Measuring the Impact of COVID-19 on CRE Property Valuations

May 2020

CRE Research

Commercial real estate’s immunity to the COVID-19 • Payment is made in cash or its equivalency pandemic is about to be tested in a multitude of ways. Each of the commercial property sectors: Lodging, Re- • The sales price is not impacted by special or creative tail, Multifamily, Industrial, and Office are going to face financing terms or concessions their own unique set of COVID related challenges. The In summary, market value is representative of a transac- million-dollar question looming for each of the market tion where no exceptional factors influence the parties participants, i.e. owners, brokers, lenders, and apprais- (buyers, sellers, lenders) to the transaction. ers, is straightforward and simple to understand, but not so simple to answer: COVID-19 would be considered an exceptional factor that would influence all parties to a transaction. The market value definitions, nor the additional bullet points above, What is my Property’s Value? provide much clarity or guidance for appraisers to rely on Appraisal of commercial real estate is an interesting en- when appraising a commercial property during this pan- deavor with its share of skeptics, even when the market demic. The concepts of market value as previously de- is stable and operating efficiently. The Uniform Standards fined do not contemplate how short-term occupancy and of Professional Appraisal Practice (USPAP) 2020-2021 revenue declines caused by external forces, beyond the edition defines market value as, “a type of value, stated control of the owner/property manager, should be treated as an opinion, that presumes the transfer of a property by the appraiser. Until the pandemic surfaced, many com- (i.e., a right of ownership or a bundle of such rights), as mercial real estate property sectors were pacing above of a certain date, under specific conditions set forth in their previous year’s performance metrics. Employment the value definition that is identified by the appraiser as and other market-level indicators such as interest rates applicable in an appraisal.” Appraisal organizations and and the availability of financing were favorable and readily taxing authorities have their own generally accepted or available across all major metros in the United States. statutory definitions of market value containing the following concepts: What Creates Real Estate Value?

• Buyer(s) and seller(s) are typically motivated Real estate is considered to have value in the market • Both parties are knowledgeable, informed and acting when the following four essential elements are present: in what they consider to be their own best interest (these elements are commonly referred to using the ac- ronym DUST) • Neither party is affected by undue stimulus (duress) • Demand – This suggests that someone wants to • Reasonable marketing time and exposure have purchase the property and has the financial means to been given purchase it

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• Utility – The property has recognized viability in the The formula for the direct capitalization approach is marketplace NOI / Cap rate = Property value:

• Scarcity – The property or properties are in short sup- ply relative to the demand for them in the marketplace

• Transferability – The property has clear title and can be moved from one person/entity to the next

When appraisers are engaged to determine the market value of a commercial property, they will generally ar- rive at their opinion of market value by performing an The second method is Yield capitalization or Discounted income approach. The income approach is based on the Cash Flow. This process involves converting future cash- value principle of anticipation. The principle of anticipa- flows into present value by utilizing an appropriate yield tion is predicated on the perception of future benefits or discount rate. Other time value of money calculations being received by the owner. In commercial real estate, and metrics can also be determined from the DCF pro- those benefits take the form of cash flows supplied to forma to measure the viability of the investment. These the owner over the holding period and the reversionary metrics take the form of the investment’s internal rate of cash flow (net proceeds) at the time of sale. return, cash-on-cash return, equity multiple, etc.

The income capitalization approach is defined by the Ap- The formula for yield capitalization or discounted cash praisal Institute as a “set of procedures through which flow is as follows: an appraiser derives a value indication for an income- producing property by converting its anticipated benefits (cash flows and reversion) into property value.” R R R R

