Recognition of growing problems in commercial real estate went media mainstream with an article in the New York Times, Some Fear Commercial Property Loans Will Be Next Stage in Downturn by Louise Story, 21 August 08.
Of course those of us in the biz knew that it was coming – see Quelle Surprise! Commercial Real Estate Loans Looking Wobbly at NakedCapitalism for a quick overview of various commentators’ past statements and Research Zeitgeist: Commercial Real Estate Next? at Research Recap for some updated info.
But one warning, a lot of the discussion centers on securitized mortgages with a dash of economic decline rippling through real estate. While not downplaying the first and believing that the second will be more of a problem than most predict, don’t forget cap rate decompression and tightening of standards in LTV (loan-to-value) and DSC (debt service coverage).
In simple form, the cap rate is the return on equity. If you buy a building with $1 million in net cash flow and pay $10 million to buy it – the cap rate is 10%. The lower the cap rate, the higher the value. So cap rate compression increases the value of the building and decompression lowers the value – regardless of the cash flow. A residential property with $1 million in net cash flow may have sold in the past at a 7 cap for $14.3 million but sold at the height of the market at a 5 cap giving a $20 million value.
If you borrowed 85% LTV on your $20 million “value” your debt will be $17 million. If the cap rate moved only to 6 – the value would drop to $16.7 million. Even with an 80% LTV new loan (and 70-75% is more likely) the new debt would only be $13.4 million and the loan will be in default – with no change in cash flow.
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