Real Estate Market Outlook, August 2010 – Time to Make Fertilizer

By William S Mathers

The current outlook for commercial and residential real estate over the next couple of months is bleak. Commercial property derivative markets expect commercial property values to slightly decline over the next few years. S&P/Case Shiller Home Price Indices forecasts would indicate that housing values would tend to remain flat, although Fannie Mae reports home values will decline. Yet there is some good news.

Commercial Real Estate

From the July 2010 edition of “Real Estate Derivatives Monthly” by Stephen Gould of VYPAR Capital Market Partners, for commercial property the NCREIF NPI is up 4.1% for the year to date. Although there has been gains, the derivative markets in the US and London do not feel the rise in commercial values is sustainable. There are many reasons the markets would take this position. The two biggest reasons in our assessment are the current job market followed by the defaults in commercial mortgages. With unemployment at such high rates, the demand for leasable space from office, retail, and warehouse is much lower since the demand for workspace and products drop. Adding more stress to the situation is the fact that many newer developments have added to the supply levels as demand was falling. The new developments were doomed. We are now starting to see the activity in foreclosures of commercial property pick up pace. Many of these properties are being let go by the banks at values less than five times the initial loan amount. Here is where the NPI index will take a beating.

The NPI represents the quarterly total returns of a large representative pool of income producing investment grade properties. Three components make up the index – income return, capital value, and total value. The Income Return is the quarterly net income divided by the estimated expenses, represented in the formula:

IR = (NOI) / [BMV + (½)CI – (½)PS – (1/3)NOI)

BMV is the beginning market value, CI is capital improvements, and PS is partial sales. Notice it is not an actual income value, but a ratio that takes into account quarterly costs such as partial sales of property (i.e., selling an out parcel of land) and capital improvements in the denominator. Capital value is similarly handled as a ratio to measure changes in property value. In the equation below, EMV represents the end market value. The denominator takes consideration of improvements and partial sales, per the following:

CV = [(EMV – BMV) + PS – CI] / [BMV + (1/2)CI – (1/2)PS – (1/3)NOI]

For the total value we add the income return and capital value.

The income return ratio tends to remain flat over time – hovering around 2%. Capital value ratios are where it gets interesting; the BMV and EMV values are based on appraisal estimates if the property had not been sold. As the banks chew through their bad commercial debt, the heavily discounted properties affect the appraisal estimates.

Each property included in the index is only required to have an independent appraisal done every three years. In between the building’s owner report what they feel the building value should be. Therefore, as new independent appraisals are done for the properties we suspect the appraisal values would tend to be lower. The index should fall.

Residential Real Estate

On the residential side of the market, we are seeing the housing tax credit stimulus subsiding. Unemployment has affected the housing market. No longer are we seeing just subprime borrowers or others losing homes they simply could not afford, but folks who lost their jobs not being able to pay their mortgages. Standard & Poors project the National Composite index to remain flat for the next year. Fannie Mae projects home values to decline over the same period.

As we all know, real estate is a local affair and there are some bright spots for the moment as seen in the chart below.

State /Zillow Home Price Index (%)/ Unemployment (%)
Delaware / 24.8 / 8.5
West Virginia / 6.1 / 8.5
California / 3.5 / 12.3
Oklahoma / 1.7 / 6.8
Massachusetts / 1.4 / 9.0
Nevada / -11.9 / 14.2
Florida / -11.2 / 11.4
Arizona / -11.1 / 9.6

The states of highest home value loss are Nevada, Florida, and Arizona. Unfortunately, the index values of the other states are also in negative territory.

The states with home value increases (to date) also tended to have lower unemployment. California is the exception for now, but their home prices are expected to decrease in the near term. It will be interesting to see if they join Florida, Nevada, and Arizona. We do not have any information on why Delaware property went up so high, but the trend for price growth seems to indicate employment is a factor.

The Glass is 1/32 Full

To end on a positive note, overall the market is adjusting pricing to real demand levels. At the newer price levels, there are more realistic project opportunities if you are able to obtain financing. However, there are a significant number bad projects that you need to avoid at almost any price – you get what you paid for.

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