Tuesday, March 1, 2011

We Need More Foreclosures.....Unfortunately

Current rental prices are unsustainable with middle class income being driven down. This does not just apply to residential properties but, more importantly applies to commercial properties. Rents have leveled off and gone down some, but not enough. For every cent you pay per square foot, the prices that you charge have to change accordingly, mostly on the smaller end. If you walk down the street and into a flower shop, the flowers will be more expensive, mainly because of the rent that the owner must pay. The inflation rate is low, right? Prices are going up, not necessarily because of inflation, but mainly because of rental prices. Loan values were pushed up, property values were pushed up, and now the only way to force these prices down are foreclosures.

When a borrower obtains a commercial loan, the main factor that is looked at is the debt service coverage ratio. The basic principle behind this is, for every dollar that goes out, how many dollars come in? This is calculated using the net operating income (NOI). Here is a sample:

$50,000 gross income
$5,000 property taxes
$1,500 property insurance
$2,500 vacancy allowance (5% of gross)
$41,000 net operating income (NOI)

The vacancy allowance line-item has been historically 5%, but it has been ever-increasing, especially with retail or office space due to the fact that there are many vacancies. Some investors would require a 20% vacancy allowance, but for the purpose of this example, we're using 5%.

The typical debt service coverage ratio requirement is 1.25. For every dollar that goes out, $1.25 comes in. Using this example, the maximum gross mortgage payment on this property could be $38,500 per year which, at a 5% interest rate. A commercial bank would allow a maximum mortgage balance of $550,000.

This goes a bit deeper as the value is typically based on the capitalization rate of the property. The capitalization rate is a tricky number to determine, but a rule of thumb in the private money world is right around 8.0%. In the conventional commercial financing world, it would be 7.0% or less. To determine value using the capitalization rate, you would divide the NOI by the capitalization rate which, using an 8%, gives us a value of $512,000. Obviously no one would do a loan of $550,000 with a property valued at $512,000. Using a 7.0% capitalization rate, which would give us a value of $585,000 and an 80% loan to value (LTV) loan would be roughly $470,000.

Enough about the technical data, at least we have a basic understanding of valuations and debt servicing. As foreclosures mount and properties are liquidated, investors who buy these properties demand a higher capitalization rate which drives prices down. Consider this example; you own a property and when you received your loan, it was valued using a 6.0% capitalization rate. This gives you a target price per square foot of $2.00. If the property next to yours forecloses and an investor purchases that property, he has the ability to rent the property for $1.50 per square foot where he can out-compete with you. You must continue to try and rent the property for $2.00 per square foot. This is why we see so many "For Rent" signs on commercial properties, because they're unable to compete. This has driven down prices and forced more commercial owners into foreclosure, but that is not enough and that is why we need more foreclosures in order to get prices down to a reasonable level.