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.

What Matters Most?

Which direction are home values going to go? Is net operating income from residential rental properties going to go up or down? Subprime foreclosures, interest rate changes, tightening underwriting standards, a weak dollar, potential recession, and overbuilding are all variables being used to construct endlessly varying scenarios to explain what's going to happen next. Most of these scenarios have elements that make sense, but which ones make the most sense?

The simplest way to go is to simply listen to the opinions of experienced real estate professionals. There are a lot of smart people who have been around through multiple real estate cycles, and many of them are quite vocal. Although you will hear a lot of differing opinions, you can pick the one that makes the most sense to you.

I personally like fact based decisions. One fact based approach is to take available historic information, develop a model which explains the history, and use that model to forecast future results based on current data. Such models typically have dozens of variables, and the math becomes very complex. For example, a recent paper assessing the likelihood and factors underlying subprime defaults contains the following paragraphs:

I was at a dinner the night before an Urban Land Institute forecasting conference last month, and the keynote speaker (an economist with a major accounting firm) mentioned their commercial property forecasting model had more than 60 variables. Almost always these models are proprietary and we never get to see how they work, and even if we did get to see them, most of us are not going to question the math. Instead, we decide whether or not to believe the forecast based on the reputation of the person or firm presenting the forecast. In, the end, this is not all that different than just relying on the opinion of the professional that seems to make the most sense.

The approach I like is to rely on some simple rules of thumb. Simple rules of thumb sound like a country boy, backwoods approach to decision making, but academics have demonstrated they can be a powerful decision making approach which rival complicated models. Academics don't call them simple rules of thumb, they call them simple heuristics (hyur-is-tics). I will too, because it sound more sophisticated.

What kind of rules apply to residential property net operating income and values? Here are a few which I will discuss in coming posts:

1. Residential property values go up when interest rates go down.
2. Residential property values appreciate and net operating income growth is strong when the ratio between new jobs and residential permits is greater than 1:1.
3. When values escalate more than what is indicated by the first two rules they revert to the mean.
4. Markets with a combination of good weather, interesting landscapes, and water do better than markets that have bad weather and are flat and dry.

How can simple heuristics we all can understand compete with complex models? Because in any complex situation there are always a few factors which have a strong effect and many other factors which tend to cancel each other out. Complex models try to take all the variables into account by looking at historical results, but when they do that they sometimes end up with a model that only reflects that history and is not a good predictor of the future (a result called overfitting).

An excellent discussion of these principles can be found in a book by Gerd Gigerenzer titled Simple Heuristics That Make Us Smart.