It’s no secret that as we sit here in May of 2023, there has been a significant deterioration of values across asset classes in commercial real estate. In fact, I haven’t been in a meeting or on a call in the past several months where the level to which prices have fallen has not been a topic of conversation. Questions about office buildings dominate these discussions since their value has clearly decreased the most and some of the basic going forward assumptions are a guess at this point. Time will give us the answer of course, but by simply looking at some big picture metrics we can start to get a sense, which gives us a lot to think about.
Early in my career, a well-known investor sensed my nervousness as I was presenting a set of cash flows and told me something along the lines of: “Don’t be intimidated by the math in real estate, you basically learned everything you need to know in 10th grade algebra, we are always just solving for X.” That may well be an oversimplification, but there is some truth to it. In fact, if we isolate the key variables in a basic valuation, we can get a sense of how much values can move. Move them all at once, and the results can be staggering.
To keep things simple, let’s isolate what I consider to be some of the bigger macro assumptions when valuing an office property: Exit cap rate, base rental rate, interest rate for debt, and loan to value ratio. It’s simple to look at each of these items and see how much value can change as each variable shifts using a hypothetical office property and some round numbers:
Residual Cap Rate:
- An asset with an NOI of $7,500,000 using an exit cap of 5% would have a value of $150,000,000.
- If the exit cap rate moves up 200 bps to 7% the value shifts to $107,000,000, nearly a 30% move.
- Assuming a ten-year hold, this will equate to about a 15% difference in current value.
Base Rental Rate:
- Changes in base rental rate affect NOI over time, but if permanent can have a tremendous impact on both annual income and the residual value.
- If the hypothetical property is 250,000 rentable square feet, rents for $50.00 gross, and rent decreases 10% or $5.00 per square foot, then cash flow could decrease as much as $1,250,000 after the existing leases expire. The good thing is the impact isn’t typically sudden in a multi-tenant asset with staggered lease maturities.
- The effect on value is seen both in the lower annual NOI and a lower residual asset value since that lower NOI is capped on the back end. Using the example above, the residual value will be affected by 20% or about 11% in present value with reduced annual income costing another 4% in present value.
Interest Rate for Debt:
- Interest rates have risen dramatically as we all know. Using very simple assumptions (and of course the real world is never that simple!) of a 65% LTV, 25-year amortization and a standard fee structure, a 300 bps increase in interest rates would increase debt service nearly 25%.
- The effect of this is significant. It directly decreases the annual cashflow the property owner receives directly in proportion to the increased debt service which means that the amount of capital returned to the equity investors on an annual basis goes down. If an investor wants to keep their IRR the same, they need to pay less for the property.
- Holding the equity returns constant, an increase in interest rates of 300 bps will reduce value by about 12%.
Loan to Value Ratio:
- A lower LTV means that to purchase a property of a certain value, more equity needs to be used as the LTV decreases. Equity will be more expensive than debt, so if the equity returns stay constant the purchase price must move downward to account for a more expensive capital structure.
- Again, keeping this math simple, using our hypothetical office building with a $7,500,000 NOI, a 10% decrease in LTV from 70% to 60% would mean an additional equity investment of $15,000,000.
- Holding IRR constant in this instance then would decrease the purchase price by about 6.5%.
The above examples are quite general, the numbers are rounded, and there are certainly other factors involved in a proper valuation, but they are useful to illustrate how far values may have fallen. Although, there hasn’t been a rising interest rate environment for quite some time, typically when interest rates are rising, we are in a growth period so investors can also underwrite an increase in income. Today, that is not the case. Office rents are falling, costs are increasing, and it remains unclear how we will use office space in the future. It is certainly not universal, as there are always market and asset level exceptions, but it is easy to make the case that office values may be off 40-50% and in many cases much more than that, as we still have yet to include assumptions such as increased downtime, higher leasing costs, a lower stabilized occupancy and others. At the and of the day however, any analysis is just a tool to determine what value might be, it’s the actual buyers that truly determine market value. Transactions are still largely stalled in the office sector, but as investors are diligently studying the demand side they will develop theses on what assets will perform and which ones will be left behind. The discounts won’t be uniform, and it will be each investor’s individual strategy that will determine the pricing. There will be clear winners and clear losers at the asset level and investors that have well founded theses and execute well on assets in the middle will make tremendous returns.
John Kevill is managing principal of the boutique brokerage and investment firm Solitude Cove Capital and a senior advisor to consulting firm Arcturus.