For many, 2008 was a painful financial experience. As it relates to real estate, home

prices in most cases have eroded. Commercial properties are facing huge “maturity risk

exposure” (pending re-fi requirements). Lenders are trying to generate or keep cash….

and stay afloat.

One of the reasons cited for the ongoing distress in 2009 is the “valuation conundrum”.

More commonly, this is expressed as “No one knows where the bottom is” or “How do

we ‘price’ things now”?

Without question, current valuation is very difficult to accurately and precisely to gauge.

The primary valuation tools (comparable sales and income generation) are either

“frozen” (no sales) or “flawed” (who’s numbers can you believe?). Thus, how do we

“value” assets in this current environment?

Professional appraisers have always used a tool often overlooked in the marketplace.

Very simply, it is a cost analysis. Most times, this somewhat obscure method is not

given its due respect. Other times, such as now, it is the only method with any sort of

“semi-fixed” analytical base. Very simply, since site and building improvements have a

substantial “fixed cost”, it has a very useful basis in “stressful times” since a large

percentage of the components are “not stressed”, i.e., substantially “fixed”. For

improved properties, building values normally equate to 70-85% of overall asset value

(in a stable market). The key word here is “semi-fixed”.

By semi-fixed, I mean that most hard and soft costs are rarely discounted (substantially)

in the market. Even if discounted, they are much less likely to be materially impacted.

Even if difficult times, discounts of +-20% of hard and soft costs would be – draconian.

Most times today we hear construction costs are “down” about 5-10% from peak levels.

If land values can be reliably estimated, then a reasonable estimate of current value

(discount from par/cost) can be estimated via a simple “Band of Investment” analysis.

Table 1 illustrates the point. All figures can be readily adjusted to suit exact situations

(Class A-; B+; C-; land value erosion; etc). The results of a Cost Analysis (not

approach), even in a “stressful” market, can help firm value estimates. In the worst

case, such an analysis can also be tested against cap rates and/or yield requirements

from other methods (sales; income).

Insert Table 1

Thus, if an analyst is able to “isolate” the adverse market conditions for the major cost

factors (in this example, building costs), overall property value estimates will be much

more precise than attempting to value by non-existent sales comparisons or nebulous

income projections. Very simply, pro-rata component allocations for all aspects of a

property will then lead an analyst to a reasonable, defensible and bankable estimate of

value. Further, they will be based on more clearly defined factors such as actual

commodities for materials, construction time, and reasonably based fees.

Conclusion

Many real estate cycles have come and gone. This current “recession” at some point

will pass as well. Success in 2009 will accrue to those who understand all aspects of

current valuation. This includes the application of all value tools, current and detailed

understanding of site and submarket specific research, and application of solid analysis

and, oh yes, judgment. Those unable to produce solid market based opinions/estimates

are to be judged impostors, not analysts.

Dennis Duffy, MAI, Principal

RCDH & Co.

Article published in DCBIA, February 2009. Pipeline. Washington, DC: DCBIA.

If property taxes continue to increase, they run the risk of forcing DC tenants to other jurisdictions.  Already, one prime tenant , Carlyle Group, has offloaded some of its space to Rosslyn.  If Carlyle cannot afford to operate in DC, who can?  In addition to that, RCDH sees a secular trend for increasing the use of telecommuting, office hoteling, etc as occupancy costs continue to escalate.  Thus, demand for office space in DC may erode.  With pending (material) federal budget cutbacks, either rent erosion or cost-cutting are, without question, of the federal agenda.

DC has done this in the past (i.e., ignored operating cost dilemmas faced by tenants).  In the early 1990’s, DCBIA warned DC Gov’t of the striking gap between DC and the adjacent suburbs in terms of operating costs (for office space, now approaching $12-$15/SF as of 2011).  Those warning were, essentially, ignored.  A year or two later, DC Gov’t came back to DCBIA and asked for “assistance” in marketing the City as a prime business location.  DCBIA is a champion of this city and gladly provided any and all assistance it could.

