In spite of our shaky economy, residential and commercial property values have improved in many parts of the country.
Cheap money and easier lender underwriting guidelines are two of the main reasons why property values have appreciated right along with our increasing rates of inflation.
Since the Credit Crisis began in the Summer of 2007, both commercial and residential property values have fallen significantly throughout the U.S. Accordingly, property owners are more likely to walk away from their “upside down” properties if their existing mortgage debt exceeds current market value.
Lenders Have More “Skin” in the Game
In many regions, residential and commercial properties experienced price or appraised value declines of 50% or more since the last market peaks near 2006 – 2008.
Increasing vacancy rates in small to larger retail shopping centers, office buildings, or other commercial property types made it more challenging for owners to refinance or sell their properties at prices anywhere near the peak values.
When purchasing commercial real estate, typically the lender provides most of the capital for the purchase, as opposed to the borrower. Whether the buyer makes a 5%, 10%, 20%, or a 35% down payment, it’s the lender who has more “skin in the game” or money invested in the deal.
As such, the lender is not as optimistic about the property as the prospective borrower, 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 real estate, it’s 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 rate (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, or the quality of the tenants, lenders tend to look first at the numbers.
Many commercial real estate 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 seize 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
The capitalization rate is a measure of a commercial 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 present 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 record-low interest rates.
The lower the cap rate used, 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, why not ease lending underwriting analysis calculations, so property values stabilize or actually increase?
As a result of the declining cap rates considered by both lenders and investors, commercial real estate values increased for prime buildings, such as apartments, office, retail shopping centers, and industrial storage facilities.
As the Credit Crisis continued onward between 2008 and 2013, 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.
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 underwriting analysis formulas, as well, to better determine property values and loan amount limits.
Inflation Is the Key to Prosperity with Real Estate
When incomes are stagnant or declining, one of the best ways to improve property values 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.
Once again, real estate continues to be one of the best asset hedges for inflation, so more flexible underwriting guidelines can help property values continue to increase right along with the higher rates of inflation.