Investing in Commercial Real Estate – Can it Weather the Credit Crisis and the Downturn?

Lately, a lot of investors and friends have asked my opinion about the effects of the credit crisis on commercial real estate. You’d have to be living in a cave not to know about residential values falling, but there doesn’t seem to be a general consensus about where commercial is going. If I had to forecast, and technically I do because the fund I co-manage operates as an asset based lender collateralizing on commercial real estate, then I would say we are heading back to reality. To understand where reality is, I think it’s important to understand the unreal place commercial real estate has been in. During the boom, commercial real estate, and most notably income properties, seemed to lose their very definition. Income property by its name is supposed to produce income. Since real estate became everyone’s favorite alternative investment, there were a lot more buyers competing for the same income properties and many of those inexperienced buyers didn’t understand the methods of valuating them.

The fervor to just own property seemed to be greater than the glaring fundamentals of the property they were buying. Commercial real estate’s most basic valuation method is the income approach, and the outcome provides a capitalization rate (CAP). Without going into a whole seminar on the topic, it is basically net income before debt divided by the price. While people should have been buying properties north of an 8% CAP (the higher the better when you are the buyer), they were buying them down in the 5′s and 6′s, and I have even seen some extremely over-valued scenarios in the 3′s. At those prices, there is a lot of out of pocket money going into servicing the debt on a monthly basis, and it was happening all in the name of price appreciation. That’s just not how this investment is supposed to work. However, it was actually working for a brief time because of the upward momentum of the market, and if your time horizon was short, there were decent profits to be made off of a flip.

We are now seeing CAP rates starting to creep back up north of 7%, which translates into lower values. High valued areas are still coming in lower than that, but that is a function of perception on future valuations and not a reality based off of current cash flow. The numbers are under the microscope even more so because of more stringent lending guidelines, and also due to the fact that most of the buyers that are left are professional investors that live and die by these valuation formulas. . At the end of the day, if you are valuating commercial real estate on price comparisons then it looks like it’s starting to slide.

However, if you are basing your valuations on the income approach, it’s clear that commercial real estate is going back to exactly where it should be; producing income. When I was first getting involved in real estate, I received the best piece of free advice from a very wise man. He said, “Owning commercial real estate is like a business and almost every business needs to generate income. So let the income be the cake and the appreciation be the icing, and everyday will feel like a birthday.”

Copyright: Dominic Mazzone, Regent Global Funds 2008