It is further stated, “this conversion can be accom- What Impact Does COVID-19 Have on Property plished in two ways. One year’s income expectancy can Value? be capitalized at a market derived capitalization rate or at a capitalization rate that reflects a specified income The impacts on property performance are going to be pattern, return on investment, and change in the value of easy for appraisers to identify. Reduced rental revenue, the investment. Alternatively, the annual cash flows for reduced occupancy, increased short term risk, etc. What the holding period and the reversion can be discounted will be harder to quantify is the immediate impact to at a specified yield rate.” In layman’s terms, there are the property’s value. The direct capitalization method two methods to determine market value using the in- discussed earlier assumes the property is operating at come approach. The first is called the direct capitaliza- a stabilized level of operation. Presumably, the property tion method which capitalizes a single year’s net operat- will have achieved stabilized market occupancy, stabi- ing income (NOI) using a market derived capitalization lized market rental collections, stabilized market oper- rate (cap rate) to determine the value. ating expenses; each of those components contribute

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to the utilization of an appropriate market derived capi- •This rationale is already often applied to talization rate that converts the net operating income properties that suffer from long term vacancy into market value. By capitalizing a single year’s income issues in the form of a “lease-up” deduction to stream, the appraiser is essentially implying the prop- the value determined after capitalization erty is going to perform to that standard into perpetuity. • Potentially increase the capitalization rate by some fac- Below are questions the appraiser must grapple with tor to acknowledge an increase in the “short term” risk during the current COVID-19 crisis. •This may take the form of a 25 bps to 50 bps • Does COVID-19 change the market’s or the property’s adjustment “stabilized” metrics? Even though the appraiser(s) may make what appear to be • Does COVID-19 change the long-term value prospects nominal adjustments to the capitalization rate, those ad- of a property’s intrinsic DUST elements? justments can/will have a dramatic impact to the valuation.

• Does COVID-19 become the new perpetual state of See the chart below to understand the impact the capi- the property’s ability to generate cash flow? talization rate plays on the overall property value, based • Are any pre-COVID-19 data points relevant? on each $1 dollar of NOI:

• Sales prices $1 OF NOI AT DIFFERENT CAP RATES • Cap rates @ 4% cap rate = $1/.04 = $25.00 of Property Value • Lease rates @ 5% cap rate = $1/.05 = $20.00 of Property Value @ 6% cap rate = $1/.0 = $ of Property Value The answer to these questions will become clearer as 6 16.67 COVID-19 testing and other medical advances paint a @ 7% cap rate = $1/.07 = $14.29 of Property Value more accurate picture of the status of the pandemic. @ 8% cap rate = $1/.08 = $12.50 of Property Value Until those items related to the pandemic are known at a macro level and appraisers can accurately determine • Reduce the percentage of common area maintenance how long the pandemic is going to impact commercial (CAM) charges realized by the owner as reimbursable by property performance; appraisers will probably choose the tenants to utilize some of the following techniques when valuing commercial properties during these uncertain times. • Retail, office, and industrial properties often utilize triple net (NNN) lease arrangements and bill • Assume stabilized operations of the asset still exist back certain charges to their tenants, it will be when utilizing the direct capitalization method harder to recover these charges now

• Treat revenue/occupancy losses as a form of Appraisers must also be vigilant in keeping up to date “external obsolescence” and make a line item with regulatory and other market changes during this deduction to the property’s market value after time. Certain aspects of the appraisal process have al- applying a capitalization rate to the NOI ready changed regarding physical property inspections, timing of when lenders are required to have completed

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appraisals submitted relative to disbursing funds, etc. Multifamily Reading as much market commentary as possible and digesting data in real time are going to be imperative. Conventional multifamily is still outperforming its coun- Each market is unique. Each market has and will be im- terparts as of right now. Forbearance programs have pacted by COVID-19 differently. The appraiser must in- provided a lifeline for Fannie Mae and Freddie Mac mul- sure he/she is competent and up to date on all things tifamily loans. Owners are eligible for 90-120-day for- that impact or could potentially impact the valuation of bearance of mortgage payments, however, opting into the property they are appraising. those agreements also prevents owners from evicting tenants for non-payment of rent.