Moving forward, this time, in my view, is VERY different.  Federal deficits are unconscionable and getting worse, not better. There appears to be a growing political backlash against more spending.  This was NOT the case 20 years ago.  Thus, the primary tenant base for the City may be eroding, if not by choice, by circumstance.  It is mandatory for DC Gov’t to cut expenses (as the Feds are just now beginning to do), fairly tax occupants, and provide a “pro-business” climate (which pays most of the bills you reference).  Most of the recent legislation, tax rates, etc proposed in the City are anything but “pro-business.”

Please encourage the City to take this to heart before more “Carlyle situations” arise and budget woes worsen.

Feb 2011

Dennis Duffy, MAI

Principal/CEO

RCDH & Co.

A review of Table 1 on aggregate sales volume over the past 5 years indicates that there is indeed a continuing sale trend in terms of total sale volume.  For each of the past 2 years, the prior year’s sale volume exceeded the earlier year by more than 50% (+63% from 2001 to 2002; and 55% form 2002 to 2003).  Prospects are that trend will continue.

Table 2 indicates that the average sale price/property is (and has been) in the $60-70M category.  Only in year 200 did this average figure well exceed the $60-$70M norm.  This is attributable to product mix and more limited sale activity as market observers were trying to understand macro market trends at the time (economic bubble was starting to “pop”).

While average prices were remaining fairly stable, Table 3 indicates a sharp average price increase.  For 2002, average price/SF equate to $275/SF; for 2003 it was $298/SF.  So far in 2004, it is at $315/SF+-.  Partially, this is attributable to property “mix” (Class A versus number of Class B sales).   More importantly, however, it appears to be driven by declining cap rates.

Table 4 shows a sharp decline is cap/yield rates post 2001.  Clearly this was driven largely by the Fed’s interest rate policy (post 9/11 cuts to stabilize the economy).  Average cap rates have declined from 8.8% in 2002 to just above 8% today.  Currently, “average” cap rates appear to be steady from 2002, but averages can be deceiving.   As any buyer will tell you, Class A projects have cap rates that continue to decline.  They are now commonly in the 6-7% range for quality properties.  When contrasted to the “average” (8.1%), the significance of the gap (Class A versus Class B/C) is apparent.  In addition, the present figures do not yet include several “brewing” deals that will push even the average figures lower.

Given these recent, local trends, and the widely held view that interest rates will climb in the near future, what is a buyer to do?  Should they wait for cap/yield rates to rise (lowering value)? Should they “bite the bullet” and buy anyway, even with the prospect that values may decline post closing?  Are cap/yield rates based more on underlying interest rates, or are they more driven by supply/demand factors?  In other words, are the present cap/yield rates “sustainable”?

Obviously, there is no easy answer.  Further, as usual when it comes to real estate, “it depends” (ever heard that statement?).  For most submarkets, the answer is that current low rates are NOT sustainable.  As it relates to Downtown DC office buildings, the answer is that they ARE sustainable.  Why?

Interviews with investors with experience in other markets are enlightening on the subject.  (Funny:  Once again, we seem to learn more from outsiders who are not “wrapped up” in local details as much as we are).  DC is expected to continue to have sustainable cap/yield rates in their view.  The reasons are as follows:

1. Our traditional “slow growth” as compared to other areas is, in this case, a benefit, not a problem.  It will allow investors to constantly monitor economic progress here more so than other submarkets.  Other markets are more uneven.  This complicates the projection process and increases risk.  Thus, our general stability will continue to attract buyers, especially if world events deteriorate.
2. Land supply constraint will continue to press values higher and faster than rents will increase.  Thus, cap/yield rates must decline as a result.
3. Replacements costs will also increase.  In addition, and in contrast to many “bubble markets” of the recent past (Boston; SF; Denver; etc), DC replacement costs and sale values rarely diverged by a significant amount.  In more volatile submarkets, large value shifts occurred in this comparison.  This drives investors away, and creates huge value swings (i.e., not sustainable).
4. Weaknesses in other submarkets will continue.  While there is improvement noted in published in many national statistics in the past 30-60 days, that still is insufficient for investors to start buying elsewhere in significant amounts.  We would view this as a low level of either property or portfolio risk spreading.
5. Stock market factors are also improving, but again, this is not expected to siphon dollars away form real estate.
6. The Fed has limited room to increase rates.  Analysts are expecting up to a 50 b.p. increase over the next 12-18 months.  To date, real estate has not seen this increase “passed through” to the buyers as yet.  Real estate has historically been a very “pass through” oriented industry (leases; mortgages).  If that has not occurred as yet, can it be said that cap/yield rates are primarily interest rate driven?

