Vacancy/Concessions

Vacancy in most submarkets in the PMA has increased since the end of 2008. Most of PGP’s recent survey’s show vacancy typically in the 5-8% range for stabilized properties. Most managers are reporting that they are able to maintain reasonable occupancy, but have needed to start offering concessions, which were very uncommon in the market from 2005-late 2008.  Concessions range from waiving move-in fees to 1 month free rent (most common).

The downtown market; however, is expected to be impacted significantly more than the suburban markets due to the large amount of new supply in the market. Between January 2008 and December 2010, more than 3,000 apartment units will come on line in the downtown, or close-in east side markets. All of these units are elevator served and plan to serve the upper end of the market. However, due to the national recession, many of the potential tenants (22-30 year olds) have been hit hard by unemployment and can no longer afford to pay the rental rates that developers had planned in the $2.20 – $2.50/SF range. Absorption is in process at many of the projects with more developments to come on line in the next year. Stabilized complexes have already begun to lower rental rates dramatically and concessions are prevalent and typically include 1 month free rent and discounts, or free, garage parking. Vacancy has dramatically increased to near 8-10% in many of our recent surveys for stabilized properties. It is unclear where the downtown market rental and vacancy rates will end up, but due to the large new supply, everyone’s guess is that it will likely be below $2.00/SF and near 10% for multiple years.

Rental Rates

Similar to occupancy, rental rates are also declining in most submarkets. In suburban areas, managers are typically reporting rental rates $20 to $100/unit lower than a year ago. Managers at more luxury suburban complexes have seen the most significant decrease in rates as tenants are trying to reduce spending during the national recession and are opting to decrease rental payments when possible. Thus, where a luxury suburban complex was getting $900 – $1,000 for a 2BR/2BA unit in mid 2008, rents have typically decreased close to $100/unit and a concession of 1 month free may still be needed.

This rental rate decline is hitting the downtown market as previously discussed, but is also affecting some new suburban development. There are a few newer complexes around the suburban areas of the PMA that were originally planned as condominiums, but were converted to apartments due to the decline in the single family market. Many of these units are 1,400SF + townhouse units with attached garages, etc. The developers had expected rents close to $1.00/SF. However, the market is definitely experiencing a “rental cap”, where tenants are generally not willing to pay more than about $1,300-$1,400/unit, no matter the amenities or unit size in the suburban areas at larger apartment complexes. As these complexes lease-up, concessions of 2-3 months free have been seen, which decreases the overall economic rent. It will be interesting to see long term how these projects progress at a stabilized occupancy.

Investment Market Conditions

The current investment market conditions are very unstable in the PMA and greater Oregon area for multiple reasons: 1) decrease in investor demand for product 2) increase in capitalization rates 3) lack of available financing/ changes to underwriting requirements 4) investors who have capital are waiting on the sidelines in many cases for the market to bottom out. All of these market conditions tie together in one way or another and have led to a definite decrease in apartment values across the board. However, many sellers do not need to sell and have not been willing yet to capitulate to new market conditions

The biggest impact on property values has been from a significant increase in capitalization rates. Early in 2009, there was literally no good sales data to show what the increase was. However, recently, there have been a few sales of complexes (20+ units) that show cap rates generally 7.0+. To illustrate the dearth of sales in the first half of 2009, it is noted that in the first half of 2007, there were 60 sales of 20+ unit properties, 47 in 2008 and only 24 in 2009 according to CoStar. However, of the 24 sales, 5 of them were Section 8 properties that were purchased for LIHTC rehab and are not considered typical arms-length investment transactions. Thus, only about 19 sales have occurred during the first half of the year. Of the sales, only 2 have been 100 units or more and one of these sales was a 100 unit LIHTC property in Springfield. In regard to supply of properties for sale, LoopNet shows about 90 apartments for sale in Oregon of 20+ units as of early July. This number was about 30-50 typically during the height of the market in 2007 and early 2008.

In discussions with brokers, buyers are typically looking to purchase investment grade properties at 7.25 to 8.0% cap rates. The one closed sale of 100+ units in the PMA was in Tigard for a 1970s property and sold for a 7.6% OAR. This property would have likely been a 6.25 to 6.50% cap in 2007 or early 2008. Brokers report that most sellers are not interested in selling for 7.5% + and therefore, there is a large supply of apartments for sale on the market with little activity. Brokers have reported frustration with sellers who believe that conditions will “return to the way they were” with rates back in the 6 to 7% range. This is especially true with the less savvy sellers of smaller properties.

