The Real Estate Capital Scoreboard® – April 2009
Chicago, Illinois, April 1, 2009 – Commercial and residential income-property values and mortgage underwriting continues readjusting to more conservative levels not seen in more than a decade. While most buyers and sellers are tangled in a pricing stalemate, funding sources define debt and equity metrics based on refinancing and renegotiating terms. However, such metrics substantially vary from the sizing dynamics that many investors have grown accustom to.
Current underwriting realities mainly include stringent resizing of existing cash flows, higher capitalization rates and lower new-construction costs — all summarized as follows:
Cash Flows Readjustments:
- Best case is assumes annualized with a careful review of recent trailing three months occupancy and collections.
- “Re Forma” vs. Pro Forma – whereby funding sources expect outright lower income in anticipation of more challenging economic conditions. Numerous lenders expect income levels to drop from 3% to 6% during the year.
- Expense increases – Higher vacancies translate to carrying more common area expenses. Furthermore, few investors expect meaningful lower taxes and operating costs.
Higher Capitalization Rates:
- 8% is the now new valuation benchmark for most commercial properties; Single-tenant, credit deals secured by longer-term leases hover in the 7% range.
- Below 7% reserved for prime residential and trophy properties or properties with substantial contractual upside.
- Full service lodging starts at 9% to low single-digit range as RevPAR and operating cash flow have been substantially reduced since 2008.
- Smaller projects based on 1031X trades may be priced as much as 50 bps lower than typical capitalization rates, as demand remains brisk.
- Substantial widening for C-Properties by at least 150 basis points or more — moving into the double-digit range. Price reductions of 30% or more are common as compared to Credit and Class-A/B assets, as this segment of the market remains very illiquid.
New Construction Realities:
- Despite public infrastructure spending, construction costs are lower as construction spending has decreased and competition has increased. Commercial building construction costs have fallen by more than 10% during the past year.
- Return-on-Cost yields are in the double-digit range. As investors focus on purchasing projects well below replacement costs and higher-leveraged debt is scarce, development yields must be priced 200 basis points or more above cost of debt.
According to Aaron Gruen, a member of the Real Estate Capital Institute Advisory Board, “While declining rents, rising capitalization rates, and challenging economic and financial conditions make for black moods for real estate investors and developers, this is a good time to prepare for the return of prosperity.” He adds, “From a longer term perspective, prices are more likely to be bargains, constructions costs are low, and loans are likely to be prudently made and taken.”