Reese's Observed Conditions

Just What Are the Market Fundamentals Now? | June 28, 2011

I recently read an article by Peter Ingersoll in the March 2011 Registry-Bay Area Real Estate Journal entitled “Mind the Fundamentals”. Mr. Ingersoll cleverly integrated references to football and stories/quotes by Green Bay Packers coach Vince Lombardi to a discussion of the current real estate market. This article got me questioning…..just what are the fundamental of the current market? My specific point of reference with regard to market watching is the Bay Area, but my readings tend to be national in scope. Here are a few highlights and quotes that I have recently read that are of interest to me and may be to you as well.

In Mr. Ingersoll’s article, some of the math of capitalization rates and interest rates were interesting to me as an appraiser. This is especially true in that the long term impact of the Feds if interest rates are raised. Cap rates have risen, but not substantially. What if a property is purchased at today’s rates for say an 8% capitalization rate. If the interest rates rise and the loan is adjustable, the indicated capitalization rate based on existing leases on the property would also rise and the value decline.  In order to keep the value up, rents would have to increase greater than the increasing cost of expenses. Wonder why the smaller investors are sitting on the sidelines and watching and not active? This uncertainty may be one of the reasons.

More recently, in an email that I was copied on between a Marcus & Millichap broker and Cam-L Investments Inc., the following was asked: 

“Even if you locked in rates for the next seven years at current low rates, what happens seven years out when rates will probably be 9-10% and you haven’t been able to keep rents above inflation?  What’s the value of real estate then if you currently buy at 6-7% cap rates, but market caps, then need to be in the area of 9-10%?”

Yes, this was used as a marketing question to try and lock in current loan rates (further sales of listings), but it speaks to what is happening in the marketplace at this time.  Also taken from this email is the following.

Current cap rates are NOT taking into account the tremendous risks investors are facing over the next 3-5 years. Greece is going to default:  the Euro will probably collapse, 61% of the entire federal debt will mature within 4 years, and most world banks are in a world of hurt…next defaults will probably be Italy and Spain.

In a nut shell there is tremendous risk out there and trying to predict interest rates over 12 months is an exercise in futility.

“On of the last Profitable tools and reasons for owning investment real estate (which is illiquid) is the ability to use leverage.  But with so many unknowns in our financial systems and unemployment stick as it is, an investor almost has to sacrifice leverage and put 30-40% down, (apartments are probably the safest bet). But then the question remains, can rents be raised above the inflation rate on an annual basis? True inflation is probably currently running about 5%.

I am not normally a pessimistic guy, but we are entering TOTALLY uncharted territory.”

In an article by Daniel Thomas, a correspondent for the Financial Times, published on June 3, 2011 entitled “Caution still keynote for commercial property”,  owners and investors are noted as expecting activity to remain subdued in the next six months.  In this article, investment decisions were also reported to be held back by uncertainty.

Here’s another warning from an article in the June 22, 2011 Appraiser News Online.

UCLA’s Shulman: CRE Prices Pushed Beyond Fundamentals

The second quarter UCLA Anderson Forecast released June 15 showed that commercial real estate prices are being pushed beyond their fundamentals by low 10-year treasury rates and well-capitalized investors, according to a June 16 MBA NewsLink article.

David Shulman, senior economist at UCLA Anderson Forecast, told MBA NewsLink that with the economy growing at 3 percent a year, “it will take a long time before the fundamentals catch up and the net operating income justify the valuations at a higher cap rate.”

Shulman noted that stocks are currently trading at “nosebleed levels” for multiples of cash flow — either funds from operation or adjusted funds from operation. However, bankers who avoided commercial real estate loans last year are aggressively returning to the market, according to the article.

“Simply put, a near-zero federal funds rate and 3 percent 10-Year U.S. Treasury yields have lit a fire underneath the high-quality end of the real estate market,” Shulman told MBA NewsLink. “The public equity REITs perceive themselves to have an unusually low cost of capital, and they are buying top (assets).”

Meanwhile, as bids for high-end properties begin to increase, Shulman noted that more investors are showing interest in mid-tier properties. “People may say location, location, location, but when the money turns on or the money turns off, it doesn’t matter,” said Shulman, according to MBA NewsLink. He also noted that low-end properties are benefiting from low interest rates. 

These authors are echoing each other! Are we in for another real estate crash in the future? Are these the unintended consequences of the Fed controlling interest rates, the banking industry and the market’s response to these controls as it tries to right itself? 

On the housing front, FHA lenders Fannie Mae and Freddie Mac plan to sunset the program that allows higher debt ratios on homes in higher priced areas on October 1st.  In October 2011 the maximum loan will decrease from $729,750 to $625,500 with a minimum of 3.5% down payment. The effect of this move, if it happens, means that those sellers with homes listed between $910,000 and $780,000 will see the largest impact.  The net effect of these changes means additional downward pressure on sales prices as fewer buyers are able to qualify for conventional financing. I expect this will have the effect of further suppressing home prices in the Bay Area where in most cities the average price is at the higher noted end of the current jumbo loan range. 

Will the change in financing guidelines by these agencies further depress the residential market which in turn will impact the commercial market through a trickle-down effect?

All these questions and no answers; wish I had a crystal ball!

I invite you, reader(s), to share your comments on this post. Maybe we can figure it out together. I’m personally feeing the effects of this questionable time in my appraisal practice. I’ll probably be a little cautious in using the market indicated lower capitalization rates when valuing properties…….it’s all about the Fundamentals!

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