The Falbey Report: January 2011

Tuesday, January 25, 2011

What Does the Future Hold for Master-Planned Communities?

According to ULI – The Urban Land Institute, master-planned communities (MPCs) “are usually a product of long-term, multiphase development programs that combine a complimentary mix of land uses…(that) typically occur on ‘greenfields’, that is, tracts of formerly undeveloped land often at or beyond the urban fringes.”¹ The classic MPC is primarily residential in nature with a mix of dwelling units of several different sizes and configurations as well as price points. They often include commercial and recreational components.

In today’s market, MPCs are the redheaded stepchild. The reasons are manifold:

MPCs are usually large-scale developments that have multiyear life cycles which means a commitment of substantial capital at the beginning, and capital is not currently interested in MPC development – too risky, thus too expensive;
With the current huge overhang of residential properties in most areas, there isn’t sufficient demand for more new housing;
The recent plunge in housing prices makes it impossible, in many instances, to build and sell new housing that is priced competitively with existing;
This often produces zero residual land value, and, so far, no one is giving land away;
In addition, in most areas where there might be some demand, the regulatory environment has produced added costs that at the present time eliminate any opportunity for competitive pricing.

That’s the story today, but what about the future? There is a lot of palavering to the effect that the day of the exurbs has passed, and all future development will consist of dense, compact (smaller units), mixed-use, high-rise properties on infill urban parcels. I’m not buying it and here’s why:

The job market will recover eventually;
When it does, the overhang of existing properties will be absorbed, thus creating demand for new;
This will result in an increase in housing starts, and not all of them will be compact urban development;
Why? Because Generation Y will age, and when it does, its members will begin to turn away from the live-work-play in the same place. They will start families and many will want detached single-family residences with yards. That’s not a desire that’s unique only to a particular generation.

Most of the residences in new MPCs undoubtedly will be smaller than in the past for at least two reasons:

The party’s over in the United States. The changes currently occurring in our world as well as our economy are imposing a downward shift in lifestyle affordability, which in turn affects quality of life. We will not see a return of the rising tide that lifted the Boomers’ ships to incredible highs. There will always be an affluent class, but the middle class will be poorer;
Housing costs, including the added costs of ever-increasing regulatory measures, as well as the costs of transportation from the exurbs to workplaces, schools, etc., will eat a greater hole in Generation Y members’ budgets.

These factors and others will be met only by downsizing the residence. But, the good news for the residential development community is that MPCs are not a class of dinosaur.

¹Trends and Innovations in Master-Planned Communities, 1998, Schmitz and Bookout, ULI-the Urban Land Institute, ISBN 0-87420-800-9.

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Monday, January 17, 2011

The Cap Rate – Part 3: What It Is; What It Does

In Parts 1 and 2 on the Capitalization Rate, we discussed how the cap rate is utilized and how it’s calculated. In this final section, we’ll discuss the flaws in the cap rate and what its recent history and usage tell us.

1. What is the basic flaw in the use of the cap rate as a measure of return on a long-term investment?

The basic flaw in the use of the cap rate is its focus on a single year, whereas a typical income property investment is a multi-year proposition. Thus, you have to recalculate the cap rate for every year of the projected life of the investment. You basically are estimating NOI for each of those years as well as the projected value for each year; then, using the IRV formula discussed in Part 2, you calculate the return those numbers indicate by dividing the given year’s NOI by that year’s estimate of value for the property (R=I÷V).

2. In the middle part of the last decade, cap rates compressed to as low as 1% - 2%, while bond rates hovered around 5%. What motivates “sophisticated” investors to settle for such a low rate of return in an investment that’s as high risk as real estate?

To put that into perspective, here’s an example:

· A property is producing NOI of $250,000 and is acquired for a total purchase price of $10,000,000, or a cap rate of 2.5% ($250K ÷ $10M);

· Assume the purchase price represents $500 per square foot;

· The purchaser expects to sell the property within 2 years at a price of $650 per square foot.

Where is the investor’s real profit motivation?

Obviously, it isn’t in the cap rate during the operating years. It’s in the anticipated appreciation of $3,000,000 realized in the resale two years or less down the line. In other words, the investment expectation was to flip the property quickly for a profit sufficient to lift the overall rate of return as measured on the short life of the investment, such as by using a discounted cash flow method like the Internal rate of Return (IRR) method. Discounted cash flow analysis will be a topic of future postings to this blog.