In summary, it would appear that for the first time in recent (last 5 years) memory, cap/yield rates are now more supply/demand (of capital) driven than in many years.  In fact, the only other time in recent memory where such a similar shift occurred (i.e, cap/yield rates were not tied directly to underlying interest rates) was in the early 1990’s recession.  Then, investors didn’t care what financing costs were (assuming financing was available in the first place!).  A property was either vacant or occupied, and pricing was based more on a $/SF (cost) analysis than yield driven.

The good news is pricing and cap/yield rates appear to be “sustainable” for the near-tem.  RCDH would NOT expect “buy rates” to increase in the same proportion as underlying interest rates as they more upward in coming months.  The best news is that real estate really has shown it has the capacity to perform at exceptional levels.  This, by itself, will continue to attract more institutional capital on a long-term basis, which will further help create “sustainability”.

Dennis Duffy, MAI

Principal, RCDH & Co.

Published in DCBIA, June 2004.  Pipeline, Washington, DC: DCBIA.

RCDH has conducted an extensive search for comparable hi-rise apartment complexes recently sold in Washington DC Metro and nationwide. In certain local cases, the application of the Income Approach indicates market values of +/-$300,000/DU.  In other more “suburban” cases, market values can equate to +-$200,000/DU. In both examples, all assumptions and data (rent levels, vacancies, expenses, etc.) are well supported by market evidence.  In fact, they (assumptions), in some cases, can be deemed conservative.  Yet no local sales have traded at unit values even close to these pricing levels.  The most recent sales are only in the +-$110-$150,000/DU range, with 1 sale at $175,000/DU. How is the investor or analyst to reconcile such a wide discrepancy?

Issues/Solutions

Table 1 illustrates a summary of the most recent “high end” apartment sales in DC metro.  Here, unit values range from +-$110-$150,000/DU, with one sale at $177,000/DU.

Insert Table 1.

Can these “comp sales” support unit value (via the Income Approach) well above those indicated by the sale data?  Answer:  Yes and No.

Step 1.

To the extent that the cap/yield rates provide consistent results, they can be and, in fact, are very comparable.  Should cap and yield rates be divergent, however, they are not as useful, as ordinary adjustments are not likely to yield defensible conclusions. In this case, net adjustments of over 50% are needed to arrive at Income Approach conclusions.  In the example at hand, the sale data abstracted cap and yield rates are at consistent levels.  Sales of quality high-rise product generally are in the 7-8.5% range, with most currently in the 7-8% range.  Thus, cap rate data can be applied to actual or projected cash flows on an individual property with a good level of confidence. The issue is that the resulting unit value via the Income Approach is now well over $200,000/DU is certain local cases.

Step 2.

Given this situation, RCDH conducted a national sale search recently constructed apartment projects.  The results of this study are shown in Table 2.

Insert Table 2

The number of recent sales of high-end apartment complexes built from 1995-2001 during the past 3 years, with a market value of more than $200,000/DU is about 20 in the entire US (as of 4Q/00).

Again, the data indicates a fairly consistent unit value conclusion given the wide range of locations (Boston to San Diego).  In addition, cap and yield rates are also surprisingly uniform.  From that perspective, again, the sale data is, in fact, comparable despite wide locational variances.

