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.

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.

The biggest news in the retail market has been the filling of chapter 11 of General Growth Properties (GGP). According to GGP’s Quarterly 8-K, they own more than 167.7 billion SF of retail space. NOI for the first quarter of 2009 for GGP was $608.6 million, a decrease of approximately 4.1% from the $634.5 million reported in the first quarter of 2008. Overall occupancy for all of GGP’s properties is at 90.9% compared to 92.7% from a year ago. 167 retail properties, including some of the largest malls in the nation, are involved in the recent bankruptcy filling. Some of the local retail properties involved in the bankruptcy proceedings include: Division Crossing (101,000 SF) in Gresham and Pioneer Place (370,000 SF) in downtown Portland.

The real estate industry is responding quickly.  “Sustainability”, “LEED”, “carbon credits”, “cap and trade” are terms that are rapidly infiltrating our day to day conversations with developers, architects and the financial community. 

To maintain a competitive advantage, we will need to provide our clients with knowledge and tools to help them maximize their returns by employing green technologies.  Enhanced value will manifest itself through lower operating costs, faster lease-up and more aggressive cap rates.

At PGP Valuation, our Sustainability Practice Group has been networking with our partners at Colliers CMN to build a diverse and knowledgeable team to assist our clients with decisions about sustainable development.

Our offices in the Pacific Northwest are well positioned to take the lead in this emerging sector, as our region has been ahead of the curve:

• As of 2007, Portland and Seattle each had about the same number of LEED certified buildings as New York City, Los Angeles and San Francisco combined. 
• Seattle was the first city in North America to establish a LEED standard for all public buildings.

The benefits of building green will be social, environmental and economic.  Commercial buildings, because of their large size, can make a measurable contribution to the sustainable movement.  PGP and Colliers can be the market leaders in valuation and brokerage of green buildings.  Future generations will be the beneficiaries.

The significant turmoil in the real estate capital markets has resulted in a considerable vacuum in financing opportunities for Manufactured Home Communities. Once a favorite of the now inactive CMBS/Conduit loan industry, the MHC asset class has become increasingly reliant on Fannie Mae, life insurance company, and commercial bank loan executions. Many MHC and RV Resort operators, in addition to borrowers across every asset class, had found favor in recent years with aggressive Conduit lending programs and their high loan-to-value and low debt service coverage thresholds. With the disappearance of this segment of the capital marketplace, the availability of competitively priced, non-recourse first lien financing for MHC’s outside of Fannie Mae does exist, however with comparatively less attractive terms.

Portfolio life insurance companies are still in the market and are providing non-recourse financing, however their fixed rates range from 7% to 8%, which is 1.5% to 2.0% higher than Fannie Mae fixed rates today. Commercial banks will loan up to 75% loan-to-value on MHC’s, subject to debt coverage requirements of 1.25x typically. The best bank pricing today is in the low to mid 6% range, and the borrower must sign a personal guarantee. The bright spot for MHC financing continues to be Fannie Mae, but they too are getting tighter in their underwriting and pricing. The highlight of Fannie Mae’s offerings today includes a variable rate loan program with fully indexed rates in the high 4% range and a lifetime cap between 6.75% and 7.25%.

Zachary E. Koucos

Associate Director HFF

858.812.2351 Office

858.552.7695 Fax

Securitized lending for individual properties (CMBS or conduit loans) emerged in the mid-1990s as a very popular lending option for commercial real estate including MHCs. Conduit lending was embraced by lenders as a way to generate lending profits while shifting the risk of defaults to bondholders who purchased the bonds that were collateralized by the individual loans. In some years conduit lending accounted for up to 60 percent of annual commercial lending volume. Borrowers benefited by having very attractive (interest rates and leverage) non-recourse financing available for most properties including MHCs, which had previously been viewed by many lenders as a special purpose asset. The existence of conduits also resulted in better terms being available from non-conduit or traditional balance sheet lenders as they had to compete with conduits to obtain business. However, the recent capital market turmoil brought the origination of conduit loans to a halt as the buyers of these bonds, or CMBS, exited the market. With conduit lenders gone from the market, many MHC borrowers with existing conduit loans are facing challenges in refinancing their properties.

Tony Petosa

Senior Vice President

Wells Fargo Multifamily Capital

760.438.2153 Office

760.505.9001 Cell

760.438.8710 Fax

tpetosa@wellsfargo.com

To use a Vegas analogy, we went from a “hot” craps table where everybody is winning, to the desperation of placing your last dollar into the slot machine on the way out, hoping you’ll get lucky. OK, maybe not that extreme, but close. Over the past several years, there were many options to finance your MHC; you had the CMBS/conduit lenders, the life companies, GE, commercial banks and the Fannie Mae DUS lenders, to name a few, and they all wanted a piece of the action.

