Tag Archives: cap rates

Healthcare Real Estate Transactions: A Few Considerations

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Healthcare is real estate heavy. Not until healthcare reform was formally introduced were the majority of private and public healthcare providers scrutinizing their swelling real estate portfolios with similar risk assessments and accountability measures as their employee-dense corporate industry peers.

Over the past decade, healthcare providers have increased outpatient care, both close to hospital campuses and, more recently, in retail settings. Inevitably, the growth will have to continue to accommodate the transfer of patients into more efficient care settings. Yet with statistics such as: 1/3 of all hospitals will need to find alternate use, healthcare costs and infections are at an all-time high, and technology rapidly reducing redundancies, any new or adaptive real estate use will certainly be scrutinized.

Given the tremendous task of analyzing a property or portfolio in today’s capital complacent, regulation rich healthcare real estate environment, it is important to note that the potential buyers and sellers of these transactions take note of the following:

Real estate, which may consume up to 50% of providers’ balance sheets, is valued at book value. So, determining the fair market value (FMV) of a portfolio may be difficult without true comparisons especially noting the separate and distinctive build-outs in the field. This lack of transparency typically favors the seller, especially in locations where a lack of supply and pent-up demand exists.

Currently, hospitals with whom we are speaking are more interested in monetization now, than possibly any time in the last decade. Determining what to keep and what to sell is commonplace. With regards to a future merger, the real estate assets are being used as a source of financing for the transaction. Thus, determining the hierarchical distribution of assets as they pertain to compensatory value is necessary. We are noticing that most providers typically sell their weakest ancillary units first. Some buyers may look past their first few purchases for future consideration of a larger portfolio.

Healthcare is very attractive as it holds a high barrier to entry. Large amounts of capital have been raised over the last few years all the while interest rates have been moving lower. This allows providers that are seeking to sell real estate the opportunity of selecting several long term capital partners or buyers at attractive prices, especially when given the credit of the provider is strong. EBITDA’s are certainly shrinking for all medical real estate deals.

To grasp what is moving and why -or- to request a proposal for a property or portfolio, please contact MREA for one of our experienced medical real estate advisors.

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Effect of Rising Interest Rates on Commercial Real Estate

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We admit it is dangerous territory to talk about rising interest rates, especially when predicting a potential up or down movement. We have not come anywhere close to the topic over years of participation within the commercial real estate sector.

Around 2005, there was heightened speculation that interest rates would rise and the undoing of commercial real estate would begin. It never happened. Seven years later some of those same properties are trading at double that of 2005 prices.

So, why are we touching on this subject today, especially given the number of forecasters whose speculative predictions became fodder for news pundits and critics? Well, with the stock market improving without real improvement in bond yields, due in part to the Fed buying bonds and keeping rates artificially low, one of two things will likely occur; the stock market will drop or treasury yields (and their correlation to interest rates) will move higher, or both. Both should be moving in relative tandem, yet, they are not. There are several factors that we have explored that explain this phenomenon, but we will stick with what we know.

Interest Rates and Their Correlation to Commercial Real Estate

Interest rates are percentage rates at which interest is paid by a borrower for the use of money that they borrow from a lender. When speaking about the potential for rising interest rates in the future, we should mention their impact on capitalization (cap) rates, a simple measure of return that fuels commercial real estate investment decisions and demand. Similar to interest rates, a cap rate is a percentage of yield that an investor seeks when purchasing a rented property, along with the property itself. To simplify, total the income from the tenant(s), subtract the expenses of operating the property; you get X. Now, determine the price that you are willing to pay for the property; you get Y. Z is the cap rate.

X divided by Y = Z (convert to percentage, ie. .0845 = 8.45% cap rate). This is the annual percentage yield that an investor expects to earn by investing in the entire property with tenant. The longer the lease and/or strength of the tenant, the lower the cap rate and higher the price an investor is willing to pay.

If you were to observe a historical chart that featured treasury bond yields, a leading indicator of interest rates and then cap rates, you would notice that these move in succession, one following the last. From beginning to end, the move may take 3-4 years. With any sudden jolt to lending rates based on poor economic circumstances, historically it takes a longer period of time for investor cap rates to catch up. Because we suffered through the worst recession since the Great Depression, along with the banks reluctance to move assets off the balance sheet and investor demand very weak, cap rates are still in limbo.

