The performing "Class A Market" is different than and priced differently than the "Distress Market".
Recommending a value or proposed sales price takes a disciplined approach comparing market trends and market demand. Our job as investment brokers is to be able to thoroughly evaluate the property-- including recent comparable sales, an evaluation of income and expenses to determine net operating income, replacement cost, and competitive positioning within the market. In addition understanding the motivations of the Seller, macro conditions in the market place, and financing costs and availability, also need thorough consideration today.
In my opinion there are two distinct and different markets today. Class A properties, that are stabilized with good tenants and good income are scared and are trading at surprisingly low cap rates. Distress properties -- with income that won't support the debt service, or properties that are unfinished, or poorly performing, in areas with little demand, are being sought by a different category of Buyer. Distress vs. Class A Institutional are really different markets and should be and are priced differently.
Class A doesn't just mean "expensive finishes" it means strong demand.
In the current market environment, the best income-producing properties—those distinguished by superior quality of construction and the right location are likely to hold their value, keep their tenants and appreciate sooner and more than others. Early in this recession pricing correction affected all properties, including those with the strongest operating performance and, in the case of new developments, the potential for such performance. But now it is back to fundamental evaluation and underwriting. Location, Rent Rolls, Great management and the like make a real difference.
The relative attractiveness of good buildings to tenants and investors should allow them to stay ahead of the rest even in the challenging years ahead; their values have hopefully bottomed out as the broader market continues to find the bottom. Anecdotal evidence suggests that cap rates on scarce Class A properties with real income and good lease terms are therefore sought-after assets and those cap rates have already come down.
Distress Buyers and Distress Prices are different than most well performing Class A properties. The current cap rate decline starts with that fact that there is more capital (debt and equity) in the market than there is product. That factor alone has pushed values up and cap rates down-- but only for strong assets. Distress deals get picked over and trade at dramatic discounts to replacement costs; if they trade at all.
Institutional investors are seeking quality NOI. We are reading reports and hearing about deals in northern California where pricing with cap rates as low as 6+% based for good assets. But if it isn't class A -- and if the lease terms are short and there is any scent of distress or credit quality risk -- or if the likelihood of vacancy and rent-up risk is high --then the Cap rate is more like 9% -- and or price per square foot-- well below replacement. That said, there is a great deal of anxiety out there as to how far cap rates have fallen and does it make a risk adjusted sense for them to stay low?
The current imbalance of available high quality class A properties and the amount of capital seeking to invest in them has created what a number of analysts and market participants call a "scarcity premium." I believe that the distressed properties that are coming to market are those with little hope of value recovery for the foreseeable future (more than three years). These are two distinct markets; priced differently for different categories of buyers.
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May 31, 2010