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Finding Value in Commercial Real Estate

Historically low interest rates are providing opportunities for investors in non-traded real estate investment trusts (REITs).

The headline in the Sunday paper was grim: “42% of Georgia’s homes underwater.” (The Atlanta Journal/Constitution, 4/14/13). Data complied by Zillow at the end of 2012 identified the worst 1% of U.S. ZIP codes where homes are worth less than the mortgage balance. Georgia has almost 25% of those ZIP codes.

Housing prices in America peaked in 2005. By the end of 2008, the Case-Shiller home price index showed the largest drop in history. The housing bust spurred massive banking and Wall Street failures, the deepest recession since the 1930s, a government bailout fueled by debt and easy money, the lowest interest rates in more than 50 years, and a stock market that just recently surpassed 2007 peaks.

Real estate precipitated the crunch, complicated by a host of intertwining factors. Nevertheless, a basic truth was ignored: real estate is a cyclical industry. Boom-bust cycles are reality. We went from a long boom in the 1980s, to a real estate depression in the early 1990s, another boom fueled by leverage and increasingly lax lending standards, to another bust starting in 2005. As in past cycles, pain produces opportunity for gain in the early stages of recovery.

Real Estate Investment Trusts (REITs) were created by Congress in 1960 to help fuel real estate expansion by allowing smaller retail investors the same access to diversified portfolios of income-producing real estate as that enjoyed by large institutional investors. REIT shares may be traded in liquid form on a stock exchange, or REIT stock my be held in a non-traded non-liquid form. When a new REIT is launched, it is in a non-traded format as money is raised and properties acquired. Therein may lie an opportunity.

As real estate prices neared the peak, REITs in some cases overpaid for properties, seen clearly only in retrospect. After the crash, for new REITs formed with no pre-crash high priced (non-legacy) properties, bargains emerged.

Commercial real estate is not purchased on a per square foot basis; prices are driven by capitalization rates, i.e., cap rates. Essentially, the cap rate is the current yield from a property, much like a bond yield. The cap rate is calculated by dividing the income from a property, net of fixed and variable costs, by the total value of the property. A property that sells for $1 million with a $50,000 annual net cash flow has a cap rate of 5 percent. The cap rate is the cash flow divided by the purchase price.

Like real estate itself, cap rates are cyclical, driven by investor sentiment. Low interest rates have sparked a chase for yield and traded REITs have seen price appreciation and a lowering of yields. But for sharp-eyed professionals in the non-legacy REIT space, cap rates in the 7.5 to 8% range are possible. A great deal of debt is coming due on commercial properties that the banks will not finance. Figuring out cash flow is the key.

Suppose you buy a property for $100, to make the math simple. At an 8% cap rate, you make $8 per year. But you don’t spend $100. You take advantage of low interest rates and borrow $50 on an amortizing loan. In five years the cash flow has improved to $8.82 per year and cap rates have dropped to 7%.  You sell the property for $126 ($8.82/.07=$126). Your loan balance is now $45, so you net $81 on the sale. Your $50 investment became $81 or a 12% per year return. ($126-$45=$81). This is a simplified example and ignores costs of sale and other factors and is not purported to be a projection of returns from any particular investment.

 The point is that the spread between the underlying 10-year Treasury note rate and cap rates on certain types of properties is at an all time high.  Easy money has produced pain. Low interest rates up against cap rates in the 7% to 8% range spell opportunity. As with any specific investment, risk factors must be understood.

 Lewis Walker is President of Walker Capital Management LLC. and Walker Capital Advisory Services, Inc., a Registered Investment Advisor (R.I.A.) Securities and certain advisory services offered through The Strategic Financial Alliance, Inc. (SFA).  Lewis Walker is a registered representative of SFA which is otherwise unaffiliated with the Walker Capital Companies.  3930 East Jones Bridge Road ▪ Suite 150 ▪ Peachtree Corners, GA 30092 ▪ 770-441-2603 ▪ lewisw@theinvestmentcoach.com

This post is contributed by a community member. The views expressed in this blog are those of the author and do not necessarily reflect those of Patch Media Corporation. Everyone is welcome to submit a post to Patch. If you'd like to post a blog, go here to get started.

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