This said, with interest rates at all time lows, asking prices, and their correlation with cap rates, sit at levels where most real estate investors (and some banks) just aren’t comfortable. Now the US has found its footing, will investment demand might switch roles and lead interest rates higher? We think so!

Whether you believe the government response to the panic was appropriate or not, we feel if distressed properties were released shortly after the 2008 stock market collapse, cap rates would have climbed higher as fewer investors would be bidding. This would have created the commercial real estate “shoe to drop” and ultimately led to a significant US economic restructuring and global depression.

By controlling the process, the Fed has essentially allowed national and global participants the time to multiply to create enough demand so that economy and commercial real estate stabilizes and leads interest rates in the future. So, and as the Fed indicated, they will keep fed funds rate low until 2014; no big deal. Global investment demand will determine where we go from here and it is guaranteed that mortgage interest rates will begin their rise this year.

Valuing Medical Real Estate on Cap Rates…Fuggedaboutit!

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Physician and investor ownership of medical income property still sits as a relative newcomer on the expansive list of commercial real estate investments, which includes office, retail, industrial, among several others.  All-in-all, there may be over 100 specialty and categorical types of commercial real estate investments if broken down by industry and tenancy (single, multiple).

Commercial real estate brokers typically will arrange all investments alike, utilizing a simple formula known as cap rate pricing so as not to confuse or curtail into any real estate investment type.  But, every commercial property user (from Fortune 500 company to auto repair franchise) and investment (fully-leased hospital medical office building to empty warehouse) is uniquely, comparatively different.  So, to achieve proper valuation the asset needs to be compared directly to those of competitive properties with a percentage emphasis on who transacted, why and how, as well as economic conditions within the submarket, city and national economy.  It is our experience that most buyers and sellers will place a greater weight on certain factors when transacting, especially when motivated by a needs or capital availability basis.  This is botched recipe that has led to the relative uncertainty for our sector as a whole.

So, it takes a skilled eye and real-time comprehension of certain functionality of business and investment types, as well as a wide array of financial and economic data points to properly price and transact in the commercial real estate marketplace.   Unfortunately, just a handful of brokerage platforms adhere to a heightened sense of knowledge and disclosure when advising their clients, primarily due to inefficient formulas for pricing commercial property.  While this is certainly not a testament against commercial real estate brokerage platforms, it is a testament about a vast investment class that in some conversations remains broken based on inefficient pricing mechanisms, one of which includes cap rate pricing.

Example.

A cardiovascular care facility has a Net Operating Income of $100,000, and the sales price for the property is $1,000,000, therefore the cap rate is 10%.  Most property investors, and now physician investors, are becoming more comfortable with this simple strategy of valuing a property for the purposes of an exit basis.

But, what does a cap rate of 10% tell you?  Let’s first discuss what it does not tell you.

A cap rate does not tell you what your return will be if the property requires financing.  With an overwhelming majority of property requiring financing and terms changing daily, what are the costs of capital? Nor, does it appropriately account for tax and interest calculations either. It cannot pit an apples to apples comparison of unique property characteristics.  It does not tell you who, what, why, how or where.  Prior to contracting on a needs or investment basis, it is very important to know the competition in the market and how, why they can transact at certain levels.  Simply doing some quick math to obtain a cap rate does not accomplish this.

If not healthcare real estate, we will be happy to direct you to advisors with a keen eye on the rolling ball.  If your physician, user or investment group needs to determine the price of which to contract in the today’s commercial real estate market, please contact us for a proven transactional formula that may lead to a higher or lower price dependent on a variety of factors.  

What is Wrong With Commercial Real Estate?

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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.

Healthcare Real Estate: Past, Present, and Future

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Continuing on our path towards emerging from what some have considered the worst downturn since the Great Depression, the majority of the Greater Houston medical landscape has weathered the storm in good shape. Now, with the advent of healthcare insurance reform, many supply-demand economists are predicting a solid future for the healthcare real estate industry and its continued growth.