What Property Types/Valuations are the Most Will these forbearance agreements impact the market Impacted by COVID-19? value from an appraiser’s perspective? If the owner is not able to evict tenants for non-payment of rent, does Lodging/Retail the appraiser utilize the new lower effective rent calculations based off actual rent collections? Will sales prices Lodging and retail properties have already had to be impacted due to the new owner’s potential inability face the immediate reality of lost revenues due to to recoup deferred tenant rental payments? the pandemic. Hotel operators in hard hit areas have The refinance market is primed to take a hit within the seen occupancies plunge from their stabilized 70% agency financing space as well. Several thousand loans range into the high single digits, or in some cases, were taken out as interest only, or with significant por- have been forced to close their doors all together until tions of the loan term being interest only. Property own- the crisis subsides. Data tracked by Trepp shows the ers were betting on value appreciation over the duration percentage of lodging properties financed by CMBS or of the loan term by increasing their rents and market CRE CLOs that did not make their April mortgage capitalization rate compression. COVID-19 has effective- payment stands at approximately 20%. This is in ly eliminated those realities. comparison to the previous months where that percentage hovered around 2%. Retail properties If rent collections go down and capitalization rates in- financed using the same mechanisms were at about crease at all it is going to be difficult to meet refinance 10% (grace not due) status in April, meaning they did valuation, LTV, DSCR, Debt Yield hurdles. Fannie Mae not make their April mortgage payment, compared and Freddie Mac are also increasing reserve require- to 2% in the previous months. ments which reduces borrowers’ effective purchasing power. This reduction in purchasing power will immedi- What happens if those properties miss another mortgage payment or two, slide into default, then ately be seen in in the form of lower sales prices. Those new lower sales prices will become the comp set for ap- special servicing and are sold at significant losses? praisers to utilize when determining capitalization rates Do those foreclosure, special servicer type of and property values. sales(s) transactions become the appraiser’s new “market” for sales comps?

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Student Housing In markets like Houston where the impacts are being felt from COVID-19 and the oil glut, it will be tough Student housing operators are facing the odd reality of sledding for those office property owners. Appraisers their residents’ college campuses being completely shut can at least look back to previous slumps in oil prices down with no access to students and/or faculty. Many to gauge the economic impact to office valuations. universities are trying to forecast if/when they will be able to reopen their campuses to their students and faculty. If campuses remain closed for the upcoming 2020 Next Steps? fall semester, student housing assets are going to suffer If you are a commercial property owner, be proactive. loan defaults at an unprecedented level. When college Try to adapt to this new normal in ways that would oth- students (and their parents) realize how much money erwise seem unconventional. Create revenue opportuni- can be saved by living at home or someplace cheaper ties by looking at every possible alternative use of your than on/near campus, do those students decide to come asset. If you end up needing an appraisal, make sure you back to amenity laden “student housing” complexes? have your previous years’ financial statements in order, be able to articulate how you plan to make it past this Office crisis, and know what similarly situated properties are doing to weather the storm. There has never been a Office property owners will not know their fate more important time than now to prudently and actively until each state begins the process of opening back manage your property’s expenses. Minimize all control- up for business. Once that happens, their office lable expenses and make sure the appraiser knows how tenants will have to make the decision to either send you intend to do that. If your property’s value is infected, their workforce back into an office environment or it has a better chance at survival with a clearly defined continue to have them work from home. From an plan in place to return revenues to pre-COVID-19 levels. appraisal perspective this asset class is probably the most stable right now, but that can change rapidly over the coming weeks/months.

For more information about Trepp’s commercial real estate data, contact [email protected]. For inquiries about the data analysis conducted in this research, contact [email protected] or 212-754-1010.

About Trepp Trepp, founded in 1979, is the leading provider of information, analytics and technology to the CMBS, commercial real estate and banking markets. Trepp provides primary and secondary market participants with the web-based tools and insight they need to increase their operational efficiencies, information transparency and investment performance. From its offices in New York, San Francisco and London, Trepp serves its clients with products and services to support trading, research, risk management, surveillance and portfolio management. Trepp is wholly-owned by Daily Mail and General Trust (DMGT).

The information provided is based on information generally available to the public from sources believed to be reliable. 5