Commercial Real Estate: Finding Real Value

A Discussion around Current Events pertaining to Real Estate

OK Boomer

Well, I’m not a boomer. It’s just what I do in my day job. But I get why people think boomer when it comes to real estate chatter. It’s a market with some pretty significant barriers to entry, mainly cost, that keep most people under 30 out.

For most too, the first experience you have in real estate is buying your first home or condo. You generally don’t think about real estate except for surfing Zillow while you daydream. But there is a very large market for people in need of real estate. Think about it, almost 400 million people in the United States, all in need of housing. Then you have malls, strip centers, gyms, warehouses, event centers, country clubs, restaurants, movie theatres, bowling alleys, and much more. Commercial Real Estate(CRE) basically encompasses any business need for brick-and-mortar real estate as well as any rental or tenant based real estate. Residential encompasses any personal and familial need.

I hope this article stands to serve as an in-depth introduction to you about the finer details of CRE as well as the current state of CRE markets, which have been seeing some interesting events occurring as of late that I haven’t seen reported in the news. To qualify myself I’m a CRE lender, and a lot of this knowledge is that which I’ve acquired as part of my trade in helping people to acquire real estate, as well as observations I’ve made about the real estate market I service. There will be some extrapolations to residential and the broader capital markets as I try to paint similarities and differences for you all.

For your own personal use, you may find this article enticing if you’re looking to acquire CRE, or are someone interested in investing in real estate, or are just looking for an insider’s perspective on what the real estate markets are looking like at present. I hope you enjoy.

A Brief History

It’s likely you know that real estate caused the ’08 market crash. Let’s talk about it.

Essentially, as encompassed in this clip from The Big Short, a lot of independent groups all across the vertical chain of residential real estate got very comfortable taking on risk because it paid well. And over a span of 40-50 years of constant real estate growth, people started taking risks that relied on the market to continue going up.

This led to the severe unwinding of leverage in 2008. Essentially an 80 year event, the great debt cycle, as discussed by Ray Dalio.

Here’s a link to Ray Dalio’s Economics if you’d like to understand the reference better.

Since 2009, we’ve seen a large change in the way risk is read and approached. Income verifications returned, appraisals and valuations made some sense again. And the market began an upward trend. But we did experience one thing that I don’t believe most lenders really understood since we haven’t seen it in 80 years. The 0% interest rate environment. Last time we held at 0% for a long period of time was after the great depression, so very few in banking knew what kinds of risks came from an elongated period of 0% interest.

And so the period between 2010 and 2019 was filled with people taking advantage of an extremely low cost of capital. Why not take on as much debt as possible if you can get a 7, 8, 10, 12% return on investment annually? Your cost of capital is 3-5% as an established operator. And banks were lulled into a false sense of comfort when it came to repayment ability, because affordability was so high.

And many who began utilizing debt in this period really didn’t understand how debt instruments work, all they cared about was the monthly payment and costs to them.

2020-2022 was a very frothy time. With real estate valuations shooting higher by the day, many felt a fear of missing out in wanting to buy a home and jumped on, bidding 10-25% over market price in many instances. And for a while, banks were accepting this as the “new paradigm”. But that environment couldn’t last. And with the Federal Reserve(Fed) beginning to raise rates to combat the inflation surge, the cost of capital began to rise in response. It may have felt slow and grueling listening to Powell speak about quarter point and half point rises, watching capital markets react negatively month after month, but it was a relatively quick hiking cycle based on history.

The Cost of Capital

The cost of capital is important, as most goods and services in the US right now are purchased with debt.

Overall, the national average card debt among cardholders with unpaid balances in December 2022 was $7,279 – Lending Tree

Any large purchases are almost always debt based. A house, a car, most people don’t have the capacity or even an interest in making these purchases with cash. And because of this, the cost of capital is all the more important for these markets.

The average car payment as of August 2023 is $738/mo - @GuyDealership, Twitter

And right now, people are financially strapped, and even though inflation has been brought under control, new purchases are fetching expensive monthly payments because of the offsetting rise in interest rates. To compound this, credit markets are tightening, so lenders are being all the more stringent in determining your creditworthiness, meaning you may not qualify for the caliber of credit you did before, even if your credit metrics didn’t change.

