Fantasy Pro Formas: A Quick Return to the Past

FANTASY PRO FORMAS: A QUICK RETURN TO THE PAST

“Though difficult to measure in a limited transaction environment, commercial real estate valuations have clearly returned to more rational relationships with property-level fundamentals.  However, the deleveraging cycle and structural headwinds will result in a slow recovery with pockets of volatility to be expected.  Extreme discipline is assessing both the asset level and macroeconomic risk will be critical to making the right investment decisions”.

PIMCO, June 2010

More than a year later, PIMCO’s read on the future of the market had mixed results.  True, pockets of volatility have emerged, and yes, investors are well advised to exercise extreme discipline with investment decisions, but have valuations really returned to rational relationships with property fundamentals?

Anecdotes from the Market

Recently I have had a common conversation with clients and colleagues who are losing bids to buy commercial real estate assets.  In every circumstance they speak about the winner pushing perceived value by loading up the pro forma with fantastical assumptions about the future.  These reports seemed to be supported by recent news articles referring to investor’s perceived relative safety of commercial real estate versus stocks and bonds, and the higher risk-adjusted current yields real estate offers. S & P has picked up on this trend in its CMBS market review.  S & P reported that appraisals for new CMBS loans appear to be building in upside rents and occupancy to arrive at a value instead of using in-place rents and tenancy at closing.  Let’s look at some of the important factors behind the pro forma:

NOI Growth & Cap Rate Compression

Rapid pro forma NOI growth should be a primary concern.  In most property markets, NOI growth would be based on net absorption of available space, back below local market long-term averages, to support rent rates and force tenants to compete for superior space.  However, net absorption is driven by job growth, diluted by increasing efficiency in the use of employee space, and consumer sentiment.  Although the U.S. has experienced some job growth (some estimates peg the figure of 1.25 million jobs, of the 8 million lost, have returned) it is weak and not consistent across all property markets.  Only in very select markets can we reasonably assume any measurable acceleration of job growth and the resulting net absorption of vacant space.  Thus, identifying and quantifying potential job creators is critically important to justify aggressive occupancy and rental rate assumptions.

Quality of Income

The Great Recession created winners and losers with American businesses.  For tenants who still remain, creditworthiness is widely divergent.  Correspondingly, we are well served to avoid assessing the likelihood of collecting contract rent from tenants uniformly across the roster.  Tenants having signed leases in 2006-07, the peak of rental rates for all product types, are even more of a concern.  Tenants with above average credit quality should be underwritten with care when their contract rent is 20-35% above current market rates, and plenty of alternative spaces in the sub-market beckoning them.  W.P. Carey School of Business’ Mark Stapp recently told GlobeSt.com, “One mistake people make is to treat all tenants in an office building as having the same risk profile.  The borrower then applies the same discount rate to everybody by discounting the net operating income.”  Apparently the CMBS market has already picked up on this theme.  A Barclays Capital strategist, Julia Tcherkassova, recently commented on the rating agencies now being quick to check exposure to any recently downgraded tenant and adjusting their ratings on existing issues accordingly. 

Return Expectations Cap Rates, and Discount Rates

Once investors are convinced of the positive forward looking NOI trends, it’s not a long leap to then push down cap rates in their DCF models.  Main stream investment theory says that it’s typically during these periods of presumed NOI growth that investor’s expectations drive cap rates down causing current returns to fall and asset values to grow.  Currently, the most often cited justification for lower cap rates I’ve heard relate to the all-time low interest rates driving down investor expectations on current returns, which investors hope to compensate for with an effective option on the assets future upside value.  At this point the potential for problems has been compounded: higher assumed NOI figures and terminal value, discounted back to present value at a lower rate.

REC’s CREDDVal Module

REC’s Commercial Real Estate Due Diligence and Valuation (CREDDVal) module is a fully automated discounted cash flow tool which has been internally developed in response to these and other growing valuation concerns. The DCF is fashioned after the Real-Time Valuation models where the discount rate constructed from the combination of the term structure of interest rates and individual tenant credit assessments.  These two components comprise the effective discount rate, and differentiate properties based on the tenant rent roll and the projected path of the risk free rate and the local real estate premium.  CREDDVal allows an investor to test hundreds of differing scenarios about the future and how they impact the expected investment returns.  Furthermore, CREDDVal differentiates similar assets by:

• ·    Assessing income quality by quantifying the differences between contract and market rents over the investment horizon.  By looking at this metric in the context of market vacancy we can truly assess the riskiness of the revenue projection.
• ·         Analyzing individual leases and quantifying the impact of FSGBYES, NNN, and Gross lease structures, all contained within the same property.
• ·         Valuing income from a lower credit tenant differently from the income expected to be received by a higher credit tenant.
• ·         Quantifying the impact of lease rollovers on operating cash flow and the property’s ability to meet DSCR and LTV covenants.
• ·         Identifying future risk management areas, and demanding answers to questions relating to adequate return for assumed risk.