Interviews indicate that buyers will only pay such high unit values under the following circumstances:

1. Local supply constraint is well known, long-standing and a difficult process.
2. Rent growth is supported by local economic and effective household income growth.  Said differently, population growth alone is not enough. Tenants must have the ability to pay luxury rents (effective demand) on a reliable basis (good job security; broad market depth).  This limits pricing to markets with high income and education levels where market fluctuations do not materially alter the tenant base.
3. Since this pricing category is limited to the most recently delivered product, verifiable cost figures are a must.  Application of these parameters to older product is not indicated.
4. Clearly, as one approaches $300,000/DU, sale volume thins very quickly.

Given such a rapid shift in unit value ($110-$150,000/DU) over the past 12 –18 months to figures now over $200,000/DU, the uniformity of buyer criteria and rates of return is a strong indication of defensible market value conclusion via the Income Approach.  This is in spite of the absence of local sales at these much higher unit values.  Said differently, local investors are long-term holders who rarely “mark to market” (i.e., absence of sale data locally).

Step 3.

In the event the national sale database is not acceptable or pertinent (lender underwriting rules, etc), an analyst can employ the “condo conversion” methodology.

Basically, in this scenario, an investor acquires the property on a “wholesale” basis (as an apartment complex) and then re-sells individual units to tenants at a “retail” price. In fact, several of the “national” sales appear to have this as a “buyer motivation”.  Thus, it would appear that this analytical tool also is grounded in actual market activity.  In the event this analysis is used, market based assumptions relative to condo price, absorption (sellout), conversion costs, “insider discounts”, yield rates, carrying expenses, etc, must all be supported by market evidence.  In the data in Table 2, a fairly uniform ratio of “wholesale” to “retail” pricing is reported in the cases where this factor is known.  Further, with proper analysis, the resulting “wholesale” conclusion should indicate a reliable barometer of value.

Conclusion

Based on the preceding, Washington metro appears to lag the national market in terms of unit pricing for some aspects (luxury; Class A; high-rise; close-in) of the multi-family market.  It is, therefore, recommended that a complete analysis of all aspects of a particular investment consider these three steps as a minimum.  Otherwise, the underwriting of such properties may be incorrectly evaluated.

Dennis Duffy, MAI

Principal of RCDH & Co.

Published in DCBIA, July 2001.  Pipeline, Washington, DC: DCBIA.

Relative Valuation…How low is too low? Income return spreads to 10-Year Treasuries have fallen steadily over the past several years for those areas with the largest inventory of office space.  In the most recent quarter, income spreads “jumped”, perhaps impacted by a valuation “lag” created by the rapid decline in Treasuries yields from quarter-to-quarter or a sign of a downward valuation correction in the offing.  Our interpretation of historical NPI relative returns in combination with the changes in capital market conditions is that office property appreciation relative to other property types and assets will be a challenge for most metro areas.

Holding income growth constant for a moment…The futures market is now pricing the five-year forward 10-Year Treasury Note at a 4.75% yield, nearly 100 basis points above current levels.  A rise in yields on risk-free assets would dampen appreciation, all else equal.  Moreover, those MSAs that have relative valuations near or below all-time lows over 10 Year Treasury Notes would have even lower appreciation prospects should their income return spreads widen toward historic average levels.  At the same time, compression in risk premiums within second and third tier markets over the past several years could reverse trend.

Can returns be salvaged with income growth? Before bottom-fishing in those markets where office valuations appear to have corrected above the relative return trend, it is critical to evaluate expected income growth prospects.  We combine the implied forward Treasury rate data and the average income return spread data with the intermediate-term growth forecasts from well-regarded forecasting groups to derive an (albeit rudimentary) total return outlook for the largest office markets.

Such forecasts impute a strong measure of job growth in their forecasts and imply a healthy relative return outlook for markets such as Dallas, Atlanta and Philadelphia office markets but a far less optimistic outlook for New York, Washington, DC, Boston, San Diego, and Baltimore.

