In a published article by Royce Rowles of PGP Valuation Inc, Royce discusses the ratio between annual net income and sales prices.

“While the NOI may be falling at many properties (due to increased vacancy rates and/or more competitive rental rates), it almost certainly does not account for the entire value decline in this market. Major value declines also come from the changing status quo between buyers and sellers. Buyers have become much more patient and are expecting a much more favorable ratio between their NOI and purchase price. In other words, when there are fewer buyers (as often is the case in a down market) capitalization rates move upward. In situations where there are recent comparable sales, anyone valuing a property can easily extract and apply very current and realistic capitalization rates to estimate Market Value. This is because during times of appreciation, the market is usually active. Extracting supportable capitalization rates is easy. However, when transactions are scarce finding market capitalization rates can be significantly harder. When this happens, oftentimes sellers have an unrealistic opinion of value because they are relying on dated capitalization rate sources.”

So how do you extract capitalization rates, when transactions have been scarce? The following page discusses five ways to analyze capitalization rates.

National Surveys

According to the 2^nd Quarter 2009 National Investor Survey prepared by Korpacz, capitalization rates for self-storage facilities range from 7.00% to 10.00% with an average of 8.55%. Korpacz is just one of several national surveys providing important perspective relating to overall trends in the market. It’s important to not place too much emphasis on national surveys as there may be wide fluctuations in regional and local markets. However, a national survey is an important starting point to get an overall perspective of what capitalization rates are doing on a national level.

Existing Sales

In analyzing existing sales over the last couple of years, the older the transaction dates the superior the marketing conditions. In almost all cases, this outweighs some of the less important qualitative adjustments such as quality, condition, and age. As appraisers, it is more important to select more current sales outside the market than older sales within the market area.

Capitalization rates for self storage facilities have increased 100 to 150 basis points over the last 12-18 months, with typical capitalization rates ranging from 8.0% to 10%. Transactions sub 8.0% are hard to find in this economy. It seems like the days for buying a property based on a ”Pro Forma” is gone. Buyers will only look at current in place income and expenses, since this is how lenders are underwriting properties. Here is what we are see regarding capitalization rates in this market:

• Good quality / good location (8.0% – 8.5%)
• Average quality / average location (8.75% – 9.5%)
• Fair quality / poor or saturated location (10% – 12%)

Band of Investment Technique

Because most properties are purchased with debt and equity capital, the overall capitalization rate must satisfy the market return requirements of both investment positions. Lenders must anticipate receiving a competitive interest rate commensurate with the perceived risk of the investment or they will not make funds available. Lenders also require that the principal amount of the loan be repaid through period amortization payments. Similarly, equity investors must anticipate receiving a competitive equity cash return commensurate with the perceived risk or they will invest their funds elsewhere.

Effective Gross Income Multiplier Method (EGIM)

This multiplier is used as an indicator of value and takes into consideration the proportion of expense to every dollar of effective gross income. It is derived by dividing the sale price by the Effective Gross Income. Typically, effective gross income multipliers, which are derived and applied before considering expenses, are used without adjustments. The expected trend is as expense ratios increase multipliers decrease. It is common to put weight on those comparables with similar expense ratios (% of Effective gross income). The following table is a sample.

Broker/Listing

Brokers’ perspective are very important, as they have a pulse of what is going on in the area. Appraisers typically quote brokers in their reports, as well as provide several listings. Below is a sample of self storage listings currently on the market throughout the country.

Accurate valuation is enhanced by solid operating history. However, it is common to rely upon expense comparable data when valuing properties through direct capitalization. Understanding how operating expenses vary from region-to-region is key, especially for specialized lenders and investors looking to expand into other national markets. The table to the right is a sampling of over 200 expense comparables located throughout the country (evenly distributed). In addition, we have added information from the most recent Self Storage Almanac. Possible considerations for comparing operating expenses are discussed below.

Real Estate Taxes: Every state has its own method for calculating property taxes. There are several states (like Michigan and California) that reassess facilities based on sales price. Therefore, since the definition of “Market Value” assumes a sale, appraisers are forced to use an amount calculating the value of the property and the tax rate. Each local jurisdiction must be reviewed and understood. This can oftentimes cause headaches for refinances and construction loans.

Insurance: Rates are fairly similar across the nation. Special consideration should be given to flood, earthquake, hurricane, or other natural disaster areas. Typical range for this category is $0.15 to $0.25/SF. It is typical for lower rates to be achieved through blanket policies. It will be interesting to see if or how much policies rise over the next couple years due to a variety of factors.

Utilities: Both location and climate play a role in this category. Densely populated areas typically see higher energy costs. The number of climate controlled units at a facility should also be considered. Typical range for this category is $0.15 to $0.40/SF.

Repairs and Maintenance: This category includes cleaning out the units, replacing doors, landscaping and any maintenance associated with the facility. Areas that require a snow removal expense and/or elevator servicing are typically higher. Long term expenditures are also affected by climate; however, these expenses are typically covered in the reserves category. Typical range for this category is $0.15 to $0.30/SF. Age and physical characteristics play a part in budgeting for this category.

Off-Site Management: This is typically done on a percentage basis (EGI). Therefore, areas with higher rents result in higher management costs. Typical costs range from 4% to 6% of Effective Gross Income. This expense is not to be confused with General/Administrative expenses.

On-Site Management: This category is greatly impacted by location and average living expenses. Unless zoning restricts, it is common for resident managers to live on-site. Expenses are often higher for facilities not offering living accommodations for managers. Typical range for this category is $0.75 to $1.25/SF.

Advertisement: The amount of competing facilities and the property’s access and exposure are primary considerations for this category. Typical range for this category is $0.20 to $.40/SF.

General/Administrative: Fairly comparable from region-to-region. This expense includes accounting, legal fees, other professional fees, and general administrative costs. Typical range for this category is $0.25 to $.40/SF.

Reserves: This category takes into consideration capital improvements over a holding period. For self-storage facilities, it would typically include replacing the roofs, resurfacing the streets, and replacing the fencing and storage doors. Typical range for this category is $0.10 to $.20/SF.

Now that the effects of the credit crisis have become more fully evident while continuing to grip our economy, 2009 has revealed a repositioning within the real estate markets. Commercial real estate values are returning to the core fundamentals that always drove the market prior to the rise of Commercial Mortgage Backed Securities (CMBS). The availability of easy, non-recourse money and the flood of investors transitioning away from Wall Street in the late 1990s led to an unprecedented spike in demand, which caused a dramatic increase in prices and a loosening of investment standards. The results have been painfully evident.

The last couple of years have represented a time in which markets stagnated, not solely due to the lack of available capital, but also due to the gap in expectations between buyers and sellers. Sellers clung to memories of historically low capitalization rates and aggressive rent projections, while buyers assumed the worst in their cash flow analysis and disregarded cap rates altogether. The chasm between buyers and sellers over the last couple of years has widened to the point of stunting almost all activity in the market. The result of the stagnation is that market values are relatively vague across most property types. However, in the self storage industry, this separation of value between buyers/sellers is not as pronounced as other property types. However, due to the lack of capital, capitalization rates for self storage facilities have increased 100 to 150 basis points over the last 12-18 months, with typical rates ranging from 8.0% to 10%. Transactions sub 8.0% are hard to find in this economy.

Most industry experts concur – the commercial real estate market trails residential and is affected by all of the additional external influences that affect the economy as a whole. When combined with the still-compounding effects of stock market fluctuations, increasing unemployment rates, decreased consumer spending (although some moderate, recent gains), and ongoing corporate restructuring and downsizing, conditions are likely to worsen in the near future. As just one more reminder, key markets such as New York are just beginning to feel the impacts of financial sector lay-offs with commercial space inventories dramatically increasing and residential foreclosures accelerating. These key markets set trends across other areas of the nation. In addition, one should be mindful still of the $3 trillion of commercial market debt coming due with no real sense of how this will be absorbed. Negative impacts could be substantial without a plan and available capital.

In addition, as financial institutions continue to flounder or be seized by the FDIC, related asset workouts are the growing trends. In the past, the FDIC would typically take over one bank in a time span covering years. In 2009, the FDIC has seized over 100 banks to date and the number is anticipated to rise rapidly. Sitting on the books of these failed financial institutions are portfolios of properties that must be immediately appraised for true, current value and factored against the current market conditions in order to dispose of the assets. While perhaps not directly deepening our economic crisis, this will most likely extend the overall recovery cycle with commercial real estate looking at another 5-7 year window for more healthy conditions.

With all of these factors in play, expect market participants in the future to be more realistic in their internal underwriting, but to place emphasis on initial cash-on-cash returns and a flight to quality. Well-located, good quality product will slowly begin to move again as the expectations between buyers and sellers move toward each other.

Jeffrey R. Shouse, PGP Valuation Inc

Self Storage Director

The Tenant

Walgreens is a national, retail drugstore chain that sells prescription and non-prescription drugs and general merchandise. The company was founded in 1901, and as of August 2009, operated 6,996 drug stores located in 49 states and Puerto Rico. The company is publicly traded on the NASDAQ National Market, the New York Stock Exchange, and the Chicago Stock Exchange under the symbol WAG, and is included in the Standard and Poor’s 500 Index and the NASDAQ 100 Index. Moody’s rates Walgreens long-term debt A2 and short-term debt Prime-1. Standard & Poor’s rates Walgreens long-term debt A+ and short-term debt A-1. The outlook from both agencies is stable.

Investment Demand

There is currently strong investor demand for Walgreens properties, as market participants are attracted to the absolute net lease structure, long-term lease, moderate cash-on-cash returns and strong creditworthiness of the tenant. There was a lull in Walgreens sales during the first couple quarters of 2009 due to asking prices that were still targeting peak of the market values. Over, the past several months a majority of sellers have re-priced, which has increased sales volume substantially. Walgreens investments are attractive to a specific pool of investors to balance risk within their portfolios.

It is worth noting that the inventory of Walgreens listings is quickly evaporating, which is primarily due to recent increased sales volume and the fact that this tenant has substantially reduced expansion efforts.

Capitalization Rates

The subject property of a resent appraisal we completed was a Walgreens in Lane County, OR. The following table summarizes regional cap rates trends.

The 2008 sale transactions are no longer relevant because market cap rates shifted upward substantially since these sales occurred. The 2009 transactions indicate a cap rate range from 7.3% to 8.2%, and an average of 7.7%. Comp 1 (7.3%) is a sale that occurred in early 2009 (negotiated in 2008), and is likely a low indicator for current market cap rates. Comp 2 (8.2%) had marketability issues associated with prospective buyers having to assume existing financing that limits annual cash-on-cash to less than 1%. This issue put substantial upward pressure on the cap rate; therefore, this comp overstates prevailing cap rates. Comp 3 (7.5%) is the best indicator from this dataset given that the sale reflects current market conditions and this is a straightforward transaction.

The following table summarizes four additional cap rate examples of recent Walgreens sales in the Western region.

The additional cap rate comps show a range from 7.3% to 7.8% and average 7.5%. Based on interviews with two brokers that specialize in selling net leased investments, the most prevalent market cap rate for Walgreens is currently 7.5%, which is supported by the preceding data.

The impact of the recession and financial crisis on commercial real estate has been widely reported. With securitized lending out of the picture and banks less able to lend, purchase financing has been more difficult to obtain and available in smaller quantities. This has led to a slowdown in sale transactions for commercial real estate. To compare how convenience stores have fared, the chart below shows the trend in volume of transactions for west coast convenience stores and service stations as reported by CoStar Group Inc.

Sales volume reached their peak during late 2007 and early 2008 as a number of oil companies rapidly liquidated stores. By mid 2008, however, lenders had begun to pull back, and rapidly increasing fuel prices made operators’ margins difficult to predict. Property transactions fell precipitously, and at the height of the credit freeze sales were off more than 50% (3^rd quarter 2008 vs. same quarter 2007). Sales have rebounded slightly since then, but 2009 is still on pace to lag 2008 by 26%. During the period, many oil companies were in the process of liquidating portfolios of stores, which has not only cushioned the fall in transaction volume, but also contributed to the peak sales volume in 2007/2008. Additionally, CoStar Group Inc. has expanded its geographic coverage over time, so these figures may understate the decline in volume.

Although the majority of convenience store sales involve owner-operators, price trends have correlated strongly with the real estate investment markets. Just as capitalization rates peaked for many property types in 2006, data show median prices peaked for c-stores at roughly the same time. The chart shoes median and quartile prices for west coast c-stores and service stations.

Following rapid price appreciation of 31% in 2005 and 18% in 2006, median c-store prices have fallen for three straight years. Nevertheless, the fall has been muted, amounting to a decline of 16% since 2006.

Note that the lower quartile prices have held relatively steady while upper quartile prices have fallen the most. This is likely and indication that few owners of high-quality stores are willing to sell in a distressed market

In conclusion, data indicate that c-store values are falling. However, the decline appears to be less of a sudden correction than a gradual adjustment ongoing since 2006. Anecdotally, many owner-operators have found purchase financing difficult to find. Undoubtedly, this has hurt transaction volumes, but pricing has held up fairly well considering the pressure mounting on other sectors of retail.

Who among us has not been subject to greater and closer scrutiny, or has scrutinized others in greater depth in the recent climate of market distress? How do valuation experts report the meeting of the minds of the buyers and sellers when those players are on the sidelines?

The market downturn has been more widespread, more inclusive of the spectrum and breadth of property sectors than at most times in the past several low points in business cycles. The sickly symptoms in pricing and demand during the relatively recent past have been more like those afflicting limited-market properties in normal times. Scarcity hasn’t been an issue in the availability of most product types. Transferability and effective purchasing power have been curtailed by the constraints on the flow of credit. And the resulting muting of demand, has effectively stepped on the brakes in the marketplace slowing the velocity in transaction activity.

Is anybody in the market really out there, in the market? Are appraisers the voices in the wilderness calling out for somebody, anybody, to tell them what’s going on out there?