Availability of Capital

Although medical real estate did not experience the same severe disruption to capital lines that commercial real estate faced in late ’08 and through ’09, capital remained available to the sector; albeit at a higher cost. Debt financing demanded greater equity, higher pricing, guarantees and committed take-out financing, which made it it difficult to finance real estate projects. Many institutional investors were on the sidelines. However, the projects with average to good fundamentals were funded.

From this experience, the industry was forced to adapt to a lower tolerance to risky ventures. Thus, due to this collapse in rick beginning in ’08, we can guarantee investors will no longer come to expect 90 percent debt financing, sub-6.25 percent cap rates and lax underwriting by lenders. Significantly higher equity requirements, a strict focus on Class A and newly built  properties, rigid due diligence procedures, and higher pricing have become the standard.

Pre-2008, many of the larger banks consumed financial instruments that we now know were toxic waste, subprime mortgages being the most publicized. In 2007, and well into 2008, banks were issuing funding commitments on development projects with 0-25% pre-leasing. When the credit markets turned south, most of those projects were canceled, foreclosed upon, or the related hospitals booted the developer and either shelved the project or turned it over to another managing entity. Those institutions that maintained sensible lending criteria and stuck to their knitting remained in the market and found a loyal group of developers/borrowers. Lender due diligence has become more rigid. Pre-leasing requirements of 65-75 % on new development projects are now required.

Unfortunately, many real estate practioners are attempting to enter this sacred market without ever stepping a toe in.  These recent entrants into the market will find themselves redlined and eliminated from further consideration, due to a lack of reliable capital, a depth of experience, or both.  On top of this, the relationships that have been developed by hospital to physician, physician to physician, and physician to developer requires a long history of accomplishments prior to jumping in head first.

Hot Investment Sector

Throughout the recession and the credit crisis, an imbalance between the supply of buildings and the capital seeking to acquire them has caused values to remain buoyant. Prior to the recession, capitalization rates were firmly trending downward, driven by higher prices and sustaining a seller’s market. Cap rates were in the mid- to low-6s with a few trades breaking the 6 percent barrier. Once the recession hit, the volume of transactions subsided as credit was difficult to obtain, driving down values and sending cap rates north of 8.5%. Meanwhile, most medical buildings continued to exhibit strong fundamentals during this period, unlike commercial office, industrial and retail properties which have suffered increasing vacancies, delinquent tenants, past due loan payments and lenders calling loans.

This imbalance is more pronounced today as institutional investors such as REITs are flush with cash seeking quality investments. Hospitals are the main source of supply as they consider monetization strategies to sell non-core real estate assets. Because a financial strategy of diversifying capital sources is gaining strength among the hospital community, the volume of monetization transactions and outsourcing new development projects to ‘established’ healthcare real estate players should increase. There is ample capital awaiting these opportunities.

Search for Stability

Many hospitals and health systems suspended projects during the recession. Why? Inaccessibility of capital, weaker operating performance due to declining patient revenue and increasing bad debt and charity care, uncertainty surrounded the economy and employment, and the political gamesmanship regarding healthcare reform. Even when capital was available, hospital CEOs and their staffs made strategic decisions to delay expansion efforts because of these market uncertainties.

Overarching all of this, however, is the future pace of an economic recovery. As of today, economists are debating the threat of deflation, a double-dip recession, and the potential onset of inflation. We are in tenuous economic times, both domestically and internationally. Consumer confidence is lower than estimates. Housing prices continue to search for a bottom. Commercial real estate loans are defaulting at an alarming pace. Corporations hoard cash awaiting the next economic shoe to drop, thereby delaying capital spending… hiring. Until the economy finds its footing, our country will face high unemployment rates, depressed capital spending levels and consumer cautiousness. Healthcare providers will continue to struggle over decisions to proceed with new facilities.

Construction Costs..Up or Down?

One of the recession’s benefits has been the resulting decrease in construction labor and materials. Depending on the region of the country, developers have experienced a 10-20 percent reduction in construction costs over the past 18-24 months. This phenomenon, though, may be short lived as the market has experienced increases in most construction items. However, with little competition from the commercial real estate market for new construction resources, stable construction prices may prevail a bit longer.

