Virtually all commercial real estate (CRE) both locally and nationally has experienced some decline in value from its peak a couple of years ago.

A large part of the decline in CRE values is due to increasing capitalization rates. Capitalization rates are the ratio of building income to building value and reflect an investor’s perceived risks associated with a particular property. Capitalization rates are also influenced by the cost and availability of investment capital, particularly mortgage capital.

Prior to mid-to-late 2008, financing for CRE (like the residential real estate market) was inexpensive and easy to attain. The low cost of capital contributed to capitalization rate compression. Significant increases in CRE values were realized because of this compression.

When it started to become clear that much of the continued increase in the value of CRE was not economically supported, both the availability of financing and investor’s perceived risks started to drastically change. This trend is continuing to this day with lenders pulling back loan-to-value ratios and shortening amortization periods, and with investors requiring higher rates of return to account for the risks of operating in this environment.

Wall Street “conduit” lenders which once provided such attractive loan terms such as interest-only periods, longer loan amortization periods, and non-recourse loans, have all but vanished, leaving traditional lenders such as banks as the primary source for financing. Needless to say, the loan terms at banks are substantially more conservative than what the conduits had been offering.

Even seller-financing has been making a comeback, but again at terms that are far less attractive than the conduits.

And now it is certainly not difficult to see the significant impact that increasing capitalization rates are having on the market, and the problems it is causing for investors and lenders alike. Investors are seeing their equity erode or vanish, and lenders are dealing with renewing or refinancing loans that suddenly don’t meet their loan-to-value ratio requirements.

In many cases these issues have more to do with changes in prevailing loan parameters than with adverse changes in net operating income. An investor with a property that met both loan-to-value and debt coverage ratios just two years ago may now find it difficult or impossible to refinance the building at today’s terms, even though the building remains fully leased and the income is unchanged.

Thus, a number of lenders have been engaging to some degree in a process that has become known as “extend and pretend,” whereby they “extend” the existing loan and “pretend” that the value of the property will return by the end of the extension period. This process appears to reflect a belief that the adverse changes in value are related more to issues with liquidity and credit markets than with deterioration in property fundamentals. But “extend and pretend” will likely only work if occupancy or rental rates remain stable or increase in the short term. (Rapid inflation may also serve to validate this process.)

Factors to watch

This leads to the important question looming overhead with respect to the property income side of the value equation. Specifically, factors such as occupancy and rental rates have much more of an impact on value, and cash flow to the mortgage. It is these factors that should be watched more closely.

The problems that arise when a property’s income declines have more far-reaching implications than increasing capitalization rates. At the end of the day, when a property can no longer generate sufficient income to meet the debt service, there can be no more “extend and pretend.”

Having to deal with a loan that is value-constrained by rising capitalization rates is much less troublesome to lenders than a loan on a property that can no longer generate enough income to pay the mortgage.

Accordingly, the primary predictors of the direction of CRE values in the near-term will be the income-related factors of occupancy and rental rates.

There have been declines in occupancy and downward pressure on rental rates over the past few quarters across all property types in the Twin Cities market. The following excerpt is from NorthMarq’s “The Compass” market report for third-quarter 2009, covering the Minneapolis-St. Paul metro area:

“First-half [vacancy] numbers for all property types were not particularly encouraging. Overall vacancy among all property types increased to 14.2% (16.3% including sublease space)—figures last seen in 2004. Office vacancy saw the largest increase, rising to an overall rate of 17.9%/20.7%. That was followed by industrial, rising to 15.1%/17.2%. Medical office moved up to 12.7%/13.2%. Retail vacancy increased substantially, reporting 9% (10.3% with sublease) — the highest level in more than 10 years.”

Furthermore, the report cites continued downward pressure on rental rates, indicating that most of the recent activity has been from tenants with expiring leases that are shopping around and renewing for short-term leases at lower rates.

This trend is likely to continue into 2010, and a really good measure for how bad it will get will be the income-related trends of occupancy and rental rates.

Found here.