In a red-hot or bubble real estate market like the mid-2000’s, this form of thinking is prevalent.

But then cap rates decompress (rise) back to historic norms, or higher. Why? Because when the bubble bursts, realization sets in that properties were overvalued. The market is uncertain where values will stabilize, so sales are few. Most sales in this situation are short sales or distress sales (bankruptcy, foreclosure), and don’t represent fair market value. Compounding the problem is the rising vacancy rate and increasing concessions to tenants due to business failures and the reduction in space needed by those tenants who survive by eliminating jobs.

The uncertainty revives the awareness of risk inherent in real estate investments, so the required rate of return increases accordingly. The greater the risk, the greater the required rate of return on invested capital.

In this kind of market environment some investors foolishly assume an ability to raise rent levels or cut vacancies or lower operating expenses or some combination thereof, which will increase NOI in future years; thus, increasing the rate of return. That, however, won’t happen because leases are binding contracts that span years regardless of changes in the property’s ownership; thus rents cannot be raised arbitrarily until the lease expires or is breached by the tenant

In the meantime, it’s good to remember that in past recessions the recovery of the commercial real estate sector consistently has lagged that of the larger economy. On a brighter note, effective rent should start to grow once job growth begins. When that occurs, then we should start seeing an easing of vacancies and tenant concessions in the marketplace. With the growth of NOI, values will start to rise, confidence and investor interest will be enhanced, and cap rates will begin to compress again.

At the moment, however, cap rates in the 5% to 5.5% range are seen only where the property is a core asset. These usually are well constructed, well-located, modern buildings enjoying 95% to 98% occupancy on long-term leases with very creditworthy tenants and located in gateway cities.

Tuesday, January 11, 2011

The Cap Rate - Part 2: What It Is, What It Does

In an earlier posting to this blog, we introduced the concept of the capitalization rate or cap rate, and discussed the basics of it. This discussion will expand on that discussion.

Simply put, the cap rate measures the return on total capital invested in an income-producing property in any given year of operations. Total capital invested means all equity and all debt utilized in the deal. It also can be used to determine the market value of such a property.

There are three components to the cap rate: Income; Rate; and Value, which combine to form the acronym IRV. Income generally is net operating income or NOI. It is derived from Gross Income (expected income from all sources). First, loss of income from vacancies is subtracted, then credit losses are subtracted. This leaves Gross Operating Income (sometimes referred to as Adjusted Gross Income), or the funds generated by the property available for use by the owner.

Operating Expenses, or OPEX, are deducted from Gross Operating Income. This results in Net Operating Income (NOI).

Thus, expressed a little more clearly, the components of IRV are:

I = NOI

R = return on capital invested in any given year of operations, or the hurdle rate sought by investors

V = the market value of the property, given the NOI and hurdle rate

If you know any two of these components, you can calculate the third, as follows:

I = V x R

R = I ÷ V

V = I ÷ R

What’s reflected above is the overall cap rate. But this is a little more complicated than it appears to be at first blush. Because the overall cap rate measures the return on all capital invested, it consists of a lender’s component and an investor’s component. The lender’s component is known as the Lender’s Average Weighted Cost of Capital (WACC). The Investor’s component similarly is known as the Investor’s Average Weighted Cost of Capital.

The lender’s WACC is calculated as follows:

Mortgage Constant, depicted as the Greek letter kappa or К (i.e., Annual Debt Service ÷ Original Principal Balance of the Loan)

x Loan-to-Value Ratio (relationship between total cost and the loan amount, aka LTV)

= Lender’s WACC

Example: LTV = 70%; К = 8.25%, then the Lender’s WACC = .0508 or 5.08%

The investor’s WACC is calculated as follows:

Investors’ % of the investment (the equity portion of the deal)

x Investors’ hurdle rate (investor’s minimum acceptable rate of return)

= Investors’ WACC

Example: Investor contributes 30%; Investor seeks 9% minimum return

Investors’ WACC = .0270 or 2.7%

So the overall cap rate is:

Lender’s WACC (.0508)

Investors’ WACC (.0270)

Cap Rate = .0778 or 7.78%

So, what does all this really mean? The first year’s cap rate has to equal or exceed 7.78% for all parties to achieve their goals. Thus, the current year’s NOI, when divided by the purchase price (value), has to equal or exceed 7.78%.

The third and final installment on cap rates will explore its flaws and what’s been happening to cap rates in recent years.