What are we searching for? In the good old days, as recent as twenty-four months ago, it was difficult for investors to make a mistake in any market. The pipeline was flowing with a slurry of cash and credit. Buyers were buying, Sellers were selling. Some sectors were doing “land office” business. Does anybody remember this? The market was speaking loud and clear about their views regarding a clear and exuberant relationship between income and value. Hindsight is calling into question the rationality of those perceptions, but it was what it was—and the relationships of income and prices were defined by the overall capitalization rates associated with the deals. The players’ expectations were committed by virtue of securitization, for better or worse and in sickness or in health.

Looking back with an eye toward the deals taking place during the recent exuberance, and even just using a low level magnifier, the relationship that buyers and lenders had entered into was more fragile than anyone would want to admit, then or now.

But now we’ve got a problem. Not the bubble; not the bursting of the bubble ….market analysts are lacking market-based information with which to fully understand the future benefits of ownership for investors. Investors are also void of access to the information, mostly because there isn’t much.

One option for appraisers would be to make predictions of proper capitalization rates based on most recent bona fide transactions, whatever can be found. We can always defer to our infallible judgment and breadth of experience…but each of these data resources is vulnerable for lacking true emulation of the meeting of the minds in the marketplace.

If only we could use interviews with buyers that would identify their view of required cap rates needed to close a deal were the solution to the quest, we could stop this discussion here. Everybody’s got an opinion. We can’t fabricate capitalization rates, can we?

I suggest we don’t, at least not without reasonable basis from the market’s perspective… lest we get caught when it matters. Most of you who are reading this likely think it always matters. Cap rates can be constructed from the matter that comprises the deal, particularly from the investor’s perspective, and for the benefit of the appraiser, tested for reasonableness.

One of the fundamental weaknesses in understanding and projecting cap rates in transitional markets is the need to look in the rear view mirror at past transactions in order to try to make educated guesses about the next transaction. This is not as much of a challenge if stability characterizes the forecasted climate. We’re talking about capitalization rate forensics because market instability is diminishing our traditional levels of predictability.

Forensics

So let’s get forensic. But before we do, let’s digress. What does “credible appraisal” mean? Most agree that somewhere in the process of the credible appraisal report presentation, the reader is led from premises to conclusions and they are able to walk away from their reading with a market-based perspective.

Appraisal academia typically starts the lesson plan imploring the student to test their conclusions for reasonableness. As elementary as this teaching is, the absence of reasonableness is on the Top 10 List of most frequently observed appraisal deficiencies. I liken the concept to sitting on the curb, across the street from the subject property, when all the research is conducted, and the analysis nearly complete, and asking whether the conclusion and its components are truly market-based.

Forensics is relevant here. Mostly because as observers of the market, without a good supply of transactions to study, we need to dissect our overall cap rate conclusions, and in litigation, the conclusions of others, to get a closer look at the quantity, quality, durability and risk associated with collecting lease income anticipated from the investment.

It is appropriate to remember that value is created for investment real estate most often by a combination of debt and equity. The deal has got to work in terms of providing sufficient return to both the debt and equity participants. Lenders appreciate this concept especially.

Investors are also aiming to first pay the lender and then have sufficient funds left over to justify handing over the cash to own the illiquid asset and its attendant risks that often require management expertise, at of course, some cost. So in the process of dissection of the rate, we need to understand that the cash-on-cash return, the equity dividend component, is the analogous measuring stick with which to compare the vehicles in the investment spectrum, which range on the low risk end, from the mattress; to the greatest risk, demanding the highest return, venture capital.

In the mattress, liquidity and management are not typical negative factors. There is however, risk of erosion of effective purchasing power. In the next level, the high safety/low return vehicles are the time deposits, money market and “passbook” savings accounts. Most classes of investment property lie somewhere below the stock market, and somewhere above theses traditionally safe, low return vehicles. So in the forensic analysis of the rate components, one target variable to evaluate is the available cash dividend, and its proper relationship with its competitive investment vehicles.

Investors will most always say that they’d sacrifice some cash-on-cash return for some upside property appreciation that also contributes to their total return.

As of late, the closer scrutiny of the overall rate is most typically undertaken by an appraiser who is facing a thinner supply of market transactions, and is in need of using anecdotal supplemental insights. The appraiser is more often applying a test of reasonableness via a Band of Investments analysis. Similarly in any adversarial proceeding it is typical for the “opposing” party to dissect the components of their adversary to check for reasonableness. Most decisions handed down in disputed valuation cases evaluate the reasonableness of the respective parties’ assertions.

Debt

The debt portion of the analysis is often pretty straight forward. This component of the overall rate consists of the return to the lender, and is calculated based on probable loan to value ratio, amortization schedule, and likely interest rate applicable to the loan. The mortgage constant is calculated, and the weighted return to the lender represents one of the overall rate’s components. Not all lenders are shut down. Their credit criteria, is however, likely requiring greater equity contribution and more stringent pay back terms. Far too few appraisers are consistently up to date with their knowledge of available loan terms.

Equity

The equity position is a little more challenging to know well, in that the equity dividend rate has historically been extracted from market transactions. If we had these, this discussion would be moot. So the next best thing, a proxy for the extracted dividend rate, relates directly back to the equity dividend rate desired or anticipated, as it compares to alternative riskier, or less risky, investment vehicles. These alternative vehicles need also be evaluated with regard to their degree of liquidity and management burden.

Dissection

Most of the readers of this discussion are likely looking for a practical way to employ this analysis to their advantage in an adversarial proceeding. You should be so lucky that you’ve narrowed the differences in value estimates with the assessing jurisdiction down to net income and overall rate. This may represent a fantasy dispute, because many debates appear to center on whether the sun rises in the east, or west.

Nevertheless, let’s work the equation backwards solving for one of the debt or equity variables, with the intent of testing the reasonableness through dissection of the assessing jurisdiction’s cap rate.

The first and most obvious (and typically most effective) test is to evaluate the reasonableness of the equity dividend rate assuming both parties have narrowed their dispute on anticipated NOI, by subtracting the debt component from the overall rate. By definition, the remainder component is the equity position. With an atypically low overall rate asserted by the assessing jurisdiction, the equity dividend rate will be atypically (and unacceptably) low relative to that needed to entice an investor into this particular real estate investment. This evaluation is conducted on a comparative basis comparing the assessment jurisdiction’s implied equity dividend rate, with less risky, more liquid, and non-management required alternative vehicles, e.g., the CD, Bonds, Money Market or Passbook Savings.

By employing a working forensic knowledge of the theoretical components of the overall rate, you can test and solve for reasonableness of both your asserted overall rate, and that of the opposing party.

As a side note, user beware of the possibility of skewing the OAR downward through manipulation of the NOI in the analysis of the few transactions that may be available, where reliable income data is not readily available from a knowledgeable source. This behavior is found within the category of appraiser-based data as opposed to market-based data.

For example, with recent market conditions, a spike in vacancy rates has been generally commonplace. Many data services track vacancy and report it to subscribers. More than a few times assessment jurisdictions have been observed substituting current actual market vacancy rates for anticipated stabilized rates applicable to the property in their imputed income pro forma. Out the other end comes an appraiser-based, artificially skewed, lower-than-market overall rate purportedly derived from a market transaction. This has been observed more frequently when fewer transactions have occurred and fewer details are available from parties to those transactions for analysis.

Practical Forensics

This sort of dissection doesn’t require any sort of advanced scientific approach. To mix metaphors, no rocket science is needed. The overall rate is a simple conversion rate that expresses the relationship between a market-based perspective of net operating income, and the price an investor would reasonably be expected to pay for the future benefits associated with owning that income. The components of the rate represent a multitude of assumptions, but are simplified into adequate returns, sufficient for both the debt and the equity positions. Through a thorough understanding of the rate components and the reasonableness and market-based support for the components as they interact to form the overall capitalization rate, we have a better understanding of capitalization rates even without a prolific amount of market activity.

Now, it’s time to sit on the curb, and ponder the reasonableness of the rate.

TODD S. LIEBOW, MAI, is a commercial and industrial real estate appraiser and an Executive Shareholder in the firm of PGP Valuation Inc located in Portland, Oregon. Mr. Liebow’s professional appraisal experience includes five years as a commercial and industrial appraiser for the Clackamas County Assessor’s Office, in Oregon City, Oregon. Since 1983, Mr. Liebow has been in private practice with PGP Valuation Inc, specializing in valuation analysis for ad valorem tax assessment appeals and other forms of litigation. Mr. Liebow is a designated member of the Appraisal Institute and is a past president of the Greater Oregon Chapter of the Appraisal Institute and the Oregon/Southwest Washington Chapter of the International Association of Assessing Officers. He has chaired the Portland Building Owners and Managers’ (BOMA) taxation and legislation committee and has been a member of the Associated Oregon Industries’ committee on property taxation. Mr. Liebow is also a member of the Institute for Professionals in Taxation and was the Chair of IPT’s 1997 Property Tax Symposium as well as the Overall Chair of the 1999 Annual Conference. He has served as a member of both the IPT Annual Conference and the Property Tax Symposium committees several times over the past 15 years. Mr. Liebow has authored several articles on the ad valorem assessment system and has lectured frequently on tax and valuation issues. Mr. Liebow is a founding shareholder of Lewis and Clark Bank, a community bank in Oregon City, Oregon. He serves on their Board of Directors and is a member of their Loan and Corporate Governance Committees. In recent years, he has addressed Appraisal Institute Seminars on “Valuation of Environmentally Impaired Properties” and the American Bar Association/Institute for Professionals in Taxation’s Advanced Property Tax Seminars on “How to Create an Effective Appeal Team”, “Common Errors in the Appraisal Process,” “Selection and Evaluation of Attorneys,” “Hot Topics in Appraisals,” and “Valuation of Commercial and Industrial Property — Beyond the Cost Approach.” He is a graduate of Lewis and Clark College, with a BA in Philosophy with Honors, 1978.

The last couple of years have represented a time in which markets stagnated, not solely due to the lack of available capital, but also due to the gap in expectations between buyers and sellers.  Sellers clung to memories of historically low capitalization rates and aggressive rent projections, while buyers assumed the worst in their cash flow analysis and disregarded cap rates altogether.  The chasm between buyer and seller over the last couple of years has been wide, to the point of stunting almost all activity in the market.  The result of the stagnation is that market values are relatively vague across most property types.

Most industry experts concur – the commercial real estate market trails residential and is affected by all the additional market conditions in play. When combined with the still-compounding effects of stock market fluctuations, increasing unemployment, decreased consumer spending (related impacts to retail sales and more), and ongoing corporate restructuring and downsizing to adjust to the greater cycle, conditions are likely to worsen in the short- to medium-term. Key markets such as New York are just beginning to feel the impacts of financial sector lay-offs with commercial space inventories dramatically increasing and residential foreclosures accelerating. These key markets set trends across other areas of the nation.

In addition, as financial institutions continue to flounder or be seized by the FDIC, related asset workouts are the growing trends. In the past, the FDIC would typically take over one bank in a time span covering years. In 2009, as reported on CBS’s 60 Minutes, the FDIC has seized over 50 banks to date and the number is growing. Sitting on the books of these failed financial institutions are portfolios of properties that must be immediately appraised for true, current value and factored against the market conditions in order to get them sold. A related increase of property sales to liquidate these assets, both previously foreclosed properties and those in active loan management, will have direct, negative impacts on the market through further increases in inventories and the liquidation of assets at drastically reduced prices to facilitate rapid disposition and cash flow.

With all of these factors in play, expect market participants in the future to be more realistic in their internal underwriting, but to place emphasis on initial cash-on-cash returns and a flight to quality.  Well-located and tenanted product will slowly begin to move again as the expectations between buyers and sellers move toward each other. However, the flight to quality will benefit the some markets sooner than other areas of the U.S.

Finding The Bottom Vs. Finding Value
by Jackson Cooper, SIOR, CCIM – Managing Director
Sperry Van Ness – Boise, ID

Arriving at a decision on the best strategy for how to successfully navigate the commercial real estate market during these challenging economic times is vexing to many an investor. Do I, or don’t I??? That is the conundrum facing most commercial real estate investors in today’s market. Do I, or don’t I liquidate my portfolio (or at least my non-performing assets)? Do I, or don’t I stand on the sidelines and wait-out these turbulent times? Do I, or don’t’ I get aggressive and take advantage of the decline in property values and the spike in acquisition cap rates? In the text that follows I’ll put forth counsel based not upon the emotions of the times, but rather the forthcoming advice is based upon my years of experience in successfully advising clients in both advancing and declining commercial real estate markets.

It is often said that you can only count on two things in life: death and taxes. There is a third thing that is often overlooked…market volatility. Whether markets are moving up or down isn’t really the issue. The issue is whether or not value can be added or created in the investment being considered. What tends to happen to the non-sophisticated commercial real estate investor is that they rely on upward moving markets to create value for them. If the market happens to move in your favor that is a plus, but it should not be the sole basis upon which your investment decision is made. You need to be able to add value to an asset through operational improvements, repositioning, restructuring, recapitalizing, re-tenanting, or other proactive strategic or tactical value enhancements. This is the mark of a savvy investor.

It doesn’t really matter whether you’re looking at the equity market, commodities market, bond market, the commercial real estate market, or any other investment market, as all investment markets have certain similarities…It is my hope that the following five points will be useful in refining your investment philosophy moving forward:

1.Market Timing: Let me be very blunt right from the outset…not only is it an exercise in frivolity to try and time a market bottom, but many significant investment opportunities will simply pass you by as you stand on the sidelines waiting for that almighty market bottom to occur. I know…smart investors buy low and sell high right? Sure, but there is a difference between recognizing value and opportunity that lead to superior investment returns, and trying to wait for that ethereal moment in time that represents the exact bottom of a market. Put simply, one in a million will correctly time a market bottom, while many investors will generate significant returns by exploiting the opportunities that a declining market provides.

2.Professional vs. Amateur Investors: Tough times tend to separate the wheat from the chaff. The challenge facing most commercial real estate investors today is to become honest with themselves in determining whether they are in fact astute commercial real estate professionals, or whether they were among the masses just riding a wave while it lasted. You see professional investors are always in the market…during good times and bad. They understand that more “lasting wealth” is created in declining markets than in overheated advancing markets. You see it’s the non-professional investor (stupid money) that is both late to the market, and then overstays their welcome by holding on too long. In point number 1 above I mentioned top of the market…Whenever you reach a point in the market where everyone (even your cab driver) is a “real estate investor” you know you’ve found the top of the market.

