August 9, 2022

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Getting Rid Of The Slump In Commercial Real Estate: Is It Time To Wait?

Arguably, our Walmart store properties have decreased in value by 25% in the past six months. But the cash flow has not changed.

Written by John E. McNelis, Director, Real Estate Development Corporation McNeills Partnersfor Wolf Street:

Years ago — suffering from the Great Recession — one of Tennessee’s best developers shook his head at his financial statement and said, “My net worth has halved, but my cash flow hasn’t changed.” He was not alone. Commercial real estate across the country lost about forty percent of its value during those trying times.

His unfortunate comment admitted two things: the devaluation of his portfolio, but more importantly, the fact that it didn’t really matter. While his property is worth half that amount, it is still occupied by rent-paying tenants.

Because this savvy investor has gone through so many downturns—it’s like a high school reunion, they’ve snuck into you—he’s completely withheld the mortgages he placed on his properties. Due to little debt outstanding, he was not compelled to sell his property when its loans became due; He can refinance instead. Thus, his only losses were on paper – the dwindling numbers on his financial statement – and he still collected his rent. And when the market rebounded within two years, so did its financial statement.

Fast forward to today.

Real estate values ​​may not have dropped much yet, but she’s staring down the rabbit hole. We looked at our retail holdings in January, thinking we’d do a little pruning. We considered selling a Walmart supermarket in the Central Valley, and asked one of our favorite brokers what it would bring.

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Because Walmart’s lease is short-term, he said the property would sell at a capitalization rate of 6 percent; That is, the buyer will want to earn 6 percent annually of the purchase price. Thus, if the rent was $200,000 per year (it’s not), the purchase price would be $3.33 million ($200,000/.06 = $3.33 million).

We weren’t ready to sell in January, but we were last week. We checked again with our broker. He explained somewhat timidly that the nightmares of the past six months – a bear market, spiraling inflation and interest rates – would have buyers insist on an 8 per cent return today. This means that our Walmart will now sell for $2.5 million ($200,000 / .08 = $2.5 million).

In other words, the value of this property can be said to have fallen by 25 percent in the past six months. Such a witty Tennessee, we decided we’d rather keep our losses on paper and choose not to sell.

This example illustrates the close similarity between the retail characteristics of an individual tenant that the bond market bears: the price of both tenants decreases when their yields rise, and, conversely, increases when their yields fall. To oversimplify things a bit, the fluctuations in the value of each are irrelevant if you don’t sell: If you buy a $1,000 Treasury bond, pay 5 percent interest and hold it to maturity, you get 5 percent each year and all of it off your prime. But sell when interest rates go up to 10 percent, and you’ll only get a much lower rate. On the other hand, sell when interest rates fade to 2.5 percent and you’ll get a much higher amount.

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The same math applies to individual tenant retail: If you don’t sell, “your cash flow is the same.” If you do, you are riding the market like a mechanical bull.

My model also makes a different point: Even if we accept a staggering decline in commercial property values ​​- it is possible – we are unlikely to see the emergence of a vibrant buyer’s market. Instead, sellers with the financial means will put their wares back on the shelves and wait for a brighter day before selling.

Instead of a buyer’s market, we are likely to see buyers and sellers holed up a mile away, entrenched in their own expectations, while we watch the speed of the market evaporate like spit on a griddle.

Sellers forced out of their strongholds may be killed by death, divorce, annulment, catastrophe, or simply excessive influence, but there is so much money chasing real estate these days that they may live to fight another day.

Back to that shrewd TN. He understood that the net worth to show off, the cash flow to eat. So are you? by John E McNelisauthor Make It Into Real Estate: Getting Started as a Developer.

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