Spring 2009 issue of Horizons

Raise Your Expectations CERTIFIED PUBLIC ACCOUNTANTS AND BUSINESS CONSULTANTS

The real estate market began to turn in early 2007. The bulk of the blame can be attributed to loans made by lenders using poor underwriting standards and the sale of these loans to investors doing the same. This process was exacerbated by Wall Street rating agencies that bought into this lending style. When rating agencies finally began devaluing these packaged loans, the damage was already done. Losses were shared by most major capital providers, and a resulting capital shortage ensued. Even those with the capacity to invest waited to see how far the values would fall, causing even greater losses. The graph below shows how enticing the real estate investment market became to capital sources. From 2004 to 2007, the amount of private investment in real estate more than tripled; however, in a relatively short period of time from the peak, this activity has already returned to the levels seen in 2004.

The real estate turmoil reached its pinnacle after a series of major events hit the headlines – the government takeover of mortgage giants Fannie Mae and Freddie Mac, Lehman Brothers filing for bankruptcy, Merrill Lynch selling to Bank of America, the Federal Reserve bailout of American International Group, JPMorgan Chase purchasing Washington Mutual and Wells Fargo purchasing Wachovia. Similar instances are likely to be seen in the future, in spite of the $700 billion bailout package approved by Congress. What does this signal for things to come in the commercial real estate industry? We believe there will be three major changes – increased stability, decreased lending requirements and purchasing opportunities. The stabilization the U.S. government provides by purchasing Fannie and Freddie will ease investor unwillingness to commit and provide investors with the confidence to reenter the market. Decreased lending requirements will likely follow the government intervention. Funds will not be provided as easily as investors and developers became accustomed to during the last few years; however, some of the current requirements are simply overly conservative. The Federal Reserve has already said it will expand the range of collateral it will accept for loans. Lastly, opportunities are always present during difficult times. Interest rates remain low and funds are still available to those that meet the new underwriting requirements. Those still treading water after the dust settles may find unique “value-add” investment opportunities that can be acquired at a low price point today, with strong potential for higher rental income and related returns into the future. Capitalization Rates Cap rates are the most common way to measure the current value of investment real estate. The calculation of a cap rate is based on a simple formula – the following year’s expected net operating income divided by the sale price of the property. For example, a retail property with an expected NOI of $250,000 and a sale price of $3,125,000 would have a cap rate of 8 percent. This means that an investment of $3,125,000 will yield an annual return of 8 percent on the investment, or $250,000 per year.

Total Investment Activity Total Investment Activity

$100 $120 $140

$0 $20 $40 $60 $80 $40

Billions

01 02 03 04 05 06 07 08

Source: Real Capital Analytics, Grubb & Ellis

Corrective measures were inevitable. Banks and other financial institutions were forced to reevaluate their underwriting standards, passing additional costs to consumers. Higher interest rate spreads, additional fees, and the need to inject additional equity into the projects were requested from developers. In the current environment, lenders want to make loans with enough cash equity to mitigate their risk, resulting in a shortage of capital sources and a decrease in real estate values.

u spring 2009 issue

54