Fiduciaries’ Response. Real estate investment fiduciaries should consider weighting their office property investments out of those markets where relative valuations are high and growth prospects are low (i.e., overpriced) and towards those that are reasonably valued relative to historic averages and that have promises of healthy income growth.  With many prominent markets now or recently “overpriced”, and with the CMBS/Wall Street crowd now demanding performance, it would seem that a bias toward (overpriced) “dominant markets” may yield to what we would call “accounting” driven markets.  It is happening in the stock market.  It must happen in the real estate market.  With the ever growing need/demand for yield, and a better understanding of risk, office investors will have to “return to the numbers”, and not brochure pictures.

Dennis Duffy, MAI, Principal

William Bott, CFA, Senior Consultant

Joseph Buttarazzi, Senior Consultant

RCDH & Co.

Counterintuitive as it may seem, while the capital return component jumped, the market value of office properties in the index and the denominator in the return measures decreased to levels not seen since the second quarter of 2006.  Blame the paradox on a high amount of partial office property dispositions in the quarter.  By virtue of the return formulas employed by NCREIF, partial sales result in a pronounced bump in the numerator for the capital return measure, but a disproportionately lower reduction in the denominator.

It is also apparent that CBD office properties in New York City and Washington, D.C., accounting for 13% and 9% of the office property index capitalization, respectively, played an outsized role in pushing the index returns higher.  New York CBD offices returned 8.53% and District CBD offices, 6.27%.  Recent upgrades in office rent growth outlooks have compelled many investors to rush back into a few prime markets, contributing to a recent swelling of valuations.  Less deep office markets, however, like those in Boston, Dallas and San Francisco, where future office rent growth prospects are equally or even more optimistic, have not yet seen a corresponding jump in market valuations.

We are more concerned, however, with the generally predictable income return component of the index.  Trailing 12-month office NOI/SF growth for properties within the index is -4.8%, below the EGR/SF growth of -4.7%.  Office occupancy and EGR/SF growth have been declining steadily since the second quarter 2008, but heretofore, property managers have maintained superior (and mostly positive) NOI growth by curtailing discretionary operating costs.  But the second quarter NOI change suggests that expense management is no longer enough to counter the effect of the continuing drop in market rents and rise in vacancy in many submarkets.

Consequently, we take encouragement from the positive quarterly showing for the NCREIF office property index, but the results are too narrowly dependent on one-time gains and a few “trophy” locations for us to see it as more than an uptick that might just as quickly reverse course.  Moreover, while many reputable prognosticators foresee office asking rent growth spikes in the near-term, the declining trend of in-place office NOI/SF would need to arrest consistently before we could proclaim a bottoming out of the U.S. office market.

Dennis Duffy, MAI, Principal

Joseph Buttarazzi, Senior Consultant

RCDH & Co.

Washington, DC

On the other hand, RCDH would advise investors to be extremely careful at present.  Why?  There are several reasons.  They are:

1. Recent world events (Eurpope, Thailand, etc) seem as complex(and intractable) as ever.
2. Commercial real estate forces are only “less bad”, especially as it relates to “non-core” or “trophy properties”.  Most submarkets continue you have “special market challenges”.
3. As importantly, banks are still in dire straits, with virtually no profits other than gaurantted retruns generate by zero interest rates.
4. Owners are or soon will be in a situation where cap costs will start to become a major problem (lease expirations are now starting; absorption is down; physical work is need; functional changes are needed; etc)..
5. Reports of equity funds actually returning cash to source investors is disturbing.  To our experience, very little precedent for such dramatic steps as that has occurred in the past.
6. Most immediately, this will, in some submarket categories, have a negative impact on value.  Some of the recent “price stabilization” evident in the market is attributable to “product scarcity”, and correspondingly, large amounts of available equity.  Recent cap rate “compression” will now likely dissipate, or, minimally, flatten.
7. More importantly, it signals that lenders and regulators “have won”…..by simply delaying.  The famous “mark-to-market” and “extend and pretend” and “delay and pray” phrases of the past few years have corrupted the system so that “price discovery” in less than core markets will now be next to impossible to measure.

Why?

