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.

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

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

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

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

Read more of what Bloomberg had to say here

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

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

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

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

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

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

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

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

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

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

About the Author

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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)

2) Get an Insurance Quote - Are your insurance expenses in line with the market? Many times owners stick with the same insurance plan and company for their community for years and years. Don’t get stuck in a rut. Test the market and shop around to find the best insurance plan for your community. Doing so could save you big not only in NOI, but also give you the peace of mind that your community is adequately insured.

3) Pass Through Utility Expenses – Are utilities expenses eating away at your bottom line? By passing the through water, sewer, and trash expenses on to the residents owners help to protect themselves from overuse and abuse of the utilities by careless tenants. Passing through the utilities expenses to the residents can sometimes be a touchy subject, especially in areas where vacancy is high, so owners have been known to discount the space rent to help mitigate a portion of the increased costs to the residents.

4) Image is Everything - What first impression does your community give to potential residents? The best tenants will be looking for high-quality, attractive communities. Simple practices such as a fresh coat of paint, pressure washing common area exteriors, and picking up trash are all affordable ways that please those paying attention to detail. A few flowers and nice landscaping will also add greatly to your community’s curb appeal.

5) Put Your Best Face Forward - Who is the face of your community? Your choice of staff will be the face of your business. Managers who can give a good impression to potential tenants with charisma and attentiveness, as well as capture your vision of professional service, will attract and retain your tenants and encourage referrals. Capitalize on the great supply of talent swimming in the current job market.

6) Space Rental Income Is Not Everything - How much ancillary income does your community produce? The most successful owners in this industry have recognized that income is not limited to the monthly space rent. Additional income generators include RV/boat storage, pet rent, safe deposit boxes, and a host of other creative ideas. It is also important to look at miscellaneous income items which could include administration fees, late fees, and merchandise sales.

by PGP Valuation Inc MHC specialist Kevin Evers

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.

1.) Market Intelligently – Are you maximizing your marketing dollar?Are you thinking outside the box? A variety of marketing tools exist intoday’s self-storage industry. In addition to traditional media types such as print ads and yellow page listings, an effective website can beessential to capturing today’s savvy consumer. Approximately 80% ofyour tenants will come from a certain demographic and are comingfrom a select few marketing programs. Know your demographic!Some great ideas can be found in Ken Brown’s great article in theFebruary 2009 SSA Globe Magazine.

2.) Don’t Give it Away for Free – Are concessions hurting or helpingyou? Concessions are a powerful tool to attract tenants. However, becareful not to advertise blanket specials. Instead, concessions shouldbe strategically targeted to increase income by discounting specific unittypes that have historically low occupancy levels. This will not onlyincrease the productivity of those unit types with higher vacancies, butwill also sustain the economic productivity of unit types heavilydemanded by the market.

3.) Leverage Zoning – Are you aware of the extra value hidden in theland beneath your facility? Knowing the zoning code that governs yourparcel can open up opportunities to create substantial income streamsthat are steady, dependable, and low-maintenance in nature. Potentialways to leverage your zoning include RV storage, cellular tower’s,billboard leasing and a host of other creative ideas.

4.) Maximize Unit Efficiency – Is the layout of your facility negativelyaffecting your income generating potential? Maximize the productivityof your property. Remember that overall income trends upward as unitsizes decrease in most markets. To the degree that the market willabsorb them, partition unnecessary large units into unit sizes that rentat a higher price per SF to recapture lost potential income. Again, knowyour demographics! Ending up with too many 5×5 units will result in lowoccupancy and unsatisfied income expectations. 

5.) Image is Everything – What first impression does your facility give to potential customers? The best tenants will be looking for high-quality, attractive facilities. Simple practices such as a fresh coat of paint, pressure washing doors and exteriors, picking up trash, and sweeping out units are all affordable ways that please those payingattention to detail. A few flowers and nice landscaping will also add greatly to your facility’s curb appeal.

6.) Put Your Best Face Forward – Who is the face of your facility? Your choice of staff will be the face of your business. Managers who can give a good impression to potential tenants with charisma and attentiveness as well as capture your vision of professional service will attract and retain your tenants. Capitalize on the great supply of talent swimming in the current job market.

7.) Track Your Performance – Do you know exactly what your facility’s weakness is? Do you know how potential customers are being received by your staff? By keeping detailed records on a per unit basis you can address individual supply and demand issues. By keeping track ofyour customer service and tenant flow you can notice trends that may help you capture more business. In both instances, tracking your performance can help you chart your path to increased value.

8.) Know Your Neighbors – Do you participate in your community? All things being equal, the vendor that establishes more relationships within the community and becomes known for its services will always generate the most business. Get involved with businesses and residents, and you will gain a more intimate knowledge of your market area, which will allow you to customize yourself to their needs.

