Arguably, our property with a Walmart store has dropped 25% in value in the last six months. But the cash flow has not changed.
By John E. McNellis, Real Estate Developer Director McNellis Partnersby WOLF STREET:
Years ago, plagued by the Great Recession, one of Tennessee’s top developers shook his head at his financial statement and said, “My net worth is down by half, but my cash flow is the same.” I wasn’t alone. Commercial real estate across the country lost about forty percent of its value during those tough times.
His regretful comment acknowledged two things: the drop in value of his portfolio, but more importantly, the fact that it really didn’t matter. Though he was worth half as much, his properties were still occupied by rent-paying tenants.
Because this savvy investor had survived several recessions (they’re like high school reunions, they sneak up on you), he had been downright teetotal on the mortgages he had placed on his real estate. With little existing debt, he was not forced to sell his properties when his loans came due; he could refinance instead. Therefore, his only losses were on paper, the reduced figures on his financial statement, and yet he collected rent. And when the market recovered in a couple of years, his financial health recovered.
Fast forward to today.
Real estate values may not be down much yet, but they are looking down. We looked at our retail holdings in January, thinking we’d do a little pruning. We considered selling a Walmart supermarket in the Central Valley and asked one of our favorite brokers what would sell.
Because his Walmart lease is short-term, he said the property would sell at a 6 percent capitalization rate; that is, a buyer would want to earn 6 percent per year on his purchase price. So, if the rent was $200,000 a year (it isn’t), the purchase price would have been $3.33 million ($200,000 / 0.06 = $3.33 million).
We weren’t ready to sell in January, but we were last week. We went back to check with our broker. Somewhat sheepishly, he explained that the nightmares of the past six months — the bear market, inflation and sky-high interest rates — would make buyers insist on an 8 percent yield today. This means that our Walmart would now sell for $2.5 million ($200,000 / .08 = $2.5 million).
In other words, this property has arguably dropped 25 percent in value in the last six months. Like that wily Tennessee, we decided we’d rather keep our losses on paper and chose not to sell.
This example demonstrates how closely single-tenant retail properties have to the bond market: both decline in price when their yields rise, and conversely rise when their yields fall. And, to simplify things a bit, the fluctuations in value of each are irrelevant if you don’t sell: If you buy a $1,000 Treasury bond that pays 5 percent interest and hold it to maturity, you’ll get your 5 percent back. cent each year and all of your principal back. But he sells when interest rates rise to 10 percent, and he will only receive a much lower price. On the other hand, sell when interest rates drop to 2.5 percent and you’ll get a much higher amount.
The same math works for single-tenant retail: if you don’t sell, your “cash flow is the same.” If he does, he will ride the market like a mechanical bull.
My example also implies a different point: Even if we allow for a dramatic drop in commercial real estate values, it is possible, unlikely, that we will see the emergence of a vibrant buyers’ market. Instead, sellers with the financial means will put their wares back on the shelves and wait for a sunnier day before selling.
Instead of a buyer’s market, we are likely to see buyers and sellers holed up a mile apart, entrenched in their own expectations, as we watch the speed of the market evaporate like spit on an iron.
Sellers driven out of their strongholds by death, divorce, dissolution, disaster, or simply over-leveraging may be slaughtered, but there is so much money chasing real estate these days that even they may live to fight another day.
Let’s go back to that wily Tennessean. She understood that net worth is for bragging, cash flow is for eating. You too. By John E. McNellisauthor of Succeeding in Real Estate: Getting Started as a Developer.
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