Due to MHCs being a proven asset class within the finance world (high performing loans and low delinquencies), they were viewed as favorably as a Class A apartment complex in a strong Southern California market. At the peak, it was common to see 10 years interest only, 80%+ leverage and a sub-100 spread on any given community. Then, much like the economy as a whole, the bottom fell out and we went from an extremely liquid and aggressive market to a cautious, selective, downright tough market.

The good news is that we are still closing loans under the Fannie Mae DUS program. Although the terms are not quite as attractive, it is still possible, and realistic, to get a non-recourse, less than 6% fixed rate loan with a 10 year term and a 25 to 30 year amortization schedule at 75% leverage on high quality communities. Other than that, you may be able to find a local bank or a life company to consider something on a recourse basis and/or a more conservative structure.

Todd Elkins

Vice President

Grandbridge Real Estate Capital LLC

205.978.1920 Office

205.978.1852 Fax

telkins@gbrecap.com

www.gbrecap.com

With the capital market providers still on the sidelines , owners of manufactured home communities basically have two choices when it comes to financing – Fannie Mae and everything else. I divide it into two choices since Fannie Mae is the best option in the market today and Capmark is actively closing loans through its Fannie Mae platform. The main issue is having the community qualify for a Fannie Mae loan from the quality standpoint. The community generally has to be 3.5 star quality and higher, 50% of the spaces have to accommodate multi-sectional homes, very little park owned homes, 5% or less RV sites, good amenity package and has to show well. Current underwriting guidelines are 80% LTV with a 1.25x debt coverage ratio with terms ranging from 5 to 30 years. Amortization schedule of 25 to 30 years. Keep in mind that Fannie Mae has been tightening their underwriting requirements, so a deal that fit the program a year ago may not qualify today.

If the community doesn’t qualify for Fannie Mae, then it falls into what I call “everything else”, meaning Capmark works with the borrower to try and find a loan. There are several smaller banks that will lend on manufactured home communities throughout the country. The underwriting is going to be more conservative than Fannie Mae, generally LTV of 60 – 70% with 1.30 + debt coverage ratio. The terms are going to be shorter as is the amortization. Capmark also works with life insurance companies to fund loans for manufactured home communities. Some insurance companies will lend on communities that don’t qualify for Fannie Mae program ; it really comes down to deal specifics.

As a community owner who needs financing in this challenging environment, it is important to allow more time to get your loan closed and it is very important to work with lenders that know what they are doing.

Damon B. Reed

Vice President Capmark Finance Inc

205.991.6700, Ext 8191

205.991.9101 Fax

205.601.2855 Cell

Damon.Reed@capmark.com

Underwriting parameters continue to become more conservative. Fannie Mae recently announced that all-age communities (non-age restricted) will need to utilize a 25 year amortization, as opposed to the standard 30-year amortization. Fannie is taking a harder look at asset quality and only wants to lend on the highest quality communities. That being said, Fannie Mae closed on over $1 billion in manufactured housing business in 2008, which was a huge jump from the previous year. Rates are still very attractive for communities that do qualify, with 10-year loans currently pricing in the 5.75-6.25% range. With limited other financing options, we expect to continue to see a large volume of manufactured housing owners seeking Fannie Mae financing in 2009 for their communities.

Andrew Tapley

Senior Vice President Multifamily Finance

301.215.5578 Office

301.634.2151 Fax

atapley@walkerdunlop.com

www.walkerdunlop.com

In the next 12 to 24 months do you foresee any new financing sources or options that are not currently available for MHC owners?

I have been lending on manufactured home communities since 1995 and it’s hard for me to imagine that the capital market providers will stay on the sidelines forever. I think we are several months away before any of the Wall Street firms dip their toe in the securitization market. I do think by 2010, we will see some “conduit’ lending for manufactured home communities, albeit on much more conservative terms that what was done in 2007. Manufactured home communities as an asset class are holding up well compared to other commercial property types. If that trend continues, you may have more life insurance companies and even pension funds start to lend on communities. Overall, I am optimistic that the worse days are behind us and that we may start to see “normal” lending emerge in the near future.

Damon B. Reed

Vice President Capmark Finance Inc.

