Southern California Industrial Real Estate Blog

Falling Cap Rates Hit the “Red Zone”

November 29, 2006 on 12:30 am | In FASCINATING INDUSTRIAL REAL ESTATE INFORMATION, FASCINATING INFORMATION, FUNNY...MONEY, Investment Opportunities, New Developments, OFFICE BUILDINGS, PROPERTY MAINTENANCE, PROPERTY WISH LIST, Uncategorized | 6 Comments

Falling Cap Rates Hit the “Red Zone”

With Cap Rates Having Fallen About as Low as They Can Go, Investors Must Be Prepared To Alter Buying Strategies

 

The spectacular rise in property values that has largely fueled the buying frenzy within commercial real estate over the past three years has resulted in investors flipping properties for big gains, in many cases after buying and holding them for just months instead of years.

At the same time, a new report notes, cap rates for almost all property types have been doing the Limbo, and now they’ve gone about as low as they can go.

Investors and underwriters alike are alarmed at how far cap rates have fallen, driving returns into the “red zone,” the point where the spread between purchase cap rates and 10-year Treasuries falls below 250 basis points.

At this level, Dennis Yeskey of Deloitte Consulting points out, there is no room for error, as real estate values may no longer generate a viable risk-adjusted premium over the cost of borrowing money.

“If an investor is buying a building today at a 5.5 or 6 cap rate and thinks he or she is going to sell it next year at a 4 cap rate, they’re in for a rude awakening,” notes Yeskey, national director of Deloitte’s Real Estate Capital Markets group and principal author of the firm’s 2006 Real Estate Capital Markets Industry Fall Update. “Right now, you need to be very careful you’re not overpaying, because increasing property values aren’t going to bail out investors who overpay.

“They’re going to have to look at the underwriting and see where they can either fill vacant space or increase rental rates in order to get the returns they want. In other words, they’re going to have to earn returns the old-fashioned way,” he added.

The good news, Yeskey said, is that cap rates are finally flattening out.

“They couldn’t go much lower. And investors get that; they realize they shouldn’t be buying buildings at such a thin spread. Real estate is not a liquid asset, there should be a risk premium over Treasuries.”

As a result, Yeskey believes, we’ll see less churning going forward and more investment based on the potential for deriving revenue from raising rents and operating buildings efficiently rather than from cap rate compression.

From a macro perspective, Yeskey said it couldn’t happen at a better time. “It looks like we may time this just right, if fundamentals hold. We’re in really good shape in terms of supply and demand. There hasn’t been a lot of new construction. That may be changing, but right now we’re seeing a nice return in demand. Rents have started to move up in most markets, which is very good news for investors. And in some, like Midtown Manhattan, you’re seeing rent spikes of 15% to 20%.”

Yeskey said commercial real estate markets haven’t always fared so well in the past.

“Usually, when cap rates get this low, alarm bells go off,” he said. “Every time in the past 30 years that we’ve pushed cap rates down near Treasuries, it’s the old story: ‘Houston, we have a problem.’ ”

This time, the industry responded quickly and didn’t keep developing when rents were falling and market fundamentals were going down. Yeskey said there are several reasons to account for this.

“First, there’s a lot more discipline among lenders and investors. And quite frankly, there’s a lot more information available now to make better decisions. You also have to factor in construction costs, materials and supplies, which have soared (in cost) over the past few years. That created further friction that limited new development. And you can chalk up some of it to increased government oversight. In certain areas, instead of taking two years to gain the necessary approvals and put up a building it may take three or four depending on the level of scrutiny and approvals needed.”

The ability of the industry to keep market fundamentals in check is a big reason why commercial real estate has been, and continues to be, among the best-performing investments. Returns have exceeded almost every other investment option over the past five years, and appear likely to continue on that trajectory into 2007.

“We’ve seen an unprecedented flow of capital into real estate, well beyond anything we predicted for 2006,” Yeskey said. “You see funds forming left and right as investors line up in search of returns that only real estate has delivered recently.”

If there is a dark cloud on the horizon, Yeskey said it would be the increasing debt levels creeping up across all property types. Debt offerings are increasing in size and in number, while debt service coverage ratios are dropping.

“People are really starting to leverage up and the competition is such that we’re starting to see underwriting standards sag,” said Yeskey. “If there is one big area of concern it would have to be the dropping debt service coverage,” Yeskey noted. “That ratio was as high as 1.5, but even as rents have risen, the average ratio has dropped down to 1.3. People are leveraging up properties more, debt service is higher, and that means they have less of a cushion should there be a downturn.”

With no end in sight to the amount of capital in competition for real estate deals, Yeskey does not foresee a pullback or curtailment of investor activity in real estate any time soon. Rather, the search for yield is driving more investors to look in smaller tier markets and invest in smaller sized buildings and to seek out property niches that may generate the types of returns they’ve enjoyed in the past.

“There’s still a lot of money coming in and it’s got to find a home. We’re seeing a lot of interest among investors in so-called niche-plays, things like healthcare facilities, medical office buildings or even student housing. We think we’ll see more investors start buying infrastructure, things like airports, toll roads, tunnels and bridges. There’s been more of that overseas but we think it will catch on here as well.”

“Of course, you’ll still see a lot of investors still clamoring for the core, stabilized properties, buying at 5.5 to 6 cap. They may not see a lot of yield, so they’re going to have to work to increase rents. And that means they’ll be holding onto properties longer, waiting for the rents to roll over and lease it up at a higher number. In many ways, investors are going back to basics.”

