By James Cook
At first glance, this title may sound crazy, but there is a new paradigm that I have been observing, and watching clients enjoy for the last nine months or so. When you get a good appraisal or broker’s opinion of value today, it will almost certainly come in 15 to 25 percent below the peak of 2021 or early 2022, and in most of our client’s cases, this translates to a significant amount of money, millions usually.
So how can I say this is a good thing for you, the seller?
Well, let’s first discuss why commercial real estate values are down, before you move on and assume I am crazy.
Interest rates have increased from a 3 or 4 percent to 6 or even 8 percent within the last 18 months.
Believe it or not, this has a pretty big impact on MHC values. Why is that when all the buyers are using cash? Well, there are a couple of things to note. While buyers may close all-cash sometimes, almost every major buyer eventually finances their purchase. So, the cost of debt doubling, on let’s say a $10 million purchase, is huge. When we used to sell great properties at a 4 or 5 percent cap rate, a $400,000 net income could translate to a $10 million in value (i.e., a 4 percent cap rate). Today, a loan for 65 percent of that purchase price, or $6.5 million, will cost $390,000 in just interest, assuming a 6 percent rate. Now, if you want to amortize the loan, the all-in payment would be closer to $480,000 on a 30-year amortization schedule. So, as the seller of a property producing $400,000 in net income, you ask the $10 million price tag you were offered two years ago, or even a year ago, by the laggards in the market. To do so, the buyer would have to withdraw $3.5 million, plus transactional costs from their treasury or savings account, and then lose $80,000 a year after debt service or make a negative rate of return of roughly 2 percent.
This scenario is very simplified, but you get the idea. No buyer with millions in equity today is likely to make that choice. Then you ask, why not just pay all cash?
Well, equity today is making 8-plus percent, typically with additional upside, while the deal you are offering only pays a 4 percent rate of return, with work and risk. The buyer can buy a 5-year, or 10-year treasury note and make a state tax-free income of 4 to 4.5 percent (as of mid September). Therein lies the problem, to which there are only two solutions; lower your price and/or have TONS of upside remaining in your property.
Sorry to go into a wonky math lesson, but I like to use examples instead of generalizations. Here’s a little proof I may be right. The fact that ACROSS ALL SECTORS of commercial real estate sales have fallen by 70 to 80 percent in 2023.
That is the worst slowdown in almost two decades.
The market is screaming that values are down, even though no seller wants to hear it. To add insult to injury, $2 to $3 trillion in commercial loans balloon by 2025, and the debt markets are the tightest they have been since 2008.
Roughly half of those loans will default and either end up in an “extend and pretend” situation or foreclosure. This has lenders reeling and very nervous about putting new money on the street. Add that to the fact that every treasury they bought and every loan they made in the last 4 to 5 years has had to take a write-down, which is the kind of thing that caused SVB, Signature, and then First Republic to fail.
While no owner is happy to hear their property is down by 20 percent, or more in some cases, I will try to layout below why they are in a much better spot selling that same manufactured home community today for $8 million than they could have been in two years ago for $10 million.
The Good News and Why Now Is the Time to Act
With all that perspective, let’s accept one thing — 2020, 2021, and early 2022 were a major bubble. The Fed created this bubble and burst it, and I can’t figure out why they don’t just take a long pause on rate hikes. The speed and magnitude of the hikes are damaging the banking industry and, in turn, commercial real estate, and will eventually cause a wave of stress across the entire economy.
OK, let’s get to the good news. If you get real, right now, accept the current market pricing, hire the right broker, run a process, and get bids from all the real buyers at once. There is still cash in the transaction, many times more than 80 percent. The main reason this makes sense is that today your cash actually has value. That is the good news. Two years ago, you would have sold, paid your taxes, and probably netted $7 million post-tax (using our $10 million deal and assuming you are a long-time holder, fully depreciated, no debt, etc.). The treasury markets were yielding an average of 1.5 percent, so on your $7 million, you would have netted a whopping $105,000 a year. Here is the fun part. When treasuries went to 4-plus percent the cash value of those treasuries would be decimated. Compare that with an owner selling the same deal today for $8 million, netting $5.6 million in post cap gains, recapture, the Affordable Care Act, and then purchasing 4 percent treasuries. Their net income is $224,000, or two times higher than before.
Here is the clincher… many people almost expect the Fed to tear at the economy like they have the banking system. Then, they expect the Fed to reverse and lower rates. Now, that could take 12 or even 24 months, but your treasuries at 4 percent yield will go up nicely in value.
The take-home is this: You can’t time the market, top or bottom (as Buffet has always said), but a seller getting 80 percent of their highwater-mark price today is a better deal for seller than the buyer. Almost anywhere sellers put their money in 2020-2022 it would be down, and in many cases, more than 20 percent. So, you made the right move to hold past the peak, but don’t stay too long at the party.
I think we are in the perfect spot in the market where an owner can still sell for a good number, buy some treasuries, and sit back and relax. There could be some bargains coming soon or your value could take a much bigger hit depending on what the Fed does on hikes in the next few months. Banking is really in a tough spot and while we are still getting loans done, it is not easy, and debt is way more expensive.
How You Can Take Advantage
So, how are we getting deals done?
Volume is down and listings are down, so funds and buyers still in cash that must be deployed are jumping on the best properties and the ones with a lot of upside. Then, in “market deals”, where the seller doesn’t want to take as big of a discount, we are seeing them agree to owner financing. We are seeing as many seller-financed deals this year as we have seen in the last 10 years. This can be a win-win since the seller gets their price and surety of closing since there is a guaranteed lender, and buyers are often willing to put up non-refundable money much faster with the lender-risk removed. The seller also gets a pre-capital gains-tax return that is above the treasury yield, and the buyer gets a rate that is lower than the market rate. Spreads between treasury rates and borrowing rates are pretty high, mostly 200-300 basis points, in some cases 400 basis points, which is why financing is so hard on returns.
This makes for a perfect opportunity to carry paper and take advantage of that delta while solving both the buyer’s and seller’s challenges.
About the Author
James Cook is the national director of brokerage for Yale Realty and Capital Advisors. He entered the manufactured housing and RV property asset class in 2005 as a licensed agent listing homes for a local investor. In 2012, he founded the fully integrated finance and brokerage shop and has accumulated transactions exceeding $1 billion. He offers perspective at a national level, providing insight into the niche industry.
