Most investors rely upon the Income Approach to Value far more than any of the other approaches when measuring the worth of income –producing real estate. The Value of a property, to them, is directly associated with the amount of NET income that can be produced by a property. The formula is quite simple to arrive at a value indication from this approach. Take the annual Gross Scheduled Income that can be produced; subtract all of the operating expenses, and the Net Operating Income (NOI) is derived. The NOI is then divided by the market-derived Capitalization Rate (CR) to arrive at a Market Value Indication (MV). Yes, I know there are lots of nuances, I know there are other approaches to valuation using income, but this simple explanation is adequate for this discussion. It is also representative of the more sophisticated tools.
So, the simple formula is NOI/CR=MV. What happens if the NOI goes up and the CR stays the same? The MV goes up. What happens if the NOI stays the same and the CR goes up? The MV goes down. Again, simple arithmetic.
What then is the outlook? I think that the NOIs will either hold or decline, and I lean to the latter. What are the possibilities – Vacancies could go up in the face of the current economy with a rise being seen in virtually all sectors – offices, retail spaces, industrial spaces (residential units, not so much yet). One of the responses to this is often to lower asking rents to try to ‘out-compete’ your competition. This is not a secret formula, though – everybody knows it. In the end, there are still only ‘so many tenants’ and ‘so much space’. Maybe vacancies climb and asking rents still go down. Either way, the NOI goes down!
How about if the CR rises? As appraisers, we estimate applicable current CR from several methods, but for small investor properties, in particular, we are strongly led by the local market activity and the data derived from the recent sales activity. What then, is the outlook for Capitalization Rates?
This is not so simple a question, and the ‘estimated answer’ is also not simple. We do know that an investor wants to maximize his return on investment, and often the vehicle selected (i.e. stocks, bonds, CDs, real estate, as examples) is chosen based on the investor’s opinion of where the highest, reasonably reliable return can be found. And, of course, the investor’s comfort zone must be considered as an intangible.
Rates of return, however, fluctuate based upon both micro and macro economics. For the last several years, Capitalization Rates have been at historic lows. This is because income producing property can produce income in 4 different ways: 1 – net cash flow from rental operations; 2 – tenant-paid mortgage reduction; 3 – tax shelter derived primarily from property ‘book-depreciation’; and 4 – appreciation of the property value. And while the income from 1 and 2 may not have been exciting, some income from 3 was probable due to the high prices being paid and therefore lots of value in assets to be depreciated. However, the expectation of 4 paying off like a loose slot machine was clearly a driving force. It seems to have lost some of its glamour, though, according to the doom and gloom we get daily doses of from the media and the governments.
Another aspect that must be considered is that money is a commodity – a least after roof, beans, and Calvin Kleins are taken care of. And we have the federal government dumping TRILLIONS of dollars of this commodity into the market. Most of it is not going to creating consumable goods. It’s going into infrastructure, bailouts, and other places that result in no effective consumable (buyable) production. Therefore, the supply of money would appear to be escalating dramatically while the pile of merchantable goods is not rising proportionately. As is the case with all commodities, too much brings the value down. For money, this translates into another boogie-man, called inflation.
And where is all of this money coming from? There really are only two places (yes, I know that ultimately we taxpayers get to come up with it unless our 80% stake in AIG turns immensely profitable). But in the short term it must be borrowed or printed. No other choices. Now this would seem to create a dichotomy – one side increasing competition for borrowing the available money (which would drive interest rates up) and the other side creating an abundance of money (or oversupply, driving interest rates down). But an oversupply of money causes the inflation tide to raise all waters. Lenders, not wanting to see their principal eroded with inflation pressures near to their rates of return (if not higher) will raise their lending rates.
So what is the probable outlook? In my opinion, we will see both rising interest rates and increasing inflation rates in the face of the government riding over the hill to our rescue. More unintended consequences, unfortunately.
And how will this effect Capitalization Rates? They must go up, as well, to compete for investment dollars on the one hand, and to allow an increment of hedge against inflation (which is not the same as appreciation, exactly).
If you have followed all of this, you now understand that my expectation is that NOI may well go down, and CR may well go up. Apply the formula above to see what happens to income producing property values.
For similar and unassociated reasons, the entirety of the commercial real estate market responds to market conditions in a manner much like income properties. It is my opinion that current economic conditions, together with the ill-conceived methods being applied by government to save us, bodes ill for the commercial real estate sector in the mid-term.
