Is A Commercial Bubble About To Pop?

[Scott.A]

I came across this article this morning:
http://wolfstreet.com/2016/11/16/wh...rillion-commercial-property-bubble-in-the-us/

The lead paragraph...

Warnings about the loans, bonds, and commercial-mortgage-backed securities (CMBS) tied to the vast $11-trillion commercial property sector in the US have been hailing down for months. Moody’s Investor Services just warned about the rising delinquency rate of some $360 billion in CMBS it rates. Delinquencies of 60+ days jumped from 4.6% last year to 5.6% in September.

What do you think? Are we on the verge of big correction in the commercial market? We're certainly not seeing this kind of steep climb in prices in our neck of the woods.

 

[Meandering]

Janet Yellen had commented about "over-valued" commercial real estate at her last Fed meeting. That bond method helped, I'm sure.

Yup, commercial Real Estate bubble. Every piece of commercially zoned land here has a for sale sign on it.

Field of dreams, if you build it they will come.


.

 

[Terrel L. Shields]

Field of dreams, if you build it they will come.

Reminds me of Ag land. High crop prices never last as long as your land mortgage. Today corn is $3/bbl. Farmland prices and cash rents are down and farm debt rising rapidly. Farmers who bought at market peaks got burnt bad, and should have realized the risk. Chapter 12 is their only option that can salvage a part of their assets.

 

[Meandering]

Yeah but,

market conditions were "average" when they took those loans.

 

[Michael S]

I came across this article this morning:
http://wolfstreet.com/2016/11/16/wh...rillion-commercial-property-bubble-in-the-us/

The lead paragraph...

What do you think? Are we on the verge of big correction in the commercial market? We're certainly not seeing this kind of steep climb in prices in our neck of the woods.

There's a lot of cash chasing relatively few deals. Yields have been driven down by strong demand from institutional buyers. If you have $100 million to invest in commercial real estate you have to buy. Banks have money to lend so they want to make deals as well. Ultimately yields and cap rates can't really go any lower. Why buy real estate at a 4% yield when you can buy a bond that is far less hassle and risk (with much higher liquidity) at the same or even higher yield? If you bought a commercial property at a 6% cap rate based on NOI of say $1 million you paid $16.667 million. If cap rates go up from 6% to 7% and NOI remains unchanged your value drops down to $14.285 million, a loss of 14.3%. Interest rates might need to increase more than 100 basis points for cap rates to rise 100 basis points but over the next couple of years that's a pretty likely scenario. The numbers are even worse if you bought at say a 5% cap. Then you would lose 16.7%

 

[Scott.A]

Reminds me of Ag land. High crop prices never last as long as your land mortgage. Today corn is $3/bbl. Farmland prices and cash rents are down and farm debt rising rapidly. Farmers who bought at market peaks got burnt bad, and should have realized the risk. Chapter 12 is their only option that can salvage a part of their assets.

That we are definitely seeing here. Just finished a farm report earlier this week with adjustments above 4% since the beginning of the year.

 

[Gobears81]

There's a lot of cash chasing relatively few deals. Yields have been driven down by strong demand from institutional buyers. If you have $100 million to invest in commercial real estate you have to buy. Banks have money to lend so they want to make deals as well. Ultimately yields and cap rates can't really go any lower. Why buy real estate at a 4% yield when you can buy a bond that is far less hassle and risk (with much higher liquidity) at the same or even higher yield? If you bought a commercial property at a 6% cap rate based on NOI of say $1 million you paid $16.667 million. If cap rates go up from 6% to 7% and NOI remains unchanged your value drops down to $14.285 million, a loss of 14.3%. Interest rates might need to increase more than 100 basis points for cap rates to rise 100 basis points but over the next couple of years that's a pretty likely scenario. The numbers are even worse if you bought at say a 5% cap. Then you would lose 16.7%

The institutional guys getting into investments that they never would have in the past, which has pushed up prices, and it is hard to envision much upside for some of those sectors. I appraised a manufacturing property leased to a multinational company that sold for a 9.59% cap rate (based on rents/ sale price). That property was actually leased below market and with a healthy lease term remaining. It was not new, so the major downside is vacation of the tenant after several years, particularly given the rural location. But if I had several million dollars to spend on an investment like that, it is considerably more attractive to me than the 6-7% cap rates on newer freestanding retail properties that are leased above market, so you see not only a more rapid rate of depreciation but amortization of the above-market rents as the lease ages. There is hardly any upside to those types of properties, and scenarios where there is a loss are abundant in my opinion. I understand that 1031 is driving a portion of this, but there are better ways to spend that money than to purchase a property that could likely result in a loss. I appraised a new retail strip leased to national tenants for 10-year terms in a depressed location and the rents were at least 60% over market. Sold for a 7% cap and I drove by that property a couple weeks ago-one tenant has already vacated. In my mind, there is only downside to a property like that. So much risk to get a 7% return for a few years! Those types of properties are, in my opinion, the most vulnerable to a market correction. Perhaps not in the next year, and maybe not even in the next two or three, but I do foresee a trend reversal at some point.

 

[Scott.A]

So how much should this information factor into the cap rates we apply to our analysis? If we are looking in our crystal balls and see a correction on the horizon that might be next year or 5 years, do we bump up the cap rates even though the market is active on the surface? It reminds me of watching P/E ratios in the late 90's. Everyone knew the that the P/E made no sense and was way too high, but the market was paying for it... right up to the point that it didn't. Then it all came crashing down. How much of valuing property in an inflated market is up to us being realists, even if it makes us look like doom-sayers?

 

[Gobears81]

How much of valuing property in an inflated market is up to us being realists, even if it makes us look like doom-sayers?

Our job is to emulate the market. Turn that around for a second-should we appraise properties higher than what the market suggests simply because that sector seems to be under-priced? You and I might have our own opinions of the intrinsic value of the property, but if the market analysis indicates that they will continue paying said prices on the effective date of the appraisal, you might be prudent to document in the report that there are fundamentals suggesting future downturns are possible or likely, but market value is based on the most likely selling price as of that date. With that said, market value is also based on its future earnings potential, not its past. So many of these booms have poorly planned construction projects that are the last, or near the last to show up, and those are quite often the first ones to go down. Our job is to evaluate when that saturation point hits and when to say that this project isn't feasible.
There is a sector which I am familiar with that experienced huge appreciation over the past ten years. All of us in the office recognized how overpriced it was getting, but those prices kept getting met. At one point, there was a significant level of new construction and the properties, which were considerably under-assessed, were re-assessed to market. Market participants recognized the new construction, of course, but just anticipated that the low assessments would continue forever. Somewhat of a perfect storm. Sometimes the market gets things wrong.

 

[Michael S]

I just appraised a freestanding retail store leased to a national cell phone company that was marketed at a 4.5% cap rate. It was a great location but the rent was absolutely the top of the market and it's only a 10-year lease. You can practically go buy a McDonald's ground lease for a 20-year term at that rate. Needless to say I did not come in anywhere close to that cap rate.

While there certainly appears to be a bubble, there's still a lot of cash looking for yield and not finding it in the bond or equity markets. Personally I'd take the S&P 500 over the next five years vs. that a new retail strip center with national tenants on 5-10 year NNN leases at above-market rents. As long as yields across all asset classes worldwide remain low, real estate will continue to be an attractive investment, even at historically low cap rates.