Jim MacCrate, MAI, CRE, ASA, has worn many hats in his career. He taught a number of the appraisal classes I have taken through the Appraisal Institute and I think he is one of the few people who actually understands the “J-Factor.” His wife Judy is an SRA and is an accomplished appraiser in her own right, having managed an appraisal panel for a large lending institution throughout its various mergers for a number of years. I can only imagine the riveting conversations at dinnertime.

This week Jim applies the cart before the horse theory to the interplay between the stock market and the private commercial real estate market.
…Jonathan Miller

In the June 22nd issue of Systems and Forecasts, Gerald Appel stated “Unfortunately, despite the 18% decline in REIT stocks since their peak on Feb. 7, 2007, valuations still do not give a clear buy signal for REITs. Rather, valuations imply that there is still several percent room to the downside for REIT shares before their valuations (relative to underlying property values) reaches average levels. On the other hand, valuation data are consistent with the notion that further downside to REITs, if any, should be limited as long as industry fundamentals remain solid.”

The industry fundamentals are not solid. Capitalization rates are increasing as mortgage interest rates are rising. This is a warning sign for commercial real estate investors and advisors, such as the accounting industry, who should take notice of the action in the public and private markets.

The following chart summarizes the historical total returns (yield) on equity real estate investment trusts as reported by NAREIT and MacCrate Associates LLC:

The publicly traded REIT market may be reacting only to the changes occurring in the interest rate environment but it may also be considering other changes that are taking place in the economy, such as slower growth, globalization, over building in certain markets, and other factors that tend to impact the value of commercial real estate. The historical five year return of 24.38% is an aberration compared to the long term average return between, say, 14% and 17%. Historically, returns on real estate investments regress toward the norm. What goes up must come down eventually! If the returns regress toward the mean is a fact of nature, watch for the pattern that we have experienced for the last five years to reverse and a further adjustment downward will occur in the public markets as well as in the private direct markets.

For example, the following simple analysis will provide an understanding of how real properties can be affected during a cyclical downturn. Let’s use the following income and expense assumptions in the current market for a suburban office building compared to what occurs when the market declines modestly, say a 10% decline in market rent:

The basic formula for direct capitalization is that the net operating income divided by the overall rate of return equals value. If the current overall capitalization rate is 6%, the indicated value of this property is approximately $6,336,893, say $6,335,000.

In a cyclical downturn, the current rent will decrease because the demand for space has declined. It is not unreasonable based on historic information that market rents can decline by 10% or more. In addition, expense reimbursements may also decline. Vacancy and credit loss usually increases during a downturn in the real estate market. Concessions are also made more attractive including the standard work letter and free rent to attract tenants. The current capitalization rates are at an all time low and would surely regress back to at least the norm or higher, say 9% or 10%.

The net operating income dropped by $86,231; more than 22% which is not uncommon. In fact, the drop in income can be substantially higher. If the expected net operating income in a weak market, $293,982, is capitalized at 10%, the indicated value of the property has dropped to $2,939,982, say $2,940,000. We did not factor in changes for free rent, increased work letter allowance and other concessions or increase in operating expenses which would just make the situation worse.

Based on our simple analysis, the value of the property has dropped $3,397,071, or approximately 53%, without considering the other approaches to valuation, such as a discounted cash flow analysis, cost approach and direct sales approach.

No wonder why investors are concerned about the price of equity REIT shares which represent an investment in a company that owns a portfolio of properties that can be affected if the certain real estate market segments weaken. In fact, in the direct-private market capitalization rates began moving upwards late last year signaling a price trend reversal. And, the equity REIT market has reacted accordingly. Rents must increase to offset the higher cost of financing and increases in operating expenses or real property values will fall.

Note: a special thanks to Nancy Reiss of The Write Stuff and Max Ramsland, MAI for their help with this.