Cap Rate News

The Sell Off of Commercial Real Estate Begins

Author: Warren K. Hoppke, SRPA - Principal of http://www.appraiservalues.com specializes in Los Angeles commercial and industrial real estate. He provides full real estate appraisal services throughout Southern California, including mortgage lender reports and detailed forensic appraisal reporting requirements for court testimony.

As Wall Street reels from major losses many cash starved Wall Street firms, financial institutions, and some insurance companies are scrambling for capital to shore up struggling balance sheets. Liquidation of real estate assets will be one of the first places firms will look for cash.

Prices are on the decline and many firms will soon be in the market hocking their commercial real estate in trade for cash. To top it off, unemployment has doubled over the past year and continues its upward spiral.

This double whammy will result in investors placing upward pressure on capitalization rates as vulture funds hover around looking for fire sales on commercial real estate. Unfortunately, one feeds on the other and as Wall Street layoffs start commercial office and industrial markets will be hit.

For example, GE has been selling off its commercial real estate and many other cash strapped corporations and financial institutions will follow. Credit has contracted by almost 400 billion dollars. As credit contracts it has a multiplier effect. The multiplier effect can be 3 to 4 times the amount of the contraction. As Leman Bros. goes under approximately $150 billion of bonds will default.

As reported by AFX News Limited, besides banks and other financial institutions pension funds have been among the top investors in mortgage backed securities (MBS) and collateralized debt obligations (CDO). After years of channeling money into MBS and CDO portfolios of mortgages bundled and sold as debt securities the total size of pension fund securitizations are massive. Thomas Martin, president of the Homeowners Consumer Center estimates pension funds will take a 1 trillion dollar hit from devalued securities.

The nations largest public pension fund the California Public Employees Retirement System (CalPers) could take a hit as large as their $2 Billion dollar residential mortgage portfolio.

Has the Great World Wide Depression started ?

The first phase started in the residential market from the bottom up as prices rose faster than incomes could support creating a drop in demand. As demand dropped off due to affordability issues builders were in denial and continued to build because their astute real estate advisors said demand was stronger than ever because of high population growth. After their buyers got into a home they quickly found out they could not afford to make the fully amortized payment. As a result, builders started to realize that affordability was the dominate player in the demand for residential real estate and not just new household formations and population growth.

Technically, prices should deflate until they reach equilibrium in line with median income levels. Since markets tend to overcorrect either on the upside or the downside the real estate market will most likely overcorrect before comes back to equilibrium. With the entrance of a government mortgage bailout a monkey wrench will be throw into the mix. The markets will now stabilize at higher levels than equilibrium thus creating a long flat period of very weak demand for real estate. This could last for the next decade until incomes catch up with prices and consumers have a chance to save for down payments.

The 2^nd phase is the unemployment created by the down turn in real estate.

The recession that started in the 1990’s started with the rise in unemployment creating a drop in demand for housing which then infected commercial real estate. Now, with Wall Street and financial firms collapsing and major corporations starting to layoff, the 2^nd phase has started. This is the double whammy that we did not have in the 1990’s and that’s why this will be many times worse the 1990 downturn.

As employment unwinds it will set the stage for another round of price declines. As people lose there jobs they will not be able to make their house payments which will force more and more people into foreclosure. This will create additional downward pressure in the housing market. Additionally, the retail, office, and industrial markets will experience a drop in demand as businesses cut back. This will result in increasing vacancy levels and declining rents as layoffs and faltering businesses continue the downward cycle.

Expect to see commercial real estate price declines throughout 2009 and 2010 as cap rates rise due to increasing vacancies, declining rents, and increasing investor risk premiums. We should never forget there are business cycles and real estate is by its very nature cyclical.

Again, to answer the question will cap rates increase one need only look at the equation:

Cap Rate = Risk free Rate + Risk Premium + Capital expenditures - minus expected appreciation.

We now have two of the four variables on the rise.

Author: Warren K. Hoppke, SRPA - Principal of http://www.appraiservalues.com specializes in Los Angeles commercial and industrial real estate. He provides full real estate appraisal services throughout Southern California, including mortgage lender reports and detailed forensic appraisal reporting requirements for court testimony.

Is a Subprime Commercial Mortgage Meltdown Next
by Warren K. Hoppke, SRPA
     Member Appraisal Institute

Turmoil in the commercial mortgage backed securities (CMBS) market is increasing. As more lenders implode several of the largest credit rating agencies like Fitch have issued warnings about credit quality.

Commercial foreclosures - when will they begin. Costar reported CBRE Realty Finance Inc. took a net loss on two foreclosed assets and halted making new investments. As a result, Wachovia wants an increase of 26.7 million in CBRE's warehouse line of credit. The company may have to pledge some of its assets to meet the request. The two properties in question are a 434-unit condo conversion in Bethesda, MD and a 508-unit condo conversion project in Towson, MD. 

