Read more of what Bloomberg had to say here

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

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

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

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

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

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

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

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

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

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

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

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

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

Download PDF article here

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)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

About the Author

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

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

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

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

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

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

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

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

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

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

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

What causes declines in Market value?

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

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

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

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

Finding Market Capitalization Rates without Recent Transactions

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

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

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

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

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.

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

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

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

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

Read more of Sasha Pardy’s article on Costar

National Dealership Trends

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

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

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

National Industry Trends

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: NADA, AutoExec Magazine, May 2008

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

Regional and Local Trends

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

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

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

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

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

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

Current Listings/Most Likely User

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

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

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

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

Local Supply and Demand Considerations

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

Summary of Supply and Demand Considerations

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

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

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Circuit City lost its battle with the recession early in the game and was forced into chapter 11 even after the initial closing of 155 poorly performing stores across the Midwest. With a lackluster showing of buyers to purchase existing leases and bleeding capital at the seams; no other choices were left but to close the remaining 567 stores and liquidate all assets. It comes as no surprise to many consumers that they followed the demise of fellow electronics retailer CompUSA which declared bankruptcy in 2007 and closed all 229 of its stores shortly thereafter. Best Buy, the only remaining electronics retailer of its kind in many markets, currently has 1,010 stores across North America and plans to open 50 more stores in 2009. This is half as many openings that they did in both 2007 and 2008. Expansion plans have slowed with the turning of the economy; however, looking at their stock price it doesn’t appear that they are going to be having a going out of business sale anytime soon. Best Buy bottomed out to its lowest since 2003 in mid November at $17.63 but has since rebounded to its current price of $29.16/share.
Many consumers hardly shopped at Circuit City; citing its poor selection, dimly lit buildings and terrible customer service. Even when their liquidation sale began on January 16th, many consumers left the stores empty handed, mentioning that the ‘deals’ certainly weren’t deals at all. Best Buy has always tried to serve its customers as best as possible. Although net income is down,  its revenue is up. As consumers continue to cut back on their spending and the recession deepens, Best Buy expects its sales to decline 8% in 2009. The coming months will determine Best Buy’s fate. With online shopping more convenient than ever and no signs of a resolution to the current recession, it’s difficult to determine how things will shake out for Best Buy.

We have been in a recession since December 2007, and as the recession cuts deeper into consumers’ wallets, they are looking to the new presidential administration for assistance. Many people believe the new administration will help buoy the market with new spending. President Obama’s $819 billion stimulus package passed the House of Representatives with little trouble considering it is filled with a Democrat majority. President Obama stands firm that his recovery plan will “create more than three million new jobs over the next few years.” 1.9 million jobs were eliminated in the past year, with 1.2 million of those loses occurring in the fourth quarter of 2008; the US is in need of job stimulation and growth. The decrease in consumer spending is deepening the recession and breeding high unemployment. Oregon has the 6th highest unemployment in the United States as of December and is headed higher. The national average is currently at 7.2% and Oregon is stretching almost two points higher at 9.0%. Some of our neighbors are experiencing slightly higher unemployment, with Nevada at 9.1% and California at 9.3%. Much of the presidential administration’s stimulus plan calls for significant infrastructure upgrades to roadways and bridges throughout the United State. However, 750 thousand of the recent job losses have been in office using industries: white collar jobs. What new jobs will this stimulus plan be creating for those consumers? Questions to be answered in the coming weeks as earnings reports are released, first quarter projections are made and more legislation is passed through the hands of our elected officials. Overall, one thing remains clear: as retail bankruptcies increase and unemployment soars, consumer confidence will continue to decline.