Matrix Blog

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.

Tags: Soapbox Blog, James MacCrate, Straight from MacCrate

1 Comment

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. Jim scratches his head as to why Wall Street and accounting firms often don’t see it coming in regard to real estate problems.

It is amazing that the Wall Street firms, such as Bear Stearns and Goldman Sachs, are having problems with their real estate loan portfolios and may be creating a time bomb that may create major problems in the economy. They appear to be repeating the same problems that the banking industry had in the late 1980’s and early 1990’s. I guess the accounting industry has also forgotten what happened because they should have an experienced professional real estate staff assisting the auditors in reviewing the loan packages, real estate appraisals and the like. Clearly, the auditors, such as PricewaterhouseCoopers, Deloitte & Touche, and KPMG, should be right on top of this situation with experienced real estate professional appraisers on their staffs. Investors may suffer losses because these firms may not have instituted proper safeguards, similar to FIRREA and other banking regulations to protect the investors from any losses.

Similar problems will probably occur in the commercial real estate market shortly (in a year or so). The rating agencies, such as Moody’s and Standard and Poor’s, should be right on top of this situation, along with the designated real estate appraisal professionals working at the major accounting firms.

The Federal Institutions Reform, Recovery and Enforcement Act of 1989(FIRREA) was passed to provide standards for real estate-related lending and associated activities by national banks to minimize losses from unsafe and unscrupulous lending practices. Maybe a similar law is required to regulate the Wall Street firms to protect investors from potential losses. Wall Street has an obligation to protect investors from losses due to the complex nature of many investment products and the underlying assets. The SEC and other investors, such as the state retirement systems that invest heavily in real estate, should review their current oversight procedures to insure that safeguards are in place to prevent a repeat of the debacle that occurred approximately seventeen years ago.

FIRREA is suppose to provide protection for federal financial and public policy interests in real estate-related transactions by requiring real estate appraisals performed by a State certified or licensed appraiser for all real estate-related financial transactions with few exceptions. (In fact, shouldn’t all real property appraisals for any purpose be performed by a State certified or licensed appraiser such as divorce, estate tax purposes and the like? That is not mandatory in every state, but it should be to protect the general public).

FIRREA further stated that the appraisal reports conform to generally accepted appraisal standards as evidenced by the Uniform Standards of Professional Appraisal Practice (USPAP) as promulgated by the Appraisal Standards Board of the Appraisal Foundation. Some these standards have been modified in the last several years increasing the risks to investors. The reports must written and contain sufficient information and analysis to support the institution’s decision to engage in the transaction. Appropriate deductions and discounts for proposed construction or renovation, partially leased buildings, non-market lease terms, and tract developments with unsold units must be analyzed and reported.

FIRREA further stated “if an appraisal is prepared by a staff appraiser, that appraiser must be independent of the lending, investment, and collection functions and not involved, except as an appraiser, in the federally related transaction, and have no direct or indirect interest, financial or otherwise, in the property. If the only qualified persons available to perform an appraisal are involved in the lending, investment, or collection functions of the regulated institution, the regulated institution shall take appropriate steps to ensure that the appraisers exercise independent judgment. Such steps include, but are not limited to, prohibiting an individual from performing an appraisal in connection with federally related transactions in which the appraiser is otherwise involved and prohibiting directors and officers from participating in any vote or approval involving assets on which they performed an appraisal.” Wall Street firms should have a similar procedure to insure that the real estate professionals are independent and not pressured to provide unrealistic indications of value just to make a loan package look good for resale to investors.

FIRREA specifically states that real estate loans should reflect “all relevant credit factors, including:

• The capacity of the borrower, or income from the underlying property, to adequately service the debt.
  
• The value of the mortgaged property.
  
• The overall creditworthiness of the borrower.
  
• The level of equity invested in the property.
  
• Any secondary sources of repayment.
  
• Any additional collateral or credit enhancements (such as guarantees, mortgage insurance or takeout commitments).”

Real estate markets should be monitored based on a thorough analysis of the real estate cycle, such as Glenn Mueller’s analysis from Dividend Capital so that investors can react quickly to changes in market conditions that are relevant to making investment decisions. Reappraisals may be required. Many factors that should be monitored and considered at a minimum include:

• Deteriorating economic conditions.
  