Now, as with the car example above, the vehicle debt market turns over every 6-7 years while the real estate debt market turns over every 25-30 years. So the influence of recent inflation and interest rate increases is not yet as prevalent on real estate as a whole. But affordability is very low right now for new home buyers and investors looking to utilize debt. The average new mortgage monthly payment is just under $3,000.

Up until now, we’ve been discussing the personal consumer, personal credit, and residential mortgages. We’re now going to take a deeper look at businesses, the business owner, and the commercial investor, the crux of this article.

If you thought the cost of capital for individuals was bad, would you be surprised to know that the cost of capital for businesses is worse? Unless you have an extremely strong cash flow and balance sheet, you’re not getting the best(A paper) rates from institutions right now, and lending institutions are doing everything they can to push out the low-rate paper on their books.

Low-rate paper is actually a loss to institutions. If they wanted to sell 3% interest rate paper, they would have to offer them to the market at a discount in order to sell them right now because that 3% paper has to compete with what the market deems as par or the average loan. And a lot of institutions are stuck with metric tons of this low-rate paper with no interested buyers.

What I am personally seeing in the marketplace is a lot of regional banks forcing businesses, even longstanding relationships, to pay off their loans because of broken covenants like lack of repayment ability or a single late payment or not enough cash in reserve.

Covenants are basically rules a business has to follow to stay compliant with their loan. And when one is broken, the bank can “call” the loan, forcing the business to refinance the debt elsewhere, in the process also taking on higher risk debt, going from A paper to B paper, and getting worse terms.

Essentially what this forces is businesses with low rate debt and a modest financial position to acclimate to the current market environment and get competitive rate debt, increasing the business’ cost of capital and decreasing their financial position. And what most people, even those who operate in the residential real estate space, don’t necessarily understand, is that much of the existing CRE debt is on shorter term balloon notes, often with payments as interest only. The residential market is most often a fixed rate, long term environment, while the commercial environment is much more diverse and mixed. A business cares more about the monthly payment, an individual cares more about favorable loan terms.

Affordability

Affordability is a bit different for individuals seeking to buy residential real estate than it is for businesses seeking to buy CRE. For an individual, you verify your income, talk about your expenses, and the bank determines whether or not you can afford the monthly mortgage payment.

Whether a business wants to buy investor properties, buy to occupy and use, or buy multi-family apartment complexes, the business is judged based on its cash flow. A business’ cash flow is essentially its income, and instead of looking at percentages of income, a lender determines a business’ ability to repay by calculating something called debt service coverage. It’s a ratio, that shows what the annual costs of the loan will be compared to how much the business historically makes annually.

This is how a business is determined to be able to repay the loan. A 1.15-1.2x debt service coverage ratio over a 2 year lookback is usually sufficient for any bank or institution. Another way to say this is a business has a 15 to 20 percent buffer in income to make loan payments.

The problem is that as interest rates rise, so too do the monthly payments or annual cost, so a business that could service its debt at 5% interest cannot service the same debt at 11% interest. And as I said before that commercial is much more frothy with short term loans, balloon notes, interest only components, hard money loans, and the like, that usually come due in under 10 years, the turnover rate on CRE debt is much faster than residential debt. That in combination with businesses being forced out of their low rate debt due to broken covenants and you have a CRE market with a slew of business owners and investors unable to service debt at current market rates or looking for new lenders to refinance them out of their note coming due or the bank calling the note.

This is causing a lot of churn. But at the same time, the churn is almost entirely consisting of refinances, some who can’t service their mortgage debt on current operations. Who is out here purchasing properties to open new businesses? Who is the new entrant in the marketplace?

The answer? Novel demand for CRE has been turbulent over the last 2 years, but I would say that there is still consistent demand for CRE. The problem is that these buyers do not have much in the way of cash on hand and again struggle to service the debt on a mortgage by cash flow standards. So there is less purchasing overall taking place. And lenders aren’t as keen as they were 24 months ago to lend at high LTV’s(Loan to Value) when the cost of capital was lower, affordability was higher, and repayment ability was better.

