Most people are familiar with the great danger caused to scuba divers by decompression, otherwise known as the bends. This condition is generally caused by the negative effects on the body of a rapid ascent in water if the body has not had time to acclimate to changes in pressure. It is particularly dangerous when the body has previously had a very rapid descent.
For much of this decade, owners of commercial real estate benefited from what industry insiders called ‘capitalization rate compression.’ The current decompression in the commercial real estate markets in valuations and capitalization rates is the financial equivalent of the bends for real estate owners and capital providers.
For market participants who do not fully understand this situation, decompression can be hazardous to their financial health. We will explain how cap rate compression and decompression interact in this article.
To understand the current environment, let's first review how values for income-producing commercial properties are determined.
Owners and lenders start by projecting the property cashflows after expenses to calculate the net operating income (NOI). Various assumptions are used to determine NOI during the investment period, including occupancy, renewal probabilities, current and future market rents, capital expenditures, etc.
The annual NOI estimates, plus an exit – or reversionary value – are discounted to a net present value using the investor's desired discount rate.
This discount rate is derived from a combination of a risk-free rate (the U.S. Treasury rate for the equivalent period), plus a premium for each of the additional risk factors inherent in real estate: local market risk, inflation, illiquidity, management of the property and, of course, an appropriate return on the capital employed.
Ultimately, the discount rate generates an internal rate-of-return calculation, which allows the investor to determine if a potential investment justifies the inherent risks.
The projected cashflows from a property over a period of time must include a variety of assumptions. A key assumption is the sale price of a property at the end of the investment period. Because this can only be projected, experienced real estate investors will also employ the cap rate to determine the value of their investment.
The cap rate is a proxy for the long-term discount rate and is a simple calculation. It reflects the year-one NOI from a stabilized property divided by the purchase price.
As a simple example, assuming that a stabilized shopping center will produce about $1 million in NOI, and assuming further that the investor can buy this center for $10 million, the cap rate is 10%.
The debt factor
Let's look at how simple changes in the debt component of the cap rate can affect values in changing markets. Commercial real estate is, of course, very capital-intensive, and the industry relies heavily on debt leverage.
The amount and cost of debt available at any point in time has perhaps a greater impact on real estate valuations than any other variable in both good and bad times. Experienced observers know that too often, investors will pay as much as they can raise from their debt and equity capital sources.
As cheaper and larger amounts of debt become available, investors will pay more for properties, thereby pushing down cap rates. In over three decades of boom-and-bust cycles, real estate investors and their lenders have repeatedly proven unable to resist the temptation to use more aggressive valuations and inflated levels of debt leverage beyond the capacity supported by the property.
Let's assume that an investor is looking to purchase a property and is considering an office building that is nearly 100% occupied under long-term leases. The investor projects that the property will generate $10 million annually in net cashflow. Based on lending standards at the time, how much will the investor pay?
Using the years 2005 through 2007 as an example, the 10-year year Treasury (the risk-free rate proxy) was generally in the 4% range.
At that time, extremely aggressive lenders, particularly from the commercial mortgage-backed securities (CMBS) markets who were originating to sell to others, were offering very narrow spreads over the Treasury rate at very high loan-to-value ratios (LTVs), meaning very little equity from the borrower.
Lenders were also applying loose underwriting standards, often originating loans based on pro forma NOI numbers (sizing the loans on future projections rather than on actual cashflows). They assumed that market conditions would always improve and that property owners could continually raise rents and keep buildings occupied.
The only considerations for many lenders seemed to have been, how much can we lend and how quickly can we originate?
In our example, a CMBS lender might have offered a total of 90% financing at a blended rate of just under 6%. How? The lender might securitize 75% of the capital required at a spread of only 150 basis points (bps), or 1.5%, over the Treasury rate for a senior mortgage loan of 5.5%.
This lender would then sell to a mezzanine lender – which is not secured by a mortgage on the property, but rather by an interest in the equity stake – a junior piece of the debt equal to 15% of the total capital at a 12% interest rate. In total, the investor-borrower could then obtain a loan at 90% leverage with a blended rate of 5.93%.
In this case, all the investor would need is the last 10% of the total required capital. Our investor decides during this period of cheap capital that he/she would be satisfied with an equity return of 15.0% on the remaining 10% of the capital required. When combined with the 90% debt at 5.93%, the overall blended cost of capital for the entire capitalization is now 7.43%.
