It is ironic in 2007 and 2008, I was asked by our accountant to value properties and loans on our books due to the last cycle. I told her I had no clue, there were too many unknowns. Commercial real estate is starting the same cycle that residential real estate saw in the last crisis. How do you value commercial real estate in this crisis? Where do we go from here?
Background on the Commercial real estate market
The commercial property market is looking allot like the 2008 residential crisis. There are many examples of the impending crisis like office space or restaurant / bar space. Remember, to value a commercial property one of the primary methods is the income approach (Net operating income/Capitalization rate). Unfortunately, neither rental rates or cap rates are fully known at this time. There are huge question marks of what the actual income will be going forward and furthermore there is considerably uncertainty on the true riskiness of the asset. Recall, capitalization rate is the required return set by the market on a property.
Values of commercial properties plummet
Unfortunately, just as in 2008 for residential, commercial properties will take a large hit in this crisis as vacancy rates increase, rents decrease, and capitalization rates increase to compensate for the increased risk. The best way to illustrate is through a quick example. I assumed that rent dropped 25% (this is what is predicted in many office markets) and I assume that the cap rates will rise substantially with the new virus paradigm from 7% to closer to 9%. On top of these changes, vacancy rates have also increased. This resulted in a 48% drop in the value of the property.
|Pro Forma now||After Coronavirus pro forma|
|$/ft||6||4.5||* 25% drop in rental rates|
|Annual||$ 118,536.00||$ 88,902.00|
|Vac/Other||5926.8||assume 5%||$ 13,335.30||* vacancy now 15%|
|% change in value|
|7 cap||$ 1,473,233.1||$ 977,922.0||34%||baseline|
|$ 760,606.0||48%||** rises to 9%|
Commercial real estate is just getting started & will be worse than the housing crisis
The coming crisis in commercial is going to look allot different than the prior residential crisis. On the commercial side there are structural changes occurring especially in office and retail
- Office is going to be the most hard-hit commercial category as businesses drastically reduce their space and allow more employees to work from home. Furthermore with the virus, companies are reevaluating central corporate headquarters and moving to smaller remote offices. Both of these trends will drastically reduce demand for office space and drive prices down considerably.
- Retail will also get hit hard as the bricks and mortar transitions overnight to online shopping. Not all retail will get hit the same, but many of the smaller stores will not make it through the digital transformation that was accelerated by the pandemic.
In contrast to the housing crisis, the commercial crisis will be considerably harder and take longer to resolve. For example, what do you do with a 300k foot single tenant office building? Who will take this space? Or what do you do with a vacant JC Penny, in the past a gym, church, or possibly school would take the space but all these industries are also struggling.
The answer could be nobody anytime soon in many cases so the property owners are stuck for what could be many years without tenants and negative cash flow for maintenance, taxes, insurance, etc. Unfortunately, many times it is next to impossible to reconfigure a large single tenant office building for a different use. This is in stark contrast to the housing crisis where at a price you could always find a tenant to rent.
The changes in commercial real estate and associated pain from substantially lower values is just getting started. The 2008 residential real estate crisis provide a little bit of a roadmap, but unfortunately commercial will be much more difficult as there are structural changes drastically altering demand for office, retail, gyms, houses of worship, etc.. 2008 was relatively straightforward with the market able to absorb the excess inventory. On the commercial side, it will take years for the market to absorb these changes as they are much larger and deeper than what the residential market went through. Look for a considerable number of casualties in the commercial real estate market as the pain is just getting started.
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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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