As an appraiser, however, I must continue to use accepted methodology and respond to what the market is actually doing, from day to day – not try to see the future. But that’s fairly easy – my crystal ball came out of the same eastern European factory as everyone else’s, and it’s just as cloudy, so no one really expects prescience from me.
So, the simple formula is NOI/CR=MV. What happens if the NOI goes up and the CR stays the same? The MV goes up. What happens if the NOI stays the same and the CR goes up? The MV goes down. Again, simple arithmetic.
What then is the outlook? I think that the NOIs will either hold or decline, and I lean to the latter. What are the possibilities – Vacancies could go up in the face of the current economy with a rise being seen in virtually all sectors – offices, retail spaces, industrial spaces (residential units, not so much yet). One of the responses to this is often to lower asking rents to try to ‘out-compete’ your competition. This is not a secret formula, though – everybody knows it. In the end, there are still only ‘so many tenants’ and ‘so much space’. Maybe vacancies climb and asking rents still go down. Either way, the NOI goes down!
How about if the CR rises? As appraisers, we estimate applicable current CR from several methods, but for small investor properties, in particular, we are strongly led by the local market activity and the data derived from the recent sales activity. What then, is the outlook for Capitalization Rates?
This is not so simple a question, and the ‘estimated answer’ is also not simple. We do know that an investor wants to maximize his return on investment, and often the vehicle selected (i.e. stocks, bonds, CDs, real estate, as examples) is chosen based on the investor’s opinion of where the highest, reasonably reliable return can be found. And, of course, the investor’s comfort zone must be considered as an intangible.
Rates of return, however, fluctuate based upon both micro and macro economics. For the last several years, Capitalization Rates have been at historic lows. This is because income producing property can produce income in 4 different ways: 1 – net cash flow from rental operations; 2 – tenant-paid mortgage reduction; 3 – tax shelter derived primarily from property ‘book-depreciation’; and 4 – appreciation of the property value. And while the income from 1 and 2 may not have been exciting, some income from 3 was probable due to the high prices being paid and therefore lots of value in assets to be depreciated. However, the expectation of 4 paying off like a loose slot machine was clearly a driving force. It seems to have lost some of its glamour, though, according to the doom and gloom we get daily doses of from the media and the governments.
Another aspect that must be considered is that money is a commodity – a least after roof, beans, and Calvin Kleins are taken care of. And we have the federal government dumping TRILLIONS of dollars of this commodity into the market. Most of it is not going to creating consumable goods. It’s going into infrastructure, bailouts, and other places that result in no effective consumable (buyable) production. Therefore, the supply of money would appear to be escalating dramatically while the pile of merchantable goods is not rising proportionately. As is the case with all commodities, too much brings the value down. For money, this translates into another boogie-man, called inflation.
And where is all of this money coming from? There really are only two places (yes, I know that ultimately we taxpayers get to come up with it unless our 80% stake in AIG turns immensely profitable). But in the short term it must be borrowed or printed. No other choices. Now this would seem to create a dichotomy – one side increasing competition for borrowing the available money (which would drive interest rates up) and the other side creating an abundance of money (or oversupply, driving interest rates down). But an oversupply of money causes the inflation tide to raise all waters. Lenders, not wanting to see their principal eroded with inflation pressures near to their rates of return (if not higher) will raise their lending rates.
So what is the probable outlook? In my opinion, we will see both rising interest rates and increasing inflation rates in the face of the government riding over the hill to our rescue. More unintended consequences, unfortunately.
And how will this effect Capitalization Rates? They must go up, as well, to compete for investment dollars on the one hand, and to allow an increment of hedge against inflation (which is not the same as appreciation, exactly).
If you have followed all of this, you now understand that my expectation is that NOI may well go down, and CR may well go up. Apply the formula above to see what happens to income producing property values.
For similar and unassociated reasons, the entirety of the commercial real estate market responds to market conditions in a manner much like income properties. It is my opinion that current economic conditions, together with the ill-conceived methods being applied by government to save us, bodes ill for the commercial real estate sector in the mid-term.
As an appraiser, however, I must continue to use accepted methodology and respond to what the market is actually doing, from day to day – not try to see the future. But that’s fairly easy – my crystal ball came out of the same eastern European factory as everyone else’s, and it’s just as cloudy, so no one really expects prescience from me.