3.Invest in Opportunities not Asset Classes: The most successful investors are fluid in their approach…they see changes in the market as being synonymous with the creation of new opportunities. While I certainly understand the synergies that come from developing a niche focus, I don’t believe they can make-up for the increase in diversification and scale that comes by exploiting opportunities across asset classes. Are you a retail investor, or a commercial real estate investor? Are you a multifamily investor or a commercial real estate investor? You see it is my belief that the core of sound commercial real estate investing is present across asset classes. The same characteristics that make an investment attractive in one asset class are ostensibly the same in others. Location, current market dynamics, tenant mix and quality, entitlement and construction risk, absorption and vacancy (supply and demand), age and construction quality, micro and macro economics, NOI and valuation drivers, etc. are relevant regardless of whether you’re investing in industrial or office assets. Furthermore, it’s important to be flexible in the structuring of your investment opportunities. As an example as long as the risk/reward ration falls within your investment guidelines it shouldn’t matter whether you are a principal in entirety, have a limited ownership interest, where you investment falls in the capital structure or any number of other considerations. You either like the opportunity or you don’t…the rest of the issues are just details to be worked out at the negotiating table.

4.Understanding Opportunity: Rarely will you come across a static opportunity in the sense that it will stand idle and wait for you to act…Significant opportunities are not only scarce, but they typically operate on the principal of diminishing returns. The longer you wait to seize the opportunity the smaller the return typically is. In fact, more likely is the case that the opportunity will completely evaporate if you wait too long to seize it. Keep this thought in mind; when opportunity knocks…answer the door. I can’t even begin to count the number of times I watched people miss great opportunities due to a poor sense of timing. Not too surprisingly, people who possess a poor sense of timing usually don’t even understand timing is an issue. How many times have you witnessed someone holding-out for a higher price, better valuation, evolving markets, technology advances, or any number of other circumstances that either never transpires, or by the time they do, the opportunistic advantage had disappeared? I’ve observed the risk adverse take due diligence one step too far, the greedy negotiate too long, the impulsive jump the gun, and the plodders move to slow. As the saying goes “timing is everything.” The proverbial window closes on every opportunity at some point in time. As you approach each day I would challenge you to consistently evaluate the landscape and seize the opportunities that come your way. Better to be the one who catches the fish than the one who tells the story of the big one who got away…

5.Seeking Sound Counsel: The smartest commercial real estate investors surround themselves with professional advisors who extend their strengths, shore up their weakness, improve their access to market knowledge, and provide more visibility and broader access to investment opportunities. What really separates the successful investor from the average investor is that the successful investor has a broader sphere of influence and a larger network helping them to be successful than the novice investor. If you ever wonder why certain investors seem to get access to the best deals, it is usually because the professional investor simply enlists more resources working on their behalf.

My advice is this…don’t let the current market conditions intimidate you. Rather create an opportunistic approach to commercial real estate investment that will simply adapt your investment guidelines to the current market dynamics. There is every reason to get into the market and take advantage of once in a generation opportunities that exist now.

About the Author

Jackson Cooper, SIOR, CCIM is the Managing Director for Sperry Van Ness in Boise. He has served as a Senior Advisor for Sperry Van Ness for 5 years specializing in office, industrial, multifamily, hospitality, retail and land for development property transactions. With over 30 years of commercial real estate experience, his knowledge is leveraged through the innovative concepts of Sperry Van Ness. Prior to relocating to Boise, Idaho Jackson was the first Sperry Van Ness affiliate in Oregon and was honored in the Wall Street Journal as one of Sperry Van Ness’ top Advisors in 2004 & 2005.

To date Jackson has closed over 1 Billion dollars in sales transactions. Jackson is extremely active in the commercial real estate industry, holding the designations of Certified Commercial Investment Member and Society of Industrial and Office Realtors. He is a member of the National Association of REALTORS, Ada County Associations of REALTORS, Boise Metro Chamber of Commerce and Boise Chapter of BOMA. Jackson Graduated from Washington State University with a Bachelor of Arts Degree in 1970. Jackson is currently licensed in Idaho and Oregon. Through Jackson’s experience over the last 30 years he has gained local, regional and national expertise of market knowledge & trends. Along with the national platform of resources that Sperry Van Ness provides, Jackson can present each client with up-to-date analysis and state-of-the-art marketing concepts to maximize their investments.

For more information you can reach Jackson at any of the contact points listed below:
Email: cooperj@svn.com
Phone: 203.363.7000
Web: www.jacksoncooper.com
Copyright © 2009–Jackson Cooper
This Office Independently Owned and Operated
All information presented by Sperry Van Ness (SVN) has been obtained from sources deemed reliable.
SVN makes no representation with regard to the accuracy of the information contained herein.

The day of reckoning has long passed its arrival industry wide; the time to take charge of our future is now. Our challenge is three fold: how do we forget everything we have learned; yet, exploit all of the skills we have accumulated from years of experience; and, give up our mental memory of the future? We as real estate practitioners need to take charge, we need to build, we need to buy, we need to invest; so, we need to ask ourselves: What will it take to get back into the game? How we will stay relevant until that time for each of us arrives?

Real estate as an asset class always was a worthwhile investment for three reasons: we were led to believe that it was a hedge against inflation; it was an asset that you could buy with leverage; and, that the combination of safe leverage and rental increases were in some way driven by the existence of job growth across our economy.  In Q1 2009 the economy lost 1.9 million jobs and unemployment currently sits at 8.5%. Since 1939, our job growth over any 120 consecutive reporting months-a decade-has always been in excess of 12%. In January of 2010, we will acknowledge our own “lost decade” as there will be no effective job growth between January 2000 and January 2010. During the same time, we have added 13%-14% new office stock across the U.S. market place. This is clearly not good for the asset class.

Economists believe that unemployment will crest by the end of 2010. If history repeats itself, in 1986 and 1987 we had a valuation peak followed by financial crisis, followed by a political solution to the economic collapse. It wasn’t until 1994-eight years later-that the marketplace truly settled and began to grow. During 2006 and 2007 we had a valuation peak followed by extraordinary financial collapse and a political solution to this economic strife. If history repeats itself, we’re not back to a stabilized marketplace until 2014.

Accelerating or retarding the speed of recovery is the reality of a synchronized global recession. We have complications associated with a forecast of job loss or valuation loss due to the world’s increasingly interwoven economies and financial systems. As globalization speeds the flow of economic benefits in good times, in times of contraction, globalization transmits trouble with enormous speed and force affecting economies all over the world. Our economy shrank at a 6.3% pace at the end of 2008 which was the worst showing in more than a quarter of a century.

Unemployment rises, home values fall, and investment portfolios shrink so consumers cut back forcing companies to slash production and jobs. The U.S. consumer is 70% of U.S. GDP; the U.S. represents about 1/3 of the world’s GDP; therefore, the U.S. consumer is 20% of the world’s GDP. At the same time, we face growing protectionism sentiments across the globe verses our collective need to stay synchronized globally to get out of this recession. How do we get through the global recession that sees a great decrease in demand for all products let alone real estate space? When we emerge from recession to recovery, how do we have a sustainable path that makes good business decisions not just for one year, but for many years to come? If real estate is a “location” business, where is your business positioned to exploit the opportunities that 2009 and 2010 will bring forth?

A long period of healthy economic growth convinces people to take bigger and bigger risks. In the fall of 2008 former Chairman Greenspan insisted that the precipitating factor of the 2008 crisis was the failure to properly price risky assets. As you consider your play in this real estate cycle, consider your capacity to evaluate, analyze, identify, assess and price risk. You must consider the partners who have provided equity capital to your individual business plans as well. Without goal congruence as it relates to evaluation, analysis, identification, assessment and ultimate price of risk, the proverbial rug is likely to get pulled out from under your business plan. It’s bad enough that we stand on shifting sands vis-à-vis the regulatory ground rules that our government seems to be placing upon us. As we stabilize housing, fix the banking system, get credit flowing and re-regulate the financial markets-remember that hope and fear are inseparable. We need to ensure that those who provide the equity for America’s deleveraging are in sync with the real estate owners and operators as to how they identify, assess and price risk. We believe that investors like risk (volatility of outcome) so long as they can price it; but, what investors hate is uncertainty-not knowing how big a risk is. Markets buy and sell risk that is wanted and unwanted.

Real estate is about risk shift and the market place is where this shift (for price) takes place. Today however, capital “markets” seem to be an oxymoron. We don’t see capital flows returning to the levels we experienced in 2007. The combination of devaluation of assets, lower loan-to-value (LTVs) and decreasing velocity of transactional turnover should cover all but about $50-$70 billion of the capital needs of our industry. We don’t see securitized mortgage lending returning until there is stability in the interpretation of mark-to-market valuation as well as sale treatment by the accountants on the balance sheets of our financial institutions. Pricing of course will be critical for the “new securitized world” given the volatility (risk that must be priced) heretofore bond buyers have experienced since June of 2007. 

Today, the market doesn’t know what to expect. There is regulation uncertainty and there is a fear that regulation will change, leaving us regulation by deal. Can and will the government change the rules on the business community whimsically?

Money supply’s effectiveness depends on how quickly people spend it-that is called velocity. If people horde cash, velocity falls and more money is required to keep the economy moving. As velocity continues to fall faster than the Fed can pump up the money supply, our government must spend on goods and services. Yet Congress does not have its own stash. Every dollar it injects into our economy is taxed or borrowed out of the economy. Our economy has stalled, with insufficient aggregate demand, with a decline in demand for goods and services, sales fall. Production is cut, people are laid-off, unemployment rises and declining profits further depress demand creating a vicious circle. We have to increase demand through consumption, investment, net exports and government purchases. Cheap credit, the usual route to recovery has failed to work. Lenders have pulled back; borrowers are focused more on paying down debt and building up savings. Keynesian economists advocate increasing government spending to combat economic downturns and generate jobs.  

Motivations matter. Banks, whether they are local, regional or national interpret “troubled assets” and the use of TARP or PPIP money differently. “Toxic” to a local bank may be acquisition, development and construction loans for home builders while “toxic” for the largest banks in the globe may be mortgage securities. The motivations of banks differ from life companies (regulated by 50 different state regulators) which are different than the motivations of a securitized lender (and whether we are dealing with a trustee, a master, a primary, a sub, or a special servicer). In this market place knowledge matters, motivation matters, relationships matter.

Our future gets clearer every day. If our crisis was caused by a dramatic under pricing of risk, resulting from a combination of endless supply of capital and an insatiable appetite for leverage; then, our future is one of lower leverage, greater transparency, greater regulation and an organized marketplace where transactions are done responsibly. Regulation has the tendency to create accounting rules and capital requirements that aggravate financial retrenchment during a slowdown and financial access in a boom.

All real estate makes money; the only question is who owns it at the time.

Ariticle written by Jack M. Cohen, CRI, CMB, Chief Executive Officer of Cohen Financial

Download PDF article here

The dislocation in the commercial real estate capital markets that exists today in the second quarter of 2009 has frustrated users of capital and left them feeling hopeless. The small universe of debt and equity providers that are willing and able to provide capital today want to advance less loan dollars on your deal while also taking on less risk. Most of the time that means that it’s a deal you cannot make.  Thankfully, after successive quarters of bad news, most of us are past the denial stage and are making attempts to exist in a broken market.  The leverage being offered by capital providers today would make sense if cap rates were closer to double digits, but unless and until that market correction happens, there will be further frustrations as both borrowers and lenders are fighting to preserve their equity and maintain returns seen earlier in the decade.  The following are some survival tips that could help your deal:

1.    Focus on the borrower/sponsor.  If you haven’t already, organize all personal financial information into a well presented document that clearly lists all assets & liabilities as well as a schedule of real estate owned that includes mortgage data. Also include a resume with past projects that demonstrate you have the appropriate experience necessary to perform on the subject business plan. Borrower’s are being scrutinized much more today than during the last boom. Give the lender every reason to promote your deal up the food chain.

2.    Focus on operations. If vacancy is up in your submarket, make sure you have a documented plan for tenant retention & expense management. Include your managers and leasing brokers on every aspect of the plan that is appropriate.  A solid business plan will illustrate to a potential lender that you have your head in the game and make you someone they want to lend to.

3.    Reduce risk wherever possible. A development deal may need to move forward because of a pending land loan maturity.  Attracting a development loan will be difficult, but may be possible if you reduce risk by attempting to presale your development, in whole or in part, to a serious buyer who is willing to make a sizeable earnest money deposit. This could add a credit enhancement to your deal by showing the lender they have an exit with some teeth in it.

4.    Consider smaller investments (loans < $5 Million). The majority of debt providers who are in the market right now are making loans under this amount, thus increasing your chances.

5.    Partner up. A new equity partner, whether a local operator, a high net worth individual, or an institution, can provide additional loan guarantees on a new loan and could infuse cash into a lagging project that is facing a loan maturity. You dilute your ownership position, but you could save your investment and you may find a partner who will complement your weaknesses in areas such as cash, operations, local expertise, etc. 

6.    Adjust expectations for returns. The 55-60% loan to values we live with now vs. the 80%+ values we saw often during the last boom are requiring investors to use more of their cash to get into investments which puts downward pressure on leveraged returns. 

7.    Hire reputable CRE finance professionals. Ask around and commit to hiring a mortgage broker who you trust or comes recommended by someone you trust. It’s essential to exclusively engage a mortgage broker early in the process that will be accountable to you and the transaction. A mortgage banker plays a dual role by uncovering investments for the lender while sourcing the appropriate solution for the borrower. Look for brokers who receive their compensation from the borrower and not the lender.  It’s important to the deals success to have one professional as the single point of contact who is your advocate in the capital markets, much like you would have one listing agent. 

8.    Explore underlying loan assumptions & seller financing.  According to Real Capital Analytics April Issue of Capital Trends, more than 50% of deals being done right are being capitalized with assumable debt and/or seller financing.  This can be a good source of capital for someone who must transact because of a 1031 exchange deadline.