Personally, what I’m seeing is that as a lender, historically over the last 2 years I would have to work through 2 to 3 loan requests to find a viable one. Now, based on the past 6 months, that number is up to 6 to 8 loan requests. Essentially, there are a lot more unqualified borrowers looking for mortgage debt based on the current market pricing. Keep in mind, at the interest rates of 2021, these underqualified borrowers would have qualified for the same debt they are looking at today. Now, this brings things to an interesting head, and this has to do with Asset Valuations.

Asset Valuations

Usually, affordability and liquidity run the market, and pricing slowly rises year over year. That’s not the case right now, you have a very inelastic market. In 2020 and 2021, supply was low and demand was high. In 2022 and early 2023, we saw demand lower and supply still low. Now, we’re seeing supply increasing. For my economics friends, essentially the Supply and Demand chart has been quite dynamic since 2020. But with the current environment of increasing supply and decreasing demand, we’re sitting in a somewhat precarious position. Price, technically, should go down. But it hasn’t yet. Not significantly.

Something interesting has started taking place in the last 60 days. And it’s not everywhere, not yet, but I’m starting to see appraisals come back low. Very low compared to purchase prices and what I expected. And the strange part about it is, this has happened across multiple states with multiple loan requests, from multiple reputable appraisal companies.

What these markets have in common is that they are well established, saturated markets where cap rates have drifted down into a very low, secure environment, and people became comfortable purchasing at these cap rates.

Cap Rate is a measure of a property’s yield over a year, calculated by dividing its net operating income by its asset value. – JP Morgan Insights

Now remember what I said about how repayment ability is determined by the cash flow of a business? Aka, its income? Well, net operating income as mentioned in the JP Morgan reference is what a property can fetch if it charges market rent after all general costs like insurance and tax. And that income is used to pay for the mortgage debt.

Cap Rate = NOI / Property Value

If the monthly cost of mortgage debt increases, you need increased income to service the debt. If the income can’t increase or the market rents won’t increase, the only other option is to lower the value of the property to where the market rents can service the mortgage debt.

Essentially saying, a 4% cap rate property can’t service a 10% interest CRE loan. And cap rates are rebounding to reflect the current market environment in certain markets where demand has fallen far enough away to where appraisal companies have to use comparable properties that were sold under this new valuation model, either by fire sale, default, or the like. When a 4% cap rate increases to an 8% cap rate with no change in NOI, you have to reduce property valuation by 50%, per the equation above.

The consequences of this are there are many sellers and owners that may now be underwater on CRE. I’ve seen in the few examples that have come to me so far that a 2017 buyer is heavily underwater, and the appraisal came back 65% below asking price.

And because of the inelastic market due to a lack of liquidity, this is a situation that can be perceived as “the floor falling out” of the CRE market in certain geographic areas that have fallen prey to low cap rate satiety.

This market development obviously has widespread effects on CRE owners and the market as a whole but is likely a foreshadowing of the events to come with residential. Where residential doesn’t necessarily have cap rates, residential does have affordability based on individual income of buyers and will likely see something similar take place where investors hit a glass ceiling of what they can charge in market rents but cost of capital continues to rise.

I get the feeling though, that the Fed will step in as this event begins to come to light on the residential side and will lower interest rates or increase QE, providing a more liquid marketplace or better affordability. This feeling comes from next year being an election year and inflation being down around 3-4% right now. There’s a narrative where the Fed can lower rates in the near term to “save” the market from the floor falling out. We’ll come back to this at the end.

Creditors

The evil banks, the institutions that provide you with access to debt, how dare they charge you costs for capital. Usury!

Really though, lending institutions are an important piece of the CRE market because they’re the ones financing the majority of a CRE purchase. It’s important to understand how a lending institution looks at things so you know what you can and can’t utilize them for.

Speaking to asset valuations and the pickle that it puts lending institutions in, a lender has to lend based on what is perceived to be the fair value of an asset, and there are two main methods of deriving what fair value is.

1. Comparables – looking at local similar CRE and considering how it was valued

2. What someone is willing to pay for it

Each has their positives and negatives, and no valuation method is perfect. It’s about getting close.