• Changes in the borrower’s financial capacity.
  
• Major change in project design or configuration.
  
• Construction delays resulting from cost overruns which may require renegotiation of loan terms.
  
• Project target market change.
  
• Demographic indicators, including population and employment trends.
  
• Zoning requirements.
  
• Current and projected vacancy, construction, and absorption rates.
  
• Current and projected lease terms, rental rates, and sales prices, including concessions are changing.
  
• Rent concessions or more discounts resulting in cash flow below the level projected in the original appraisal.
  
• Current and projected operating expenses for different types of projects.
  
• Economic indicators, including trends and diversification of the lending area.
  
• Valuation trends, including discount and direct capitalization rates.
  
• Slow leasing or lack of sustained sales activity.
  
• Discovery or change in the environmental integrity of the site and surroundings.
• The exclusion of excess land.
  
• Loan renewals or extension requested.
  

The loan portfolios require testing to insure that the original appraisals have been prepared correctly and if it is determined to be inadequate or otherwise unacceptable, a new appraisal should be ordered. The real property interests should be reappraised annually until the risk rating improves for that particular loan. Random sample reappraisals should be conducted periodically to identify patterns of over or undervaluation by appraisers and/or firms, property type, location or market segment. These reappraisals should not be performed by the original appraiser.

These firms could improve on FIRREA by requiring a range in value reflecting the best case, most likely case and the worst case performance scenarios. Real estate appraisal is not science, but it is an unbiased, objective opinion of value based on logical reasoning supported by market information. Generally, a range in value is more meaningful because it shows the extremes that might occur and can be developed through a sensitivity analysis of the projected cash flows and valuation conclusions, possibly utilizing Crystal Ball Software. In the current environment a number of forces impact the process of determining the value of real property interests and marking assets and liabilities to market. Maybe Wall Street and their advisors should consider implementing the guidance provided by FIRREA and the banking regulators to reduce the risk exposure for investors.

Tags: Soapbox Blog, James MacCrate, Absorption, Straight from MacCrate

1 Comment

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, he ponders taking the red eye to Las Vegas or searching the real estate classifieds and risk another purchase. …Jonathan Miller

Real estate investment risk is the probability that an investment’s actual return will be different than expected. Measuring risk is difficult, especially when a turning point in the market is apparent. Yesterday, Bill Gross, bond investment guru at PIMCO Funds, became bearish on bonds, and predicted that rates on ten-year treasury bonds, while expected to dip a bit in the next few years, may approach 6.5% over the next five years or so. That does not bode well for real estate investors, who can no longer expect the high favorable returns achieved during the last five years.

But should investors ever really expect high returns? Smart investors may be able to, if they manage their risks effectively. A qualitative risk profile must be developed for a real estate investment to properly assess the inherent risks before committing equity or debt.

Risk 101

The Appraisal Institute and several textbooks generally list the following types of risks that lenders and investors must consider.

• Business risk
  
• Financial risk
  
• Liquidity risk
  
• Inflation risk
  
• Management risk
  
• Interest rate risk
  
• Legislative risk
  
• Environmental risk
  

Each of these risks is a different piece of the puzzle that makes up the whole investment picture

Saggy sectors; Loose lenders? Fix those trouble spots!

At the same time that rents are rising, growth is slowing in many sectors. This is an example of business risk. If a local market relies on an industry that is losing jobs, retail and services will suffer. This makes it more difficult to lease already vacant space. Landlords must decide if it is worth it to release the space to get the higher rents, when there may not be another tenant to take over the space.

To increase loan volume, many lenders reduced their debt coverage ratio requirements and have permitted higher loan to value ratios during the last two years. Lenders reduced requirements in order to take advantage of favorable market conditions and affordability so they can increase the volume of transactions. This has been going on for two years. Combine this with an interest rate increase and financial risk will skyrocket.

Sink or swim?

Then there is liquidity risk. Real estate isn’t soda pop. It is a relatively illiquid asset. In a downturn, you can’t just switch to a healthier asset class without a lot of time, paperwork, fees, oh and lawyers. The real risk is the cost of selling and the missed opportunity. If you are desperate, you can always call up your local real estate broker and who may very well offer to buy the assets at a substantial discount, say 50- 60% of market value.