Last months report by Banc of America Securities warned of a "broader fallout from Subprime mortgage deterioration" when homeowners with about $515 billion in adjustable-rate home loans -- more than 70 percent of whom are Subprime borrowers -- get higher monthly mortgage bills as rates reset before year-end. Another $680 billion worth of mortgages will reset in 2008, the report said.

According to S&P’s Equity Research, apartment vacancy rates in 2Q increased for the second consecutive quarter.  R.E.I.T. analysts warn that rising cap rates could threaten planned projects especially for highly leveraged R.E.I.T.'s. Wall Street Investors are now demanding much higher IRR's because of recent market conditions. NCREIF One-Year Returns ranged from around 6% in 2003 to above 15% for 2007 Q2. NCREIF returns are reported on an unleveraged basis. For highly leveraged properties higher loan costs could drive down effective IRR's if market conditions deteriorate.    

Bloomberg News reported Lone Star Funds would not complete takeover of Accredited Home Lenders Holding, citing “drastic deterioration in the financial and operational condition”.

According to the Wall Street Journal, Goldman Sachs recently liquidated positions in Global Alpha fund as well as its North American Equity Opportunities hedge fund in order to curb its risk profile. Moreover, three French hedge funds put a freeze on redemptions operated by BNP Paribas a Fench bank with about $2.2 billion in assets. According to Rueters News Service they stated "The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly, regardless of their quality or credit rating,". Moreover,  according to CNBC.com Peter Schiff, president of Euro Pacific Capital said, "I think this is the Hindenburg, we've got all of this bad mortgage paper all around the world and it's going to get worst."

Mortgage spreads have risen sharply up 30 bp to 65 bp as reported in Commercial Mortgage Alert by www.CMAlert.com . As the meltdown increases we expect mortgage spreads to go much higher on CMBS mortgage pools of properties in the $1,000,000 to $10,000,000 range.

Colliers International Real Estate Brokerage reported in its Outlook 2007 cap rates in the 4th quarter of 2006 have spiked upward 20 bp to 35 bp for all asset classes except multi-family residential.

Boulder Net Lease Funds LLC Q2 Net Lease Market Report indicated the industrial segment had the largest increase a 23 bp rise, bringing the mean cap rates to 8%. Next was office with a 20 bp increase to a mean of 7.7%, and finally retail with a 10 bp increase to a mean 7.1% cap rate.

As reported in our last blog, the spill over from the Subprime mess from the residential housing market is now causing a credit crunch in the CMBS mortgage market driving rates higher. As liquidity dries up and rates go higher many properties that were purchased at extremely low cap rates may go into default.

Lenders are now requiring higher mortgage rates to compensate for the perceived risk in the capital markets. As a result, decreasing loan to value ratios and increasing debt service coverage ratios are becoming common place. Many small and medium size commercial property borrowers have 3 to 5 year VIR loans. As these borrowers try to refinance they may be stuck. As cap rates rise and prices decline many of these borrowers may simply walk away if prices fall substantially. You will find a good example of such a scenario in an article in Real Estate Weekly, July 21, 2004, by Marc Weider. 

The real estate market moves much slower than the stock market or any other market. Typically, the commercial real estate market lags the residential market. As a result, we expect cap rates to rise and certain commercial real estate asset class prices to start declining around the 3rd or 4th quarter of 2008. This will be generally limited to specific asset classes and certain regional market sectors starting with retail and price ranges in the $1,000,000 to $10,000,000 range, unless the overall economy begins to deteriorate. 

In addition, some larger highly leveraged deals may end up being purchased at substantial discounts as so called vulture funds buy these properties up. For example, CNNMoney.com reports Blackstones $39 billion real estate buyout of Equity Office Partners (EOP). This large deal only makes sense if markets keep rising i.e. rents and land values. Further, it was reported that Blackstone paid a premium to beat out rival Vornado and take EOP private. CNNMoney.com reports that since the purchase Blackstone has been selling off properties at lightening speed in the most attractive markets.

The question arises does Blackstone know something about the commercial real estate market that we do not know.

The final question is, if cap rates form around the equation Cap Rate = Risk free Rate + Risk Premium + Capital expenditures - expected appreciation, will investors continue to push up the Risk Premium and will Expected Appreciation not materialize in 2008, 2009, 2010 ?

AppraiseThis

Sub prime Appraisal Meltdown
by Warren K. Hoppke, SRPA
 www.AppraiserValues.com

We have heard allot about the Sub prime Mortgage Meltdown, however, nobody has asked the question, "What about all the fraud and inflated appraisals" generated by aggressive sub prime lenders that will cause a Sub prime Appraisal Meltdown.

