What's ahead for commercial real estate finance?Whenever we write about real estate finance and make predictions, we always review past predictions. Reviewing our last forecast, our main prediction continues to hold true. In mid-2005, we wrote, "As long as there is steady economic growth and the economic and social atmosphere of the New York metropolitan area New York–Northern New Jersey–Long Island is the most populous metropolitan area in the United States and the third most populous in the world, after Tokyo and Mexico City. remains attractive, gross income receipts from commercial properties will continue to improve. Consequently, investors will continue paying large sums for properties with initially small returns. Capitalization rates Capitalization Rate According to the Appraisal Institute, it is a method used to convert an estimate of a single year's income expectancy into an indication of value in one direct step, by dividing the income estimate by an appropriate rate. will remain the lowest for rent-regulated apartment buildings, where rents are far below market levels." Not all our predictions came true. We thought cap rates for buildings without upside potential Upside potential The amount by which analysts or investors expect the price of a security may increase. upside potential The potential price or gain that may be expected in a security or in a security average, generally stated as the dollar would increase with the rise in short-term rates. Short-term rates have moved dramatically upward, but the rise in longer-term rates has been slower, resulting in a flat yield curve Flat Yield Curve A chart that shows that the yields of bonds with short maturities are equal to the yields of bonds with longer maturities. . Since yields on long term real estate assets are believed to compare favorably with long-term bond rates, cap rates have not yet increased as predicted. Low capitalization rates continue to pose a problem for prudent lenders. Today, loans at 75% of purchase price often have inadequate initial debt service coverage. For both investors and lenders, the decision to invest requires a belief in the eventual rise in cash flow from a property. In today's market, cash flow from a property can be increased by some combination of the following: expense control, conversion to condominium condominium In modern property law, individual ownership of one dwelling unit within a multidwelling building. Unit owners have undivided ownership interest in the land and those portions of the building shared in common. or cooperative ownership, additional improvements and increasing the rent roll. While many owners consider expense control first, recent rises in energy costs, real estate taxes, water expenses and insurance costs have precluded many from realizing savings on their acquisitions. The best managers now just manage to keep operating expenses Operating expenses The amount paid for asset maintenance or the cost of doing business, excluding depreciation. Earnings are distributed after operating expenses are deducted. from growing too fast. Ownership conversion and the development of properties' potential as "for sale housing" is now a waning phenomenon in many markets, as increasing interest rates reduce the numbers of qualified purchasers. This recent change decreases the amount investors will pay to purchase rental apartments for their conversion potential outside of New York City New York City: see New York, city. New York City City (pop., 2000: 8,008,278), southeastern New York, at the mouth of the Hudson River. The largest city in the U.S. . In New York City and other markets, with supply constraints and rents suppressed by regulations, the conversion potential still attracts buyers willing to accept low initial returns. For the rental housing investor, the decline in conversion potential is offset by rising demand for apartments. If a household is not a buyer because of high carrying costs Carrying costs Costs that increase with increases in the level of investment in current assets. , then it adds to the demand for rental housing and market rents increase. Rising rental rates have been noticeable in New York New York, state, United States New York, Middle Atlantic state of the United States. It is bordered by Vermont, Massachusetts, Connecticut, and the Atlantic Ocean (E), New Jersey and Pennsylvania (S), Lakes Erie and Ontario and the Canadian province of since the last quarter of 2005. While the windfall of conversion has decreased, the potential for improving yields through rising residential rents continues to draw buyers and lenders. Although housing prices have held the attention of the public, professional real estate investors A real estate investor is someone who actively or passively invests in real estate. An active investor may buy a property, make repairs and/or improvements to the property, and sell it later for a profit. have been focusing on rising office, retail and hotel rents. Landmark or trophy office buildings in New York City are commanding over $100 per square foot rents and average midtown mid·town n. A central portion of a city, between uptown and downtown. midtown Noun US & Canad the centre of a town office buildings rents are in the $60 to $70 per square foot range. Even downtown and less desirable mid-block office buildings are seeing rents at or above the highs last achieved at the end of the technology stock bubble. Retail rents in high traffic areas continue to break records and hotels are seeing strong increases in both average daily rates and occupancy. Consequently, commercial property value growth is now greater than residential value growth. There is a surfeit sur·feit v. sur·feit·ed, sur·feit·ing, sur·feits v.tr. To feed or supply to excess, satiety, or disgust. v.intr. Archaic To overindulge. n. 1. a. of capital for investment in all flavors of equity and debt. This excess of capital has compressed lending spreads to historic lows. Eventually, attractive yields in other asset classes like bonds, stocks and commodities will draw dollars away from real estate if there is a slow down in rent increases and continued expenses increases. While we do not see an imminent decline in New York City real estate, if the economy slows and both demand for commercial space and consumer buying power Buying Power The money an investor has available to buy securities. In a margin account, the buying power is the total cash held in the brokerage account plus maximum margin available. Also referred to as "Excess Equity. decline, real estate values for all asset types may decline. This decline may be precipitous. Some market participants have never seen a decline in real estate values or have chosen to forget the declines of the market just 15 years ago. It isn't bold to predict real estate values will stop growing and decline for a period, unless one predicts the time and the duration of the decline. Prudent investors and lenders look for opportunities in all market conditions. Even in a downturn, there are buildings with unrealized potential for investors and the lenders who understand the objectives of their customers. We can only predict M&T will help our clients take advantage of opportunities as they arise in any part of the real estate cycle. BY GARDNER SEMET AND SCOTT LUBLIN, GROUP MANAGERS, COMMERCIAL REAL ESTATE, M&T BANK |
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