VIEW OF THE MARKET
Volume II, Issue #3, 3/15/10
For this month’s newsletter, we want to discuss two items, risk and return and replacement cost. First, let’s talk about risk and return in commercial real estate. As many of you know, there is a lot of money on the sidelines looking to acquire loans and property at a discount. There have been a number of deals in the market in the last six months that were sold at cap rates in the 6%-7% area for apartments and 7%-8% for class A leased office. We believe these buyers are again overpaying for properties and are not looking at the risks inherent in commercial real estate. If an investor buys an apartment building at a 6.5% cap rate and finances 70% through Fannie or Freddie at 2.5% over the 10 year Treasury Note of around 3.7% or 6.2%, is this a good deal? Apparently yes, to the firms that have been doing these deals. These transactions, as we’ve stated before on VOM, are “Déjà vu” all over again and will turn out to be big money losers. The investor is buying commercial real estate at too low of a risk adjusted return and only because they have capital to deploy and/or the cost of financing is artificially low.
Commercial real estate is subject to many risks, especially in today’s tumultuous economy, such as; tenant/occupancy risk, economic risk, interest rate risk, market/competitor risk, financing risk, inflation risk and government risk. Government risk refers to the unabated tax and spend policies of the current administration and the negative impact on private sector investment. Most investors will agree that the Federal Reserve has pushed interest rates down to zero and they are artificially low across the interest rate term structure. Most investors also believe that higher inflation and interest rates are likely in the next few years. If this is the case, then the apartment deal above will turn out to be a bad deal just like the investors who bought apartments in 2006 at a 5% cap rate and have now given the property back to the lender. The cap rate is a measure of the rate of return on a cash flow and is comprised of three components, the risk free rate of return, i.e. the 10 year Treasury Note, a risk premium (for the risks mentioned above) less the projected income growth or inflation. Therefore, to derive a current cap rate on apartments or any commercial real estate asset, we take the current 10 year Treasury note of approximately 3.7% plus a risk premium estimated at 7.5% (historically the risk premium has been in the range of approximately 2% to 7.5% and due to the increased volatility in CRE and the economy the higher will be used) less an inflation rate of 3% or a cap rate of 8.2%. So the true risk adjusted cap rate for the above apartment or any similar real estate deal should be in the 8%-9% range and not 6%-7%. An excellent article titled Cap Rates & Real Estate Cycles on commercial real estate returns and cap rates is by Cornerstone Real Estate Advisors and can be found at CREA.
The second topic we want to discuss is replacement cost in commercial real estate. Replacement cost, as many of you know, is what it would cost to reproduce a commercial real estate asset using current costs. This includes costs for land, hard construction costs, soft costs and fees and financing expenses. Many investors use replacement cost as a metric in determining if a real estate price is acceptable or if a deal is good or bad. We agree with using the replacement cost metric that states “if an investment can be made at less than replacement cost then it must be a solid deal”. This is true in a stable real estate market and normal economic conditions but is not true in this type of real estate market and economy. We are currently experiencing the worst economic downturn since the Great Depression and the commercial real estate market is in a secular downturn with property values down on average 50%, a large number of defaults and foreclosures, poor fundamentals and lack of debt and equity capital. In this type of environment, replacement cost should not be used as the imprimatur of being a good deal because replacement cost never goes to zero. One of the components of replacement cost is land and it may have no value, however, hard and soft costs will decline in this market but there will always be some minimum cost for materials, labor and overhead. Additionally, financing costs may decline but there will always be an interest rate and loan fees. What investors should use instead is the lesser of the income approach or replacement cost. The income approach is an analytical and appraisal technique used to value commercial real estate by discounting a series of cash flows over some time period. If the price paid for an asset is lower than the lesser of the income approach or replacement cost then it should be purchased. In this environment, especially with foreclosed, unleased and problematic real estate, the income approach will always be less than replacement cost. For example, many luxury hotels today have no net operating income because of falling room revenue, high occupancy and a high level of fixed costs. Although this hotel may cost $500,000 per room to reproduce the income approach may yield a lot lower value of $200,000 per room and the project should be acquired if it can be had for less than $200,000. Investors who use the lower of income approach and replacement cost comparison will assure they have made a solid investment decision.
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