Real estate valuation in uncertain times: Is the worst really over?

Government bailouts, TARP, TALF and a U.S. recession fueled by a steep rise in the unemployment rate and continued job losses have all contributed to a certain degree of uncertainty in all real estate asset classes. The U.S. economy reportedly entered a recession in December of 2007, but was not announced until nearly a year later in November of 2008, according to NBER. Moreover, the New York and New Jersey lagging economy and regional business cycles may lag behind the rest of the nation's recovery according to the Second District Federal Reserve Bank report of September 2009. The Fed's Report attribute this concern to a recent weakness in both the financial services sector, which is roughly down 42,000 jobs from its peak in January of 2008 in addition to the hospitality sector. Both job sectors touch upon many other industries, including real estate and state/city tax revenues. The report also states adverse job trends with a New Jersey July 2009 unemployment rate of 9.3% and 8.7% for the same period reported for New York City. The economic impact has reportedly dropped new development sales by more than 65%, according to Street Easy and Jonathan Miller, corresponding with a drop in co-op or condo sales of 21.4% according to a second quarter Elliman's report. Adding to a drop in sales price is longer absorption periods, increased vacancies and prolonged marketing periods of six months or more. On the office front, vacancies in Manhattan are in excess of 11% according to a third quarter C&W report, making 2009 the weakest 12-month period in 13 years according to the same survey. Most office experts forecast a continued softening with no near term signs of a positive uptick. Although retail sales show some indication of growth, most likely fueled by the "cash for clunkers" program and a peak in gasoline prices, continued store closures and bankruptcy filing are imminent (e.g. Circuit City, Home Expo, Linens 'n Things, Steve & Barry's, Washington Mutual, Wachovia, etc.). Analysts estimate that 10% to 26% of all retailers are in financial distress. However, Long Island's vacancy rate according to the 2Q CoStar Report is 4.9%, with a quoted rent of $29.00/SF, a slight decrease from the 2008 indice. New York Metro warehouse and industrial vacancy rates have increased, but here again are reported at less than 5% for the Long Island region. However, a notable decline in overall pricing of 10% to 20% was indicated by several notable sources. Rental rates are reportedly averaging in the $8 to $10/s/f range, with flex space approximating $15/s/f, according to CoStar's 2Q report. In terms of residential, new housing pricing remained relatively unchanged in July and are reportedly 11.5% lower than a year earlier according to a recent Case - Shiller NY Metro survey. In fact, modest price gains of less than 1% were noted in certain markets. Part of this uptick is attributed to low interest rates, but most experts project a continued, but more moderate decline through year-end. As stated earlier, national full-service hotel occupancy is at the 60% level, approaching the historic peak of 55% in 2001. Reported ADRs are also down, with many planned projects put on hold, including several notable sites in Manhattan. A recent report indicated a fifth of U.S. real estate loans are in distress. This trend is expected to continue while the commercial real estate sector continues to experience increasing vacancies, declining rents, and concessions become the norm. Adding to this commercial loan debacle is the reported $800 billion of CMBS notes maturing over the next three years, which will now be priced under new credit conditions and lending standards. As such, deteriorating property performance and increasing CMBS defaults are imminent. The recent lender philosophy of "extend and delay" is certainly prevalent with no realistic exit tragedy prevailing. A case in point is the recent Stuyvesant Town CMBS debt of $4.5 billion now in jeopardy according to a recent Fitch report as set forth in recent Globe Street and Journal articles. So, how do the above discussions impact real estate valuations? Firstly, yield spread on both the capital and investor sides are up. Typical matching t-bill spreads are ranging from 300 to 400 basis points on most asset classes. Yield rates have increased to the 9-10% levels, while loan-to-value ratios have decreased to 75% and below in conjunction with higher debt coverage ratios of 1.30 to 1.50. Commercial interest rates still remain attractive in the 6 to 6.75% range with 5-10 year fixed terms and 25 to 30 year amortizations. These fundamentals have resulted in higher cap rates of 100 to 200 basis points. As a result of deteriorating fundamentals industry wide, market conditions obviously favor both buyers and tenants according to a third quarter Korpacz Survey. Obviously, buyers will wait on the sidelines for the right opportunity to invest at higher cap rates, lower pricing and more favorable IRR's. Renters will be able to negotiate more favorable lease terms and concessions at "pre-boom" rental rates. So where are we - back to basics and real estate fundamentals and, yes, positive cash-on-cash returns. Richard DiGeronimo, MAI, CRA, SRPA is president/founder of R. D. Geronimo Ltd., Mineola, N.Y.