The Mortgage Lender Implode-O-Meter (http://ml-implode.com/) which tracks  U.S. lenders that have "imploded" or are on their ailing/watch list has now risen to 102 major U.S. mortgage lenders that have been affected in some way by subprime loans.

As the industry unwinds the layoffs will grow and will include many in house staff review appraisers along with major appraisal management companies. I just received an email from a large appraisal management company stating that they will let you know when and if they will be able to pay their appraisers for all of the appraisals prepared for many of the subprime lenders that are going under. Looks like appraisers get the short end of the stick again. It happened in the late 1980's during the Savings & Loan crisis and is happening again. Who says history does not repeat itself.

In the early 1990's many appraiser E & O insurers were sued by lenders trying to recoup their loan losses of the 1980's. Does history repeat itself, it sure looks that way. Get ready for E & O insurance meltdown and E & O insurance rates to go through the roof as a result of all those inflated appraisals. Appraisal meltdown will happen in late 2007, 2008, and 2009 as lenders again blame the appraisal industry. Whose fault is it really? State licensing agenies for lack of enforcement and allowing thousands of unqualified appraisers into the industry. The lender pressure to perform those endless value checks required by most all mortgage lenders pushing valuations to the upper outer most stratosphere. Or is it the overly aggressive lenders greed for killer profits which are sold to greedy Wall Street investors and Hedge funds.

Many of the residential and commercial review appraisals I have performed during the last 6 months have been on extremely inflated appraisals. One in particular in the Los Angeles County area was over inflated 200%. Another in the Orange County area was over inflated by 150%. You ask does the same fate await the commercial subprime market?

Let’s take a look. Yes, the commercial subprime market has been marketing 100% to 125% LTV loans for the last several years. Cap rates have been rapidly moving down to all time lows due to investor demand on expectation that rents will continue to rise and appreciation will continue. Small to medium sized commercial property prices have been increasing rapidly. Debt service coverage ratio’s do not exist any more or have moved to all time lows as a result of negative cash flows. A negative cash flow is suppose to be a trade off for expected future appreciation.

Most all of the sub prime small to medium size commercial properties have negative equity dividend rates. Most are on variable rate loan products and many borrowers could not support the negative cash flow generated by extremely inflated prices. For example, total consumer debt now stands at $7.4 trillion, almost double what it was at the beginning of 1990 according to Anna Bernasek Fortune Magazine. This could have negative consequences for many mom and pop commercial property sub prime investors. When the market turns many of these people will lose there properties to foreclosure. If interest rates go up cap rates will go up and prices will fall. Even if interest rates do not go up investors will demand substantially higher yield spreads. Wall Street investors will want to be compensated for the perceived risk rising out of the subprime housing sector which is now spilling over into the CMBS commercial market in the form of tighter credit standards.

You say, what will make rates go up when the economy is doing so well. Larry Kudlow of CNBC says we have a goldilocks economy. Well, stagflation for one and a credit crunch for the other. The subprime market is already starting to tighten its lending standards with higher down payments and higher rates to offset the risky lending practices perceived by investors in CDO's according to Fitch Ratings which provides ratings on commercial debt obligations. As reported in Yahoo News Fitch reports defaults on commercial mortgages originated this year could be up to 15 percent higher. Moreover, the housing market is weak and unemployment from the housing and sub prime melt down will increase. The bottom line, a slow down is in the works and it will hit commercial property late next year as credit standards tighten, rent expectations do not materialize, and appreciation rates flatten or go negative.

Moreover, the Bush Administration has recently started a new trade war with China by imposing tariffs on some imports. Additionally, sanctions on tainted products such as cat food, toothpaste, etc. will start a round of trade barriers on imports. This could start a continuation of the decline in the dollar possibly pushing up rates here. Notwithstanding, even if all other economic factors remain equal, tightening credit standards and investors demanding higher yields due to the overall increase in perceived risk in captial markets will send cap rates upward.  

In the long run the ultra low Cap Rates cannot be sustained over a typical 10 year holding period. When the market turns and interest rates edge up and or as price appreciation levels off or declines a price correction will send a message to overvalued commercial properties in the form of higher cap rates.

Appraisal meltdown in commercial real estate will be the result of over inflated appraisals utilizing discounted cash flow spread sheet assumptions that indicate unrealizable continued high long term income growth rate expectations, understated expenses, and understated going out cap rates. Discounted cash flow projections like these will never materialize over a 10 year holding period and therefore will cause appraisal meltdown in the sub prime market.

As a result, get ready for the commercial appraisal meltdown as lenders begin to sue appraisers to recoup losses for overvalued commercial appraisal valuations.

AppraiserValues.com provides residential and commercial review appraisal services for financial institutions, private money investors, law firms, and governmental institutions.