Distressed Properties and Property Values

As commercial vacancy rates continue to increase and property values decrease, the region is faced with more commercial real estate on the market. These properties may become distressed if property owners don’t address the hard realities of their real-estate holdings and enter into sometimes difficult discussions with their lenders and/or sources of capital.

Nationally and in our region, certain industries are being hit harder than others. Three that come to mind are hospitality, retail, and financial services. Here are some of the reasons why.

Companies are controlling costs by decreasing travel budgets, while individuals are reducing leisure travel to save money. Both of these situations translate into reduced occupancy rates at hotels.

Certain retailers are focusing on top-producing locations and closing locations that don’t contribute enough to the bottom line. Other retailers have already disappeared from the landscape and are unlikely to return.

Financial-services companies are trimming human resources and searching to reduce operating costs. Do they still need the same amount of office space?

Overall, most businesses are looking for ways to reduce operating expenses. To do so, many are renegotiating rental rates.

As a whole, the hospitality, retail, and financial-services sectors are substantial users of real estate. When they contract space to maintain their operations, the market can be left with a variety of empty buildings. On the other hand, property owners of certain types of real estate may be more immune to some of the downward drafts caused by the regions’ economy. But they still need to keep a watchful eye.

The contractions in today’s market are stressing the real-estate industry in the form of lower rental revenues and property values. Complicating the matter is the difficulty some property owners and developers have accessing cash and credit.

Property owners who borrowed money for a project based upon a specific value of the property at that time and who have an interest in selling the property or restructuring the debt may be ‘upside-down.’ In other words, they may owe far more on their mortgage than the property is worth today.

The Cap-rate Factor

Many of the financial problems inherent in our economy, such as reduced consumer confidence and spending as well as reductions in employment, contribute greatly to contractions in rental income and net operating income (NOI) for income-producing real estate. However, another factor that has significantly affected the fair market value of these properties is the increase in capitalization or ‘cap’ rates.

A cap rate is based on the rate of return that an acquirer of a property is looking to earn (assuming no debt on the property). The most common way that income-producing properties are valued (and therefore sold or purchased) is by applying the cap rate to a property’s net operating income. Changes in cap rates are based on market factors and can have significant impact on the ultimate value of a property.

For example, if a property generates $800,000 in annual net operating income and the market cap rate for this property is 8%, then the value of the property would be equal to $10 million ($800,000/8%). However, if cap rates increase (which they have) and the new cap rate is 10%, this property would now be worth $8 million. Additionally, if the NOI decreases by 20% to $640,000, the value of this property now becomes $6.4 million.

As illustrated by this example, what we see today are rising cap rates and decreasing income from properties, which fuels declining property values. This combination creates challenges for property owners with loans to repay and lenders with decreasing values of loan portfolios. In short, property owners may be left holding undervalued real estate when compared to the original purchase price and the outstanding debt on the property.

Some lenders are looking to divest themselves of non-performing, undervalued notes discounting them by as much as 60% in some parts of the country. However, even at deeply discounted rates, some properties may not be a good value. For instance, if a lender applies a 25% discount to a $4 million note written in 2002 and the current value (because of credit issues with tenants, contraction of net operating income, and increased cap rates) of the property collateralizing it is less than $3 million, this may not be such a great deal.

The decreasing value of property is one of the characteristics leading to the credit crunch. Even though local and regional lenders are writing commercial real-estate loans to creditworthy clients, national lenders are most often looking to establish and strengthen relationships with the most-experienced and financially sound real-estate companies. Many investors still need access to capital to restructure debt and finance new projects.

Profiting with Distressed Properties

For clients with cash and access to credit, there are opportunities to pursue in the region. However, it must be ‘patient money.’ If you’re acquiring a distressed property with pre-existing tenants, do your research. When evaluating a potential acquisition, the final decision is as much a marketing decision as a financial one. Here are some questions to consider:

What is the credit-worthiness of the tenants?

What are the lease rates and lengths?

What is the realistic rate at which you think current tenants will renew their leases?

What is the realistic marketability of the project given its location and the activity in the market?

Will you need financing for the project? Where will you get it?

Which lenders in the market are active?

How long can you support the property if it generates a negative cash flow?

What are the tax consequences of the deal?

This whole scenario, unless intelligently discussed, can be fraught with confusion, frustration, dead ends, and unique circumstances.

If property owners and managers can look forward and realistically project their ability to retain their tenants, attract new tenants, negotiate their operating costs, and maintain a flow of capital, they will be better able to weather the storm and build a solid foundation for the future.

When charting a course through today’s economic obstacles, a seasoned real-estate accountant is invaluable. Such an individual can anticipate challenges before they arise and revise business and financial models to position the organization for success. For instance, if a client is going through debt restructuring, it’s important that their accountant communicate with lenders to evaluate acquisitions and divestitures and help them minimize tax consequences.

As real-estate companies and lending institutions throughout the region find themselves adjusting to the distressed commercial real-estate market, we advise working together in a spirited effort. By doing so, we will position our region for economic growth and prosperity.v

Ed Kindelan is Real Estate Services Group leader at Kostin, Ruffkess & Co., LLC, a certified-public-accounting and business-advisory firm. Beyond traditional accounting, auditing, and tax consulting, the firm also specializes in employee benefit plan audits, litigation support, business valuation, succession-planning business consulting, forensic accounting, wealth management, estate planning, fraud prevention, and information-technology assurance. The company has offices in Springfield, as well as Farmington and New London, Conn.; (860) 678-6000;www.kostin.com