9.) Utilize Security – Do tenants know your facility is safe? Reliable and visible security features will attract high quality tenants and lend to the credibility of the facility. Video surveillance, electronic gates, fencing, individual unit alarms, and on-site management are all becoming standards in the self storage community.

10.) Storage Income Is Not Everything – How much ancillary income does your facility produce? The most successful operators in this industry have recognized that income is not limited to the monthly rent of their units. Additional income generators include RV/boat storage, specialized wine storage, safe deposit boxes, and a host of other creative ideas. Also, look at miscellaneous income items which could include administration fees, late fees, merchandise sales, truck rental, video conference rooms, and auctioning services.

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

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

What causes declines in Market value?

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

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

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

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

Finding Market Capitalization Rates without Recent Transactions

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

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

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

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

Introduction

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

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

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

Appraisal Process

1) Define the problem

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

2) Preliminary Analysis and Data Collection

3) Highest and Best Use Analysis

4) Land Value Estimate

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

6) Reconciliation of Value and Final Value Conclusion

7) Report the Defined Value

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

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

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

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

1.     Buyer and seller are typically motivated;

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

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

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

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

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

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

Appraisal Reporting Options

An appraiser has 3 options for written reports:

Self Contained

Summary

Restricted Use

Three Approaches to Value

• Cost Approach
• Income Approach
• Sales Comparison Approach

Cost Approach

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

Or

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

Replacement Cost New

All costs to construct

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

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

(+) Profit

Sufficient entrepreneurial incentive to compensate risk

• -Varies based on market sector

Developers (10-20%)

Users (5%)

Sources: Market survey, alternative investments

(-) Depreciation

Three Types

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

(+) Land Value

Cost of equivalent substitute site

• -Valuation techniques

Sales comparison (most typical)

Residual analysis

= Cost Approach Value

Most Applicable for:

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

Limited Application for:

• Investment properties

-mostly to test financial feasibility

• Older construction

-difficult to measure accrued depreciation

Cost Approach in a Declining Market

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

Replacement cost becomes a less reliable indicator of market value.

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

Income Approach

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

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

Direct Capitalization – Most Commonly Used

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

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

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

A basic Income Approach is:

Potential Income – Vacancy = Effective Gross Income

Effective Gross Income – Expenses = NOI

NOI /Capitalization Rate = Value

Limitations - The limitations of this approach include:

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

Common Mistakes - Common mistakes made by market participants include:

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

Income Approach in a Declining Market

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

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

Sales Comparison Approach

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

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

Sources of Comparable Data

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

Typical Units of Comparison

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

Most Applicable for:

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

Sales Comparison Approach in a Declining Market

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Debt Coverage/Equity Dividend Analysis – Most investment properties are purchased with debt and equity capital; therefore, the cap rate must satisfy the market return requirements of both investment positions. Lenders must anticipate receiving a competitive interest rate commensurate with the perceived risk of the investment or they will not make funds available. Lenders also require that the principal amount of the loan be repaid through period amortization payments. Similarly, equity investors must anticipate receiving a competitive equity cash return commensurate with the perceived risk or they will invest their funds elsewhere.

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

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

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

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

The preceding table clearly shows that cap rates bottomed out in the third quarter of 2007. As depicted in the Retail Cap Rates – OR table ahead in the Cap Rate Trends section, strip centers in the Oregon marketplace have consistently been trading at lower effective cap rates compared to the national averages. This region’s resilience to the changing national real estate market is commendable; however, the sweeping change in the mindset of investors has caught up here as well. Due to the substantially reduced transaction volume (down as much as 75% in 2008), it is rather unclear when the inflection point occurred; nonetheless, local cap rates have bottomed out and are on the rise. Pinpointing the applicable cap rate for the subject using national survey data is very subjective. The most reasonable cap rate that can be derived from this analysis is presented in the following table.

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

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

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

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

Capitalization Rate Conclusion – For investments of the subject’s general size and price, and when sales activity is brisk with relative market stability, the Market Extraction Method is most often relied upon by buyers and sellers to develop cap rate decisions. However, recent events indicate rapid and profound shifts in the financial environment and the economy on local, national and global levels. The other two approaches developed have varying limitations, but generally support the upward shift in cap rates. The subject has a strong track record for retaining tenants, and it is very well positioned noting prime exposure and its pad location within a regional shopping center. Taking all these factors into consideration, the following table summarizes the various cap rate indicators and provides the final cap rate conclusion.

National Dealership Trends

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

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

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

National Industry Trends

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: NADA, AutoExec Magazine, May 2008

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

Regional and Local Trends

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

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

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

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

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

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

Current Listings/Most Likely User

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

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

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

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

Local Supply and Demand Considerations

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

Summary of Supply and Demand Considerations

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

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

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