Monday, February 23, 2009

Market Timing Doesn't Work - Don't Wait

Posted by: Scott Beggs
Investment Specialist
775 336 4644

Scott joined NAI Alliance in March 2008 to assist the company with investment sales. Previously, Beggs spent over seven years with Dermody Properties as Vice President of Acquisitions and Port Management.

When discussing current investment opportunities with investors, I have heard a lot of them say that they are expecting further deterioration in values and that they are going to wait for those opportunities to emerge. On the surface this seems logical. Why buy something today at a 10% cap rate, if you can buy a similar asset in a year for an 11% cap rate, or at a 12% cap rate in two years? Unfortunately, I think there is a bit of a flaw in this thinking.

Let’s test this strategy with a simple example. Assume that an investor has $1,000,000 and has the opportunity to buy an asset today at a 10% cap rate. Let’s further assume that the NOI grows at an average annual rate of 3.0% per year and that after 5 years the investor can sell the building for a 9.0% cap rate. Under that simple scenario, the investor would earn a 13.7% IRR. As an alternative let’s assume that same investor with $1,000,000 waits 1 year for cap rates to increase to 11.0%. In order to take advantage of that deal when it arises, the investors will have to put his or her money in a low yielding liquid account like a CD which is earning less than 2%. Under that acquisition scenario and assuming the same growth rate and exit cap rate assumptions the investor would earn an IRR of 14.1%. This is not a huge premium over the return that an investor could earn today without taking the risk that these future opportunities emerge. If you extend the waiting period out 2 years and assume that cap rates move to 12% (a 20% decline in values) the investor would earn the very same IRR as in the base case . . . 13.7%.

And what if the expectations for further declines prove false? Let’s say you wait 2 years and cap rates are still 10%. Under that scenario your IRR would be 9.5%.

The point is, you can wait and wait for the exact right deal, but there is no surety that that deal will in fact come along. And as you wait, your holding period return is being weighed down by the fact that in order to take advantage of those future deals, you’ll be earning a near 0% real return as the cost of liquidity. Be confident in your underwriting, capitalize the deal correctly, manage the hell out of the building and be confident that in five years, the world will be getting back to normal. I know that it is tough to have a long-term view in this very difficult climate, but don’t get so mired in the expectation of further value declines that you lose site of the goal of earning the highest total return you can given your current investment time horizon.

Wednesday, February 11, 2009

A Modest Suggestion to Landlords

Posted by: Chris Shanks
Investment Analyst

Chris is responsible for analyzing, valuing and marketing properties for the NAI Alliance Investments Team. He is also involved in the disposition and acquisition of investment properties for clients.

In these difficult times it is important to realize that everyone is feeling the financial burden of the real estate market crunch. Many tenants are being forced out of their space because their reserves and revenues aren’t large enough to pay for their in place leases. As a landlord you should make it as affordable as possible to keep these companies in your building. Many of them will bounce back with the economy and will once again be able to pay a market rental rate. The reason I stress the importance of tenant securitization, is that the lease-up period for vacant space is getting longer and longer. If you, as an owner, need to sell your building within the next few years you are going to be much better off having a building that has tenants, even if lease rates are below “market”, rather than one with vacancy. It was said two years ago, that buildings were worth more vacant than occupied due to the wild speculation of lease up assumptions that were ever present in those times. In today’s market one could argue the exact opposite; buyer confidence has reached such a low point that almost any vacancy is causing them to unfairly discount high quality real estate assets. This causes me to stress again the importance of keeping warm bodies in your buildings. Even if tenants are merely covering operating expenses and debt service, it is a better alternative than foreclosure. Also, having tenants in your building will suppress some of the conservatism of buyer’s lease up assumptions. Higher occupancy will equate to a fairer sales price.

Tuesday, February 10, 2009

Posted by: Dominic Brunetti
Vice President Office Properties
775 336 4674

During his career, Dominic has worked with clients such as: Centex Homes, CTX Mortgage, Landmark Homes, 1st Premiere Mortgage, AG Edwards, Alere Medical, CHSI Nevada, The CFO Group, Ameriwest Financial, North American Title, Andregg Geomatics, Manhard Consulting, HDR Engineering, State Farm, Gizmo Wireless, The Corner Doc, First American Title Company, Stewart Title Company, GI Consultants, The Hilton Foundation, Hartford, PC Doctor and more.

As a Tenant, are you worried about being offensive in asking for lease rate reductions, tenant improvement allowances or other concessions? An interesting dichotomy has arisen amongst the Tenant – Landlord relationship within the Northern Nevada office market. No, I am not speaking about the lease rate bid-ask spread dilemma. Although it may stem from this topic, the differing opinions of spiraling lease rates is a statistical conversation we can save for another time. I’m talking about the emotional fortitude it takes as a Tenant to address a current or potential Landlord with an offer that reflects the current state of the office market; economic terms reflective of a decade ago. As commercial real estate leasing specialists, we focus on preserving the Tenant – Landlord relationship while providing market knowledge based on factual data. Have you recently or are you planning on confronting a landlord, yet unsure about what strategy to employ? We want to hear your concerns and your ideas.