A lot of investors steered clear of this passive investment due to the lack of rent growth, the above market rents associated with these built-to-suit projects and the low going in cap rates. Additionally, the values for this asset class are directly impacted by cap rate trends; there is no opportunity to offset increasing cap rates with rent growth because the contract rent is typically flat anywhere from 60 to 75 years. An investor that purchased a Walgreens at a 5.75% cap rate should know that there is a good chance the property has declined in value in excess of 20% (assuming 7% & up cap rates).

The following analysis is a basic overview of how our company recently estimated the applicable cap rate for a Walgreens property in eastern Oregon.

Analysis

As will be discussed shortly in the National Investor Survey, capitalization rate have jumped recently. This is notably true for asking rates of Walgreens. The Seattle-based senior vice president of CB Richard Ellis’ net-leased group, Jeffery Thomas, was recently reported in February 2009 as saying that because debt markets have become increasingly unstable since the fall of 2007, there has been a significant increase in the number of Walgreens marketed at above 7%. He feels that the ones currently marketed below 7% are stagnating and will soon be re-priced at more realistic levels. This is noted in the following Current Listings Cap Rate Summation Table, where Comparable 6 was just recently re-marketed at a 7% capitalization rate, up from 6.75 in March, 2009. Finally, Jeffery Thomas was quoted as saying that “We fully expect to see the Walgreens’ average asking cap rate reach 8% at some point in 2009.”

The following table summarizes six current listings of Walgreens along the West Coast, with the majority of them located in the Pacific Northwest.

All three of the listings in Oregon have listing capitalization rates ranging from 7.2% to 7.5%. The one Idaho listing is being offered at a capitalization rate of 7.3%. The lowest capitalization rate (7%) is for the California listing, and it is noted that it was being offered at a 6.75% capitalization rate as recently as the end of March 2009. Noting that these are listings in a buyers market, they are likely slightly low to good indicators for the subject.

The following table presents the capitalization rate conclusion by the market extraction method.

Band of Investments Technique – Because most properties are purchased with debt and equity capital, the overall capitalization rate must satisfy the market return requirements of both investment positions. Lenders must anticipate receiving a competitive interest rate commensurate with the perceived risk of the investment or they will not make funds available. Lenders also require that the principal amount of the loan be repaid through period amortization payments. Similarly, equity investors must anticipate receiving a competitive equity cash return commensurate with the perceived risk or they will invest their funds elsewhere.

 To analyze the capitalization rate from a financial position, the Band of Investments Technique is used. Available financing information from lenders and the sales comparables indicates the following terms:

Equity dividend rates vary depending upon motivations of buyers and financing terms. Although investors have been accepting meager equity dividends in recent years as low as 4% for this property type, moving forward opportunistic buyers will be most active and will require higher cash-on-cash returns. This factor is somewhat tempered by the low returns being provided by alternative investment vehicles (stock market, bonds, etc). The previous terms and an appropriate equity dividend rate are used in the Band of Investments calculations, which are presented in the following chart.

National Survey – The investor pool for the subject property includes national, regional and local investors. While all three groups place emphasis on local cap rates, regional and national investors would also strongly consider national cap rate trends due to the potential to invest in other regions that are offering higher rates of return. The following table summarizes national cap rate trends for net-leased properties.  

The preceding table clearly shows that cap rates slowly trended upwards through the end of 2007 and the first three quarters of 2008. The rate of increase sharply escalated in the fourth quarter of 2008 when it increased by 20 basis points. The increase in the most recent quarter was even more pronounced when it jumped by 73 basis points. The year to year increase was nearly a full percentage point at 95 basis points.

Retail properties in the Oregon marketplace have consistently been trading at slightly lower effective cap rates compared to the national averages. The region’s resilience to the changing national real estate market is commendable; however, the sweeping change in the mindset of investors has caught up here as well. Due to the substantially reduced transaction volume (down as much as 75% in 2008), it is rather unclear when the inflection point occurred; nonetheless, local cap rates have bottomed out and are on the rise. Pinpointing the applicable cap rate for the subject using national survey data is somewhat subjective. The most reasonable cap rate that can be derived from this analysis is presented in the following table. 

Capitalization Rate Conclusion – For investments of the subject’s general size and price, and when sales activity is brisk with relative market stability, the Market Extraction Method is most often relied upon by buyers and sellers to develop cap rate decisions. However, recent events indicate rapid and profound shifts in the financial environment and the economy on local, national and global levels. The other two approaches developed have varying limitations, but generally support the upward shift in capitalization rates. Taking all these factors into consideration, the following table summarizes the various capitalization rate indicators and provides the final capitalization rate conclusion.

PGP Valuation and Colliers International have been able to keep pace with the changing market. Through our national platform of real estate appraisers and brokers, we are able bridge the gap between historical data and emerging trends.

There is uncertainty in the market from all sides. Buyers, sellers, owners, borrowers, lenders, brokers and appraisers continue to look at current and past events to project how the real estate markets will react in 2009. Below is summary of key factors that will impact the valuation of real estate in 2009:

Transaction Volume

There are simply fewer deals being done in the market at this time. Sales volume is off 50% to 75% in the major commercial brokerage companies. According to Real Capital Analytic’s quarter in review (Oct. 2008) sales volume is down 54% in term of total dollars and 50% in number of transactions between 2007 and 2008. However, much of this volume occurred in the first half of 2008 and year end number are anticipated to be further off – a trend that will likely continue into the first quarter of 2009. With fewer investment grade industrial properties on the market and limited recent sales to track value trends, market participants are uncertain in relation to key statistics such as capitalization rates and discount rates.

Financial Markets

There continues to be turmoil in the financial markets. Despite the recent government bailout program there is a lack of liquidity in the market. This makes financing large, institutional assets more difficult and resulted in as much as 50% of deals being done in market including assumed debt.

Leverage has changed dramatically. Highly leveraged deals with low interest rates and abundant capital fueled capitalization rate compression through 2007. With many lenders on the sidelines, lower LTV’s, and higher interest equity yields will play a larger part in pricing.

Impact on Capitalization Rates

There are two major issues to address on capitalization rates for institutional industrial investments: 1) financing, and 2) cash flow assumptions.

Financing

First, the lack of capital will continue to be a fundamental problem in the market. For those deals that can be financed, the terms are substantially different than in the recent past. Lower LTV’s, higher interest rates, shorter loan amortizations, and higher equity return requirements will result in higher capitalization rates.

Below are three scenarios. The first scenario is typical of a leveraged deal in 2007.

The next scenario shows how in 2008 loan terms have changed. By increasing the interest rate by 75 basis points, dropping the LTV from 70% to 65%, and decreasing the amortization period from 30 years to 25 years, the OAR increases by 40 basis points.

The concern in term of capitalization rates is that if equity requirements for near term cash flow increase (because there is less upside in value increase and rent growth) then the impact on capitalization rates will be higher.

Capitalization rates have seen unprecedented compression in recent years. This is due to greater leverage and more emphasis on future increases in value or cash flow. These two components have been significantly altered in today’s environment.

Cash Flow Assumptions

Many investment grade industrial properties are purchased based on a cash flow model. The most common is using Argus software to project a 5 or 10-year holding period.

If we hold discount rates and terminal cap rates level, there is still upward pressure on capitalization rates due to more conservative projection being made in today’s environment versus a year ago.

The Impact of Cash Flow Assumptions on Cap Rates chart is a case study analyzing a fully occupied 400,000+ SF distribution building with long-term NNN tenants using Argus software. Typical assumption for 2007, 2008, and a third scenario in which yield rate requirements go up are presented.

As the chart above demonstrates between the 2007 and 2007 columns, slight changes in cash flow assumptions have a significant impact on the capitalization rate. The impact would be greater if this property in case study did not have relatively long-term tenants.

It is apparent that the market is much more conservative on leasing assumptions and rental rate growth. The biggest question for 2009 is where yield rates (discount rate) will land.

The question of yield rates is difficult to quantify due to many major buyers being on the sidelines or unable to purchase assets at this time. The lack of financing and lower stock values have played a large role. With fewer buyers available, the remaining buyers should have opportunities to purchase assets with slightly higher yields that what they could have purchased in recent years.

In summary, the impact of financing, more conservative cash flow assumptions, and buyer’s able to achieve higher yield rates will push capitalization rates down through year end 2008 and into 2009. Many institutional investors are looking at discount rates from 8.00% to 10.00%, with most in the 8.50% to 9.50% range.

Capitalization Rate Survey

The previous analysis explains some of the why. The survey below is provided by Colliers International. It tracks capitalization rate trends from major industrial markets in the US.

What this means to Distribution/Warehouse Real Estate

In 2009, cash will continue to be king. There will be continued demand for good quality, stable, investment grade industrial products. However, pricing will be a contentious point between buyers and sellers. Many owners of good quality portfolios may hold their assets until some of the uncertainty subsides. Those products most impacted will be value added deals. One-off investments will continue to be in demand; however, there may be limited financing available in the short term for portfolio transactions.

One positive for industrial real estate is that its construction cycle is shorter than other product types. The market is therefore more responsive to soft demand and less likely to see oversupply. This diminishes risk for investors associated with rental rate decline or vacancy problems.

Contact for PGP Valuation’s Industrial Practice Group

If you have questions on valuation trends, please contact me:

Jeff L. Grose, MAI

Portland Executive Managing Director

Industrial Market Reports

  2009 PGP Industrial Market Watch (Puget Sound Area - Washington)

  2009 PGP Industrial Forecast (Portland)

  2009 1st Quarter - Industrial Market Report (Sacramento)

Despite a slightly rally on April 6th, equity REITs posted a 32% decline in the 1st quarter (FTSE NAREIT Equity Index). In March, REITs we up about 4%.

Shopping center and Industrial REITs were the worst performing sectors, each declining about 41% in the quarter. Manufactured Housing was the best performing sector, declining just 2%. Manufactured Housing is viewed as a more “recession proof” sector, which could benefit as people trade down to less expensive rentals.

We expect continued volatility in REITs over the next couple of months due to commercial real estate fundamentals, which are falling in most property types. If you jump into the sector, make sure you are diversified and only buy companies that have enough liquidity to roll over 2009 debt.

Going forward, our favorite sector in 2009 is Apartments and our least favorite is Office. Apartment owners will benefit due to a growing pool of potential renters and lower turnover. Office landlords are struggling due to the lack of corporate expansion; many companies are reluctant to take on new space until the economy improves.

Office vacancies are increasing in most regions in the U.S. Among our buys are apartment REITs, Equity Residential (EQR) and Mid-America Apartments (MAA), two REITs with minimal 2009 debt maturities and attractive valuations. 

Beginning in 2008, and carrying over into 2009, market conditions have led to a noticeable increase in capitalization rates.  These trends are a function of increased risk perceived by investors and more stringent lending conditions implemented by financial institutions.

As will be shown on the following pages, based various sources, capitalization rates have increase from about 50 to 150 basis points during the past 12 to 15 months. The result is that property values have declined commensurately. 

The upward trends in capitalization rates are evident from several different perspectives:

1. The most common method for analyzing capitalization rate from a financial position is the Band of Investment Analysis.

Also known as the mortgage equity analysis, this technique divides the net income between debt and equity positions. Available financing and required investor equity dividend rates are the components of this analysis. Current loan terms would be in a range of:

Mortgage Ratio:                                                     65%

Amortization Period:                                         25 years

Mortgage Interest Rate:                                         6.5%

Mortgage Constant:                                            0.0810

Equity Dividend:                                                 0.0800

These terms are used in the mortgage equity calculation, which is presented below:

BAND OF INVESTMENT TECHNIQUE
Component	%	X	Rate	=	Weighted Average
Debt	65%	X	0.0810	=	.0527
Equity	35%	X	0.0800	=	.0280
					.0807
Indicated Rate					8.1%

Mortgage Ratio:                                                     75%

Amortization Period:                                         25 years

Mortgage Interest Rate:                                         6.0%

Mortgage Constant:                                            0.0773

Equity Dividend:                                                 0.0700

Using these terms in the mortgage equity calculation, the indicated capitalization rate is 50 basis points higher:

BAND OF INVESTMENT TECHNIQUE
Component	%	X	Rate	=	Weighted Average
Debt	75%	X	0.0773	=	.0580
Equity	25%	X	0.0700	=	.0175
					.0755
Indicated Rate					7.6%

This analysis shows that even a slight change in the interest rate, or loan to value ratio, places upward pressure on the capitalization rate.

2. Comments from brokers in late 2008 and early 2009 indicate rates have increased about 100 basis points in the past 12 months, meaning a property that once traded at a 7.0% cap rate would now sell for 8.0%. 

One broker with Capital Pacific commented in March 2009 that rates for triple net leased real estate would likely be in a range of about 7.5 to 8.5%.

Another retail broker, Kevin Hemstreet, sold two triple net properties in August and September 2008 at cap rates of 6.6% and 6.9%, felt that cap rates would be between 7.75 and 8.0% today.

3. Korpacz Investor Survey, is a national survey of real estate investors and portfolio managers which shows a similar trend. The survey results pertaining to the National Net Lease market from the 1st Quarter 2009 are summarized below:

Source: Korpacz, 1st Quarter 2009  Investor Survey

This data reveals that average capitalization rates for the National Net Lease market have increased about 95 basis points over the past year. 

4. Regional net lease sales also provide strong evidence of upward trends.  Investor purchases of fast food restaurant buildings with triple net leases are charted below. 

