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Small-Cap Recap: What's Behind Real Estate Cap Rates?

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The commercial real estate game - at least in major cities - has turned into a game of "flipping."

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Prof Zucchi:

My wife's family is in commercial and residential real estate. Over the past few years, they've gone into the market to buy, and ended up selling stuff that her grandfather and father bought. Properties that we thought our childrens' children would own. They think the cap rates are ridiculous, how can people make money? They know that some of the people that bought their stuff are choking on it. People are putting in money to pay the enormous mortgages that enabled these prices. Now I see Mills (MLS) and GMH Communities Trust (GCT) in the news with accounting problems. Did they borrow too much money at too low floating rates that are now starting to squeeze their margins? Do these real estate companies really have NO earnings? Is this a Microstrategy (MSTR) in the real estate business? Is it really so simple that companies are starting to hide their losses with "Accounting Problems?" Were they ever really profitable at all over the last few years as they went on an acquisition binge?

Love the 'Ville.

Best Regards
Minyan Lenny

Hi Lenny -

I don't know GMH Communities at all so I really can't add much to that story. I have been following Mills Corp. superficially and I think it is fair to say that, in its current incarnation, it is unraveling. They do have some attractive assets, but they also carry $4b of debt against $430M of reported T12 EBITDA. If it turns out that the accounting problems mean that the cash flow is not there, I think you can write the end of the script for current shareholders. I know Vornado (VNO) has been looking at them and so has the Blackstone Group. It'll be interesting to see if they step in and for how much.

I don't know if MLS is the real estate equivalent of Microstrategy, but I doubt it. (For those who don't remember, MSTR's implosion due to its accounting shenanigans was arguably the catalyst for the bursting of the internet bubble). Most REIT's do earn real money. But you are correct that they are paying absurd cap rates for properties. Part of the reason is that REIT's these days don't see cap rates as meaningful. (For those not familiar with "capitalization rates," they reflect the expected rate of return on a property based on the underlying cash flow. If a property is bought at an "8 cap" it means that it will yield 8% return on the price). The commercial real estate game - at least in major cities - has turned into a game of "flipping." As late as 10 years ago institutional investors had investment time frames of 5-10 years; today they are looking out 2-5 years at the most. In such a short period, cash flow is viewed as a course of funds to spruce up the property until the next fool rushes in to buy it at a higher price. That's when the return on the investment is realized. Therefore, cap rates are ignored because "this time is different."

The valuation stick of choice today is "replacement cost." Would it cost more to put up a property or to buy one already there? This thinking of course is nonsense because the buyers know full well that building a new property is usually not an alternative; but it lets the purchaser assign to replacement cost pretty much whatever number they need to justify the price they are going to pay.

There are three tightly related reasons why this "new paradigm" has taken hold:

1. Flipping commercial properties is extraordinarily profitable for the REIT manager - not to be confused with the REIT investors. People do not realize the staggering amount of fees collected by managers in the form of transaction fees, asset management fees, co-property management fees (a property management fee charged by the REIT manager to the actual property manager to supervise the actual property manager; the actual property manager in turn passes that fee on to the building owner - the investors); professional/build-out fees, feasibility studies fees, and any other kind of fee you can concoct. And of course, if there is an actual gain at the end of the deal, the manager often tags on a performance fee. This is all money that comes off the top and goes to the REIT's manager rather than the investor.

To give you a sense of the numbers involved, assuming a $200M asset and a 5 yr. holding period and a 20% gain on sale, a manager could rake in: 1.5% for the acquisition and disposal of the asset ( $6.6M); 1% per year in asset management fees ($10M); 1.75% property management fee on gross rents: here we'll assume the $200M price bought 800k rsf at $250/sq.ft; avg. rents of $30/sq.ft. and a 10% vacancy rate: total management fee $1.9M; 5% of build-out costs: here we'll assume space roll-over of 50% of the bldg. and tenant improvement allowances of $20/sq.: total fee $400k; 5% of gross profits on sale: $2M. Sum it all up and you get just shy of $21M over a 5-yr. period straight into the manager's pockets, without a dime of capital at risk. Nice work indeed.

How is this possible? How can investor go along with this type of pillaging? Mostly because of reason No.2:

2. The large investors backing the REIT's (pension funds, and the likes) could care less about the returns they lose out to the manager, as long as the projected returns on their investment are above the risk-free rate of return. Let's assume that hurdle rate is 6.5%/yr., the investor requires an unleveraged $65M return over five years. With $35M coming from the projected capital gain (after miscellaneous transaction expenses such as brokerage fees, outsourced due diligence, etc.), the annual cash flow need only be $6M/year. Naturally, the key to the game is the "projected" capital gain factored into the equation at the time the asset is purchased. Over the last 5 years, that type of appreciation has been a no-brainer, and it is now a foregone conclusion that it will continue forever.

The last piece of the puzzle to create the type of frenzied flipping market we are seeing right now is cheap money, which allows buyers to leverage up capital and consummate more and more deals, at the same time. Assume the buyer puts a mortgage of 65% of Loan-To-Value (this is conservative) at Libor+ / interest only, the carrying cost would be about $8.5M/year. With gross cash rents of $21M, minus interest cost of $8.5M, minus management and co-management fees of approx. $5.5M, minus operating and cap-ex costs of $4.8M (I am assuming a conservative $6/sq.ft., though this number can vary a lot), and the net cash flow is about $2.2M or 3.1% on invested equity. This is just about the equivalent of the $6M/yr unleveraged cash flow discussed above.

As the saying goes "it's all fun and games until someone loses an eye." Using the assumptions above, the investor has almost no room for error. But not to worry, the manager's fees have been paid, and if the underperformance is the result of a broader market downturn, how can one blame the manager for a "bad market"?

The next logical question is why would anyone dump money in this type of scheme? There are several reasons. The bulls will tell you that assuming 4%/yr. appreciation for 5 years is nonsense, as annual appreciation has been closer to 15% for the last 5 years. True and I wish them the best of luck that this will continue. They'll also argue that it makes no sense to invest in Treasuries at 5% when one can get at least 6.5% in something just as solid, and with likely upside. On the topic of "solid," I have three words for you: Resolution Trust Corporation; if you do not remember it, Google it. Getting away from the pseudo-sarcasm, maybe these investors realize that the all-mighty dollar is fading, and buildings may indeed be a better store of value than treasuries.

In the end however, I am convinced that the overriding reason these deals are getting done all over the place is the issue we harp on daily in the 'Ville: when there is too much of something floating around - in this case printed dollars - those dollars not only depreciate from an economic standpoint, but they also depreciate in the psyche of the money "handlers"; the less something is worth the less people take care of it; and the less care is taken with money the more accounting shenanigans, and/or busted investments we are going to see. Welcome to the dark side of the "Greenspan Put".

No positions in stocks mentioned.
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