Anyways, what we’re observing with appraisals in the marketplace is that people couldn’t get financing to pay for properties because the market rents couldn’t support debt repayment at the valuation the property was being sold for, so sellers had to drop prices lower and lower until a banking institution was willing to lend because it financially made sense. And this happened enough times in certain markets that comparable properties are now showing this new valuation model. Maybe some of these instances as well weren’t sellers dropping their prices, so much as it is a fire sale or auction situation. In those instances, valuation by cap rate becomes even more important.

Essentially, no lending institution in such a tight credit environment as we find ourselves in now is going to take unnecessary risk by disregarding an appraisal, so they are bound to the appraisal valuations.

In the end, it technically protects the buyer, but many don’t see it that way. Buyers are angry because they believe they’ve found a property that fits their need or that they perceive as a good deal. Sellers are angry because industry professionals don’t deem their property worth what they believe it’s worth. Money, value, and wealth make people emotional. The job of a lending institution is to take the emotion out of it and logically assess risk. And the market is in the process of re-evaluating that assessment of risk. It’s just in a very abrupt way because of the lack of liquidity in the marketplace.

Unfortunately, this re-evaluation creates some distress in the marketplace that you don’t see during normal periods of growth. Owner-occupied businesses have a strong desire to buy the property they operate out of, but if the seller is adamant about a valuation that an appraisal can’t closely match, who is to pick up the balance? Not the bank, surely.

Opportunities

Where one loses, one stands to benefit. Simply put, and as I hope you all well know, the goal is to buy low and sell high. When asset valuations drop by 50-65% in certain markets, and sellers are forced to face the reality of this situation, you may find that it makes sense to invest in CRE, even if you have no experience in the industry prior.

Maybe you see a cap rate property at 9% that you believe is in a very secure neighborhood, and you have an interest in opening up a franchise burger joint. Maybe those two ideas align with how the property is built out and you can get the seller to meet the appraised value. Compared to someone who bought in 2021 with a variable rate CRE loan coming due in 2026, you’re getting a similar asset valued at half of what they bought theirs for. You may pay more in interest, but your monthly payment will still be much lower. You’re already starting out at a cost advantage compared to competitors, and you have much less principal to pay down if you want to clear the property of debt.

Maybe you see a mixed use retail store with an apartment or two upstairs, and the local residential market is holding very strong. You rent out one of the apartments, live in the other, and rent out the first floor retail storefront. Maybe between the other two tenants, your rent comes out to $800/mo, $1,000 cheaper than you would have been able to get housing elsewhere.

The point here is, as much as affordability is very important, there is value too in getting something at a value discount to the market, even if it’s less affordable. And during repricing events, there are bound to be situations where the re-evaluation can be exploited to your benefit.

Don’t get emotional about credit, banks and lending institutions aren’t. If you’re in a dire credit situation, pay off your personal obligations that are hanging you up, specifically credit cards. Use credit to your advantage, and realize that we’re in a shifting landscape and your goal should be to slide into a good opportunity making as few waves as possible, and when the loan closes, run with your newfound opportunity.

And if you think “why even try” because credit is so tight right now, get crafty. Banks may be saying no a lot, but that’s A paper. There are B and C paper lenders that still have competitive rates. If the deal makes sense and you’re willing to put in the effort, it will get done.

Final Thoughts

For people thinking “this is only the beginning” meaning that we will have years of a downtrodden economy, you’re very likely wrong. The massive debt unwinding occurred in 2008, we’re currently in the beginning of an inflationary expansion cycle, and it will likely be even more aggressive than the last 80 year cycle because this cycle has humble beginnings based on a fiat monetary system. The next 5 to 10 years will be rocky with waves of credit defaults, jumps in inflation, and a likely shrinking of the middle class. That doesn’t mean there isn’t opportunity for long term buy-in however.

It's likely that this environment where opportunities are presenting themselves won’t be publicized until it hits residential markets, and even then, it likely won’t be prevalent until the very end of that pain. There is good reason to believe that the Fed will step in and provide liquidity through QE or lower rates to bring buyers back into the demand curve before this becomes a cascade situation. It’s just the way things are now, the backstop will step in to preserve markets wherever they falter. And with that being said, now is likely an opportunity to buy something at a fairly deep discount before the price propping due to excess liquidity becomes the norm again.

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