TRIPLE NET LEASE SALES (1/08 TO 1/09)
Sale					Year			Cap
Date	Tenant	City	State	NRA	Built	Sale Price	PPSF	Rate
1/22/08	Carl’s Jr	McMinnville	OR	2,657	2007	$1,820,000	$685	6.0%
2/15/08	Izzy’s	Salem	OR	5,154	1982	$1,750,000	$340	5.0%
3/3/08	Starbucks	Syracuse	UT	1,750	2007	$1,300,000	$743	6.2%
4/4/08	Applebee’s	Pasco	WA	5,415	2005	$2,625,000	$485	6.9%
4/24/08	Jack in the Box	Grants Pass	OR	2,662	2006	$2,120,000	$796	6.2%
5/22/08	KFC/Taco Bell	Port Angeles	WA	3,200	1990	$1,335,000	$417	6.0%
6/3/08	Jack in the Box	Vancouver	WA	2,654	2007	$1,215,000	$458	5.6%
7/23/08	El Pollo Loco	Vancouver	WA	2,844	2008	$2,600,000	$914	6.7%
8/22/08	Jack in the Box	Klamath Falls	OR	3,000	2007	$2,400,000	$800	6.5%
9/23/08	Arby’s	Grants Pass	OR	2,700	2008	$2,100,000	$778	7.1%
12/1/08	Shari’s	The Dalles	OR	4,950	2008	$1,800,000	$364	7.7%
1/29/09	Taco Johns	Kennewick	WA	1,768	1981	$857,000	$485	7.3%
	Source:  PGP Valuation/Capital Pacific

On the following chart, the above data is plotted into a regression analysis, which clearly shows the upward trend in cap rates.

Based on this data, as of about one year ago, capitalization rates were about 5.75% and today would be about 7.5%. 

5. Impact on Value The relationship between capitalization rates and value is inverse and can be significant because capitalization rates are a highly sensitive input into the calculation of value.  Therefore, a slight increase in capitalization rates can have a dramatic downward effect on value. 

For example, if a property generating $100,000/year in NOI was purchased early 2008 at a 6.5% capitalization rate, the sale price would have been about $1,540,000 ($100,000 / 0.065).  Today, at a capitalization rate of 7.5%, the value would be about $1,330,000 ($100,000 / 0.075).  That suggests an erosion in value of $200,000, or about 13% ($210,000 / $1,540,000).

6. Looking ahead investors surveyed in the 1st Quarter 2009 Korpacz Investor Survey said they expect rates to increase another 50 basis points over the next 6 months. Again, these upward increases in cap rates are tied to economic conditions and more stringent lending requirements.

Like most other income property classes, with the exception of apartments, financing for self-storage properties has been hard hit with limited capital available in today’s market. Because of the management intensive nature of self-storage, lenders including banks and insurance companies who once were willing to fund loans on this property type have either taken self storage off their lending list or have tightened up underwriting parameters by decreasing loan to value ratios and increasing debt service coverage requirements. In general, underwriting Cap rates exceed 8.50%, loan to value ratios cap out at 60% and debt service coverage requires a minimum 1.30x. Only well located, seasoned and stabilized properties with sound management qualify for and have access to the lowest priced capital which in today’s market comes from a small group of insurance company lenders. Ten year fixed rates, in general start at 7.50% with the only nonrecourse money coming from insurance company lenders. 

Getting Your Property Financed
Being Capital Markets Savvy in a Down Economy
by Jackson Cooper, SIOR, CCIM – Managing Director
Sperry Van Ness – Boise, ID

I rarely have a conversation these days where the topic of financing doesn’t arise as a serious concern for my clients. When the economy is robust, and the capital markets are frothy, financing a commercial real estate transaction is a relatively simple matter. However during today’s recessionary times, the commercial capital markets are severely constrained. Not only is the supply of capital tight, but the demand may be near all time highs as well. Depending on which industry source you quote there is between $150 and $200 billion dollars of CMBS debt maturing in 2009 alone. This figure doesn’t include maturing loans from insurance companies, banks and other lenders, which means that many borrowers will be forced to secure financing in a market that presently offers little liquidity.

Given the current lack of liquidity and financing options described above, only the savviest of sponsors with solid projects will be receiving attention from lenders and investors. In the text that follows I’ll provide you with an overview of the information you need to possess in order to speak fluent finance and to increase the odds of getting your project financed.

The first thing to keep in mind is that financing serves multiple purposes beyond rate and term considerations. The proper financing strategy can allow you to increase project velocity, improve operating efficiency, conserve internal capital, increase leverage, and lower the overall cost of capital. Good sponsors focus on developing an integrated capital formation strategy surrounding acquisition, development, construction, refinancing and recapitalization initiatives. The following items are just a few of the things commercial borrowers need to address when seeking capital:

•The selection of the appropriate capital provider;
•Level(s) of the capital structure to be addressed;
•Operating considerations;
•Control provisions;
•Rate, term, pricing and structure;
•Closing time frame;
•Third party requirements;
•Certainty of execution;
•Recourse provisions;
•Exit and pre-payment options;
•Inter-creditor or other multi-party agreements;
•Post closing servicing issues;
•The effect of the capital acquired on tax, balance sheet, future projects or portfolio considerations, and;
•A whole host of other value-added considerations.

Possessing knowledge and understanding of the commercial capital markets is a critical factor in not only determining the eventual success of a single transaction, but also an entire portfolio or operating business. The first thing that borrowers must understand is that all capital providers are not created equal. There is a definite hierarchy within the world of capital providers, and understanding the value-ads offered by different capital providers is important in choosing a relationship. Understanding how to use different types of capital providers for different types of solutions/needs will be important to structuring the proper outcome. Approaching a lender for high leverage loan in today’s market without having your ducks in a row will prove to be next to impossible.

With debt service coverage ratios (DCR) nearing or even eclipsing 1.3 for many asset classes, advance rates on senior debt have certainly constricted requiring more mezz and equity investments for most sponsors to put a deal together. Making matters even more complicated is that there is no longer a clear division between debt and equity in the commercial capital markets. Given the ever increasing complexity of financially engineered structured finance solutions, it is essential for borrowers to develop a detailed understanding of the capital markets, and the structured finance options available to them. With the conservative advance noted above, it is critically important that you understand how to fill the increasing equity gap with the most affordable and effective capital markets solutions available.

The optimized use of structured finance solutions is one of the few arenas that allow commercial real estate owners to dramatically impact leverage, efficiencies and economies of scale across all business lines including acquisitions, financing ventures and operating activities. Structured finance is best defined as financially engineering the proper blend of debt, equity, synthetic, derivative, and hybrid capital in order to resolve particular transactional needs that cannot readily be met by conventional senior financing alone.

Structured financing allows for an engineered design and pricing of situation-specific financing instruments. Representative examples of typical situations that call for structured finance solutions include the following:

•Working around balance sheet or capital constraints;
•Shifting a higher percentage of the capital structure up or down in the leverage curve based upon current needs or market conditions;
•Attaining greater amounts of leverage at a lower blended cost of capital;
•Adding value and increased leverage to buyouts, yield-plays, recapitalizations, repositionings, and stress-   induced financial restructuring;
•Shifting risk and better managing control at both the project and entity levels;
•Releasing trapped equity in single assets or portfolios;
•Conversion of illiquid assets into tradable securities;

While many would choose to define structured finance in narrow terms, it is rather the limitless ability to engineer hybrid, synthetic or derivative instruments. This level of flexibility makes the engineered solution provided by structured finance so valuable. While current capital markets conditions have restricted the use and/or availability of some products, typical structured finance instruments include the following:

•Senior and Junior Mezzanine Debt;
•Straight, Convertible and Participating Second Mortgages;
•Preferred Equity Structures;
•Bond Placements, Tax Credits and other Municipal Finance Alternatives;
•Index or Currency Linked Strips;
•Swaps, Options, Caps, Collars, Swaptions, Captions, etc;
•Credit Enhancement, Financial Guaranties, Standby Commitments; Forward Commitments;

Understanding how to maximize all levels of the capital structure through the use of structured finance techniques when developing the capital formation plan on your next transaction will help you create a much more effective and efficient execution. The following items are just a few of the benefits of understanding how to engineer the right capital structure:

1. Use all levels of the capital structure to move up the leverage curve: By using the proper combination of senior debt, subordinated debt and third party equity, even in this market it is still possible to aggressively climb the leverage curve and still maintain control of the project.

2. Use different levels of the capital structure to prevent project ownership dilution: By using subordinated debt (seller financing or mezzanine financing) to fill as much of the equity gap as possible you will lower your overall cost of capital while not being forced to give up as much ownership in the project as you would by closing the entire equity gap with a joint venture equity partner.

3. Work the Lenders: In today’s market, lenders will often negotiate with borrowers where there is a benefit for doing so. It is quite possible to get a lender to write down or restructure the current financing on a property or portfolio to keep from taking back non-performing assets.

4. Negotiating the proper type of equity joint venture can be critical to the financial success of a project: If you move up the leverage curve with the proper combination of senior and subordinate debt the amount of equity needed from outside investors is minimized. Using the right preferred equity investment structure can leverage the sponsor co-invest to a smaller percentage of the project equity requirement while still leaving the sponsor with the majority of project ownership.

5. Individual Investors vs. Institutional Investors: Decide early where you choose to seek your capital partners and investors and be willing to live with your decision. With rare exception if a sponsor can meet institutional suitability tests they will be better served by accessing commercial capital markets rather than dealing with individual investors. Institutional investors have more knowledge and flexibility when structuring transactions giving owners more operating flexibility. Institutional investors have deep pockets and can provide the appropriate level of financing to allow sponsors to engage on multiple projects at one time thereby creating the ability to grow their business with greater velocity when contrasted to the leverage provided by individual investors. Additionally most institutional investors prefer passive investments and will only exercise dilution or control provisions in the rarest of circumstances. Lastly, institutional investors often times can provide tremendous non-financial value adds in the form of knowledge base, intellectual capital, market contacts and the like.

6.Resist the temptation to do “one-off” project level financings: Disparate financings at the project level can at a minimum restrict a borrowers future ability to cost effectively monetize on value creation by subjecting the property to pre-payment issues in the case of refinancing or disposition prior to the expiration of lock-out periods. Worse than trapping equity at the project level may be the fact that one-off financings restrict the ability to pool the asset with the balance of the portfolio creating a lack of optimized leverage and timely access to credit which in turn can create capital constraints by slowing acquisitions activities or operating initiatives. Lastly, large portfolios or even smaller sub-portfolios created by a multitude of one-off financings can create a management nightmare. This is due to constantly maturing debt rollover which will subject individual assets to credit, interest rate and market risk. This type of risk is not present when financing at the portfolio level due to the ability to trade in and out of collateralized pools where pricing, sizing and structural aspects are known constants.

The year ahead will definitely be challenging with regard to capital markets issues. Understanding how to access and maneuver within the commercial capital markets, and effectively leveraging the many benefits of understanding how to work the capital stack to your advantage may be the defining difference in optimizing the scalability and efficiency of your commercial real estate venture. Please take a moment to review my bio on the following page and feel free to reach me at any of the contact points listed below if I can offer any assistance to you. Thank you for your consideration.

About the Author

Jackson Cooper, SIOR, CCIM is the Managing Director for Sperry Van Ness in Boise. He has served as a Senior Advisor for Sperry Van Ness for 5 years specializing in office, industrial, multifamily, hospitality, retail and land for development property transactions. With over 30 years of commercial real estate experience, his knowledge is leveraged through the innovative concepts of Sperry Van Ness. Prior to relocating to Boise, Idaho Jackson was the first Sperry Van Ness affiliate in Oregon and was honored in the Wall Street Journal as one of Sperry Van Ness’ top Advisors in 2004 & 2005.

To date Jackson has closed over 1 Billion dollars in sales transactions. Jackson is extremely active in the commercial real estate industry, holding the designations of Certified Commercial Investment Member and Society of Industrial and Office Realtors. He is a member of the National Association of REALTORS, Ada County Associations of REALTORS, Boise Metro Chamber of Commerce and Boise Chapter of BOMA. Jackson Graduated from Washington State University with a Bachelor of Arts Degree in 1970. Jackson is currently licensed in Idaho and Oregon. Through Jackson’s experience over the last 30 years he has gained local, regional and national expertise of market knowledge & trends. Along with the national platform of resources that Sperry Van Ness provides, Jackson can present each client with up-to-date analysis and state-of-the-art marketing concepts to maximize their investments.

For more information you can reach Jackson at any of the contact points listed below:
Email: cooperj@svn.com
Phone: 203.363.7000
Web: www.jacksoncooper.com
Copyright © 2009–Jackson Cooper
This Office Independently Owned and Operated
All information presented by Sperry Van Ness (SVN) has been obtained from sources deemed reliable.
SVN makes no representation with regard to the accuracy of the information contained herein.

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Walgreens was founded in 1901, and as of March 31, 2009, operates 7,233 stores located in 49 states and Puerto Rico. This includes 59 stores in Oregon, 28 in Idaho and 111 in Washington. Walgreens opened 596 stores in 2008, a slight decrease from the 621 stores opened in 2007. Walgreens opened 69 drugstores during March, 2009, including 11 relocations. Walgreens stores generally range in size from 12,000 to 16,000 square feet, with the prototypical store being approximately 14,500 square feet.

The company is publicly traded on the NASDAQ National Market, the New York Stock Exchange, and the Chicago Stock Exchange under the symbol WAG, and is included in the Standard and Poor’s 500 Index and the NASDAQ 100 Index. Walgreens had fiscal 2008 sales of $59.0 billion, an increase of 9.7% from $53.8 billion in fiscal 2007. Net earning in fiscal 2008 were $2.16 billion, a 5.7% increase over $2.04 billion in fiscal 2007. Walgreens had March 2009 sales of $ 5.46 billion, an increase of 6.8 percent from $5.11 for the same month in 2008. Sales in comparable stores (those open at least a year) rose 1.5 percent, while comparable store front-end sales decreased 5.6 percent. Reportedly, March sales were hurt by last year’s March Easter compared with Easter being in April this year. Walgreens has recorded 34 consecutive years of record sales and earnings. As of the end of Fiscal Year 2008, Walgreens had total assets totaling $22.4 billion, an increase of $3.1 billion over FY 2007 ($19.3 billion). Moody’s rates Walgreens long-term debt Aa3 and short-term debt Prime-1. Standard & Poor’s rates Walgreens long-term debt A+ and short-term debt A-1. The outlook from Moody’s is stable, and the outlook from Standard & Poor’s is downward.

