The battlefield is quiet. Buyers have retreated and sellers have dug in. There’s chatter in the trenches. “They’ll come to us when they’re ready,” the sellers banter. “They can’t hold out forever. Eventually they’ll need a property and will come knocking on our doors for what we’ve got.” They feel proud of what they own, but inside they’re nervous because they know they can’t hold on forever. The supplies are bound to run out.
“Those sellers are crazy,” the buyers ramble. “We get better returns buying their debt than paying what they’re asking. With loan to own, there’s no operating headaches, risk of depreciation, and maintenance to worry about. Until they’re ready to concede, we’ll stay right where we are.”
The truth is, neither side can hold out forever. Businesses have a better sense of how to adjust for risk, homeowners sense a bottom to the housing market and start spending again, sellers begin to run out of cash and get tired of dealing with tenants re-trading their deals with no new tenants looking at their buildings. We will see pricing soften and will begin to move forward, accepting that they can’t have it all their way, and that in the end, commercial real estate is still a pretty good deal. You get leverage, tax advantages, and cash flow. It’s good stuff, right?
So what will this new battlefield look like? Yesterday, an MAI appraiser called to ask about how our buyers are pricing investment acquisitions in this market environment. He’d spoken with other investment sales brokers and was trying to value a retail center with 60% vacancy that an investor had decided to buy. (By the way, this purchase is great timing. If you can afford to carry for the next 20 months, you’ll do well in retail investing over the next 5-8 years).
After our discussion, here’s what we agreed on:
The exit CAP rate would have to be no less than 8.5%. A recent CoStar study shows that the mean CAP rate for the past 20 years in commercial real estate properties has been about 8.5%. During the correction in the early 1990′s the CAP rate surpassed 8.5% and reached as high as 10-11% and then settled back down to about 8.5%. It wasn’t until the early 2000′s with the tidal wave of credit and money flowing into commercial real estate, that CAP rates compressed as low as 5%. Now they’re going up.
Plan on a vacancy carry of at least 20 months. If you’re going to buy a commercial real estate asset today with significant vacancy, plan on carrying it for the next 20 months, at a minimum. You should also price rent reductions of 20-30% into your cash flow analysis to allow for the re-pricing that’s taking effect today.
Your discount rate should align with market expectations. Sophisticated commercial real estate buyers are chasing paper where they’re earning 12-13% returns. In order for buyers to be attracted to the risks with owning and operating commercial real estate, the returns must be higher, which means you should plan on at least a 15% discount rate for the term of your investment. Discount your projected sales price and periodic cash flows at 15+% to today’s present value. There’s your number.
By the way, where should we send your free 10 part email mini course? It’s 100% commercial real estate investing focused and you can get it here.