I have seen that headline a few times, but I never really believed it. I do now.
Over the past few days, I attended several expert panels at the CMSA/MBA Capital Markets Conference in Washington, DC, and I find the math to be depressing but compelling.
The availability of debt is contracting because of the absence of securitization, the deteriorating real estate fundamentals and the general de-leveraging that is occurring. At the same time, required returns on equity are increasing because of the same issues. Therefore, cap rates need to increase (and prices need to decrease) if properties are going to sell in this market.
The general consensus at the conference was cap rates, on average, will settle in at 9%. For sure, some properties will not go this wide and others will go much wider. But, when you look at the market as a whole and compare cap rates back to before securitization became so dominant, a 9% general cap rate certainly seems reasonable.
So, just by moving average cap rates from 6% to 9%, a 33% reduction in value occurs. That is before you account for deterioration in real estate fundamentals that will surely result from more pessimistic views on rental rates, vacancy, and expense assumptions.
No one knows what effect the fundamentals will have, and this will surely differ market-by-market and property-by-property. But, with very few exceptions, fundamentals are expected to deteriorate over the coming months/years.
A simple chart explains the math:
|Old value||New value||New value w/
|Net Cash Flow||$100,000||$100,000||$90,000|
This makes me wish Mark Twain was right when he wrote:
“There are three kinds of lies: lies, damned lies and statistics.”
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Jim Flaherty is CEO of CMBS.com and the creator of the Backshop loan origination system. He is a trained credit professional with experience installing enterprise underwriting systems for commercial real estate lenders, rating agencies and investors.