Goodbye 4 CAP's

Commercial valuations are going to be changing dramatically. Speakers at the Multifamily Executive conference also agreed that pricing in virtually all U.S. apartment markets will see dramatic changes through 2009 and probably beyond. They expect markets that saw 4% and 5% cap rate deals to soon start trading at 7% and 8% caps.

The Alt-A and Subprime implosion is now starting to spill over to the commercial markets.

Mark to Market Overview

Credit markets are frozen, banks are closing daily the Alt-A and Subprime market has for the most part been eliminated. This is not totally because of "toxic" mortgages, but has a lot to do with FASB 157, also known as"mark to market".

Each day, lenders must mark their assets to the marketplace. It's like you having to appraise your home everyday and, if your neighbor was under duress because she got very ill, divorced, lost her job and was forced to sell her home quickly, she may have sold it super cheap. Now, does that mean your house is worth that super cheap price, too? Clearly not. Why? Because you are not under duress. You have the time to sell your home and get a more normal price, which more accurately reflects true market conditions. But "mark to market" does not allow for this, which creates a vicious cycle.

Why is this so bad? Because, as lenders mark down their assets the amount that they have previously loaned becomes much riskier in relation to their assets. For example, say a bank has $1 million in assets and say they have $15 million in loans outstanding. Their ratio is an acceptable 15 to 1. But should they take a paper write down of $500 thousand due to "mark to market" requirements, their ratio suddenly changes to 30 to 1. This is because their assets are now only $500 thousand after taking the paper loss, while their loans outstanding are still $15 million. And at 30 to 1 this bank is viewed as a risky investment. So the stock price starts to get hit, it becomes harder to borrow, and most importantly harder to make money. The bank is then forced to sell some of its loans to reduce its ratio...at cheap prices. And this makes the vicious cycle continue.

How Rapidly Will Commercial Values Fall

Much like SFR's in mid-2007, it appears commercial values have reached their summit and its poised for a downward fall.

Reis Inc. reports that rents on U.S. office properties--including landlord concessions and discounts--were flat in this year's third quarter, the worst result for office-property owners since commercial real estate started to pull out of a prolonged slump near the end of 2004. The office market in suburban areas and smaller cities has been on the decline throughout the year; and now such previously immune, large metropolitan areas as San Francisco and Boston are experiencing vacancy-rate increases. Of the 79 markets that Reis tracks, vacancy rates increased in 66 and rents declined or were flat in 40. For the third consecutive quarter, businesses emptied more space than they took nationwide. In total, approximately 18 million square feet of space were vacated--the most since the first quarter of 2002.

The commercial market is quickly approaching the perfect storm - tighening credit market, reduced incomes, increasing vacancies and rising CAPs. Expect to see a 15-20% valuation drop from today's levels.

Mortgage Originations Down 44% in Third Quarter of 2008

Preliminary numbers compiled by Inside Mortgage Finance suggest that mortgage originations tumbled by $115 billion or 26 percent between the second and third quarters of this year. That would put 3Q08 mortgage volume down a hefty 44 percent from the same period a year ago. If mortgage originations remain weak in the fourth quarter, a distinct if not likely possibility at this point, total volume for the year will come in at only about $1.5-1.6 trillion or 34 percent below last year's $2.43 trillion level. Currently, the only sectors of the mortgage market that are seeing increased activity are FHA and VA. FHA originations, in particular, are continuing to grow while total volume declines. There are expectations that the federal government, which now controls Fannie Mae and Freddie Mac, will start loosening the two government-sponsored enterprises underwriting requirements and lower their fees in the months ahead. That could provide a badly needed boost to the residential mortgage market.