Commercial property values were recently hitting peaks with investors rushing to invest in high quality commercial real estate as yields on other assets like treasuries continued to languish. Now the tides have turned with some high quality commercial property now worth substantially less and others still increasing? Who are the winners and losers? Why the sudden change? What does this mean for cap rates and ultimately values?
What happened?
The Coronavirus struck in March, upending any sense of normalcy in the commercial real estate market. Assets that were deemed safe class A properties were now highly risky assets. Take for example a retail stores steps away from a major stadium. This was very desirable prime real estate until the virus hit. Now how valuable is this property with zero sporting events/concerts/other events?
Some property examples
- Restaurants: This was always a risky property type due to constant change in the industry, but the virus has upended all assumptions as dine in services have been banned in most locations. I’ve seen numbers as high as 30% will likely fail. If you had an A restaurant in an A location within a city, the property was considered relatively safe, now the entire industry is under siege financially and many will perish
- Retail: the recent retail numbers show a 17% decline in purchases and almost 80% decline in clothing purchases. This will be a nail in the coffin not only for many large retailers like Neiman Marcus but also smaller retailers. Think of the high end mall with all the clothing retailers, how do they survive such a dramatic drop in sales?
- Office: The office landscape has changed. Companies like twitter and Google are telling employees they can work from home, some of them will be able to work from home indefinitely. Why will large companies need so much space going forward? They will not. And the space they will desire is smaller space in less dense locations to minimize the risk of virus transmission
On the flip side some properties have excelled
- Grocery anchored centers: Grocery stores that were languishing are now hot again as consumers are forced to eat at home, this has increased margins and brought back life to a tired real estate sector.
- Light industrial: Industrial and light industrial properties were in demand before the virus hit, now the space needed to store inventory and sort items for distribution is enormous, this sector will be the biggest winner.
How does this impact commercial capitalization rates?
To value commercial real estate you can look at what comparable properties are selling for and also calculate the net operating income to determine the value. The income approach is critical to the valuation of a property. The basic calculation is Net Operating income (revenues-expenses and excludes mortgage/interest payments). The NOI is then divided by the capitalization rate to determine the value. For a basic example, lets assume a properties NOI was 100k/year and that the property was a high quality property so the cap rate was 5%, so the value is 2m.
What is cap rate?
The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor’s potential return on their investment in the real estate market. In essence the cap rate is a measure of the “riskiness” of a property. A higher cap rate would deem a property more risky and a lower cap rate would mean the property is low risk.
How will commercial values be impacted?
There are two primary variables impacting value, the net operating income from the property, and the expected return on the property (cap rate).
- NOI: the income on many properties is declining substantially due to the virus. For example, the lease rates on office space are plummeting due to lack of demand, furthermore existing office users are negotiating lower rent rates to continue their lease. On top of this vacancy rates are ticking up as companies close or substantially scale back.
- Cap rates: Cap rates are surging as properties that were once deemed “safe” are now very risky, for example a restaurant in a great location might have traded on a 4 cap, now that property might trade on a 7 or 8 cap due to the uncertainty in the industry
- Example:
- Assume a restaurant pays 100k/year in rent and it is a triple net lease, when the property was bought, a 4 cap was used, with the changes, now the cap rate has increased to 7 or 8 percent. The original value was 2.5m, now the value with a 7 cap is only 1.4m
- Assume the same restaurant now renegotiates the lease by 20% due to the new social distancing requirements and their loss in income which decreases the NOI to 80k, assuming as above the increase to a 7 cap, the value is now 1.1m
Summary
The commercial real estate market is in for a tough ride in 2020 and beyond as net income is reduced and cap rates are increased. This is just the beginning as there is considerable uncertainty as to how deep the income losses will be when leases come up for renewal and how substantial the cap rate increases will be due to the riskiness of the asset. Regardless, there will be some substantial losses that filter through the industry.
Additional reading/resources
- https://www.eater.com/2020/3/24/21184301/restaurant-industry-data-impact-covid-19-coronavirus
- https://www.cnbc.com/2020/05/15/us-retail-sales-april-2020.html
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine, The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
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