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But What Is It Worth?

Posted on August 22, 2023 Published by

“I know what the price is, but what is it worth?”

When it comes to real estate, the key element in this question applies not just to the purchase of the real estate. But also to the issue of refinancing that real estate. In fact, the level of peril for a lending institution may be much greater in the case of refinancing as opposed to financing. This is given the significant changes in the economic environment in a relatively short period of time. Given these extraordinary changes, the need for up-to-date information on the value of real estate collateral underlying loan transactions is even more critical. A few recent headlines from the financial press highlight the importance of obtaining current valuations in a fluctuating commercial real estate market.

The commercial real estate market is oftentimes broken down into six major segments. These are office, retail, industrial, multi-family, hotel, and special purpose. In this blog, we will do a 10,000-foot fly-by on three of these categories.

Multi-Family Real Estate

Apartment buildings have enjoyed a reputation as a real estate safe haven. But they may be emerging as the next major trouble spot. Investors bid-up prices on multi-family properties attracted by steadily increasing rents. Many took on too much debt on short duration notes with an expectation that rents would continue to increase fast enough to pay down the debt and improve cash flows. The problem facing many of these investors is not a lack of demand, but interest rates. While delinquency in this segment is still relatively low, rent increases have slowed. Borrowing costs have also doubled and building expenses have increased. Not a good scenario for real estate values.

According to an August 7, 2023, article in the Wall Street Journal, apartment values have dropped 14% for the year ending June 2023. This is after rising 25% in the previous year. In some cases, investors who purchased properties in the last three to five years are walking away from the properties. This is due to interest rate increases at their first maturity.  This will drive down comparable data and likely impact market prices in this segment.

Office Space Real Estate

Office space, particularly in large metro areas, has been especially hard hit. A recent Forbes Magazine headline (5/25/23) read “The $500B office real estate apocalypse: researchers find remote work’s effect even worse than expected.” Nationwide, the average office vacancy rate is averaging 17.1% compared to a pre-pandemic 2019 level of 7%. Major cities like San Francisco are seeing rates in excess of 28%. High vacancy rates will negatively impact a landlord’s ability to increase rents. Combined with the increase in borrowing costs and higher cap rates on lower net operating income, values are in for a serious beating.

Retail Real Estate

In the retail segment, particularly local shopping malls and strip malls, expect turbulent times ahead. As reported in a July 31, 2023, article in the Wall Street Journal, which characterized local malls as “stuck in a death spiral,” the real estate research firm Green Street indicated that low-end malls are worth 50% to 70% less than their peak in 2016. It is estimated that $14B of these loans come due in the next 12 months. The combination of higher interest rates, bankruptcy filings at many “big-name” retailers, and decreasing rents could be devastating.

Certainly the financial press has no shortage of gloomy headlines for the commercial real estate (and housing) markets. Because of the major changes in interest rates and the constant fluctuations in the economy, the need to obtain up-to-date values on real estate collateral is more important than ever. While regulatory compliance will certainly drive some of the timing and decisions on obtaining current appraisals, prudence and sound credit judgement should guide as a “best practice.” By obtaining a current appraisal, lending institutions can make informed lending decisions. Along with implementing early mitigation strategies of potential risks in their commercial portfolio.

Enlighten Financial can assist your institution through portfolio loan reviews (including limited scope reviews). We also provide analysis of concentration risks, potential upcoming re-pricing risks, and underwriting services to assist your lending/credit team. Take a proactive approach to portfolio management.

 

Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape. We lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.445.8133.

Apartment Buildings, image by Peggy and Marco Lachmann-Anke from Pixabay.

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“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors.”
— Bill Beardsley, President, Michigan Business Connection
“The staff at Enlighten have been available for questions, in addition to the engaged work that they do. They've been very helpful as a resource beyond the major audit.”
— Meghann Kasper, Chief Credit Officer, Bank First
“Enlighten gives us a very good second set of eyes on our transactions. They're not afraid to challenge us on some of the work that we've done, which is what is needed. I don't need to pay somebody to tell me I'm good, I need to pay somebody to tell me where I've made mistakes.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“Enlighten provided industry best practices that weren’t going to show up in an audit report. They would say, ‘Hey, I noticed you do this. This is really unique, you do a really great job of it.’ And then they might add, ‘Some other clients that I have are doing something like this.’”
— Bill Beardsley, President, Michigan Business Connection
“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors."
— Bill Beardsley, President, Michigan Business Connection