Understanding real estate values in a rising market.

With rents rising and space becoming ever tighter, it may seem like a good time for corporate users to again consider purchasing their own real estate and break from the trend of moving owned facilities off their balance sheets. Rental rates have reached all-time highs in many of New Jersey's markets, with current vacancy rates below 10 percent, on average. These facts have made it increasingly difficult to find affordable space and have forced corporations to employ longer planning horizons and fill their space requirements using more creative solutions. However, for the same reasons that leasing has become more difficult, purchasing real estate is also less attractive, as rising rental rates and falling vacancy rates elevate building values.

The relationship between real estate values and rental rates can best be exemplified by the simple concept of the income capitalization or "Cap Rate." This one-year rule of thumb is calculated by dividing net operating income (a function of rental rate) by the capitalization rate to derive value. The capitalization rate itself is a function of the investoris desired return and a combination of the costs of debt and equity employed in making the investment. As an example, an office building with a net market rent of $10 SF divided by a 10% income capitalization rate implies a building value of $100 SF, while a net rent of $25 SF implies a value of $250 SF.

As a result of this relationship, the recent rise in rental rates has also elevated building values. This correlation has remained consistent throughout most of real estate history, as prices have risen and fallen more as a function of the strength of the market than of the physical characteristics of the buildings. However, with rents reaching such high levels, the application of the cap rate formula is starting to elevate building prices above replacement costs, which has led to the realization of a "glass ceiling" on real estate values.

An important factor in realizing the existence of this glass ceiling is a more sophisticated technique of real estate valuation n discounted cash flow analysis. The discounted cash flow, or DCF technique, considers two factors: income over the holding period or cash flow and the residual value of the property or future sale price. From an investment perspective, the income over the holding period is fairly predictable, while the residual value is very speculative. Complicating matters is the tendency to use a variation of the Cap Rate method to estimate residual value, and therefore the projected residual value can be skewed. Discounting back both the income stream and the projected residual value at traditional rates of return leads to implied values above replacement costs. To offset this fact, investors often imply a ceiling on residual values. The implication is that investors in this market are reluctant to pay more than replacement cost, as they worry the residual value of the property will not meet re turn expectations.

For technology companies in New Jersey, Cap Rate analysis can provide a snap shot of value, but should be utilized cautiously when making a decision to lease versus buy. In many East Coast technology markets (i.e. Boston, Virginia) rental rates have increased dramatically as a function of demand for technology space. With increases in rental rates, the asking prices for technology buildings have often eclipsed replacement costs. As the above example indicates, a 10% return on a net rent of $25 SF implies a value of $250 SF, and most suburban office buildings can be constructed for under $200 SF.

Of course, corporate users are generally not looking at real estate as an investment, but as an alternative to the high costs of leasing. However, they do need to consider their cost of capital when making the decision to lease versus buy. If the cost of capital is low enough, the decision to buy may still be a viable option. Leasing becomes a more attractive option as the cost of capital and the acquisition costs increase. The cost of capital is generally high for technology companies, as investing in research & development facilitates substantially more growth, and the company must always consider the correlation of owned assets to stock price.