Thursday, February 5, 2009

Vulture Investors

Posted by: Scott Beggs
Investment Specialist
775 336 4644

Scott joined NAI Alliance in March 2008 to assist the company with investment sales. Previously, Beggs spent over seven years with Dermody Properties as Vice President of Acquisitions and Port Management.

Despite the fact that the volume of commercial real estate transactions fell tremendously in the second half of 2008, there is still a fairly large number of real estate investors in the market looking for opportunities. That’s the good news for sellers. The bad news is that most of these investors fall into the category of “opportunistic” or “vulture” investors. These types of investors have very high return requirements which force them into being extremely conservative in their underwriting and offer what on the surface are very low prices for real estate.

A few weeks back I was having a conversation with a local commercial real estate investor. During our discussion he asked, “How can you make money in commercial real estate these days?” I responded to that inquiry with a question of my own, “How do you define ‘making money’?” My response was not intended to be flippant. Rather it was to suggest that from a long-run historical perspective the expectation for “making money” in real estate has been much more modest than the expectations of today. The return expectations of today are being overly influenced by the excess returns earned a few years ago during the run-up in values, and by the expectation of financial duress, which is not always the reality.

During the period of cap rate compression which ran from 2004 to mid-2007, considerable wealth was created. Many investors realized significant gains in the value of their real estate holdings during that period. The really smart investors (or lucky, depending upon your view) were able to realize those gains by selling their assets prior to 2007. Some investors mistakenly view the returns generated during that period as normal, and are now expecting to replicate and exceed such returns on new investments. The primary problem I have with this viewpoint is in thinking that those gains are “normal” and replicable on a go-forward basis.

I fully admit that the risk of real estate ownership has increased as a result of the current global recession. Finance theory would suggest that this increased risk should result in increased returns (i.e. a “risk premium”). The question becomes, “Should this new ‘risk premium’ be added to the excess returns earned during the run-up in values in the middle part of this decade or should it add to a more normalized average return? Further, what is the average return that investors should expect when investing in real estate.

Rather than state an unsupported opinion, I thought I would try to provide a factual context to the question of what is a “normal” real estate return. The National Council of Real Estate Investment Fiduciaries (NCREIF) produces an index of commercial real estate returns. This index measures both the income and appreciation of commercial real estate values based on reported returns from assets around the country. From 1978 to 2008 the average annual return on the index was 10.2%. If we assume that the income component of this return was 8.0% that would mean that the appreciation component was roughly 2.0%. This time period includes the severe real estate recession of the early 1990’s as well as the sharp run-up in values from 2004 to 2007. During this four year run-up the average returns were 16.7% or 650 basis points above the long-run average. I would suggest that investors should look to the long-run average return as their benchmark, not the excess returns enjoyed during a period of aberration in the commercial real estate market. I would suggest that investors looking for 25%, 35% or even 45% returns need to remind themselves of what is a “normal” real estate return objective.

During another conversation with a group that I would characterize as “vulture” investors, we started discussing some of the various assumptions in the underwriting equation for a project (i.e. Market Rent, Downtime, Absorption Periods, etc). This “vulture investor” took every market assumption that was suggested and then discounted it by 10%. By doing so, this investor effectively eliminated the risk of achieving each of these assumptions. This concept is fine if the investor then solves for the purchase price using a reasonable stabilized real estate return objective (cap rate, discount rate, etc.), but instead this investor solved for the price using an extremely high rate of return. I would characterize this as wanting their cake and eating it too. If all of the risk of a deal is effectively eliminated by applying highly conservative assumptions, why should that investor also earn an inflated return? I would suggest if you are not willing to take on normal real estate risk, maybe you should be putting your money in 5-year Treasuries and earning 1.93%.

The decline in transaction volume in 2008 is an indicator that the Buyer’s pricing model has diverged from that of the Sellers. Based on Washoe County Assessor’s office data, the number of commercial sales (non-residential sales greater than $1,000,000) declined from 255 in 2007 to 132 in 2008. The average price of those sales declined from $11,912,908 in 2007 to $6,211,398 last year. This drop-off is symptomatic of the divergence in valuation between Buyers and Sellers.

So who is right? As with many things, I think the answer is that they both are. There will likely be deals that get done over the next 12 to 18 months at what I would describe as “vulture pricing”. These deals will be driven by the lenders (banks, life companies, etc), not the equity stakeholders. There will also be deals that get done at what I would consider more stabilized pricing. These deals will be driven by real estate investors with a reasonable perspective as to the long-run average returns to be expected in real estate and sellers that can disregard the pricing aberration that existed just a few short years ago. In the meantime, both Buyers and Sellers should not be offended that the other has a different view as to the value of real estate in this market.