205.991.6700, Ext 8191

205.991.9101 Fax

205.601.2855 Cell

Damon.Reed@capmark.com

Yes, we are seeing the marketplace gradually deepen for MHC financing as more lenders have taken note that Manufactured Home Communities as an asset class provide a reliable, low-risk investment. Life insurance companies as well as commercial and regional banks that historically have not transacted in the MHC sector are beginning to realize the inherent value of including this product type in their investment portfolios. The word is out – low loan delinquency ratios, high occupancy rates, and consistent cash flow make MHC’s one of the most attractive options for the deployment of capital in these uncertain times.

We are also seeing many public and private capital sources raising debt and equity funds for the origination of first lien, mezzanine, bridge, and structured finance transactions. More and more of these capital sources have MHC’s on their list of preferred product types. The ability to navigate the capital landscape left standing after the implosion of the MBS/Conduit marketplace is crucial today for MHC operators who are finding that their go-to lenders are no longer active or existent. The good news is that there will be capital available and looking for opportunities, albeit with a tighter strike zone on underwriting, pricing, and terms.

Zachary E. Koucos

Associate Director HFF

858.812.2351 Office

858.552.7695 Fax

zkoucos@hfflp.com

For the near future, we see Fannie Mae as the best financing source for MHCs. Fannie Mae offers long-term fixed rate, non-recourse financing to qualified MHC’s (10-year fixed rates are currently under 6%), and this has helped fill the some of the void left by the conduit market. For properties that do not qualify for Fannie Mae financing, portfolio lending programs would be the next option. Borrowers will find, however, that portfolio lending programs often require full recourse (personal guarantees) and the terms and rates are not as attractive as what can be found with Fannie Mae currently. Beyond that, seller financing may be an option if a borrower is acquiring a property. In that instance, the financing terms will be the result of what the buyer is able to negotiate with the seller. Will conduit lending return? Ultimately we believe it will, but not for the foreseeable future and likely in a more regulated environment with tighter credit standards.

Nick Bertino

Vice President Wells Fargo Multifamily Capital

760.438.2629 Office

858.336.0782 Cell

760.438.8710 Fax

nick.bertino@wellsfargo.com

With the single-family market struggling, how do you think this will affect the manufactured home community industry?

Simply put, the struggling single family market presents terrific challenges and great potential. The potential is to design creative and sustaining programs that enable companies like ours to provide quality, affordable shelter to families who have challenging balance sheets and credit histories because they are moving from housing they can’t afford to factory-built homes in community neighborhoods that present a lifestyle and a value proposition that they can embrace. The real challenge for our company is developing programs to take advantage of the baby-boomer population wanting to downsize, but not being able to sell and capture their perceived equity in the current home they have occupied for decades.

James A. Reitzner

President & Director Asset Development Group, Inc

414.507.8057

jim.reitzner@assetdevelopment.com

In the near term, on the 55+ side, the inability of our prospects to sell their homes has been affecting us for a while now. New home sales in age restricted communities have dramatically slowed given the difficulties these prospective residents face in selling their permanent homes. When houses do start to sell, and there is evidence the inventory of foreclosures and short sales is starting to move in the Sunbelt states, we’re going to be competing with some relatively cheap stick-built product. I think this will force us to revisit the floor plans and models we’re spec’ing. For a while, when the market was hot, the homes we were selling kept getting bigger and more expensive (triples, two-car garages, granite and stainless steel, etc.). This worked because the cost of alternative housing was increasing so rapidly and our customers were pulling out large amounts of equity from their homes in the north. That is obviously not the case at this point and we are going to be selling in a much more “normal” market when the ship turns.

The good news is, I think the housing correction has readjusted the market for the different types of housing. Many of those folks, and there are millions of them, that could previously have qualified for a high leverage mortgage to buy a stick built-house, are renters now. This has translated to fantastic sales results within our all-age portfolio in all regions of the country. As long as we remain focused on the overall value proposition this industry is based on, we expect this success to continue.

William Glascott

CFA Vice President Hometown America, LLC

312.604.7503 Office

312.604.3103 Fax

312.523.7584 Cell

bglascott@hometownamerica.net

www.hometownamerica.com

The manufactured home industry is able to offer individuals and families an alternative affordable housing option during an economic transition.

Manufactured home communities offer an atmosphere and amenities that a typical apartment complex does not have. These include homes with a larger living area than a typical 2 bedroom apartment unit, individual yards in which pets and children can play safely, and a similar neighborhood atmosphere to that of a single-family subdivision.

The RHP Properties portfolio (70 communities, 15 states) continues to experience an increase in occupancy due to our strong hands -on management approach during these tough economic times.