The simple answer is:  Without some product in the market, distressed or otherwise, pricing cannot be calibrated.  Once the equity sources dry up, the market (again) freezes (2009 all over again).  More importantly, equity investors are completely disgusted with what RCDH calls government and bank “mark to make believe” pricing.  Banks still cannot take all the hits needed to “clear” the market.  Government policy and enforcement (?), for its part, cannot take the systemic risk by forcing issues (lower values) beyond where things are today.  By allowing “mark to make-believe”, a continued freeze will continue for an indefinite period.

The government is getting what it wants (for now). Time will ultimately bridge the disconnect between the bid-ask gap.  In the meantime, dead equity will be allowed to keep control of assets.  Condition of the properties will continue to deteriorate, as landlords will not have capital to make improvements.  Further, these equity-light owners will not have ability to meet the market in terms of rent, as they will not be able to fund the TIs or offer other necessary concessions.  Vacancy rates will rise, operating leverage will extract a toll on the bottom line, and banks will then see further write-downs (yet again) on their loans….soon after patting themselves on the back for completing their “pretend and extend” agreements with cash poor owners.  Alternatively, they will not see the forecast value appreciation widely expected in 2011 and 2012 as the market “recovers” (or is delayed).

Its just one of those processes that will need to play out over an extended period of time.

Its really quite interesting.  Smart equity will simply bide time and wait for the weak players to relent…then banks will get keys and eventually sell for pennies on the dollar.

One arena under the radar screen, however, may have even larger consequences.  Privately negotiated joint ventures between institutions and local developers/private equity players, a popular investment vehicle over the past several years, may fill tomorrow’s headlines.  In up markets, these joint ventures appear effective, generally meeting pro-forma return hurdles set by the institutional money source.  However, in down markets, the institutional investor is exposed to substantial downside volatility, as the entrenched fees paid to their “partners” and leverage combine to create poor equity returns.  What’s more, the local “partner” (i.e., developers / private equity players) that maintain operational control, are typically left with little “incentive” to maximize value on behalf of the partnership.  In the downside scenario, the institutional investor is “stuck” with a “partner” that holds an “out of the money” call, has limited/no real cash in the deal, and a consistent fee income stream for as long as the venture exists.  Further, even though buy/sell provisions (after a pre-determined lock-out period) provide the institution an opportunity to dissolve the partnership, execution of such a provision can prove difficult.  This is especially true given the possible tactics that could be applied by the institution’s partner prior to and during the buy/sell negotiations.

The more significant issues associated with these pending J/V deals are as follows:

1. The US economy is now in what we believe to be long-term trend toward “de-levering”.  Thus, projects with highly structured and high ratio debt will continue to be problematic.
2. Obviously, J/V losses are magnified as noted.  Market recovery will take more time than most will expect.  A minimum 2 year period, and likely 3-5 year period will be needed to “de-lever” most deals due to ordinary liquidity matters, bankruptcy/litigation, partnership fights, not to mention market fundamentals in most areas.
3. To the degree that lenders must “take back” these deals, more value is lost as it now must be recognized on the institution’s books, not to mention require costly on-site asset management.
4. Investors in these deals are attempting to “smooth earnings” by delaying reporting into future quarters.  Does this remind anyone of Fannie Mae/Freddie Mac?

Overall, the most recent financial crisis has done nothing more than re-iterate the misalignment of interest among the various players in the market.  In order to prevent such issues in the future, the following minimum steps need to be taken:

1. Investment managers/advisors need to more closely align their interests with their money sources.  Investment advisors claim this is already the case.  Not so.
2. Lucrative fees need to be based on net revenues actually generated, not “transactional” or “accounting” or “valuation” based reporting.  Too many advisors are long on promises and short on real results.  Yet, large annual fees are still paid – even when performance lags significantly.
3. Accounting rules should be clear, fixed, and non-negotiable.  Said differently, quarterly reports are due quarterly (from investment inception).  No delays, amendments, etc should be allowed except in RARE circumstances.  Many advisors and/or lenders are now “rolling” or “bumping” reporting into following quarters so as to NOT report undesirable results on a current basis.
4. Cash flow distributions must be based on clearly defined, not to mention fully audited statements.  Institutional owners often receive lower cash flows due to “above market” expenses which lower the CF distribution.
5. Said differently, as also has been reported in the press, many investors are wary or “skeptical” of figures that are publicly released.  Why?  If all report according to ordinary standards and timing requirements, all cards are on the table.  Again, the process has been compromised.
6. As it relates to J/V deals, greater reserves should be required on all fronts.  All deals are not equal.  All risk is not equal.  If firms are allowed to “book” high “paper” returns, they should also be required to reserve more conservatively against disproportionate losses.

