Dead Cap Bounce

[Michael Gottlieb]

By MICHAEL GOTTLIEB

California Real Estate Journal Editor

I just couldn't help but shake my head in disbelief.

At a recent forecast event, one of the speakers - a prominent, respected manager of high-profile Los Angeles properties - had just projected that interest rates may rise 150 to 200 basis points in 2010, when the moderator asked him for his outlook on capitalization rate increases in his market this year.

His response was that there wouldn't be any. He said the properties in his market wouldn't see further cap rate declines due to the high demand for quality assets in quality markets.

Now, I've seen a lot of fiction in computing cap rates, particularly in recent years when impossible NOI pro formas were plugged into the cap rate formula to validate unsupportable pricing in the marketplace, but this struck me as blatant denial. If the cost of capital rises then cap rates must rise, right?

Since the credit market froze, commercial real estate prices have fallen 43.7 percent from their Oct. 2007 peak, according to the latest Moody's/REAL Commercial Property Price Index, or 39.5 percent according to the most recent transactions-based index produced by the MIT Center for Real Estate. Yet both indexes have suggested a flattening out of commercial property price declines in recent months and, in some markets, we actually are seeing isolated signs of cap rate compression.

For example, in the fourth quarter of 2009, Los Angeles office property cap rates declined to 8.4 percent from 9 percent the prior quarter, according to data from CoStar Group Inc., even as rental rates declined and vacancy rates increased last quarter.

The answer for this short rise in prices at a time of declining fundamentals, which Wall Street calls a "dead cat bounce" is simple.

With so little supply of quality properties or loans available in the marketplace and so much demand for safe, discounted properties among investors, these supply-demand fundamentals mean that any time a quality property hits the market, bidders line up and push pricing up as they compete for deals.

Yet this really is a dead cap bounce.

According to Realpoint, the overall delinquent unpaid balance on commercial mortgage-backed securities is up 380 percent from a year ago and is now more than 18 times the low point from March 2007. On average, loans originated at 75 percent loan-to-value in 2005 or later are now underwater, according to Moody's Investors Service. A presentation by Spencer Levy, national head of CB Richard Ellis' restructuring services initiative indicates it will take more than a decade before commercial real estate to return to peak values as cap rate's contribution to value will be negative through 2011, and NOI's contribution to value won't turn positive until 2015, as vacancies and lease rates continue to reset to reflect today's harsh economic realities.

Ultimately, I don't know how you can calculate a true cap rate today. If cap rate equals NOI divided by value, neither the numerator nor the denominator can be calculated with any certainty in today's marketplace. These are the days when people are proclaiming from conference podiums that "Argus underwriting is dead" as the market is proving that cash flow predictions are wholly unreliable and the paucity of arm's-length transactions means reliable comps are tough to find.

Cap rates provide a useful benchmark for the performance of commercial real estate. Whatever bounce we are seeing in cap rates is largely irrelevant to establishing a new baseline of values in the market, however.

The few properties that are trading at better-than-expected prices may indeed be good deals. Or perhaps they represent a faint echo of the asset-price bubble the industry is struggling to work through in the pursuit of a more reasonable equilibrium between buyers and sellers.

[John Corey]

If we want to continue with the Wall Street analogy, what is being described is a lack of market liquidity. In more normal language we have a mismatch in supply vs. demand. There is also a shift in the stratification of the demand. Buyers who might have considered a range of properties in years prior have shifted to a more narrow focus for quality.

The bounce may be closer to a quality premium triggered by a flight to safety. If that is correct the 'rise' is more 'sustainable' when you look at the niches or sub-sectors. Those sub-sectors in favor will perform disproportionally better than history implies. This also implies continued challenges with comparing past sales. Only after the focus on core assets or a the flight to safety wains will supply and demand rebalance.

John Corey

[Elaine M Lyles]

My sense is that your disbelief of the obvious marketing strategy of the speaker is correct. There is a clear intent in the marketplace for those who “have” the most to lose to suggest to the audience that there is in fact no deflated “bubble,” despite all evidence to the contrary. Just as the experts, in the midst of the bubble, were purporting that there was no “bubble.” As we all now know, the reality is that there was a bubble; and, as surely as summer follows spring, that the bubble has burst. The metaphor correctly images the mess that happens when a bubble bursts, stuff is splattered everywhere | much like our current economic climate.

Truth of the matter is that, as we begin the process of cleaning up the mess the bubble has made, no matter what methodology is being used (i.e., PPIP, TARP, Auctions, Owner Financing deals) to facilitate a discernment valuation in the marketplace whether local, regional, national or international; there is not enough volume to accurately define the valuation of an asset. The flight to quality properties that are currently trading trade based upon guestimations formerly known as projections that the new owner hopes and believes are viable, and may be depending upon the structure of the financing. Whether they used Argus or not is mute, because Argus is a valuable industry tool used to discern the value of the property based upon the “inputs” of the user. Therefore, if the user’s inputs are based upon an inaccurate interpretation|perception|representation of market dynamics/variables, so too are the results, as we’ve seen too often of late.

Clearly, the incredulous marketing strategy of the speaker being discussed is two – fold:

First, it keeps the “haves” in front of the audience continuing a dialogue of denial to delay; and,

Second, to pretend the bubble didn’t burst in order to extend the illusion of their perceived valuation in an effort to protect their invested interests.

It is much like the strategy the banks are using to further delay the inevitable. To what end will they continue the charade and to what costs/expense to the tax payer, it's hard to say. To have or not to have? That is indeed the multi-trillion $ question.