Joshua Mermell

Director of Acquisitions RHP Properties, Inc

248.626.0737

jmermell@rhp-properties.com

Many owners have indicated that one of the biggest challenges of owning MHCs is having to carry notes of community-owned homes on the balance sheet. With the lack of chattel/manufactured home financing, how are you dealing with home financing issues?

As a company, we recognized years ago that we could not “get around” the necessity of financing homes in our communities. Our business model necessitates the three critical components of our asset class: retail sales of homes, retail financing of homes and quality communities in which to place those homes all for the purpose of creating the value proposition for the customer. We purchased a finance company with an on-going book of business and solid income stream, and expanded that company’s ability to grow and service our buyers. This approach keeps our balance sheet on the properties side focused on the traditional method of valuing properties which is the Net Operating Income tied to the real estate and not blurred by the necessity to evaluate the “home inventory”, however it is represented on the balance sheet.

James A. Reitzner

President & Director Asset Development Group, Inc

414.507.8057

jim.reitzner@assetdevelopment.com

We’re doing it ourselves. You are correct though that this is a big challenge as the capital requirement associated with home sales has increased. It has worked out for us as we’ve been able to manage delinquencies and turnover because we’re in the communities every day. From a capital preservation standpoint, it has worked out as we’re well capitalized, long term investors with the critical mass that supplies geographic and demographic diversity in our loan portfolio.

We do have good relationships with the national lenders that are still out there lending and work to establish partnerships with regional and local banks when possible. We are also always looking at creative ways to add liquidity to this market through industry initiatives and working with national organizations like the MHI. I think as investors come back to the market for asset backed securities (with help from Uncle Sam) and we as an industry can demonstrate transparent and stable loan performance, more chattel financing sources will surface. However, that means that we need to be very disciplined in our lending practices and underwriting so that we ensure these notes are marketable assets when that time does come.

William Glascott

CFA Vice President Hometown America, LLC

312.604.7503 Office

312.604.3103 Fax

312.523.7584 Cell

bglascott@hometownamerica.net

www.hometownamerica.com

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.

In this article, a capitalization rate for a strip center is analyzed based on (1) market extraction; (2) national survey; and (3) debt coverage/equity dividend analysis. This is an in-depth analysis that shows how a capitalization rate can be derived when little data is available in a market area. This presentation is an example of the in-depth analysis that is done in many appraisals.

Market Extraction – The following table is a qualitative capitalization rate analysis of the five sales utilized ahead in the Sales Comparison Approach section.

The preceding grid analyzes the cap rate comparables for eight elements of comparison. The comparables are not adjusted to the subject; rather they demonstrate the variances that make them different than the subject. Each element of comparison can put upward, downward or no pressure on the capitalization rate as it relates to the subject’s characteristics. Particular attention should be paid to Date of Sale, Condition, Tenant Mix and Upside Rent Potential.

• Date of Sale - Regionally, cap rates bottomed out in early to mid 2007, remained relatively flat through early 2008, and have climbed slightly in 2008. Therefore, as the sale dates get older, the analysis recognizes further downward pressure placed on the cap rates.

• Condition - Although the subject is in good condition for its age, its overall condition, design and appeal are inferior to the comparables that were recently constructed with contemporary construction appeal. New construction places downward pressure on cap rates compared to older centers.

• Tenant Mix - Tenant mix takes into account both the quality and the durability of the tenants (length of typical lease terms, good track record for retention, etc.), which are important factors when taking into account the leased fee interest of a retail center.

• Upside Rent Potential - As demonstrated in the Gross Rent Analysis, the market rents of the subject are somewhat above (5-10%) contract rents; however, the contract rents were utilized because they appear to be durable and are most indicative of the leased fee interest of the subject. That said and all other things being equal, investors pay more for income streams that have perceived upside in rents compared to those that don’t.

The cap rate comparables indicate a relatively narrow range from 6.38% to 6.82%, and average 6.6%. Through qualitative analysis, two comparables (3 & 4) command primary consideration. Comparable 3 (6.82%) had the second fewest variances, the majority of which placed upward pressure on the cap rate. This comparable is a high indicator and reasonable sets the upper limit indicator for the subject. Comparable 4 (6.48%) had the fewest variances, the majority of which place downward pressure on the cap rate. This comparable defines the lowest cap rate that the subject could command.

Based on the preceding analysis, the capitalization rate conclusion by market extraction is presented in the table below.