Overall, investors in J/V or structured deals must review, understand and demand better execution on the dollars they invest.  Trillion dollar “writedowns” (so far) by regulated institutions due to faulty underwriting and/or incompetence is something we taxpayers do not need.  While most J/V deals are regulated “lightly” (i.e., depending on the money source), and thus not specifically implicitly “insured” by taxpayers, The Feds recent unparalleled Wall St bailout may bring about some “unintended consequences” if J/V deals adversely impact the first debt position, or major pension funds (e.g., Calpers).  Those money sources will exit the market, for all will suffer.

Dennis Duffy, MAI

Principal, RCDH & Co.

January 2009

As most investors know, “cap rate compression” has been inexorably moving lower for the past 2-3 years.  Recently, however, interest rates have moved sharply (50-75 bp.; or 10-15%) higher in the past few months.  Have cap rates followed, as per tradition?

The answer, apparently, is…no.  Since mid 2004, interest rate increases have begun a slow, steady climb.  Most investors have expected a corresponding increase in cap rates as well.  Yet, it has not occurred.

Traditional analysis has tied cap rates to underlying interest rates, with adjustments (b.p. spreads) for cap exp, appreciation, real estate risk (liquidity), etc.  Will that general “formula” remain in place?

Approximately 2 years ago, RCDH commented to its clients that “sustainability” (for low cap rates) was expected to remain in place.  Happily, it did.  Will the same scenario occur again, now that underlying interest rates are still on the rise? The answer, we expect, is yes.  Why?  There are 2 basic answers.

The simple answer is:  capital flows.  Money continues to pour into real estate as compared to other investment vehicles.  Thus, for the first time in recent memory, “cap rate compression” has been significant and will stay that way for an extended period.  Said differently, for the first time in our experience, cap rates are, in large measure, “de-linked” from underlying interest rates.  This is a function of:

1.  More cash sales than ever before;

2.  Flexible debt structures (low DCR; low amortization); and

3.  More expense “pass throughs”, among other things.

In recent months, the more complicated answer is that “costs” (hard, soft and land) have increased so sharply that cap rates have been “compressed” simply because sellers refuse to accept offers that are low fractions of cost new.

Traditionally, in “strong” investment sale markets, investors often have to “spike rents” in order to achieve a completed sale.  If rent spikes are not used, they often lose out on the buy.  In so doing, they also are able, at least on the surface, to show investors they have achieved the required “hurdle rate” for the acquisition.  In part, this technique (rationale) was driven by supply/demand market forces (low vacancy; limited new construction; etc).  Now, however, investors must look at replacement costs based on new construction figures.  As everyone in real estate knows, costs over the past 2 years have been, essentially, out of control.  Sophisticated investors have been “spiking rents” to “feasible cost levels” at future dates during the projected holding period.

From an analysts’ viewpoint, that is a fairly typical procedure.  The remaining two questions are:  How high should the rent spike be, and when should it be applied?  With accurate cost new projections now a major problem, however, this method is made more suspect.

What then can be done to properly analyze a particular property’s cash flow (and, hence, estimate value)?

RCDH has observed that in the past 2-3 months that it appears that a more rational approach would be to apply LOWER terminal cap rates.  Traditionally, terminal cap rates have been HIGHER than current (or “going in” cap rates).   This is based on the accepted concepts of:

1. The property being 3, 5, or 10 years older at resale;
2. The various profiles impacting the property over 10 years are multiple (interest rate risk; market risk; supply/demand risk; environmental risk; etc).
3. Present Value of money concept.

