Prior to the Great Recession I remember hearing that everyone should be investing in single-family homes because house prices never go down. And for years this was so. Houses prices had steadily increased in value for a number of years. This belief that housing was a sure bet was stated as an inviolable truth. Do you remember people saying that? I do. And of course, the recession hit, and housing prices plummeted.
A Real Inviolable Truth
Want an inviolable truth? I’ll give you one: The real estate market is cyclical. Real estate values go up. Real estate values go down. And that is true for both residential and commercial real estate. So I’m always taken aback when professional colleagues deride me for stating the obvious. As if my acknowledging this truth is being pessimistic. It’s not being pessimistic, any more than saying the sun always rises in the east and sets in the west.
Market Quadrants Cycle
If you haven’t seen the chart below before you should spend as much time as necessary to get a full grasp of its intended meaning. No CRE professional or CRE investor should be in the real estate business without fully understanding the four phases of the real estate market cycle.
If you are interested in learning more about the real estate market cycle I suggest you read, Is it the right time to invest in real estate? You asked. I answered where I explain in detail each of the four market quadrants.
The real question is not, “Will commercial real estate values fall?” We know unequivocally the answer to that question. Of course they will. The real question is: What will trigger commercial real estate values to fall? I can think of four reasons:
#1 – Overbuilding
When developers get ahead of demand values decline. This is a classic reason for commercial real estate values falling. At this moment in the real estate cycle are developers overbuilding? Unfortunately, I believe they are. In Portland, the city I’m most familiar with, 2016 and 2017 were record years for new development with $1.9 billion and $2.5 billion under construction respectively. The product from this two-year construction boom has already begun impacting the CRE market. Vacancy rates in most property types are slowly beginning to rise once again. As more product comes on line we can anticipate the introduction of concessions and eventually the lowering of rents as property owners struggle to maintain their property’s occupancy rate.
#2 – The Economy Dips into Recession
When the economy stops expanding workers get laid off. The lucky ones who don’t lose their jobs see their wages stagnate. To cope, some apartment dwellers find cheaper places to live. Others who enjoyed living in a one-bedroom apartment by themselves now realize they need to share a two-bedroom to make it through the downturn. Companies with declining sales realize they too need to downsize into smaller spaces or less desirable locations. Some companies go out of business altogether. When the economy dips commercial real estate values are adversely impacted.
At this moment in time do I believe we are in a recession? Nope. The economy is growing at a healthy rate, the best it has in a long, long time.
#3 – Rental Increases Outpace Wage Growth
Apartment rents have experienced double digit annual growth over the past few years. For apartment owners these have been heady days. But there is a limit to what apartment dwellers can pay in rent. And once this line is crossed apartment values will be affected. Anecdotal evidence suggests that apartment renters in San Francisco have said enough is enough. Even though the rental market is tight, renters are unwilling or unable to shell out the exorbitant rents offered at the upper end Class A properties. When that happens, there eventually is a trickle-down effect to the Class B and C properties.
Is this happening in the Portland market? It is definitely happening in Northwest Portland and maybe a few other upscale neighborhoods. There are only so many renters who will pay $2,000 a month for the opportunity to live in these fashionable properties. If this trend becomes more prevalent then the whole apartment market will feel the impact, not just those properties at the top of the food chain.
#4 – Interest Rates Rising
Capitalization rates are inextricably tied to interest rates. If interest rates rise, cap rates must eventually follow. To prove my point, shown below are three scenarios for purchasing a property with a $3,500,000 asking price and a $200,000 Net Operating Income. The purchaser is requesting a loan equal to the lower of a 75% Loan to Purchase Price or a 1.20 Debt Service Coverage Ratio (DSCR) using a 30 year amortization. So let’s go through each scenario.
Scenario #1 – Under this scenario the borrower finds a lender that will offer him a 4.0% interest rate. Doing the math, the loan amount is constrained by the purchase price, not the DSCR. So the loan amount is 75% of the purchase price or $2,625,000. The equity required to close the loan is $875,000. Both the Cap Rate and the Return on Equity are 5.7%.
Scenario #2 – Under this scenario the purchase price and NOI are exactly the same as before but the interest rate is now 5.0% not 4.0%. When that happens the loan amount is now constrained by the DSCR, not the purchase price. In order to maintain a minimum 1.20 DSCR the loan amount has to be reduced from $2,625,000 to $2,580,000. This requires more equity from the buyer at closing. His equity is now $920,000, not $875,000. With the higher interest rate and more equity required to purchase the property, his ROE is reduced to 3.7%. Notice that the property’s 5.7% Cap Rate stays exactly the same.
Scenario #3 – The buyer under this scenario goes back to the seller and says I won’t pay $3.5 million for this property anymore because if I do I get a paltry 3.7% Return on Equity. The buyer proposes a haircut to the purchase price in order to match the 5.7% ROE he received in Scenario #1. To get a 5.7% ROE with a 5.0% interest rate the purchase price needs to be reduced by $300,000 to $3,200,000. Reducing the purchase price raises the Cap Rate from 5.7% in Scenarios #1 & #2 to 6.3%. So in this case when the interest rate increases from 4.0% to 5.0% the value of the property declines by $300,000 from $3.5 million to $3.2 million and the cap rate increase from 5.7% to 6.3%.
Are interest rates rising? You bet they are. They have been going up steadily for the past several months and should continue to do so for the foreseeable future. If you would like to get a better understanding why I believe interest rates will continue to rise I suggest you read, Four Reasons Interest Rates Will Rise in 2018 where I explain in detail my thinking on this subject.
Will Real Estate Values Fall This Year?
So what are the chances commercial real estate values will fall this year? I think they are very likely to fall. The driver of this trend will be interest rates rising more so than the other three factors. If interest rates continue rising, buyers will demand sales prices be lowered to compensate for a lower return on equity. And if sellers balk at lower sales prices, buyers will stop buying altogether. Those are my thoughts. I welcome yours. What do you think will happen with CRE values this year?