The Expert: Assessing Value in Uncharted Waters

The recent capital-adequacy problems of major financial institutions has increased volatility, decreased liquidity and stalled multi-family property transaction volume, though multi-family volume is clearly ahead of commercial property volumes. This has created significant challenges for multi-family investors gauging expected cap rates and pricing.Now would seem an appropriate time to apply the time-tested principle of triangulation, the process of navigating uncharted waters by measuring the distance to known fixed points, to the difficult questions before investors in commercial real estate.We frame our analysis with three known points compared with the many uncertainties of the marketplace:• current debt and equity return hurdles, to establish theoretical pricing in today’s market, particularly in the wake of the collapse of overall lending business aside from Freddie Mac and Fannie Mae;• the impact of prior recessions on pricing and long-term cap rate spreads to Treasuries—from a top-down perspective; and• the projected impact of the current recession on real estate fundamentals—a bottom-up perspective.We conclude that, while cap rates are currently within an average 25 basis points of equilibrium, a continued near-term pricing correction of greater significance is likely. Real estate markets historically have overreacted before reverting to long-term trends, and today’s severe capital constraints will only exacerbate this tendency as the capital markets are in the midst of a de-levering phase. Moreover with the potential for interest rates to spike 200 basis points or more, we potentially will “inflate” our way out of economic turmoil.These factors can be expected to exert considerable upward pressure on multi-family cap rates over the coming quarters before settling back down from 2010 to 2011 as the economy recovers. This near-term correction is driven primarily by capital market influences, which have trumped real estate fundamentals for the past three years, both in the upside and downside price movements.The good news is that the eventual economic recovery could well support a more dramatic recovery in multi-family property pricing than has been experienced in the wake of prior recessions. Relatively strong fundamentals and low levels of construction should facilitate a speedy market rebound. In addition, a the capital markets could snap back, triggered by some degree of liquidity re-entering the marketplace.