Capitalism has an unfortunate flaw. When capital becomes the proxy for societal value, for people to do the “right” thing (or whatever the public perception of “right” is at the moment at any rate), they need to be financial incentives to do so. At the very least, the people that want to do what is right shouldn’t be punished for it. The market is never “wrong,” they say. We must buy the change that we want to see in the world.
In the past decade, the last few years really, we have seen the world’s mindset shift on some of the big issues like climate change and corporate responsibility. Consumers are increasingly voting with their pocketbooks in a way that the business world couldn’t not notice. This trend has shaped industries to become more sustainable and put an immense amount of brand value on being truly, authentically accountable.
For the property industry, an industry and investment class that takes the long term perspective when it comes to value, this has led to a big change in what people and businesses demand from their buildings. The most innovative real estate investors, owners and managers are factoring in things like resident wellness, community and sustainability into their business plans. Tenants were rewarding them with higher rents and retention rates. This is a beautiful example of where the right thing is also the most profitable, where our morality is steering our economy and not the other way around.
But this was before the virus, before everything became about flattening an infected curve. We will likely emerge from our isolation even more adamant about our new morality that our capitalism is taking. But for now, we can only deal with the immediate threat that we all face. The government imposed shutdowns are creating another conflict between morally right and most profitable that has nothing to do with consumer behavior. The first of the month means rent is due for millions of renters around the country. Many of them are out of jobs, scared, confused and uncertain. Some of them might have no way to pay their bills at all. In places like New York, up to 40-percent of renters might not have enough savings to pay rent at all.
Landlords knew this was coming. Most of the people in the property industry I have been talking to are seeing landlords coming to terms with their renters in some way, letting those in need pay back some of their rent over time or at the end of their lease. But it isn’t just about a deferred payment for many properties. Buildings have taxes to pay, loan payments to service, investor expectations to meet and loan to value thresholds to stay under. For most building owners for them to do the right thing and help the renters that need it they need to know that their buildings are not going to be less valuable because of it.
Owners are not wrong to assume that a hit to their rent collection, even if temporary, would devalue their assets. There are a few ways to value a building but one of the most common is a capitalization rate, or cap rate. This looks at the price of the building as compared to its net operating income, or “NOI.” So, if your profits are down, even temporarily, a case could be made that the building is worth less than it was a few weeks ago.
This is not just semantics. Sellers could lose money, investors could move their capital elsewhere and the around $707 million of commercial debt that is set to mature during the next three months could not be refinanced. This could potentially trigger a chain reaction where portfolios need to sell off assets, further accelerating the decline in value by setting a low market price in a nearly buyerless marketplace.
None of this has to happen. No matter how much people try to tell you differently, value is only a communal perceived reality. We have come to a consensus that we need to value buildings a certain way. So, in order for us to make sure to not hurt those doing the right thing and helping renters find a way to navigate the hardship that none of them were responsible for, we need to change our consensus and with it our perception of value altogether.
I asked Arik Kogan, VP of Financial and Investment Solutions at the commercial real estate property management software company MRI, about how he thought we could change our valuation models to help us see past what we hope will be just a hiccup in many buildings’ rent rolls. “From a valuation perspective, there is a way to account for this type of period of volatility,” he said. “It is similar to valuing a building that has not yet stabilized its rent. You can create a hybrid method that can stabilize for certain periods of time, thus excluding what can be seen as an anomaly.”
Cap rates are generally created by brokers. They are the one of the most visible metrics for commercial real estate valuation, but they are not always the most accurate. Brokers, after all, want to sell properties and earn their hefty commissions. L.D. Salmanson, co-founder of commercial real estate data company Cherre, what he thought would happen to cap rates. “My thought is that because many of the big transactions in the market, the high-end Triple-A space, is controlled by large brokerage firms, they are going to control the narrative,” he said. “I think they are going to do what any good salesperson would do and call it a one-time event and ignore it for the purpose of valuations and only leave it in for the purpose of cash flow.” This might be a case where a clever sales spin is not a bad thing. “It is probably the right thing to do because it is not indicative of where my NOI is going in the future,” L.D. added.
Future value. That is what we all want. We know what is valuable now, at this second, but the future can look very different. If this virus outbreak has taught us anything it is that. It is this perception of future value and its counterpart, future risk, that ultimately shapes the idea of value. Patricia McGarr is a Valuation Advisory Services Leader at the CohnReznick Advisory Group she made the point that, “with regards to cap rates, which convert cash flows into market values, one of the key indicators reflected in the rate is that of the risk that an investor perceives. The single biggest impact on risk right now in all markets is fear.” She thinks that this fear will go away as soon as we start to see an end to this disaster. “This is not like the prior real estate bubble that burst in 2008 and 2009, which was caused in many ways by fraudulent activities within the market itself,” she said. So determining how this will impact the various real estate markets, requires us to wait and watch two factors, how investors react and how quickly the government’s financial stimulus support gets implemented and into the hands of the population.”
There will undoubtedly be long term impacts on the perception of value of properties after this disaster ends. More weight could be put on things like resident wellness or whether or not tenants are “essential” during an emergency. But we will have plenty of time to talk about that after the virus, after life returns to some semblance of normal. For now, the property industry has a more pressing matter when it comes to valuation that is as technical as it is philosophical. We all know that landlords are going to have to come to terms with renters that are struggling right now. If we reconsider how we value buildings we will be able to avoid punishing landlords who do the right thing for humanity, society and the economy. This change will take an industry consensus and a good amount of financial acumen. But compared to all of the other adjustments we are having to make in response to this virus, that should be one of the easier things that is asked of us.