UPDATE ON REAL ESTATE MARKET VALUE CHANGES - SPRING 2009
This report presents several methodologies for analyzing the changes in property values during a recessionary economic period where sales of competitive (comparable) properties are severely reduced in numbers. In many markets, there is virtually no market activity to support the conventional “sales comparison approach”, the mainstay of the appraiser’s arsenal of valuation techniques.
Changes in Overall Rates of Return (Capitalization Rates).
Our research into rising interest rates on mortgage loans, coupled with more aggressive investor criteria for investment rates of return, have resulted in increases in overall rates of return (OARs) that are from 100 basis points to 200 basis points higher than the rates common for investment acquisitions at the peak of the market in 2006-2007. Even with no change in net profits (net operating income in appraisal parlance) the higher OAR/capitalization rates will result in reduced market value estimates.
An example taken from a recent appraisal of a hospitality property in northern California illustrates an absolute decline in market value of 21.3% of a stable, well managed business property that actually shows a modest increase in net profits.
Net Operation Income in 2007 was $375,000.
capitalized at overall rate of 5.5%,
Indicated Market Value from the Income Approach is $6,800,000. (rounded)Net Operating Income in 2009 forecast at $400,000. (+7%)
capitalized at 7.5%
Indicated Market Value from the Income Approach is $5,350,000. (rounded)
Loss in Market Value due to increased capitalization rate $1,450,000. or 21.3%
Appraisers can calculate the effects on market values from changes in OARs. The following is a series of changes of .5% in OARs over a base rate of 5%. The net operating income for this hypothetical property is $100,000. per year. The decline in market values is dramatically illustrated in the following chart. *market value calculations are rounded numbers
Base Rate OAR is 5.0%
Capitalized Market Value $2,000,000.
| Increased OAR | Reduced Market Value* | Diminution | Percentage Decline |
|---|---|---|---|
| + .5 % to 5.5% | $1,818,000 | $182,000 | 9.1% |
| +1.0 % to 6.0% | $1,667,000 | $333,000 | 16.6% |
| +1.5 % to 6.5% | $1,538,000 | $462,000 | 23.1% |
| +2.0 % to 7.0% | $1,429,000 | $571,000 | 28.5% |
| +2.5 % to 7.5% | $1,335,000 | $665,000 | 33.25% |
| +3.0 % to 8.0% | $1,250,000 | $750,000 | 37.5% |
REIT Bond Repurchasing at Discounts
Other evidence of a negative trend in market values of commercial real estate is illustrated in a recent report in the Wall Street Journal on May 6, 2009. This report confirms that many real estate investment trusts (REITS) are in the process of repurchasing public bonds at steep discounts. These bonds are essentially secured by real estate investments by the REIT and therefore, the decline in bond value is another indicator of the reduced market values of the REIT’s real estate portfolio.
The article states that in the past six months, 16 of the largest REITs have repurchased a cumulative
$3.9billion in face value of bonds at a discounted outlay of $2.5billion, an average discount of 36%. Examples include:
ProLogis, an REIT warehouse developer, repurchased $641million in bonds for $414million, a decline in value of these bonds of 35.4%.
iStar Financial, an REIT specializing in commercial property finance is repurchasing bonds due in September 2009 for discounts of 10% to 13%.
Developers Diversified Realty Corp., an REIT that develops and owns more than 700 shopping centers, purchased $160million of its bonds at a 49% discount.
Apartment & Office Building Capitalization Rates
According to a report in the Wall Street Journal on the same date, the average capitalization rate for apartment buildings dropped slightly to 6.76% in March 2009, from a rate of 6.9% in February. For the same reporting period, cap rates for office buildings also declined to 6.86% from its previous high of 7.53%. In percentage terms, capitalization rates have declined neary 9% overall, and are now reflecting the opposing forces of a depressed market demand, excessive supply, and constricted availability of mortgage credit, on the one hand, versus, the downward pressure on interest rates created by the Federal stimulus package and government interventions in the banking industry.