Dividing the $10.0 million first year's cashflow (the going-in cashflow), the value of the property to the investor is $134.7 million. The investor will borrow 90% of this amount, or $121.2 million, at the aforementioned 5.93% with no amortization, for an annual interest expense of $7.18 million.
The investor feels confident that the interest on this loan can be serviced comfortably from the cashflow, covering the interest by 1.4 times debt-service coverage ratio. What could go wrong? Let's see.
Rapid decompressionÂ Â Â
Our sample investor, eager to purchase this building at today's going-in cap rate of 7.43%, then assumes that the building will be sold in the future for a lower cap rate. After all, this cheap debt money will be available at even lower rates in the future, right?
Our investor would be hoping to sell to a future buyer, who would use even more senior debt at an even lower cost, leading to a reversionary cap rate for our investor of 6.8%, or a future price of $147 million – 9% higher than the original investor paid. This anticipated descent, from 7.43% to 6.8%, is called cap rate compression.
While it does not look like a significant change in the capitalization rate, considering that our investor only put down 10% of the equity, the compressed cap rate implies a gain on the investor's equity of 192%. Enticed by this cheap capital and by the hopes of future big capital gains, the investor plunges in.
How do these changes in debt parameters affect property values? Let's look again at our office building example. While the risk-free Treasury rate has come down to 3% or lower, lenders have required much higher spreads to compensate them for uncertainty about vacancies, refinancing risk and tenant credit.
Consequently, it is not unusual today for lenders to require spreads over Treasuries of 400 bps (4%) or higher, creating debt costs of 7% or higher. Of equal importance, where a senior mortgage loan might have been available at 75% or higher of the value of the property in 2007, it is common for lenders to provide no more than 65% LTV today.
Naturally, today's equity investor will recognize these same risks in the face of a broad and deep recession and will require a higher equity return to compensate, in part, for lower leverage allowances by capital sources. This is reflected as a new blended going-in cap rate of 11.55% for the same asset we reviewed earlier.
Most importantly the sample investor, it implies a reduction in value to $86.6 million, or a reduction of 36% from the peak value, even though there is no reduction in available cashflow. The reduction in value is entirely due to a decompressed cap rate that rose rapidly within two years, from about 7.4% to over 11.5%.
These losses in value affect both the equity and the debt providers. Looking back at our example, we see that the 2007 lender might have lent $121.2 million. Now, less than two years later, this property is underwater, with a value of $86.58 million, or an implied loss to the lender of $34.6 million, or 29% of the original loan amount.
Looking at implied losses like this in our lender's portfolio, wouldn't it be even more likely that our lender will want to lend less and charge more for debt in the future? Valuation losses such as these will only reinforce further decompression of cap rates.
Too often, real estate participants have short memories during periods of strong economic growth, and money becomes cheap and easily available.
These practices lead to the easing of basic underwriting standards by lenders. The impact of these actions on cap rates and valuations is extreme volatility, from a period of compression to rapid decompression.
Our example shows how the availability of low-rate, high-LTV financing and aggressive underwriting, can lead to massive losses to the equity and debt providers in just two years' time.
These changes in the availability and cost of debt and equity affect small and large borrowers. For example, a large public real estate investment trust recently announced it had refinanced an upscale shopping mall at a considerably higher interest rate than the debt it had taken out.
Similar companies announced comparable situations on debt they had refinanced on all asset types. These are the fortunate borrowers who were able to refinance existing debt.
A recent highly publicized case of a large institutional property owner who could not refinance debt at maturity is the borrower for the Hancock Tower in Boston. This building was purchased in 2006 for a reported $1.3 billion and was recently foreclosed on by the mezzanine lenders for almost half that price.
One may ask what steps can be taken to reverse this decompression trend. There are currently some initiatives under way by the federal government to provide liquidity to financial institutions, including several programs designed to aid both lenders and investors.
It is too early to tell if these programs will bring back lenders and instill confidence in the commercial real estate market. One thing is for certain: When cap rates and valuations start to show signs of stability and rational relationships with risk free rates, investors will return.
Preventing another cycle of rapid compression followed by decompression from occurring in the future will take continual discipline from equity and debt providers, especially in times of prosperity.
Jerome Sanzo is a Greenwich, Conn.-based consultant to hedge funds and a lecturer at New York University's Schack Real Estate Institute. He can be contacted at (203) 253-6543. Keith Kockenmeister, MAI, is principal of Sound Shore Consulting LLC, a commercial real estate consulting and investment firm in Greenwich, Conn. He can be contacted at (646) 726-0006.