The reason why cap rates are unlikely to return to their historic lows is due to a significant change in underwriting loans, availability of financing, and increased risk pricing of real estate. When interest rates were 5.0-5.5% with an 80% loan to value rate with mezzanine financing available, investors saw little risk. Plus, at that time, underwriting was very lax, and often lenders used “proforma” rents, which expected 12 month rent growth. However, current underwriting and lending conditions are extremely different. First, there are very few lenders even willing to lend on apartments at this time. A few larger banks will lend at their own terms, and a few smaller banks may be willing to lend on small properties. However, for the main segment of the apartment market, the only current lenders are Fannie Mae or Freddie Mac. Thus, these two lenders are really driving the investment market. Currently, a 1.25 DCR is driving lending compared to a previous standard of 1.15 to 1.20. Current LTVs are 75% for refinances to 80% for acquisitions.

However, the most significant change in the process is the underwriting both by the lenders, but also by potential buyers. The lenders will only loan on current, in-place rents (sometimes lower if market rents are declining in the area), and expenses generally based on historicals. This expense standard has been significant because in the past, properties were typically sold using “proforma” expenses for some categories including R/M, turnover, on-site management, and admin. If the property had seen R/M expenses of $700/unit for the past two years, the market still expected to us a number of $400-$500/unit for a stabilized proforma. However, now, lenders are generally unwilling to do this and will place most emphasis on historical expenses. Thus, where proforma expenses would have been $3,200 for an apartment 2 years ago, expenses are now $3,600. This change in underwriting significantly lowers valuation.

When looking at investment grade deals, buyers are also being very conservative at this time due to declining market conditions. If current actual, average rents are $750, but current asking rents have declined to $700/unit, investors are typically using rents lower than the current average in their investment proformas, say $730/unit. Also, instead of the typical 5% vacancy, which was common to use in previous years, investors are projecting income in line with 6-10% vacancy/concessions/bad debt. Overall, these changes in estimating income reflect lower income levels than in 2008 as investors feel that market conditions will likely further decline before they get better. Investors are also basing their expenses on historicals, generally because this is how the loan will be underwritten by Freddie/Fannie, and the DCR depends on these estimates.

Even with the changes in financing, brokers and lenders report that there are still many buyers in the market. However, these buyers are only interested in buying properties that provide a good return, and thus, require cap rates in the 7.25+ range. One broker said that historically, a reasonable cap rate should be 100 basis points over a loan rate. With current market conditions being unstable, it is reasonable to assume that this 100 basis point, or higher estimate, is reasonable. Thus, if current rates at 6 to 6.25%, then cap rates should be 7.25% or higher for most properties. Overall, due to the lack of sales, the market seems to be supporting this theory.

Summary

Overall, apartment market conditions in the PMA are declining with lower rents, rising vacancy, and increased use of concessions. This will likely continue into the next 6-18 months, or until the economy regains strength and jobs are created and tenant spending confidence strengthens. Sales of apartments will also continue to be much lower than typical until owners either need to sell for financial reasons (upside down loan coming due, etc), or until owners realize that cap rates in the 5-6% range will not be seen again anytime soon due to the changes in financing, underwriting, and buyer expectations.

PGP Valuation has been serving the Portland Metro Area and Greater Oregon for the past 30 years. We have the largest real estate appraisal and consulting firm in Oregon and serve all property types including Industrial, Office, Retail, Apartment, and Land. Feel free to call the office to speak with an industry expert for any real estate consulting or appraisal needs.

Jeremy Snow, MAI is the Multi-Family team leader in the Portland office.  His team completes more investment grade apartment appraisals in Oregon than any firm.  Jeremy also has a specialty in restricted rent apartments (LIHTC, Section 8, and RD) and has completed these appraisals all over the State of Oregon.  Feel free to contact Jeremy for investment grade apartment questions or for your appraisal/consulting needs throughout the State of Oregon.

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

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

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

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

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

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

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

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

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

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

Forensics

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

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

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

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

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

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

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

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

Debt

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

Equity

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

Dissection

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

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

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

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

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

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

Practical Forensics

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

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

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

The 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

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

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

Analysis

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

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

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

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

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

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

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

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

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

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

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

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

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

Transaction Volume

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

Financial Markets

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

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

Impact on Capitalization Rates

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

Financing

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

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

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

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

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

Cash Flow Assumptions

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

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

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

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

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

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

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

Capitalization Rate Survey

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

What this means to Distribution/Warehouse Real Estate

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

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

Contact for PGP Valuation’s Industrial Practice Group

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

Jeff L. Grose, MAI

Portland Executive Managing Director

Industrial Market Reports

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

  2009 PGP Industrial Forecast (Portland)

  2009 1st Quarter - Industrial Market Report (Sacramento)

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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