The Feds have stated clearly that they are very concerned with inflation. If construction costs rise, but rents do not, then, land values must fall. The materials that go into construction have risen, such as copper, aluminum, etc. Some investments that have properly drawn leases may be partially protected from inflationary risk. However, the interest rates that are charged are directly influenced by the inflationary expectations in the marketplace.

Dilbert’s boss buys land

Inexperienced investors have acquired real estate during this financial cycle. These investors often have insufficient liquid assets to ride any dip in the market. Since many lenders have reduced their underwriting criteria, the investor’s profile may not reveal the extent of their financial history or current financial position. This is a big risk, not only to the borrower, who may not be able to pay back the loan, but also to the lender who may end up stuck with a portfolio of non-performing loans.

The talking heads all have opinions. Whether you agree with Bill Gross, or not, you should keep an eye on interest rate risk and hedge your portfolio. Increases in interest rates will negatively impact the value of commercial real estate, all other factors remaining neutral

Also, don’t take Gross’ word for it and don’t follow herd mentality. The “wisdom” of the talking heads is one thing that inexperienced investors are too willing to follow, and often the advice is too late and a dollar short. A lot of people have opinions about where rates are going, but no one knows for sure. Since fed adjustments affect everyone in a single bound, it’s more telling to look at what Bernanke is doing. If he isn’t fixing it, maybe it ain’t broke. .but historically, the Fed has made mistakes.

Sharks in the pool

Legislative risk is always present. Politicians do not always act in our best interests, even though they claim they do. No change noted, but one must always be on the watch for political actions that can adversely affect real estate, such as the Tax Reform Act of 1986, insurance legislation in the Gulf states and real property taxes increasing at an alarming rate in some locales.

while California burns

Accidents happen, and sometimes they are real doozies. Environmental risk is always present. Some environmental risk can be controlled, but most is truly unexpected, so you have to have a contingency plan.

Safety in numbers

So, looking at eight risk factors, six have a real negative impact for all investors and two are anyone’s guess.

Three tools, if properly used, can assist investors and lenders to make informed decisions and minimize risk in the current changing economic environment:

• Real property appraisals that include a sensitivity analysis
  
• Professionally prepared by qualified and licensed individuals, proper structural and environmental due diligence, and
  
• A thorough market analysis of the critical factors impacting the local market.
  

These tools, if prepared by ethical professionals, will help a lender or real estate investor make sound decisions about the investment. In addition value and opportunistic investment strategies should be employed to maintain adequate returns on real estate investments.

Thanks to Noreen Whysel who provided some input and assistance.

Tags: Soapbox Blog, James MacCrate, Straight from MacCrate

1 Comment

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 uses negative leverage to make his point. …Jonathan Miller

Reviewers and mortgage underwriters beware. I ran across the following chart and wondered if mortgage costs are higher than the cash returns on real estate, why would anyone buy? And why would anyone lend either?

Based on this chart, at the end of last year, the average capitalization rate dropped below cost debt. This phenomenon is known as negative leverage in terms of current cash flow. Negative leverage decreases return to equity and occurs when the cost of debt is higher than the unleveraged return. The yield on a real estate investment is the capitalization rate plus growth. If this situation continues, what happens if there is no growth? The return is negative.

Financial risk, in addition to market risk, is magnified when leverage (debt) is used to acquire property. When more debt is incurred, the return to the equity position decreases at an increasing rate. This escalation also becomes alarming when equity investors are attracted to the returns that real estate has produced over the last five years and utilize mezzanine financing to acquire assets. Rising interest rates may also have an adverse impact on commercial real estate loan performance as the debt service on variable rate loans increases. Investing and lending become risky business if this trend continues.

From a lender’s perspective to protect against default, the maximum loan-to-value ratios and the debt coverage ratios should be altered or additional collateral required. (But will loan officers, corporate executives, and others who are paid based on income received by making loans act responsibly to change these ratios?) Most commercial loans are relatively short term and require refinancing in five, seven or ten years.

