• Sun. Aug 7th, 2022

Coming out of the recession in commercial real estate: is it time to hold on?

ByWillie M. Evans

Jul 3, 2022

Our property with a Walmart store has probably gone down 25% in value over the last six months. But the cash has not changed.

By John E. McNellis, director at a real estate developer McNellis Partnersfor WOLF STREET:

Years ago, in the throes of the Great Recession, one of Tennessee’s top developers shook his head at his financial statement and drawled, “My net worth has halved, but my cash flow is the same.” He was not alone. Commercial real estate nationwide has lost about forty percent of its value during these tough times.

His sad comment acknowledged two things: the drop in value of his portfolio, but more importantly, the fact that it didn’t really matter. While worth half as much, his properties were still occupied by tenants paying rent.

Because this shrewd investor had been through several recessions—it’s like high school reunions, they sneak up on you—he had been downright sober with the mortgages he placed on his real estate. With little existing debt, he was not forced to sell his properties when their loans came due; he could refinance instead. So his only losses were on paper – the reduced numbers in his financial statement – ​​and he was still collecting his rent. And when the market rebounded in a few years, its financials recovered.

Fast forward to today.

Real estate values ​​may not have fallen much yet, but they are watching the slope of the rabbit. We looked at our retail holdings in January, thinking we would do some pruning. We considered selling a Walmart supermarket in the Central Valley and asked one of our favorite brokers what he would fetch.

Because his Walmart lease is short-term, he said the property would sell at a 6% cap rate; that is, a buyer would like to earn 6% per year on his purchase price. Therefore, if the rent was $200,000 per year (it is not), the purchase price would have been $3.33 million ($200,000/0.06 = $3.33 million of dollars).

We weren’t ready to sell in January, but we were last week. We checked with our broker. A little sheepishly, he explained that the nightmares of the past six months – the bear market, soaring inflation and interest rates – would have buyers insisting on an 8% yield today. This means that our Walmart would now sell for $2.5 million ($200,000 / 0.08 = $2.5 million).

In other words, this property has probably lost 25% of its value in the last six months. Like this wily Tennessean, we decided we’d rather keep our losses on paper and opted not to sell.

This example demonstrates the close resemblance between single-tenant commercial buildings and the bond market: the price of both falls when their yields rise and, conversely, rises when their yields fall. And, to simplify things a bit, everyone’s fluctuations in value are irrelevant if you’re not selling: if you buy a $1,000 Treasury bill paying 5% interest and hold it until at maturity you will get your 5% each year and all from your principal back. But sell when interest rates rise to 10% and you will only receive a much lower price. On the other hand, sell when interest rates crash to 2.5% and you will get a much higher amount.

The same math works for sole proprietorship retail: if you’re not selling, your “cash flow is the same.” If you do, you ride the market like a mechanical bull.

My example also implies a different point: even if we concede a dramatic fall in commercial real estate values ​​– it is possible – we are unlikely to see the emergence of a buoyant buyers’ market. Instead, sellers with the financial means will put their wares back on the shelves and wait for a sunnier day before selling.

Rather than a buyer’s market, we’re likely to see buyers and sellers dug a mile apart, entrenched in their own expectations, as we watch the market’s speed evaporate like spit on a hot plate.

Sellers driven from their redoubts by death, divorce, dissolution, disaster or simply over-indebtedness can indeed be slaughtered, but there is so much money chasing after real estate these days that even they can live to fight another day.

Back to that nifty Tennessean. He understood that net worth is for bragging, cash flow is for eating. So could you. By John E. McNellis, author of Succeed in real estate: start as a developer.

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