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

These rates were driven down by equally historically low interest rates spurned by the Federal Reserve Bank’s lowering of the Fed Rate to help jumpstart the economy after the 9/11 terrorist attacks and earlier downturn in the dot.com market. While the lower rates did promote more debt by consumers and made housing more affordable, the subsequent housing boom was not built on solid economic drivers (job gains, increase in exports, etc.) and the run-up in housing prices was not supported. The hastily prepared, adjustable rate loans were bundled together and sold on Wall Street, incorrectly rated and sold to uninformed investors. The US economy, that was held up primarily by the housing market (mortgage companies, lenders, developers, home-builders, contractors, etc. all experienced substantial growth over this period) became very unstable when supply exceeded demand and home prices began to fall. Concurrently, the adjustable rate loans began to see large rate increases that the unqualified buyers were unable to keep pace with. As housing prices declined, borrowers were unable to refinance their loans resulting in defaults. The loans sold on Wall Street were spiraling in value and almost overnight, investors in the large conduit loans stopped buying the paper. Lenders that were not prepared to carry and service the massive amounts of residential and commercial paper were now burdened with loans that had no buyers at rates that were too low to sustain.

The mounting loans that were going into default coupled with the growing uncertainty surrounding the economic outlook and crashes in the global economy caused many banks to stop lending altogether. In late 2008, the Federal Government again interceded to create TARP, a $700 billion dollar bail-out for many of these lenders that had created the market instability, fearing that these companies collapse would spark further economic decline through job losses, lower retail sales and a further decline in housing prices. The government’s primary concern was the lending environment had seized up after Wall Street stopped buying paper. The uncertainty on the part of lenders continues today with some lenders quoting 600 to 2,000 basis points over the historically low Treasury rates for new loans, with only the most qualified buyers and the safest of loans being written. At the same time, loan to value ratios decreased from 90% to 100% down to 50% to 60%.

As a result, only well capitalized buyers even qualify for a loan in the current environment. While sellers have been reticent to sell, since few buyers are even less credit are available for deals priced below 7.0%, qualified buyers have realized that they now control the market and many also fear the uncertainty surrounding pricing. Investors have reported equity return requirements near 12% with limited risk to venture from the sidelines. Consequently, a stalemate between buyers and sellers has taken hold of the commercial real estate market. The standoff will likely continue until sellers, some that have already lost up to 20% in book value on their investments, need to either refinance their existing loans or cannot afford the new payments as rates adjust upwards and, in either event, are forced to sell.

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.”

The following is a sample of recent manufactured home community sales collected from across the United States by PGP Valuation.

These rates were driven down by equally historically low interest rates spurned by the Federal Reserve Bank’s lowering of the Fed Rate to help jumpstart theeconomy after the 9/11 terrorist attacks and earlier downturn in the dot.com market. While the lower rates did promote more debt by consumers and madehousing more affordable, the subsequent housing boom was not built on solid economic drivers (job gains, increase in exports, etc.) and the run-up in housingprices was not supported. The hastily prepared, adjustable rate loans were bundled together and sold on Wall Street, incorrectly rated and sold to uninformedinvestors. The US economy, that was held up primarily by the housing market (mortgage companies, lenders, developers, home-builders, contractors, etc. allexperienced substantial growth over this period) became very unstable when supply exceeded demand and home prices began to fall. Concurrently, theadjustable rate loans began to see large rate increases that the unqualified buyers were unable to keep pace with. As housing prices declined, borrowers wereunable to refinance their loans resulting in defaults. The loans sold on Wall Street were spiraling in value and almost overnight, investors in the large conduitloans stopped buying the paper. Lenders that were not prepared to carry and service the massive amounts of residential and commercial paper were nowburdened with loans that had no buyers at rates that were too low to sustain.

The mounting loans that were going into default coupled with the growing uncertainty surrounding the economic outlook and crashes in the global economycaused many banks to stop lending altogether. In late 2008, the Federal Government again interceded to create TARP, a $700 billion dollar bail-out for many ofthese lenders that had created the market instability, fearing that these companies collapse would spark further economic decline through job losses, lower retailsales and a further decline in housing prices. The government’s primary concern was the lending environment had seized up after Wall Street stopped buyingpaper. The uncertainty on the part of lenders continues today with some lenders quoting 600 to 2,000 basis points over the historically low Treasury rates fornew loans, with only the most qualified buyers and the safest of loans being written. At the same time, loan to value ratios decreased from 90% to 100% down to50% to 60%.

As a result, only well capitalized buyers even qualify for a loan in the current environment. While sellers have been reticent to sell, since few buyers are evenless credit are available for deals priced below 7.0%, qualified buyers have realized that they now control the market and many also fear the uncertaintysurrounding pricing. Investors have reported equity return requirements near 12% with limited risk to venture from the sidelines. Consequently, a stalematebetween buyers and sellers has taken hold of the commercial real estate market. The standoff will likely continue until sellers, some that have already lost up to 20% in book value on their investments, need to either refinance their existing loans or cannot afford the new payments as rates adjust upwards and, in eitherevent, are forced to sell.

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 notaccount for the entire value decline in this market. Major value declines also come from the changing status quo between buyers and sellers. Buyershave become much more patient and are expecting a much more favorable ratio between their NOI and purchase price. In other words, when thereare 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 duringtimes of appreciation, the market is usually active. Extracting supportable capitalization rates is easy. However, when transactions are scarce findingmarket capitalization rates can be significantly harder. When this happens, oftentimes sellers have an unrealistic opinion of value because they arerelying on dated capitalization rate sources.”

The following is a sample of recent self-storage sales collected from across the United States by PGP Valuation.