A Final Word

All  said, where the healthcare real estate industry goes from here may appear promising or frightening, depends entirely on your working experience within the sector.  While I would implore real estate professionals to always seek more education and relationships within this sector, be prepared to serve an already serviced industry.

CRExtract: 12.8.2010

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Opportunities await retail property investors as market slowly recovers -  Single-tenant net-leased properties with national-credit retailers will remain the most sought-after deals as high-net worth individuals and well-funded REITs compete for acquisitions. Unimpressive returns offered by alternative investments and ongoing stock market uncertainty continue to heighten private buyers’ appetite for low-risk, corporate-backed assets. Cap rates for these deals have already compressed 50 basis points this year. Yields will tighten further in 2011 but should stabilize by midyear as returns approach pre-recession levels. Lower cap rates and a shortage of high-quality assets listed will expand acquisition targets for many buyers, and properties leased to well-known franchisees will garner more attention and clear the market faster. Cap rates for these assets will average 50 basis points to 150 basis points above those for best-in-class investment-grade deals, depending on the financial strength of the guarantor. SmartBusiness

‘Special Servicers’ Getting Creative – “Special servicers are getting creative with how they’re working out the assets in this environment,” says Frank Innaurato, an analyst at Realpoint. “Rather than foreclosing on an asset, they are placing more properties in receivership and giving the receiver the right to sell the asset directly.” Avoiding foreclosure offers an additional advantage: Special servicers can sell properties with modified CMBS debt already in place. Take the case of an Arizona court’s decision in August to let a portfolio of distressed apartments be sold by a receiver for $133 million. Bill Hoffman, president of the receiver, San Diego-based Trigild, said the move allowed the buyer to assume existing financing, delivering a higher price than if the portfolio had been sold out of foreclosure. Wall Street Journal

Ashley Furniture Stores Going Out of Business -The Ashley Furniture stores in the Logan Town Centre and on Galleria Drive, Johnstown, will soon hold going-out-of-business sales after a court decision Tuesday in Allegheny County Court. The stores’ owner, Roomful Express, was placed in receivership under pressure from lenders owed millions, the Pittsburgh Post-Gazette reported on its website. Altoonamirror.com

CRExtract: 9.1.2010

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Real Estate Premium Near Record to U.S. Bonds Signals Time to Buy Property – U.S. commercial real estate yields are near the highest level relative to Treasury bonds on record, a signal to some investors it’s time to buy property. Capitalization rates, a measure of real estate yields, averaged 7.22 percent in the second quarter, based on an index calculated by the National Council of Real Estate Investment Fiduciaries. That was 429 basis points, or 4.29 percentage points, higher than the yield on 10-year government bonds as of June 30, according to data compiled by Bloomberg. It’s about 475 basis points higher than Treasury yields as of yesterday. That spread is near the record 539 basis points in the first quarter of 2009, when the U.S. was mired in the worst of the financial crisis and property prices sank.  Bloomberg

Commercial Real Estate Loan Prices Rise in July -  The aggregate value of Commercial Real Estate (CRE) loans priced by DebtX that collateralize CMBS increased to 79.4% as of July 30, 2010, up from 77.4% as of June 30, 2010. Loan values were 71.1% as of July 31, 2009. “Despite weak CRE fundamentals and increasing levels of delinquencies and defaults, 90% of CMBS loans are still performing,” said DebtX CEO Kingsley Greenland. PRNewswire

Property Owners Use Strategic Default As a Bargaining Tool, With Some Success -  If after several months of negotiations, the lender still hasn’t shown flexibility, it might make sense for the borrower to bring up strategic default. Mason notes that in about 40 to 50 percent of cases, the threat works and results in the lender agreeing to modified loan terms. The new terms might involve a reduced loan amount; a switch to a cash-flow mortgage; and normally, an extended term. The lenders’ receptiveness to the default issue depends on the size of the loan (the bigger the amount, the more reluctant they are to take the property back), the standing of the borrower and the condition of the property. Retail Traffic