Sunday, December 21, 2008

Commercial Property Values Down 50%?

The Royal Institute of Property Surveyors says the value of commercial properties in the UK will fall by more than 50% by the end of 2010 (see Guardian article here). Is that forecast plausible? Could it happen here in the US? The answer to both questions is yes.

Income property value is a function of the cash flow it generates. The cash flow has the following components:

  • Gross Potential Income (GPI) – This is the total rent the property generates if it is 100% occupied.
  • Vacancy/Collection Loss/Concessions – This is a deduction for any unleased space, bad debt, or discounted rent.
  • Effective Gross Income (EGI) – GPI less Vacancy/Collection Loss/Concessions
  • Operating Expenses – Expenses related to property operations The usual categories are real estate taxes, insurance, utilities, repair and maintenance, management fees, payroll, administrative expenses (advertising, telephone, etc.), and a reserve for capital items.
  • Net Operating Income – The EGI less Operating Expenses.

The value of the property is the capitalized value of the NOI, and is determined by dividing the NOI by a capitalization rate (cap rate). The cap rate is the annual rate of return on an all cash purchase of the property. You determine the applicable cap rate for a property by looking at the cap rates of comparable properties which have recently sold in a project’s market (more here if you are not familiar with cap rates).

Here’s an example:


What does it take to produce a 50% decline in the value? Let’s say rents fall 10%, vacancies increase to 15%, operating expenses increase to 55% of EGI, and cap rates increase to 7%. Here is the math:


How plausible is it that such declines and increases will occur? Very plausible – all such changes are well within the shifts which have occurred in previous severe recessions.