This report also illustrates the major changes in capitalization rates since 2003. Rates are +-
| Year | Apartments | Offices |
|---|---|---|
| 2003 | 8.0% | 8.75% |
| 2004 | 7.5% | 8.25% |
| 2005 | 6.75% | 7.25% |
| 2006 | 6.0% | 6.5% |
| 2007 | 6.0% | 6.0% |
| 2008 | 6.0% | 5.5% |
| 2009 | 6.7%-7.0% | 6.75% to 8.0% (1st quarter) |
Discounting for Longer Holding Periods
This approach is most applicable to the development land market where ownerships from initial acquisition through completion of the entitlements process, to active building, typically have taken 18-24 months for smaller properties. In the 2009 overbuilt markets, constricted mortgage funding, and higher holding costs, the present value of these properties can hardly be tested by current or recent sales of comparable sites, of which there may be few or none available for study. An alternative test of value is to take the market value assuming development is feasible and possible in the longer term holding period of four to five years, corresponding to the market’s wisdom that a full recovery of the economy will occur in certainly not more than five years, more probably within four years. The question, therefore, is what is a site worth today that cannot be developed for four, or five years?
The calculation is simply to find the present value measured as the discounted value of the property’s future value. A recent example for this appraisal firm involved a large development site in the advanced entitlements process, previously valued in early 2008 at $10million, assuming development would start within 12-18 months. In mid-2009, there is a surplus of developed properties and a three year inventory of developed and completed units to sell. I estimated a four year holding period and applied a discount rate of 8% to find the present value of this property.
The calculations are: $10million, discounted for four years at 8%, the present value is $7,350,000.
The current market value of this property is reduced by 26.5%.
Conclusions
The data and market conditions summarized in this paper clearly serve as a reality check for those property owners who purchased in the peak period of 2006-2007 or have appraisals of their properties in these years. The highest level of market prices and values so well documented in 2006 through early 2008 are no longer sustainable. Realistically, across the board of types and locations of commercial real estate, property values have declined in a range of 20% to 45%, and several experts predict the worst is yet to come.
Dr. Nancy Wallace, Haas School of Business, UC Berkeley, recently stated that her research indicates that the commercial market lags the residential market in recessionary periods, and in the current recession, this delayed reaction is about 20 months. The start of the residential market implosion was first recognized in August 2007; 20 months later in February/March 2009, the commercial market’s first signs of a measurable decline in commercial property values was becoming apparent in declining asking and bid prices for virtually all types of commercial real estate. REITs are a major player in the largest scale of real estate investment throughout the variety of property types and locations. According to Dr. Wallace, REIT property values have already declined from 45% to 48% and are likely to decline further.
The optimists among real estate economists like to describe the current situation, with regard to property values, as a “needed correction” after a period of irrational exuberance (to quote a famous phrase by Alan Greenspan). Our own research into a small but well chosen sample of property types and locations in the Bay Area tend to support this perspective.
We have calculated that the more or less orderly growth of investment income property values before and after the short, mild recession in 2001-2, exceeded but only modestly, the changes in the economy’s inflation indices, up to and through 2005. Annualized appreciation tended to be limited to 10% or less. Revenues tended to follow suit and often increased at even a more moderate pace.
Thereafter, starting in early 2006, market prices increased by as much as 20% per year, in some cases 25% or more, without corresponding increases in revenue generation. Now, in mid 2009, values are declining. However, the most recent sales activity we have to judge the amount of decline suggests that values are again at about what they were in 2005.
There may be further decline in commercial property values. We will have to wait until there are sufficient sales of properties in these markets to draw the needed inferences and statistical evidence of the pace and duration of decline.
This report will be updated from time to time as new events in the commercial marketplace provide evidence of change in the important subjects of property values, supply and demand, rental rates and occupancy ratios, capitalization rates, and related aspects of the real estate marketplace.
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This update report has been prepared by G.Michael Yovino-Young, MAI, ASA, FRICS, President of Yovino-Young, Incorporated, Berkeley, California. It is intended as a general commentary for readers of our website: www.yovino.com or as otherwise distributed to clients and valued associates. Prepared May 7, 2009
