time.

Reasons...
1. Smart money is slowly (very slowly right now) coming back into the real estate market, which means investors are buying based on "income requirements" as opposed to "appreciation requirements". (Sounds like the equity market eh?) Since this is the case, Capitalization and Yield Rates need to be above Interest Rates to attract buyers. (duh!) But not too long ago, say the end of 2007, buyers believed that they could afford to purchase a property with a cap rate well below their interest rate since "...rents and property values were sure to be much higher in a year or two...". (Look for those dudes to give their properties back to the bank in 2009 unless they already have.)

2. But due to the slow inflow of new buyers, it is putting pressure on the sellers and supply is increasing rapidly, forcing those who need to sell to dump prices. Recently I ran across a portfolio of multiple-family residential properties that were listed at single digit mulitpliers (price divided by one year of gross income) in an area that in 2006 had 15+/- multipliers. In cap rate terms, this is like going from a 4% to a 7%. And a good friend of mine recently sold a mid-size apartment property on the water for a 12 multiplier, when 2 years ago it would have sold for an 18-20 multiplier. Although these are both multi-family residential examples, I can give you the same story with Retail and Office.

3. Fear of rapid inflation, in the long run, is another factor driving the cap rates higher. Real estate investors typically look at a 10-year hold period. Personally I am not a fortune teller, but my son has a Magic 8 Ball and when I asked it "what does a $10 Trillion Deficit mean to the our economy?", the answer was HYPER- INFLATION, with a sub-note that said "...if I had a dollar tomorrow for every dime I have today I would be a rich man...". A quick rule of thumb on Yield Rates (used in Discounted Cash Flow Analyses) is they typically are just slightly less than Capitalization Rates plus Inflation Rates (everything else being equal).

4. Lenders are increasing spreads (interest rates), Debt-Coverage Ratios, requiring greater reserves, lowering LTVs, and on top of all that don't have as much money to lend. There is a slight chance of this turning around with the strengthening of our socialist government, but don't hold your breath. This is again putting pressure on sellers to lower prices, which increases cap rates.

Don't get me started on Retail Sales, Unemployment, Corporate Cut Backs, etc. I mean I can go on for days with this stuff.

In a nut shell, look for cap rates to increase in 2009. So a Credit Tenant (Fast-Food/Retail/Drug/etc.) with a long-term NNN lease in Orange County that once sold for a 4% cap in 2006/7 will be selling for a 6% to 7% cap in 2009. That is a 30% to 40% drop in value! Check out www.loopnet.com if you want to see the latest listings.

That is all I can muster in my 30 minute dinner break.