Written by Tim Trainor

http://www.costar.com/News

Getting real estateinvestments to grow with some smart actions

November 17, 2006 on 7:49 am | In FASCINATING INDUSTRIAL REAL ESTATE INFORMATION, FASCINATING INFORMATION, FUNNY...MONEY, Investment Opportunities, New Developments, OFFICE FODDER, Uncategorized | 10 Comments

 Getting real estateinvestments to grow with

some smart actions

As financial guru Suze Orman asserts, “You have to have a relationship with your money.”

Passive real estate investors sit back and feel confident that with time, property investments get easier and more lucrative. Proactive real estate investors want to know how much their property is yielding on its equity. Proactive investors are always looking for ways to increase their return.

“The whole point of building a larger net worth is to provide the wherewithal for living expenses while you do what you most want to do,” notes George Kinder, author of “The Seven Stages of Money Maturity.”

Those looking for maximum bang for their buck are big on yields. Yields work this way -say you have $100,000 to invest in a Certificate of Deposit. You would see which bank offers the best rate on the money -a.k.a. the best yield on their equity. If First World Bank is offering 3.28 percent and

World First Bank is offering 3.4 percent; obviously you are going to buy the CD with the 3.4 percent yield -$3,400 annually. Say you liked the return and bought a million dollar CD, the cash flow would be $34,000 and the yield would still be 3.4 percent. Yield is a constant, but the cash flow changes as the equity changes.

“In the recent marketplace, you can exchange a property every couple of years for a considerably higher yield,” confirms investor Bruce Norris.

If you’ve held an investment property in SoCal for three years or more, it’s most likely bumped up in value. Maybe it’s time to exchange that property for something that will make more money for you.

“If it is your intention to be the master of your financial destiny, you must begin paying more attention to your money,” confirms Orman in “The Courage to be Rich.”

Take the concept of yield and apply it to real estate. Let’s say you paid $500,000 for a well-located eight -unit in the property lull following the Northridge earthquake.

Because of your reputation with the lender and your promise to fix the damage and bring the building up to code, you were able to squeeze by with $150,000 down and took at $350,000 loan. When you bought the property, your cash flow (total income less expenses and debt service) was $10,000. Your yield on equity, or cash-on-cash return was 8 percent. The math is your cash flow - $10,000 - divided by the hard cash invested the $125,000 down payment.

Thanks to the growth of the real estate market in the past decade, that property has gone up in value four times, and it now worth a cool $2,000,000. The amount of the loan has dropped to $250,000, making your current equity in the property $1,750,000. Cash flow has grown to $50,000 annually. As a passive investor, you are delighted; you are making a 20 percent yield on your original investment. An active investor you divide the $50,000 net income by the $1,750,000 in equity and realize that your current cash-on-cash return is 3 percent. Appreciation has shrunk the yield on your investment.

“Some people are content to acquire and hold property,” states Norris. “More aggressive investors are constantly turning over properties to maximize the yield on their investments.”

What is the financial difference between active and passive investing? By reinvesting the $1,750,000 to earn an 8 percent yield, as the investor was receiving on their original equity, their current cash flow would be $140,000 -$90,000 more than the $50,000 annual cash flow the investment property is currently earning.

“Investing in real estate is all about math,” notes Gerald Friedkin, founder of the Friedkin

Investment Group, owners of some very nice commercial properties in Santa Monica.

Sure, part of investing in real estate is obvious -is the location good, are the structures sound -but the profits come from doing the math. To be a good property investor you’ve got to embrace a few essential commercial calculations. Knowing how to calculate these real estate revenue formulas is the first step in investing in commercial real estate.

“Aggressive investors will continue to buy and sell properties to create higher yields,” notes Norris.

If you are interested in active real estate investing, here are some terms that will be of use to you:

Holding Period: The length of time the typical investor expects to hold the property.

The length of time the typical investor expects to hold the property.LTV (Loan to Value Ratio): This represents the loan or debt portion of the property investment in terms of a percentage.

This represents the loan or debt portion of the property investment in terms of a percentage.Mortgage Constant: Mortgage constant is a rate that reflects the periodic annual payment of principle and interest on a mortgage with a level amortization schedule that will extinguish the debt.

Mortgage constant is a rate that reflects the periodic annual payment of principle and interest on a mortgage with a level amortization schedule that will extinguish the debt.Mortgage Rate: Mortgage Rate is the annual interest rate lenders charge when making real estate loans.

Mortgage Rate is the annual interest rate lenders charge when making real estate loans.Mortgage Term: Mortgage term is the number of years for which the mortgage was given.

Mortgage term is the number of years for which the mortgage was given.Equity Dividend: The “cash on cash” return (usually reflecting the first year) that measures the portion of income remaining after satisfying all expenses including mortgage debt to the initial down payment.

The “cash on cash” return (usually reflecting the first year) that measures the portion of income remaining after satisfying all expenses including mortgage debt to the initial down payment.Equity Yield: The annualized total return an investor would desire from the property (required rate of return on and of equity capital).

Jodi Summers is Director of the Investment Division at Boardwalk Realty. For your real estate needs, e-mail Jodi Summers at jodis@boardwalkrealty.com, or call (310) 309-4219. Visit her websites at www.SoCalInvestmentRealEstate.com or www.santamonicalandmarks.com.