The Joint Economic Committee Hearing in Congress on Commercial Real Estate: Do Rising Defaults Pose A Systemic Threat? heard testimony that lack of credit has negatively affected the number of real estate transactions and that real property asset values have declined an average of 35%, while capitalization rates increased 250 basis points. Retail Traffic indicated that it was difficult to price real estate assets because financing was difficult to obtain. Lenders have indicated that financing is available but borrowers cannot accept the terms.
Valuation of Real Estate Assets
Astute real estate investors realized in 2005 that real property assets would no longer be appreciating because the real estate market cycle was changing, documented during the 1990s by Jeff Fisher, PhD., Terry V. Grissom, PhD., Glenn Mueller, PhD., and Richard Wincott, MAI, who described real estate market analysis and cycles. Price Waterhouse LLP real estate cycle analysis was also included in appraisal reports prepared during the 1990s. Experience with these cycles is crucial to investing in commercial real estate. So why is Congress now being asked to bail out lenders? The markets adjusted back in the 1970s and early 1990s. They will do so again. In the meantime, appraisers should review their definitions and methods to derive accurate capitalization rates.
The Appraisal Institute defines a capitalization rate as “an income rate for a total real property interest that reflects the relationship between a single year’s net operating income of the city and the total property price or value,” commonly called “the going-in-rate.” The capitalization rate is the sum of the discount rate plus a capital recovery rate. A capitalization rate represents both a return on the investment as well as a return of the invested capital. Direct capitalization is a method used to convert an estimate of a single year’s income expectancy into an indication of value by dividing net operating income by an appropriate capitalization rate.
Usually, the discount rate would be adjusted downward by a factor to reflect the property appreciation and any increase in income over the holding period to provide an indication of the capitalization rate. If no property change in income or appreciation is expected, the discount rate would be equal to the capitalization rate. If the property is expected to lose value and the income is declining over the holding period, the capitalization rate would be higher than the discount rate. In general, the Cap Rate = Discount Rate – Expected Change in Income and Value.
Adjusting Capitalization Rates
In the current economic environment, investors expect real property values to decline as America deleverages. So do lenders. Therefore, just as in the mid-1970s and early 1990s, the capitalization rate must be adjusted upwards because income and value may not increase over the holding period. Dr. William N. Kinnard stated in Income Property Valuation, Principles and Techniques of Appraising Income Producing Real Estate “. . ., the estimation of this figure is part of the purpose of the appraisal. . .” Real estate professionals must be able to develop capitalization rates based on the applicable discount rate, income projection period and the method of capital recovery.
Method for Capital Recovery
Capital recovery depends upon several elements including anticipated appreciation that affects the future benefits derived from the ownership of real property. Normally capital recovery occurs through the resale of the property or refinancing. In a declining market, however, investors cannot assume that their capital will be recovered through the resale of their property. Also in today’s market, investors anticipate interest rates will increase and that debt coverage ratio will be higher, which prevents capital recovery through refinancing.
Accurate Capitalization rates can be derived by using the appropriate techniques with a thorough real estate market analysis. Such techniques include:
• Comparable sales, if available
• Extraction from effective gross income multipliers
• Band of investment method, based on mortgage and equity components
• Debt coverage ratio formula
• Yield capitalization techniques for extraction for all rates.
In addition to market analysis factors, Deane Davenport, MAI, suggests that appraisers also consider:
Market Participant Interviews: a dedicated section summarizing discussions with market stakeholders (buyers, sellers, property managers, real estate agents/brokers). Identify interviewees along with their qualifications. Report and analyze the most pertinent comments and how they impact value.
Comparable Listings: In addition to consummated comparable sales and leases, consider listings incorporated within the market data with the most pertinent data reported and analyzed.
In summary, in the current market, discount rates are higher (more risk premium and less debt capital meaning more equity needed) and expected growth is lower if not negative. So the capitalization rates have to be higher. Jeff Fisher, PhD. suggests that professionals should look at the NCREIF data for changes in capitalizations rates.