Drugstores have historically been fairly immune to recessions, but the current downturn appears to be adversely affecting the industry. According to IMS Health, prescriptions are growing at the slowest pace in 47 years. This appears to be the result of the recession and the fact the fewer new drugs have been introduced lately. Walgreens posted their second quarter results on March 23, 2009, and stated that net earnings for the quarter ending Feb. 28 decreased 6.7 percent to $640 million when compared to the same quarter a year earlier. Furthermore, first half net earnings decreased 8.2 percent to $1.05 billion, over the previous year. This is despite an increase in second quarter sales of 7.0 percent from the prior-year quarter to a record $16.5 billion, and an increase of 6.8 percent to $31.4 billion for the first half. Selling, general and administrative expense dollars in the second quarter increased 8.1 percent over the year-ago period, which includes 2.4 percentage points for Walgreens’ cost cutting initiative (”Rewiring for Growth”).

In response to this negative downturn and the protracted recession, Walgreens has launched cost cutting initiatives that they believe will cut $1 billion in annual costs by 2011, by reducing corporate overhead, increasing processing efficiency and improving their sourcing. In addition, Walgreens has announced that they are slowing the pace at which they are opening new stores. In 2008 their rate of growth was 9 percent, which is being gradually lowered to 5 percent by 2011.

Although Walgreens is slowing the speed at which they are opening stores, they are still expanding throughout the United States. The company’s business concept includes securing the most prime locations at signalized intersections. New Walgreens leases are effectively 25 years, with either ten five-year renewal options or the right to terminate annually after 25 years. Regionally, starting lease rates are typically 20 to 40 percent higher than starting leases for retail development with similar physical and locational characteristics; however, there are no lease escalations throughout the original term or the renewal periods. Due to the higher than typical starting lease rates and good investment appeal of Walgreens, developers are often able to acquire prime sites at above bare land value, while still realizing a large profit component.

There is still currently strong investor demand for Walgreens properties, as market participants are attracted to the absolute net lease structure, long-term lease, and strong creditworthiness of the tenant.

As I finished off my bear claw and thought things were finally wrapping up, a banker asked a question related to appraisals. My ears perked as the gentleman asked if appraisals were indeed contributing to the downward spiral in values. It seemed like a fair question; prices are negotiated based on other recent prices, which are affirmed and often modified after appraisers declare market value. The problem lends itself to the old complaint that appraisers are sitting backwards on a forward moving horse.

Gratefully, Dr. Hoenig accurately assessed that such a relationship between declining sale prices and declining appraisal values is usually a symptom rather than a cause. Appraisal report what is happening in the market. But, because the issue hits so close to home, I thought I would treat of what causes property values to decline from an appraiser’s perspective.

What causes declines in Market value?

 First let me preface my comments: Purchase price is not always equivalent to Market Value. For a myriad of reasons a seller or buyer may be willing to give or take on a purchase price for reasons unique to them. Market value is a theoretical value that assumes what a sale price should be between two very typical parties, each with equal skill sets and full knowledge of the property.

Consider this example: Royce the appraiser concluded that the Market Value for JoJo’s office building was $2,000,000 in 2006. Later, when asked to do the same assignment in 2009, he concluded Market Value to be $1,600,000. Only two things could have lead Royce to conclude a lower market value in 2009: the Net Operating Income (NOI) was significantly less in 2009 and/or market capitalization rates were significantly higher in 2009.  

Capitalization rates represent the ratio between annual net income and sales price. While the NOI may be falling at many properties (due to increased vacancy rates and/or more competitive rental rates), it almost certainly does not account for the entire value decline in this market. Major value declines also come from the changing status quo between buyers and sellers. Buyers have become much more patient and are expecting a much more favorable ratio between their NOI and purchase price. In other words, when there are fewer buyers (as often is the case in a down market) capitalization rates move upward.

In situations where there are recent comparable sales, anyone valuing a property can easily extract and apply very current and realistic capitalization rates to estimate Market Value. This is because during times of appreciation, the market is usually active. Extracting supportable capitalization rates is easy. However, when transactions are scarce finding market capitalization rates can be significantly harder. When this happens, oftentimes sellers have an unrealistic opinion of value because they are relying on dated capitalization rate sources.

Finding Market Capitalization Rates without Recent Transactions

When comparable transactions are not available, the appraiser’s best option is to look at the most recent transactions, assess how much economic conditions have declined since that time, and appropriately apply some type of upward adjustment to the dated capitalization rates.

How do you make that adjustment? How do you capture the subjective impacts of tighter lending standards and lower market confidence in a quantifiable manner? There are multiple ways to do this. Interviewing active brokers or other market participants for both general information and details on listings and failed transactions is a good place to start. Another option is the Underwriter’s Method. This method can give an appraiser a rough guideline of what a reasonable capitalization rate would be in the current lending and investing environment. Other ideas include going to other markets where recent transactions may have occurred. National surveys of investors provide yet another source that may be applicable to some property types. Explaining these methods and the pros and cons of each one will have to be saved for another article. However, I will say that each of these has strengths and weaknesses. In reality, a good appraiser should incorporate all of these into their capitalization rate analysis where appropriate.

When attempting to conclude a market capitalization rate in a down market, it is important to remember that these other methods take a hefty amount of market knowledge, reliable data, and astute judgment.

Bankers, brokers, appraisers, investors, and developers are all looking forward to when the bleeding stops and confidence again returns to the market. While in the past appraising was sometimes viewed as a necessary evil, market participants are now leaning heavily upon our work. More than ever an appraiser’s un-biased opinion combined with expertise of these complex issues can help buyers, sellers, lenders, and brokers make realistic informed decisions during a tough economic period. 

Introduction

There is broad sweeping change in the mindset of the World economy caused by the credit crisis, economic downturn and long-term uncertainty, which is having a profound impact on the real estate market. Our job as appraisers is to interpret what is occurring in the economy including supply/demand conditions, unavailability of financing, rising unemployment and alternative investment vehicles in order to credibly estimate the value of real property. The following information provides an introduction to the commercial real estate appraisal process, and summary statements with regard to how we are adapting our analysis to the changing economic conditions.

Appraisal: (noun) the act or process of developing an opinion of value; an opinion of value.  (adjective) of or pertaining to appraising and related functions such as an appraisal practice or appraisal service.

Appraiser: one who is expected to perform valuation services competently and in a manner that is independent, impartial, and objective.

Appraisal Process

1) Define the problem

• Identify the real estate
• Identify the rights to be valued
• Establish the intended user of the appraisal
• Determine the definition of value
• Determine the effective date of the appraisal
• Identify the scope of the appraisal
• Establish any assumptions and limiting conditions

2) Preliminary Analysis and Data Collection

3) Highest and Best Use Analysis

4) Land Value Estimate

5) Apply the Appropriate Valuation Techniques (Cost, Income, and Sales)

6) Reconciliation of Value and Final Value Conclusion

7) Report the Defined Value

Scope of Work: the type and extent of research and analysis in an assignment.

The scope of work is defined by the appraiser and the client.  However, the appraiser can not limit the scope of work to such a degree that is jeopardizes the reliability of the value conclusion.

The most common value scenario requested is the As Is Market Value.  Market Value is defined below:

The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently, knowledgeably, and assuming that the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:

1.     Buyer and seller are typically motivated;

2.     Both parties are well informed or well advised, and acting in what they consider their own best interests;

3.     A reasonable time is allowed for exposure in the open market;

4.     Payment is made in terms of cash in United States dollars or in terms of financial arrangements comparable thereto; and

5.     The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.

Office of Comptroller of the Currency (OCC), Title 12 of the Code of Federal Regulation, Part 34, Subpart C – Appraisals, 34.42 (g); Office of Thrift Supervision (OTS), 12 CFR 564.2 (g); This is also compatible with the RTC, FDIC, FRS and NCUA definitions of market value.

The scope of work may be defined by the appraiser, however, the scope of work must meet or exceed 1) the expectations of parties who are regularly intended users for similar assignments; and 2) what an appraiser’s peers’ actions would be in performing the same or similar assignment.

Appraisal Reporting Options

An appraiser has 3 options for written reports:

Self Contained

Summary

Restricted Use

Three Approaches to Value

• Cost Approach
• Income Approach
• Sales Comparison Approach

Cost Approach

The cost approach is based upon the principle that the value of the property is significantly related to its physical characteristics, and that no one would pay more for a facility than it would cost to build a like facility in today’s market on a comparable site. In this approach, the market value of the site is estimated and added to the estimated depreciated value of the improvements.

Or

Replace Cost of Improvements w/ profit – Depreciation + site value = Cost Approach Value

Replacement Cost New

All costs to construct

• -Direct Cost (materials, labor, contractor overhead)
• -Indirect Cost (perm. financing, marketing, professional reports)

Sources for Data: Developer’s Budget, Cost Comparables, Marshal Valuation, Bids

(+) Profit

Sufficient entrepreneurial incentive to compensate risk

• -Varies based on market sector

Developers (10-20%)

Users (5%)

Sources: Market survey, alternative investments

(-) Depreciation

Three Types

• -Physical (typical wear & tear)
• -Functional (obsolescence due to design)
• -Economical (surrounding influences)

(+) Land Value

Cost of equivalent substitute site

• -Valuation techniques

Sales comparison (most typical)

Residual analysis

= Cost Approach Value

Most Applicable for:

• New or proposed construction
• Owner/user properties
• Special purpose properties

Limited Application for:

• Investment properties

-mostly to test financial feasibility

• Older construction

-difficult to measure accrued depreciation

Cost Approach in a Declining Market

Many new projects are not financially feasible.  The lease-up or absorption/sell-out of a project becomes extended.  Many projects appraised 18 months ago that are nearing completion are no longer profitable due to extended marketing periods.

Replacement cost becomes a less reliable indicator of market value.

Land value assumptions change. In an active construction market, land is purchased for immediate development. If a development parcel is purchased now, the buyer’s assumption would be to hold until development is feasible.  Additional holding costs may require a downward adjustment to the land sales that sold in 2007.

Income Approach

In the Income Approach a property’s capacity to generate income is analyzed, which is in turn capitalized into an indication of present value. Two fundamental methods are used in this approach, Direct Capitalization and Yield Capitalization, which are described below:

• Direct Capitalization Method – The advantages of direct capitalization are that it is simple to use, easy to explain, often expresses market thinking, and provides strong market evidence of value when adequate sales are available. Direct capitalization is most commonly applied by applying an overall capitalization rate to relate value to the entire property income (i.e., net operating income).
• Yield Capitalization Method – This method is typically referred to as a Discounted Cash Flow Analysis. Market supported assumptions and projections are made for future changes in occupancy, rents, income, and expenses to arrive at periodic cash flow. The property’s eventual reversion is also estimated, incorporating anticipated changes in the property and market conditions. The resulting cash flows are discounted to a present value indication using an appropriate market supported yield rate.

Direct Capitalization – Most Commonly Used

The following steps create a basic outline of the income approach:

• Estimate income
• Estimate Vacancy and Expenses
• Derive an estimate of Net Operating Income (NOI)
• Derive a capitalization rate from a) market sales, b) band of investment analysis
• Divide the NOI by the Capitalization rate to estimate the value

The fundamental principle in this approach if anticipation.  The anticipated risk associated with the income stream is implicit in the cap rate.

A basic Income Approach is:

Potential Income – Vacancy = Effective Gross Income

Effective Gross Income – Expenses = NOI

NOI /Capitalization Rate = Value

Limitations - The limitations of this approach include:

• Lack of recent, directly comparable rental rates
• Lack of market transactions from which to derive a reliable capitalization rate

Common Mistakes - Common mistakes made by market participants include:

• Understanding the difference between current income and potential income and between fee simple and leased fee value
• Estimating appropriate expenses
• Understanding the structure of the leases in order to measure appropriate expense reimbursements when applicable
• Deriving an appropriate capitalization rate based upon the risk factors of the property

Income Approach in a Declining Market

The Income Capitalization Approach is the best measure of value for income-producing investment properties. One challenging task in the current economy is accurately estimating market rents, which requires the appraiser to measure the impacts that softer market conditions are having on rents.

Without a doubt, the most difficult and important modifications to our appraisals are occurring in the capitalization and discount rate analysis. Due to the drastic decline in investment sales over the past year, it takes a lot of creative analysis to reasonably estimate current capitalization rates. We look in the rearview mirror on past transactions, consider current listing and review national trends in order to provide the most reasonable estimate.

Sales Comparison Approach

The Sales Comparison (Market) Approach is based on the principle of substitution, which asserts that no one would pay more for a property than the value of similar property in the market. In this approach, the subject property is compared directly with other recent sales of similar properties in the marketplace. This comparison is typically accomplished by extracting “units of comparison,” for example, price per square foot, and then adjusting these units of comparison for the comparable sales for differences between the subject and each comparable.

The reliability of an indication found by this method depends on the quality and quantity of the comparable data found and the ability of the appraiser to make reasonable and supportable adjustments. In active markets with a large number of sales that are physically similar comparables, this approach is generally a good indicator of value.

Sources of Comparable Data

• Buyer
• Seller
• Brokers
• Public records
• Professional data companies
• Multiple listing services
• Other appraisers

Typical Units of Comparison

• Price/SF of gross building area
• Price/SF of net building area
• Price per unit (apartments, self storage, hotels, health care)
• Price per seat (restaurants and theaters)
• Price per door (truck terminals and distribution centers)
• Price per boat slip (marinas)
• Price per parking space (parking decks)
• Price per hole (golf courses)
• Price per lane (bowling alleys)
• Price per lot or pad (subdivisions, mobile home parks, RV parks)

Most Applicable for:

• Owner/user properties
• Special purpose properties
• Any property (retail, office, etc.) where sufficient data is available

Sales Comparison Approach in a Declining Market

Limited sales activity is making the sales approach more difficult. Investment sales are off 60% to 80%.  As much as 50% of those sales now include assumed debt.

The factors affecting value and pricing have changed. This includes buyer’s assumption on the future. For example, capitalization rates at 6% and investors IRR of 15% imply substantial increases in income over a holding period. With flat rents, higher vacancy costs to ownership, difficulty financing, the conditions in which sales took place in 2007 are much different that they are today.

Appraiser now need to do a better job interviewing brokers, analyzing active listings, and drawing a conclusion from possibly older sales prior to 2007.

