It has been well documented that commercial real estate prices have dropped significantly since 2007 and continue to suffer today, albeit a push forward in 2010. As a practitioner in the ‘middle market’ then, and today, the disruption to the commercial real estate flow and communication has been nothing but extraordinary.
The decline is the result of three very simple causes that most of us have a tendency to forget. The first reason for reduced prices is the downward pressure on rents and increasing vacancy rates. The second is increasing capitalization rates and third factor can be considered a result of the first two results – rising capital requirements.
The easiest way to obtain a value for commercial real estate, especially when comparables (recent sales) are so few, is by dividing the net operating income of a property by the capitalization rate. The capitalization rate is the market’s way of quantifying the risk for the collection of an income stream in the future. Capitalization rates are affected by macroeconomic factors such as liquidity and taxing, and microeconomic factors such as local unemployment rates and supply and demand of the certain type of asset. A lower capitalization rate will result in a higher property value and a higher capitalization rate will result in a lower property value. Capitalization rates are problematic when a market is in flux, as ours continues to be, where there is limited liquidity and decreased demand.
For all of the commercial real estate (excluding multi-family), capitalization rates have increased significantly since 2007, which has in turn tormented appraisal values for commercial real estate. As a result, many borrowers, those who have paid their making monthly mortgage payments on time, have found themselves in technical default because of low appraisal values that do not satisfy loan-to-value requirements.
This is a significant problem and poses the greatest risk of continued pressure on prices. That borrowers of performing assets are finding themselves in maturity defaults, unable to refinance expiring debt is commercial real estate’s largest issue. Unlike residential loans, which can fully amortize over a 30-year term, permanent commercial loans normally partially amortize over a 5, 7, or 10-year term. As a result, the borrower must refinance a balloon payment at these intervals.
As stewards of the industry, we hope to allow the free market determine the income stream, or risk, that is required for investor demand to re-enter the market and price stability to occur. Until we are able to obtain a clearer picture of what the future may look like, capitalization rates will continue to rise as the industry is deemed ‘too risky’ to enter.