Our property with a Walmart store has probably gone down in value by 25% in the last six months. But cash flow hasn’t changed.
From John E. McNellis, Principal at real estate developer McNellis Partners, for WOLF STREET:
Years ago, stricken by the Great Recession, one of Tennessee’s top developers shook his head at his financial statements and drawled, “My net worth is down by half, but my cash flow is the same.” He wasn’t alone. During these difficult times, commercial real estate nationwide lost around forty percent of its value.
His rueful comment confirmed two things: the decline in the value of his portfolio, but more importantly, the fact that it really didn’t matter. Although his properties were worth half as much, they were still occupied by rent-paying tenants.
Because this savvy investor had endured multiple recessions — they’re like class reunions, they sneak up on you — he’d been downright stingy with the mortgages he’d placed on his properties. With little outstanding debt, he wasn’t forced to sell his properties when their loans matured; he could refinance instead. So his only losses were on paper – the shriveled numbers on his balance sheet – and he was still collecting his rent. And when the market recovered in a few years, its balance sheet recovered.
Fast forward to today.
Real estate values may not have fallen much yet, but they are staring down the rabbit hole. We looked at our retail inventory in January and thought we’d trim a little. We were considering selling a Walmart supermarket in the Central Valley and asked one of our favorite realtors what he would bring.
Because the Walmart lease is short-term, he said the property would be sold at a capitalization rate of 6 percent; That means a buyer wants to earn 6 percent per year on their purchase price. So if the rent was $200,000 per year (it isn’t), the purchase price would have been $3.33 million ($200,000/0.06 = $3.33 million).
We weren’t ready to sell in January, but we were last week. We checked with our broker. Somewhat embarrassed, he explained that the nightmares of the last six months – the bear market, rising inflation and interest rates – would make buyers insist on an 8% yield today. That means our Walmart would now sell for $2.5 million ($200,000/0.08 = $2.5 million).
In other words, this property has probably lost 25 percent in value over the past six months. Like this smart Tennessean, we decided to keep our losses on paper and chose not to sell.
This example shows the close similarity of single-tenant retail properties to the bond market: the price of both decreases when their yield increases and conversely increases when their yield decreases. And, to simplify things a bit, the fluctuations in value are irrelevant unless you’re selling: If you buy a $1,000 Treasury bond, pay 5 percent interest and hold it to maturity, you get your 5 percent every year and that everything back from your client. But sell when interest rates go to 10 percent and you’ll only get a much lower price. On the other hand, if you sell when interest rates drop to 2.5 percent, you get a much larger amount.
The same math applies to single-tenant retail stores: if you’re not selling, your “cash flow” is the same. When you do that, you ride the market like a mechanical bull.
My example also implies another point: even if we concede a staggering drop in commercial property values - it’s possible – we’re unlikely to see the emergence of a buoyant buyer’s market. Instead, sellers with the cash to put their wares back on the shelves and wait for a sunnier day before selling.
Instead of a buyers’ market, we’re likely to see buyers and sellers miles apart, rooted in their own expectations as we watch the market’s speed evaporate like spit on a frying pan.
The sellers driven from their redoubts by death, divorce, dissolution, catastrophe, or simply excessive leverage may indeed be butchered, but there is so much money chasing real estate these days that even they might live another day to to fight.
Back to that sly Tennessean. He understood that net worth is for boasting, cash flow is for eating. maybe you too By John E. McNellis, author of Making it in Real Estate: Getting started as a developer.
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