W. Grant Norling & Jeff Grose, MAI presented the previous discussion with Perkins Coie LLP on Thursday March 19th of 2009. If you would like to meet with them to discuss anything further feel free to get in contact with W. Grant Norling at grant.norling@pgpinc.com

You can view and/or download a PDF version of the above presentation in the iPaper document displayed below.

Figure 1 “You can see we are in trouble, right?”

The answer appears to be yes. Costar talked with a few national shopping center landlords in a recent article by Sasha Pardy. The article discusses a laundry list of national retailers and how they are dealing with the economic downturn. However, there was a good deal of discussion on how landlords are dealing with rent reduction requests. It appears that tenants being granted relief are a drop in the bucket compared to those asking. Particularly interesting viewpoints came from Regency Centers and Kimco; their viewpoints are presented in the article are below:

REGENCY CENTERS
Mary Lou Fiala, president and COO of Regency Centers, said in the company’s Feb. 5th quarterly conference call, “Regency is receiving requests for rental assistance from a great number of tenants. There is a few people that we’ve made exceptions for.” The decision is made tenant-by-tenant, explained Fiala, adding that Regency requests three years of sales information, income statements, and credit applications from tenants, as well as a recovery plan.
In the case that rent reduction is granted, Fiala said, “any reduced rent is deferred and not forgiven.” She said that only 37 of Regency’s 9,000 tenants had been granted such reductions in the last month, “and in 28 of these cases, we were able to extend term of the lease.”

KIMCO REALTY CORPORATION
David Lukes, EVP at Kimco Realty Corp., said in the company’s Feb. 5th quarterly conference call, “We are preparing for a continued difficult time for our tenants and are forecasting continued weakness and uncertainty. The ability of a tenant to prosper is partly due to their cost of occupying their real estate.”
“We have a detailed concession request package that we’ve developed that’s required…and are using occupancy costs, financial help and sales history to separate the tenants that truly need help from those that are merely following the saying, ‘you don’t get it if you don’t ask,” explained Lukes. To date, the number of requests Kimco has granted are “minimal” compared to the number of requests it has received, said Lukes.

Read more of Sasha Pardy’s article on Costar

National Dealership Trends

General Auto Dealership Trends - Typically, recently constructed auto dealerships include showrooms and service facilities and range from 20,000 to 70,000-SF+ GBA and include a substantial associated site for storing and displaying their inventory. Generally the “Big 3″ dealerships (Ford, General Motors and Chrysler) have the largest dealerships, including associated site areas; however, some of the specialty dealers have larger enclosed showrooms. Even with their expansive dealerships and traditionally high inventories, the “Big 3″ appear to be losing ground in the U.S. marketplace. In 2008, Toyota and GM were the two top selling brands in the U.S. Thus, the “Big 3″ description is not as true today as it was ten to twenty years ago.

One trend in auto dealerships is the emergence of Auto Malls, which are auto sale districts typically located on the periphery of a city or market area. These “Auto Malls” are slowly replacing the existence of auto dealerships in city neighborhoods or in downtown locations. Our sources indicate that most auto dealers prefer to be located close to the synergy of other dealers, which is viewed as a strong marketing tool.

Another trend is the emergence of service as a main profit center for dealerships.  The number of bays and the enclosed service drop-off area are viewed positively. This is especially true in a time of economic uncertainty, when people retain their cars longer and require additional service.

National Industry Trends

IBISWorld Inc. is a market research organization that publishes quarterly reports on industries throughout the world. New Car Dealers in the US was updated January 22, 2009 and included a special Recession Update. IBISWorld begins its Recession Update with the following statement: “IBISWorld believes that the impact of the current recession on this industry will be disaster.” They state that total unit sales in 2008 dropped 18.6% from the previous year, reaching just over 13 million cars. Their prediction is that 2009 and 2010 will continue the downward trend in unit sales. In 2008 passenger cars outsold trucks and SUVs for the first time in eight years. Consumers will continue to move away from these more profitable larger vehicles, resulting in a decline in revenue that IBISWorld predicts will be greater than 12% in 2009.

IBISWorld predicts that a number of dealers will be forced to close before the economy recovers, which they predict will occur in the second quarter of 2010. Recovery for dealerships will be even longer as IBISWorld predicts profit margins to remain low, not exceeding 1.3% in the next five years. Historically, mergers, acquisitions and manufacturers’ efforts to reduce dealership points have been the main reasons for the decline in the number of dealerships. Future dealership closings may likely be due to decreases in profit squeezing dealerships out of the market. The following tables show the historical and forecasted revenue and revenue growth rate within the industry.

The main three reasons give for the prolonged decline through year-end-2010 is three fold. First, buyers will be kept out of the market due to falling resale values (the decreased equity of their trade-ins makes new cars too expensive). Secondly, sales financing is declining with many manufacturers finding that they simply cannot afford it. Finally, the deteriorating economic conditions are expected to remain for a couple more years.

IBISWorld believes that the recovery period from 2011 onwards is forecast to be considerably better compared to the previous decade. House prices will rise, vehicle trade-in values will increase, and various new products will begin to enter the market. During this period, new product innovation will be key to the industry’s success as consumers are expected to want more alternatives to gasoline powered products, with environmental considerations expected to play an increasing role in decision making. Finally, IBISWorld anticipates that consolidation will continue to occur in the industry in an effort to become more cost efficient and gain market share.

NADA DATA, as reported in AutoExec Magazine, is the National Automobile Dealers Association’s annual analysis of the U.S. car and truck industry, with emphasis on the retail side of the business. As of the date of this appraisal the 2009 report had yet to be published, so the data in this section is from the 2008 report, which covers the industry in 2007 and the first quarter of 2008. Per NADA DATA, the nation’s franchised new-car dealers sold 16.1 million units in 2007, down slightly from the previous year’s 16.5 million. The health of automotive dealers is very closely tied to the health of the overall economy. Even in 2007 when the economy was still growing with low interest rates and low unemployment, rising fuel costs and uncertainty in the Middle East contributed to operating profit contracting by 3%.

The industry generally acknowledges that there remains an excess number of new-vehicle dealerships. This is being dealt with by consolidation, acquisition by larger dealer groups, and manufacturers making efforts to reduce or freeze the number of dealership points. The following table shows the decline in the number of dealerships over the last 20 years.

In comparison the following table shows how many new dealerships were opened in each state.

It is important to note that the decrease in dealerships over this period has primarily occurred due to smaller volume dealers going out of business. Per the NADA, in 1988 there were 7,007 dealerships with sales levels of less than 150 new vehicles per year. As of May 2008 the number of dealerships with such low volume had shrunk to only 3,336 dealerships. In comparison, there are 12,200 dealerships that now sell more than 400 new cars per year, while in 1988 there were only 10,162 dealerships selling a similar volume.

NADA estimated that at the beginning of 2008 there were 20,700 new-vehicle dealerships. The average sales per dealership in 2007 was $33.4 million, and dealership sales accounted for 18% of total retail sales in the United States. The percentage of retail sales shows a sharp drop from the previous year when it was 22.9%.

Over the past several years, manufacturers have focused on returning to profitability by adjusting inventory to fit demand (fewer trucks and SUVs, but more fuel efficient and hybrid vehicles), but as stated previously, the 2008 sales volume has continued to decrease. High gas prices in mid-2008 also had an effect on vehicle sales and buying trends. Most analysts forecast that the decline will continue into 2009. Optimistic projections for 2009 are about 13.5 million vehicle sales. Paul Taylor, chief economist for the National Automobile Dealers Association reportedly predicted 13.1 million vehicle sales for 2009. The optimistic projections see a rise in sales in the second half of 2009. This optimistic projection is just marginally higher than the IBISWorld estimate that 2009 sales will not top 13 million.

One key to maintaining a high sales volume in the past was dealer incentives. The average incentive is estimated at $2,500 per vehicle, with widespread discounts including rebates, low to zero percent financing, and lately “employee discounts” to the general public and “free gas” or “$2.99/gallon gas for two years” which was popular when gas prices were above $4.00/gallon in the summer of 2008. Incentives reached a high of $2,603 in 2004 and the average in the first quarter of 2008 was about $2,500. Incentives increased at the end of 2008 due to falling sales volumes. This has been confirmed with many brands offering cash back incentives as high as $6,000 and employee pricing. Many brands with their own financing arm are also offering 0% interest to qualified applicants and “employee pricing”.

As was noted previously, 2008 was the first year that light trucks were outsold by passenger vehicles. Light trucks accounted for 53%of the total light vehicle sales in 2007. The ten year average was 51.3% with a high of 55.5% occurring in 2004. Sales declined in 2007, with the popular Ford F Series declining 22%, even though it remained the best selling vehicle in the country for the 31^st straight year. Truck sales for all manufacturers declined and Toyota missed its sales target for the well-reviewed Tundra by 200,000 vehicles. The decline in pick-up sales is not good news for manufacturers who look at pick-ups as a steady supplier of profits. The demand for crossover utility vehicles (CUVs, which are all wheel drive vehicles built on a car platform rather than a truck platform) will be a continued source for growth in the light truck segment. CUVs are gaining in popularity over the traditional SUV due to their higher gas mileage.

Another segment showing growth is the sale of hybrid and flexfuel vehicles. Automakers such as Toyota and Honda have experienced high demand and waiting lists for popular hybrid vehicles such as the Prius and the fuel efficient Honda Civic.

The 2008 NADA report indicated that of the big three auto makers (GM, Ford, and Chrysler), Chrysler had the lowest market share (12.90%) in 2007. By comparison, GM had a 23.77% share and Ford had a 15.55% share. These three brands had a decline in market share from 2005 thru 2007. Asian manufacturers had the strongest year-over-year performance from 2006 to 2007, with Toyota’s market share increasing from 15.41% to 16.29% and Honda’s market share increasing from 9.15% to 9.64%. Toyota continues to gain ground in the U.S. market and surpassed Chrysler in market share in 2006 and Ford in 2007. GM and Toyota are locked in a close battle for the No. 1 worldwide leader in global sales. Other imports also experienced a slight increase from 12.41% share to 13.19% share. European brands have faired worse than domestic brands and imports. Throughout 2008 all manufacturers have seen drops in sales volumes due to the global economic downturn. Brands offering hybrids and smaller economic vehicles have faired better than brands offering primarily trucks and SUVs.

In recent years (particularly in mid-2008), escalating gas prices have resulted in a shift in attitude for buyers, with a growing number of people making fuel economy a primary concern. Although gas prices have currently dropped to about $2.00/gallon from about $4.00/Gallon in mid-2008, most industry experts believe that fuel economy will remain a concern to consumers. A 2006 survey by Consumer Reports says that 37% of people in the market for a vehicle want a more fuel efficient model than they currently own. Over the prior decade, fuel efficiency was only a fleeting concern as buyers preferred larger vehicles with engines that are more powerful. Some luxury brand sales such as Cadillac remain strong. Overall, the market is in flux while buyers and manufacturers evaluate the long term impact of expected continued fuel price increases. As a result of higher gas prices, hybrid vehicles have experienced strong demand and increased sales.

A design element that has helped Honda gain ground in sales in 2008 is their flexible U.S. factories and vehicle design. Their trucks and CUVs have the same platform as their cars. This allows Honda to change a factory production line in as little as ten days to adjust to market demand.

National Dealership News – The following is a collection of news reports over the past several years that demonstrate the current auto dealership trends in North America. Much of the news pertains to the U.S. automakers’ focus on returning to profitability. All three Detroit auto makers made sizable cuts in 2008 production due to declining sales and losses.

Toyota – Toyota is the world’s largest car manufacturer and maker of the luxury brand Lexus. In an April 2008 report, Toyota and Scion inventories in the U.S. are at record levels, because of the production of pick-ups and SUVs and the company’s misjudgment about how much the U.S. market would decline. In mid-2008 Toyota reportedly slashed its 2008 earnings forecast to less than a third of what it was in the previous fiscal year. In February 2009, Toyota announced that it was heading for its first net loss since 1950, and expects the net loss to equal $3.9 billion. This is a sharp drop from their record net profit of $18.7 billion in 2007. They blame the loss on plunging sales and a strong yen.

Ford – In 2006, the Ford Motor Company announced a restructuring plan to reduce its work force by about one third. Reportedly this plan is an attempt to regain profitability. As of the first quarter of 2008, Ford announced that internationally it showed a profit although national sales continue to delay profitability in the U.S. In the past three quarters Ford has posted huge losses, similar to the other major auto manufacturers. In fact, Ford has ended 2008 with a $5.9 billion net loss. In other news, it was announced April 23, 2008, that the sale of Ford’s Land Rover and Jaguar divisions to India’s Tata Motors Ltd. was approved by the U.S. Federal Trade Commission. The sale was reported at $2.3 billion.

GM – In April 2008, GM announced it will lay off 3,550 employees. Many of these will be white collar jobs. A July 2008 news report stated that GM may consider discontinuing or selling some brands such as Hummer, Buick, Pontiac, Saab and Saturn. However, a GM spokesman reported to NADA that only the Hummer brand is currently under review. In October 2008, GM announced further layoffs and plant closures. In November, GM reported past quarter losses of $2.9 billion and forecasted they have funds for only 9 months business operations and requested a government loan of $15 billion to remain in operation. October sales of GM products fell 45%. A similar drop was reported by other manufacturers: Ford sales dropped 30%, Chrysler sales fell 35% and Toyota sales fell 23% in October.

Chrysler – In May 2007, Daimler Chrysler AG reported that they had agreed to sell 80% of Chrysler to Cerberus, a private equity firm for $7.4 billion dollars. Although there are concerns about layoffs and restructuring of the manufacturing division, shareholders reacted positively on Wall Street. In mid-2008 there were reports that GM was in discussions with Chrysler for a possible merger or acquisition. This likely would not occur until the international and national financial crisis subsides.

Dealership Closings – USA Today (story from NADA Headline) reported that car dealers have begun to focus on weeding out weaker dealers in an attempt to regain profitability. In 2007, GM reduced its number of dealerships by 229 to 6,807. They plan on reducing this number with an additional 1,750 showrooms closing in the next four years. Ford shrank by 139 to about 4,140 in July 2007, and Chrysler eliminated dealerships to about 3,300 and expects to close more showrooms in the following years. An October 28, 2008, story in the Wall Street Journal reported the total number of new car dealerships to close in 2008 will be about 700 (590 through September according to NADA). One hurdle in closing dealerships is franchise laws and possible legal action from dealers who may require a buy-out from the manufacturers.