As has been common in the past, terminal cap rates have generally been equal to or greater than initial (“going in”) cap rates.

Use of lower terminal cap rates, however, may be able to limit the number of (extraordinary?) assumptions used in a DCF moving forward.   Very simply, this procedure would be as follows:

1. Estimate cost new today;
2. Project cost new today (hard, soft and land) at a reasonable CPI rate to the termination date (normally, 7-10 years);
3. Divide the resulting future projected cost into the projected NOI in the final year (i.e., contract rent as forecast);
4. Compare the resulting (lower; imputed) terminal cap rate to present cap rates and long term investment vehicles for reasonableness;
5. Test the result PV conclusion to project cost new today to understand if the current asking/contract price bears some reasonable resemblance to ordinary depreciation schedules based on building age/condition.
6. Re-test land value.   This is necessary due to the rapidly diminishing supply of “entitled land” in all markets.

By using this method, the variables are minimized to some degree.  Only cost new and CPI estimates are material.  But they are also material in any other scenario.  The timing of rent spikes is eliminated for all intents and purposes.  This method also should also more accurately deal with cash flows for investors, from both a Debt Coverage Ratio and cash flow distribution viewpoint.  Thus, “cash shortfalls” based on rent spikes in year 3 or 4, for example can be eliminated or minimized for both the debt and equity positions.  Minimally, this will make lenders happier.  Equity investor unhappiness with diminished cash flows (from projections) can also be more limited.

There are, however, downsides to this method.  They are:

1. Analytically, it is counter-intuitive (i.e., an older building has less risk 10 years from now, versus more risk today when it is newer);
2. Relatedly, the “yield rate curve” has been higher for longer periods than for shorter debt periods for many years;
3. Some projection risk is involved (CPI costs applied to new construction);
4. Limited data exists to test how reliable a method this is over a long historical period;
5. Both land values and cost figures are notoriously fickle, and swing widely.  Thus, the “sustainability” of applying a lower cap rate to a future cash flow remains high.

Conclusion

Like all things real estate, conditions and circumstances vary widely.   It is therefore necessary to view all properties from a variety of angles to insure the best results.  By looking at current replacement cost as a starting point, at least while market conditions are very tight (present investment status), enables an investor to judge a property with a fixed a starting point as possible: current cost.

Dennis Duffy, MAI

Principal of RCDH & Co.

Published in DCBIA, June 2006.  Pipeline, Washington, DC: DCBIA.

In recent months, office building purchases have dominated the real estate news.  This has been in the form of both individual asset buys, or huge portfolio acquisitions.  Most have been in the major office markets.   Without question the top two markets are NY and DC.  Which one is best?

Over the past 12 months, an unusually large number of sales have occurred in both markets.  Table 1 shows the number of sales that has occurred in Wash DC.

Table 2 shows the number of sales that has occurred in NYC during the same period.

Table 3 shows the relationship of cap rates and T-bills as of year end 2006.  Historically, cap rate spreads have been 100-200 b.p. above T-bill rates.  What can or should be made of this recent shift?

What can be said about this data in terms of investor preferences?

The following conclusions can be drawn:

1. First, without question, both cities are clearly in strong demand.
2. Individual building values are, in many ways, staggering
3. Average prices/SF  are at all time highs.  Unit values are at xxx% of current cost new.   Just as importantly, current unit values are equal to or higher than cost new figures as recently as 2 (?) years ago.
4. Cap rates in NYC over the past 60 days have dropped to the 2.5-4% range from the 4.5-5.5% range earlier in the year.  This, without question, is a huge change in market criteria.
5. Cap rates in DC are in the 4-6% range.
6. Clearly, cap rates and volume of sales are tied directly to individual property factors.  Items such as contract rent levels versus market levels, pending lease expirations, cap expense prospects, etc all materially impact cap rates.  At the same time, for several years, real estate investors have showed good discipline in keeping cap rates in a close relationship with corresponding T-bill rates.