Commercial Real Estate Valuation appraisers use critical benchmarks to determine the value of a property, including: market rent; occupancy; operating expenses; and, capitalization rates. To consider the effect of rising interest rates on a real estate investment, an appraiser will look to the market for the following critical benchmarks. Adjustments are then made to data to reflect a best estimate based on the current effective date for the subject property.
Some of the critical benchmarks used in an appraisal report are not always calculated or analyzed the same when compared to underwriting or accounting practices, which can sometimes lead to a “disconnect” in the discussions between lenders and appraisers. In this blog, Noelle McDonald, Vice President of Valuations Services at LCS with over 20 years of experience in providing valuation services, shares insights as to how critical benchmarks are calculated for Commercial Real Estate Valuation appraisal purposes and the effects that rising interest rates can have on the estimated value of a property.
Market Rent vs Contract Rent
Contract Rent is the rental income specified in a lease agreement between the owner and tenant. Market Rent is the potential rental income a property should be able to achieve if listed on the open market, as of the effective date of the appraisal.
The current inflationary market has put upward pressure on market rents. As interest rates rise to curtail inflation, market rents are generally expected to fall in response. Long-term lease contracts signed during inflationary times may indicate a higher level of risk due to the increased threat of default or tenants vacating early and relocating to less expensive spaces. Alternatively, long-term lease contracts to national credit tenants are typically associated with less risk of default. Ultimately, the smaller the gap between contract vs market rent, the less amount of risk to a property’s income stream.
An occupancy rate expresses the ratio of a property’s leased or occupied space to its vacant or available space. This Commercial Real Estate Valuation benchmark gives an indication of the availability of space for a specified property type in a defined market area. The vacancy rate expresses the inverse of the occupancy ratio. Generally, an appraisal will estimate at least one of the two types of occupancy rates for the subject property:
- Physical occupancy– the ratio of occupied space to total rentable space. (a “size” relationship)
- Economic occupancy- the ratio of the potential income of the occupied space, to the potential income if the property was fully (100%) leased. (an “income” relationship)
In the short term, rising interest rates may exert downward pressure on occupancy rates for most property types. Higher interest rates can discourage demand for space in the near term. However, most investors could be expected to give more effort to keep buildings occupied by renegotiating lease terms to retain a long-term tenant or offering some sort of temporary concession for those struggling to make payments.
Operating Expense Ratio (OER)
This appraisal benchmark is a measure of the property’s total operating expenses. Operating costs such as real estate taxes, property insurance, utilities, typical repairs and maintenance, and management fees, etc. are deducted from the effective gross income (i.e., the earned property income less any vacancy or bad debt allowance).
The OER represents the percentage of costs to operate the property, compared to the income generated from the property. It is used to assess overall financial risk. A property showing a pattern of a higher OER, relative to similar properties in the market, is considered to involve more risk overall. The property with higher OER would conceivably be more costly to operate. It is important to note that an appraiser’s OER does not typically include an allowance for a depreciation expense.
However, the inclusion of depreciation in the OER is used commonly in accounting practices. The costs to operate a property will likely increase with rising interest rates, and properties with under-funded reserve accounts used for capital expense repairs, or unexpected real estate tax liability increases present the greatest overall risk in terms of operating expenses to investors.
Net Operating Income (NOI)
Appraisers calculate the NOI by deducting the operating expenses from the effective gross income. It is the actual or expected income left over after all of the expenses or costs to operate the building has been paid. This is considered to be the profit to the owner BEFORE the consideration of any payments for a debt. The NOI would also be the cash in hand if the owner owned the property outright. In the estimate of a property’s NOI, the appraiser does not consider whether the owner has a mortgage or any debt obligations, as is common in underwriting.
When considering the impact of interest rates on the NOI, it really is determined by an asset’s inputs to all of the aforementioned critical benchmarks. Once rent, occupancy, and expenses are estimated, the NOI is the bottom line. When a rise in interest rates pushes market rents and occupancy down, it is expected that operating expense or the OER will go up, which leaves a lower NOI. Pricing available space reasonably, maintaining stable or higher occupancies and cutting operating costs are measures prudent owners can use to mitigate rising interest rate associated risk.
Capitalization Rate (Cap Rate)
This is where income is converted into a value indication. The cap rate is the rate of return applied to the property’s NOI, without consideration any debt or loans against the property. Once the NOI is calculated, it is divided by the appraiser’s estimated cap rate to arrive at value indication (mathematically, NOI/Cap Rate=Value). This is the direct capitalization method, which is typically the most common method used within the income approach to value in appraisals.
Historical trends show that cap rates tend to move with interest rates. Interest rates are essential to consider in the development of the cap rate. The difference between the interest rate and cap rate represents a “risk spread” – best defined as the additional compensation a real estate investor can expect for assuming the risk of owning real estate versus just investing funds with the US Treasury.
The interest rate represents a “risk-free” rate, the bare minimum rate of return a real estate investor can expect to receive. In commercial real estate lending, the “risk-free” rate is usually tied to United States 10-year Treasury bond rates for real estate investments. To this “risk-free” rate, the risk of investing in real estate is added to arrive at a cap rate. If a certain property is considered riskier, the spread over and above the “risk-free” rate increases.
This pushes up the cap rate and in turn, decreases the value. Alternatively, a lower cap rate typically equates to increased value.
With the property valuation process in mind, it is critical to note that there is an inherent lag between current market activity and the data that is available for appraisal reporting. The comparable data used in the valuation assignment most often reflects transactions that occurred weeks (if an appraiser is lucky), months, to even years prior to the date of value. In a market where changes are happening rapidly, an appraiser is often challenged to make adjustments to data to reflect a best estimate based on the current effective date based on changes in these critical benchmarks and other market variables.
Changes in employment, population, consumer confidence, global pandemics, and political spending, impact commercial real estate values as well. As we’ve seen, what we thought we were sure of today, we might not be so sure of tomorrow or next quarter.
And as always….
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