From the investors’ perspective, they hope that their income will increase over time, which becomes uncertain if the economy slows, companies cut back space requirements, and corporate and/or personal incomes lag. Where does the growth come from to increase the income return from holding real estate properties or portfolios? Leverage is positive when investors can earn more on the property than it costs to finance the acquisition. Investors always gamble that price appreciation will bail them out. Although this gamble paid off in the past, people forget about the 1970s and 1980s cycles. Is today any different?

It is critical to remember that local economic conditions are the most important determinants of the potential cash flow that can be derived from investing in real estate. If the economic fundamentals weaken in a metropolitan area such as New York, real estate will be affected. Real estate cycles vary by market and by property type and are influenced by the cost and availability of debt.

Appraisers, lenders, and investors must remember that high interest rates reduce the demand for real estate and liquidity. Prices must fall when this occurs until equilibrium is achieved. Since this phenomenon took about seven or eight years to recover in the 1970s and again from 1989 to 1995, we should be prepared for the next real estate market cycle. And the FDIC as always is protecting our insured deposits, while the SEC and other regulators are protecting the ultimate investor, the general public who buys Wall Street products. As long as deals have sufficient equity and the debt coverage ratio is adequate, real estate may still produce satisfactory long-term returns.

So what happens if interest rates increase, but the cash flow to the property does not? Sub-prime problems ripple through the commercial real estate markets. Some say that will never happen. But remember, they said that in the 1970s and the late 1980s too!

To quote my friend and mentor, Bill Kinnard, PhD., who would remind us that “real-estate has a ten year cycle with a five year memory.” The natural segue to Kinnard’s statement is that real estate investors may be currently in the buying high stage of the cycle, only to find themselves, most probably, selling low at the end of the cycle, which brings up the natural conflict that we have as appraisers and counselors. As appraisers, we merely report what is being experienced in the marketplace and estimate value based on empirical data (whether that data is good, bad or indifferent).

As counselors, however, we have an obligation to inculcate or impress upon our clients the inherent risk to the reversionary value of investments acquired at the apex of market value. As many have advised, the only problem with a long term discounted cash flow analysis is that one is absolutely certain to miss the correction in the marketplace if it is not correct. However, when investors sequaciously follow the market, opportunities for others are bound to materialize. Markets have a history of providing excellent learning experiences for the uninformed.

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

Tags: Soapbox Blog, James MacCrate, Straight from MacCrate

1 Comment

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, in his inaugural post, he dashes dogma and talks non sequitor to get to the topic of appraisal review. …Jonathan Miller

Non Sequitor cartoon strip
“A pinch of preconceived notions, a dash of dogma, mix well in a bowl of innuendo, then just say the magic word” . . . and what do you get? A real estate appraisal? Or just a quote from Max in the cartoon Non Sequitur.

With all the players in the appraisal process, it’s no surprise client pressures from all sides can create biased reports. Unfortunately, lawyers, accountants and other real estate advisors who work on a performance fee basis sometimes suffer ethical lapses. They opt for fat fees, rather than fair appraisals. Even government reinforces subtle pressure on real estate appraisers by failing to protect society with required standards (minimal licensing and limited resources to monitor unscrupulous appraisers and their clients). Without such oversight, appraisers must learn to walk away to avoid compromising their ethics and professionalism.

Thus the need for unbiased professionals to review appraisal reports for fraud, incompetence, or human error. The Uniform Standards of Professional Appraisal Practice (USPAP) defines the review function as distinct from real estate valuation/consulting, so different standards apply.

Many review appraisers are independent professionals who are educated, trained, and experienced to evaluate appraisal reports. They must know the property type, the market, the geographic area, and the correct analytical methods for an accurate analysis. They judge the quality, completeness, and adequacy of the appraisal report to determine if its information is relevant and the correct valuation techniques support reasonable conclusions.

Max also concludes

Facts are a lot more fun when you get to make them up.

That’s why appraisal reviews offer good insurance and professional appraisal reviewers make qualified industry watchdogs.

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

Tags: Soapbox Blog, James MacCrate, Appraisal Pressure, Appraisal Process, USPAP, Straight from MacCrate

1 Comment