Where did my value go?

This is the question a lot of commercial property owners are currently asking me.

Two recent articles voiced excellent opinions on this subject:

“Everyone is looking for a strategy, but all the strategies are predicated on value,” said Woody Heller, executive managing director at real estate services firm Studley. “At the moment, no one has a clear sense of value.” (National Real Estate Investor)

“What the lenders are saying is we all hope things will be better a year from now," said Joel Ross, a longtime real estate investor who runs the Citadel Realty investment bank in New York. "But prices are down 25%-40% from 2007, and those prices aren't coming back.” (Fortune)

From 2004 - 2007, the Nashville commercial real estate market was as hot as any in the country. The escalated and artificial prices we saw from 2004 - 2007 were based not on commonsense real estate principles but on easy money, excessive leverage, and artificially low interest rates.

Furthermore, from 2004 – 2008, markets like Nashville were flooded with 1031 money and money from larger markets like California, Atlanta, New York, and Chicago. Investors from these cities were looking for higher cap rates (will talk about cap rates later in this post) and lower sale prices, and they found both in cities like Nashville.

As the legendary real estate investor Sam Zell said (technically, he sang it) in his 2007 Christmas letter:

Capital is raining on my head.
Everything is liquid, we're awash with cash to spend

.....The flood has drowned returns,
'Cause assets keep liquefying, monetizing, raining...

Capital keeps raining on my head
So much is out there that the world is out of whack.

When will we see balance back?
It’s gonna be a long time ’til returns meet expectations.

Well, it looks like the balance is back. From everything we are seeing, hearing, and reading, property values have dropped anywhere from 25% - 40%. And the really scary thing is that these numbers may appear to be low.

In general, the best and most accurate way to price and value a property is by using one of two approaches: the comparable sales approach or the income approach.

The comparable sales approach is most often used for owner/user type buildings and is as simple as it sounds. You simply look at what similar properties are trading for and extrapolate a value based on those comparable sales.

The problem with using the comparable sales approach in this current market environment is that we have to throw out most deals that closed from 2004 – 2007. These numbers are tempting to use, but they are artificially inflated and don’t appear to be coming back any time soon.

The income approach is typicall used for income producing properties and bases the value of the building on the building's Net Operating Income (Rent - Taxes, Insurance, and Genreral Operating Expenses) and market capitalization rates (cap rates).

Cap rates are calculated by dividing a building's NOI by the value of the building (a building with an NOI of $100,000 and and a sales price of $1,000,000 would be trading at a 10% cap rate).

When rents are increasing and vacancy is down, values are typically moving up and cap rates are typically moving down (good for sellers, bad for buyers). When rents are decreasing and vacancy is up, values are typically moving down and cap rates are typically moving up (good for buyers, bad for sellers).

The problem with using the income approach in this current market environment is that lease rates are dropping and we can't see where the bottom is. Also, vacancy is increasing and tenants that once appeared to be steady, credit tenants aren't looking so steady. As one broker friend recently told me, "There's no such thing as a 'credit tenant'."

The excessive leverage of the recent boom years amplifed realized and unrealized gains because rents were escalating and buildings were staying full. However, the excessive leverage that looked so great when the market was booming is also the same leverage that is brining people to their knees. When that anchor tenant declares bankruptcy or you drop your lease rates 30% and offer six month's of free rent, that leverage starts looking like a noose.

To account for the inflation of sales prices from 2004 - 2007 and the current lease and vacancy rates, we have to discount the values from this time period based on current market conditions. Because, in the end, a property is only worth what a buyer is willing and able to pay and a seller is willing and able to accept.

Some may wonder why anyone would sell when values are down by as much as 40%.

I urge investors to heed the words of Warren Buffett. Buffett always cautions investors to focus on the opportunity cost of investing or not investing, or in this case, of selling or not selling.

Market timing is not a strategy. It ignores the many other factors that should be considered when deciding to buy or sell a property. All investment decisions really come down to the opportunity cost of acting or not acting.

Forget the plans you made long ago and in a different economic environment. Instead, focus on the opportunity cost that exists in the reality we live in today. Far too often, people get caught up in their plan and forget to focus on the opportunity at hand.

P.S. Here is a recent article in the Atlanta Business Chronicle about the auction sale of a 33-story office tower in downtown Atlanta. Equastone Real Estate Investment Advisors bought the building 2007 for $57 million. The building was bought at auction by the only bidder at $29.5 million. This sales prices represents a 48% drop in value.