Since the Credit Crisis began back in the Summer of 2007, both commercial and residential property values have fallen significantly throughout the USA. As I have written before, property owners are more likely to walk away from their “upside down” homes, office buildings, retail shopping centers, or other types of properties if their existing mortgage debt exceeds their current market value.
Thankfully, home prices have begun to stabilize or increase in price ranges of between 5% and 20% + in various regions of the country over just the past year partly related to near record low mortgage interest rates. The faster and the lower that interest rates drop, then the higher the mortgage loan amount the prospective mortgage borrower will qualify for which drives home sales prices even higher.
Sadly, incomes for the vast majority of Americans have stagnated or declined since the start of the 2007 Credit Crisis. To best try to stabilize real estate values, the borrower either needs higher personal or business income levels, or access to cheaper money by way of incredibly low interest rates and more flexible qualification guidelines.
Lenders have more “skin in the game” than borrowers
In many regions of the USA, residential and commercial property buildings (i.e., retail, office, industrial, etc.) experienced price or appraised value declines of 50% or more since the last market peaks near 2006 – 2008, depending upon their region of the country. Increasing vacancy rates in small to larger retail shopping centers, office buildings, or other property types also made it more challenging for property owners to refinance or sell their properties at prices anywhere near the peak values in recent years.
When purchasing commercial properties just like residential homes, it is typically the lender who provides most of their own capital in the purchase deal as opposed to the borrower. Whether it be a 5%, 10%, 20%, or a 35% down payment invested by the property buyer, it is the lender who has more “skin in the game” or money invested in the deal. As such, the lender tends to not be as optimistic as the prospective borrower about the property since they have more of their own money at risk.
Commercial Underwriting Guidelines: It’s all about the numbers
When underwriting, analyzing, or investing in commercial properties, it is all about the numbers. How is the gross income? How high are the expenses or expense ratios? What is the true NOI (Net Operating Income)? What is the typical Cap (Capitalization) Rate used for the subject property’s building and location? How is the Cash Flow? What is the potential Cash on Cash return? What are the typical vacancy rates for the building type and region?
Commercial properties can be much more subjective deals for both potential buyers and lenders. Regardless of the building’s unique design style, prime oceanfront or downtown location, sales comparables in the region, or the quality of the tenants, lenders tend to look first at the numbers.
Many commercial loans are taken on by business entities such as LLC’s (Limited Liability Companies), Partnerships, or Corporations as opposed to individual borrowers. Some commercial loans are “Nonrecourse” in that the lender or creditor may only seized the subject property in the event of a default, and not pursue any of the individual members, stockholders, or partners for any additional remaining losses or deficiencies.
Cap Rates: How lenders and buyers analyze values
In years past, lenders typically used cap (“capitalization”) rates of between 6% and 10%+, depending upon property types and location. The capitalization rate is a measure of a property’s potential performance without factoring in or considering the mortgage financing. It is effectively the NOI (Net Operating Income) divided by the sales price.
The Cap Rate is also used to convert the expected future Net Operating Income (NOI) over time into a prevent value number today. Many borrowers today are willing to pay higher prices for all types of real estate partly since their borrowing costs are so low due to almost near record low interest rates. Cheap money and rising prices are akin to a “see saw” with one another.
The lower the cap rate used, then the HIGHER the potential sale price. Between the fourth quarter of 2002 and the first quarter of 2008, average national cap rates plunged from 9.3% to 6.75%. If investors and lenders can’t increase rental income numbers in the short term, then why not ease lending underwriting analysis calculations so that property values stabilize or actually increase?
As a result of the declining cap rates considered by both lenders and investors, commercial property values increased for prime buildings such as apartments or multi family, office, retail shopping centers, and industrial / storage facilities. As the Credit Crisis continued onward between 2008 and 2012, then more lenders began to consider lower cap rates for properties partly due to the rapidly decreasing interest rates as well.
Cap Rates = Interest Rates
Amazingly, some prime properties located in prime big cities like Los Angeles, Seattle, New York City, Baltimore, Washington D.C., San Diego, San Francisco, Atlanta, and Boston now may sell at cap rate prices as low as the 3% and 4% range for some multi family apartment deals which also parallels many of the best fixed rate options for mortgage loans today, surprisingly.
These rapidly declining cap rates are helping to increase commercial property values significantly in many regions of the USA today in spite of the ongoing sluggish economy, regardless of whether or not the subject property’s net operating income actually increased in recent times.
For example as it relates to trying to partly determine a commercial property’s potential value or sales price using much lower Cap Rates today:
* Net Operating Income = $100,000 per year
* Cap Rate using 7% equals an approximate value of $1,429,000.
* Cap Rate using 4% equals a $2,500,000 value.
** Please note that lenders use a few other types of property underwriting analysis formulas as well to better determine property values and loan amount limits.
Inflation is the key to prosperity when owning real estate
When incomes are stagnant or continue to decline, then one of the best ways to improve property values (commercial and residential) is to drop interest rates as low as possible and ease up the underwriting guidelines such as decreasing the allowable Cap Rates, considering higher vacancy rates, and being more flexible with the borrower’s credit and financial histories.
In spite of our questionable U.S. economy, residential and commercial property values have improved in many parts of the country. Cheap money and easier underwriting lending guidelines are two of the main reasons why property values have appreciated right along with our increasing rates of inflation.
Once again, real estate continues to be one of the best asset class hedges for inflation so more flexible underwriting guidelines can help property values continue to increase right along with the higher rates of inflation.