In local news, the Oregonian reported in June 2008 that Oregon-based car sales giant Lithia Motors announced it aims to sell 15 of its 110 stores (located in 15 states) in a cost cutting move.

The most serious concern for dealerships across the nation has become liquidity and financing for inventory. Many lenders are adjusting financing terms for inventory credit with many local banks declining to offer inventory financing.

Federal Bail-out – The U.S. Senate discussed a plan to take up a $25 billion bill on November 17, 2008, to bail out distressed domestic auto makers.  The total bill sought by Democrats could be as high as $50 billion. Reportedly, the GOP was opposed to the bail-out, even if it meant bankruptcy to some domestic manufacturers. The $25 billion was likely to come out of the $700 billion Treasury Department bail-out program, but this plan was being opposed by the Bush Administration and the GOP.

In late December 2008 the U.S. government authorized a $13.4 billion credit lifeline to the U.S. auto manufacturers. (Canada also announced a $3.3 Billion rescue package for GM and Chrysler subsidiaries operating in Ontario.) GM and Chrysler reportedly received $4 billion in bridge loans to keep them from running out of cash. This $13.4 billion lifeline is far less than the amount originally requested by the auto manufacturers and some economists predict the financial situation of the auto manufacturers will continue to decline in 2009.

The Federal Reserve has also approved GMAC Financial Services’ request to become a bank holding company, allowing it to apply for a portion of the $700 billion bail-out fund and get emergency loans direct from the Feds. Analysts had speculated that without financial help, GMAC would have had to file for bankruptcy. About 85% of GM’s North American dealers are financed through GMAC.

Service Trends - Over the past decade, there has been a growing emphasis on the service department as a profit center. The following table shows net profit trends of new car sales, used car sales and service/parts department net profits for the average dealership. Figures are estimated based on bar charts reported by NADA’s AutoExec Magazine, May 2008. As sales continue to be soft in 2008, dealerships will rely on service as a major contributor of revenue.

Source: NADA, AutoExec Magazine, May 2008

Generally, net profit achieved from service and parts has increased annually from 2001 through 2006, and remained steady in 2007. Net profit from sales of new cars continued to decline in 2007. The net profit from the sales of used cars fluctuated year-to-year. Over the past several years, dealerships have relied on used-vehicle sales for profits because of the modest return (or loss) on new vehicle sales. Profit for 2005 declined in new vehicle sales from 2004 due to large dealer incentives and large inventories. In 2006, net profit from new vehicle sales posted further declines, slipping below break-even. The trend continued in 2007. Profit from service and parts continued to show an annual increase in 2006. This source of income has led many dealers to increase the size of their service areas and become more competitive with after market repair facilities with the intent of expanding this steady profit component.

Regional and Local Trends

Interviews: To keep up with changing trends, we interviewed a number of knowledgeable market participants. Of particular note, the director of the Oregon Auto Dealers Association, Greg Remensperger, and the director of the Oregon Vehicle Dealer Association, Inc., Monty King, were both interviewed in the middle of 2007. Admittedly, much has changed in the last year and a half, but this information is included as a frame of reference to see the direction that the industry is moving. We attempted numerous times to contact Mr. Remensperger, but he was unavailable due to the Portland Auto Show occurring at the same time that this article was prepared. Mr. Remensperger’s organization deals primarily with new car dealerships and Mr. King’s organization deals exclusively with used car dealerships. Both of these gentlemen were interviewed separately, but on the whole their responses were mostly similar.

In 2007, Mr. Remensperger stated that the decline in new auto dealerships in our region could mostly be explained by consolidation. In the past, manufacturers sought to saturate the market by having separate dealerships for each of their divisions, i.e., four separate dealerships for Chrysler, Dodge, Plymouth and Jeep. Now they prefer to save costs by combining theses dealerships under one roof (much the way Plymouth was dropped altogether). He also said that their strategy is to have a customer come in to buy a Dodge, but walk out with a more expensive Jeep or Chrysler. At the time of the interview, Mr. Remensperger could only recall one franchise dealership that has closed its doors and was not consolidated elsewhere. In this case, the competition bought out his franchise and allowed him to continue as a used car dealership.

There have been a number of franchise dealerships that have closed since the interview. Three of these include Premiere Ford in Gladstone, the Lincoln-Mercury dealership on Canyon Road and the Mitsubishi dealership, also on Canyon Road. All three of these dealerships were owned by a local businessman, Joe Khorasani, who was unable to make them financially feasible or to find a buyer for the properties. In addition to these three dealerships, Gary Worth Lincoln-Mercury in Gladstone also closed at the end of 2008. The dealership originally announced that they were giving up the new car franchise, but would continue as a used car dealership with repair facilities. However, they were approached by an auto detailer who purchased the property. This property was built in 1957 and was only in fair to average condition. The loss of two Lincoln-Mercury dealers in 2008 was softened to some extent by the announcement that Landmark Ford would add a Lincoln-Mercury franchise to its current operations in Tigard. The market now has two Lincoln-Mercury franchises, both operated in conjunction with a Ford dealership.

The Portland Business Journal also reported on February 6, 2009 that Kuni Cadillac Saab was going to be permanently closed down on the following day. They reported the owner, Greg Goodwin, as stating that the Portland market was simply not big enough to support three Cadillac dealerships. Reinforcing the notion that auto service centers are the primary profit centers for auto dealerships, the Kuni Collision Center will remain open, but the rest of the 5.5 acre lot is available for redevelopment. Finally, The Oregonian reported that 21 dealerships closed in Portland in 2008,; the vast majority of these are smaller used car lots and indicate how strongly demand has dried up for car sales over the last year.

The Oregon new-car dealership industry had lower average sales per dealership than the national average at 28.76 million in 2007, but this is up slightly from 28.1 million in the previous year. The NADA estimates that in 2007 the number of dealerships in Oregon was 274, with dealership sales accounting for 20.7% of total retail sales. The 2006 estimate was 277 dealerships accounting for 18.4% of retail sales in Oregon. The numbers, although somewhat dated because the newest report will not be issued until this spring, appear to show the beginning of a downward curve that escalated as 2008 progressed and the economy worsened.

Oregon DOT: The DMV does not track the number of dealerships, just the number of dealer licenses. Relying on the number of licenses to determine the number of dealers is misleading as a dealer can use one license to operate multiple dealerships, or can use multiple licenses at one dealership to limit liability. Based on data provided by the Oregon Auto Dealer Association, of the 229 member dealerships in the State of Oregon, 86 are in the tri-county area.

Current Listings/Most Likely User

There are three listings of auto dealership in the Portland Metro area that are particularly noteworthy . Theses include the former Premier Ford in Gladstone, Town & Country Dodge in Wilsonville and the former Vancouver Mazda Dodge in Vancouver, Washington. It is important to note that the listing agents for all three of these properties are marketing them as auto dealerships, but acknowledge that the properties will most likely be redeveloped.

Tom Tethrow, with Niehaus Properties, Inc., is marketing the former Premier Ford. He stated that in his opinion the property will most certainly be redeveloped with a different retail use. He said that he really only started getting interest when he stressed the fact that the property is three separate tax lots that the owner is willing to sell them separately.

Michael Smith, with Michael Smith Properties is currently marketing Town & Country Dodge in Wilsonville. This is an unusual dealership due to Wilsonville zoning in that nearly all of the dealership is indoors, although two acres were recently added to the property. In effect, this property is an industrial building in an area built up with other light industrial uses. Michael said that if the owner finds a buyer, he plans to consolidate his Dodge dealership with one of his other dealerships in Gladstone. Michael said that he and the owner both checked with everyone they knew in the industry, but have not been able to find anyone that is interested. He expects the buyer to be a light industrial user.

The former Vancouver Mazda Dodge is available because the owner is relocating to a new dealership he had built along Vancouver’s Auto Mall. This broker was not contacted, but the marketing flyer makes it clear that the site is ready for redevelopment and is being marketed at a price that is approximately land value.

Local Supply and Demand Considerations

The major factors requiring analysis are the supply and demand conditions in the market and submarket for auto dealerships. To analyze supply and demand in the market, we have relied on published studies by CoStar Property. Please note that CoStar includes the following counties in the Portland Market in addition to the tri-counties: Deschutes, Lane, Linn, Marion, and Clark County Washington. Furthermore, their survey includes a high percentage of used car dealership and used car sales lots, both of which decrease the applicability of the data when used for a franchise dealership.

Summary of Supply and Demand Considerations

The 2008 YTD numbers reflect the average vacancy and rent for 2008 and the total absorption over the same period. The most revealing data is shown in Q4 2008, which shows a very steep increase in vacancy in the submarket. Furthermore, the absorption in the submarket was negative 31,952 SF in the second half of 2008. On the whole, the data reinforces the previous discussion and shows that the local market mirrors the problems experienced by the rest of the nation.

The following table graphically illustrates the sharp increase in vacancy at the end of 2008.

If you have comments, feedback, or input feel free to post below.

Existing home sales were down consistently across all 4 counties in 2008 by 32 to 34%
New Detached sales followed a similar trend, with Clark, Washington & Multnomah down 29-33%, and Washington down 18%
Attached housing market faired the worse, down from 40 to 54% across all four counties.
Overall, the volume of home sales was down an average of 35% for the Portland Metro Area
Pending sales dropped 30%, and New Listings Dropped 8.7% for the year, and 20% compared to the same quarter last year
Foreclosure sales now approaching 10% of existing sales, with Clark County higher at 17%
Per the local RMLS service there is a 14.1 months of inventory based on current monthly sales rate, up from 8.5% in December 2007
Total Marketing Time for Homes Per MLS is up 13% to an average of 138 days

Median Sale Price Trends

Median Existing Home Price down from 2 to 6%, averaging 5%
Median New Home Price more static in Washington and Multnomah Counties, but down 13% in Clackamas and 19% in Clark County
Attached housing down average of 5%
Median Sale Prices Are Likely Skewed by Concessions and by the number and location of the sales

New Home Trends

Construction activity and starts are at all time low
Generally selling close to 1/4 of the new units as compared to the peak of the market
New home and lot inventories are declining, but slowing sales are still keeping the overall months of inventory high
Most plat in Clark County with new detached product have absorption from 0 to 2.50 sales per month, with average at about 1 per month
Attached townhome absorption similar to slightly lower at 0 to 2 closed sales per month
2009 Volume of New Home Sales Could Go Down Further 20% if Economy Does Not Improve
More builders will file bankruptcy in 2009 & we will see builders work together or consolidate to survive
Some production builders trying to get detached housing down to $180,000 for starter home
Affordability is improving with home prices continuing to decline & very low mortgage rates, but recession & tighter lending standards offset
Long term trend for production builders: goal to match of starter home pricing to median incomes, and conform to underwriting standards.
During the peak of the market, starter home prices far exceeded the affordability based on median incomes and traditional underwriting
Median Income are likely to drop given unemployment on the rise, and near term deflation is likely
Lot and land prices have to adjust further
Interest Rate Buy downs More Common as Incentive From Builders
Trend to continued increase in number of attached town-homes entering rental pools by builders.
Some discussion between building community and jurisdications to put a temporary freeze on increased impact fees

Banks & FDIC

Restructuring of the financial system & underwriting requirements likely in near future
Continued Bank Closures Likely in next two years
Bank closures typically result in frozen lines of credit and loans being called- ripple effect for the community
Opportunity for brokers to represent buyers & to inform them of inventory becoming available
Also recommend learning the process and establishing relationship with FDIC on selling side
Fed is injecting money (liquidity into banking system), but banks are stockpiling the liquidity and not passing it on.
Commercial Real Estate Problems will hurt already troubled banks in the coming year.

Lot Value Trends

25-40% value declines in many markets
Most transactions are individual retail sales or take down sales tied to home absorption to builders
Larger custom lots and acreage lots showing big declines, with the exception of very unique parcels in limited supply
Spec financing for smaller custom builders is extremely limited, so only buyers of larger lots are production builders or individuals
Most bulk discounts analyzed using Discounted Cash Flows range at 25-35% from retail, with some up to 50%
Increase in short sales for lots, will result in builders offering new below market product with competitive advantage
Some Recent Potential Buyer Comments on Liquidation Values for Land and Lots
Developer/Builder 50 cents on dollar because they can immediately react as a producer
Inventor buyer at 20-30 cents on the dollar for wait and hold scenario

Residential Land

Demand almost non existent in 2008, and will likely be limited to short sales, liquidation sales, or speculation in 2009
Reductions in land values have been magnified by the slower home sales, lack of demand for lots, and lack of financing
Land Valuation – Focus on supported finished product type, price it right, run conservative costs, and calculate residual on yields w/holding periods.
A&D Loans are essentially non-existent except for unique well positioned projects with high equity requirements of a limited scope.
Multi-Family Land – Few sales, developers have quoted likely range from 8,000 to 14,000 per door for land at 18-24/acre garden style.
Value of entitlement no what it used to be, and entitlements will expire for many projects
Developers will continue to obtain post decision reviews to phase larger projects, in attempt to extend length of entitlements
New Washington State Stormwater Rules Effective in April 2009 have caused a rush of new applications for subdivision to maintain lot yields

Overall Comments

Really in uncharted waters- Deep Recession, new administration, new stimulus plan, new direction for TARP
Demographic Trends also shifting to more conservative for savers in the future
Hard Money Lenders Coming into Play Now
My guess is that we will bottom in early 2010, with a signs of a recovery in later 2011.
Some national experts say housing crisis could last another 3-4 years.
Private parties need to start looking at housing as a long term investment, not a quick flip product
Future success in housing market will be dependent on bringing product to market that is supported by incomes and new underwriting requirements
Qualified buyers will have a great opportunity with declining values and low rates
If you are ready to pull the trigger on a home purchase & have a good deal you should do it as long as you are qualified and not heavily in debt.

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