Please note the preceding cap rate analysis by the Market Sales Method purposely takes a rearview mirror approach. Although the analysis did take into consideration the slight upward trend that cap rates have taken over the past few quarters, it does not adequately reflect a more refined perspective of the trends moving forward. The Cap Rate Trends section ahead will further develop the subject’s applicable capitalization rate in the current economic environment. An attempt to further adjust the cap rate at this time would be very subjective.

Debt Coverage/Equity Dividend Analysis – Most investment properties are purchased with debt and equity capital; therefore, the cap 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.

Over the preceding several years, permanent financing was available at loan-to-value (LTV) ratios up to 75% and debt coverage ratio (DCR) requirements were as low as 1.15 for well located retail centers. However, loan terms have changed substantially in the current credit crunch economy. Typical loan terms today include decreased LTV ratios of 65% and DCR requirements in the 1.25 to 1.3 range. Additionally, market interest rates have increased to a point where negative leverage is occurring. That is mortgage constants exceed market CAP rates; therefore, as the LTV increases, the equity dividend (cash-on-cash return) decreases.

The following table summarizes the debt coverage/equity dividend analysis.

The preceding analysis is somewhat of a hybrid of Band of Investments Analysis and the Underwriter’s Method to derive cap rates; however, it is intended to be focused on how buyers can meet investment goals while re-adapting to old school lending practices. The loan term assumptions are fixed with the exception of the LTV ratio, which floats between 60 to 70%. The exercise is intended to provide sensitivity analysis for both DCR requirements to satisfy underwriting criteria and equity dividends to provide the investor an adequate rate of return at various cap rates. The ideal and most applicable cap rate satisfies a minimum DCR of 1.25 and a first year equity dividend of 5%. The cap conclusion derived from this analysis is presented in the following table.

National Survey – As discussed in the Market Analysis section, 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 strip centers.

The preceding table clearly shows that cap rates bottomed out in the third quarter of 2007. As depicted in the Retail Cap Rates – OR table ahead in the Cap Rate Trends section, strip centers in the Oregon marketplace have consistently been trading at lower effective cap rates compared to the national averages. This 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 very subjective. The most reasonable cap rate that can be derived from this analysis is presented in the following table.

Cap Rate Trends - The following table summarizes cap rate trends for investment grade retail centers in the Oregon marketplace over the past several years.

Capitalization rates had trended downward for several years; however, they appear to have stabilized or even trended upward slightly over the past several months due to the tightening of credit and increased underwriting standards. Interviews with real estate sales brokers that are familiar with both local and national real estate investment properties indicate that capitalization rates and corresponding values within the Pacific NW region are holding strong relative to other regions. Several factors contribute to the strong commercial real estate fundamentals in the Pacific Northwest region: (1) stringent zoning and scarcity of developable commercial sites create a barrier to entry for new development; (2) relatively favorable supply/demand conditions (stable vacancy levels) insolate existing development and ensure that market rent levels at minimum match inflation; (3) very few prime investment properties are available for sale, while demand from local, regional and national investors is still relatively strong in this marketplace; and (4) the relationship between NOI and value (capitalization rates) have remained relatively in balance relative to other regions.

In addition to the general downward trend in cap rates since 2002, the spread between traditionally lower risk (anchored neighborhood) and higher risk (non-anchored strips) investments narrowed to the point that investors were not making a distinction between the two. It is apparent that this trend is quickly being reversed as demonstrated in the following table.

The preceding table summarizes the most recent investment retail sales that have closed or are pending in the region. The emerging trend appears a reclassification of cap rates that is   consistent with actual risk characteristics. For example, the low end of the range at 6.3% is a highly marketable investment occupied by Walgreens (AAA rating) subject to a long-term lease. Cap rates for this asset class have increased as much as 25 bps over the past year. In comparison, the high end of the range at 7.6% is a well positioned property adjacent to a regional shopping center. However, the tenant mix is comprised of primarily mid box retailers that are particularly vulnerable in times of recession. Additionally, the largest tenant had a contract rent that was measurably above market, adding risk to the durability of the income stream. During confirmation of the sale, the buyer acknowledged that these issues were taken into consideration when developing his purchase offer. In all likelihood, this property would have traded at a cap rate in excess of 100 bps lower at the height of the market. This issue will be taken into consideration when reconciling the subject’s cap rate.

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 cap rates. The subject has a strong track record for retaining tenants, and it is very well positioned noting prime exposure and its pad location within a regional shopping center. Taking all these factors into consideration, the following table summarizes the various cap rate indicators and provides the final cap rate conclusion.

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.

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