Jansen Multifamily Team Blog

Benjamin Graham, the recognized “godfather” of value-investing, once asserted that “…[T]he individual investor should act consistently as an investor and not as a speculator. This means… that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money’s worth for his purchase.”  Mr. Graham’s paradigm of pragmatism related to investing in securities, but for first time in nearly a decade, his model has incredible relevance, albeit partially forced, in today’s commercial real estate market.

Puget Sound area real estate investors have spent a good portion of this decade as real estate speculators.  Market momentum, rather than actual income, became drivers of internal rate of return projections.  Fueled by cheap credit that drove this speculation, products like the zero down, stated asset/ stated income short-term home loans enabled people to purchase homes they couldn’t afford, which in turn artificially inflated land values, home values, condo values and, ultimately, apartment values.

To meet this artificial demand, local banks offered short-term construction/bridge loans to land developers, home builders, condo converters, etc.  As a result, these speculators and the vendors with whom they worked all saw sharp increases in their bottom line.  Landlords of office, retail and industrial properties took notice of their tenants’ increased profits and were able to raise rents to unsustainable levels.  The Commercial Mortgage Backed Security (CMBS) Market was apparently unaware of this economic house of cards.   Commercial property landlords utilized the optimism of Wall Street to refinance their properties and cash-out equity using LTV’s based on false values propped up by huge rents.

All of a sudden, a strange thing happened: home loans began to adjust and homeowners couldn’t pay their mortgages, home builders no longer had home buyers, local banks realized they had a slew of non-performing assets and commercial property landlords had tenants that couldn’t pay their rent, causing net operating incomes to plummet, loan ratios to fall out of balance, and the CMBS Market to collapse.

Amidst the chaos, opportunistic investors are beginning to cautiously re-enter the market.  These investors are relying on impersonal, objective reasoning to determine the value of an asset, i.e. actual cash flow.  Banks, reeling from loan losses and no longer accepting pro-forma income streams as the driver of value, have forced investors to return to the fundamentals of underwriting.  Terms such as “positive financial leverage” and “cash-on-cash returns” have taken precedent in investment analysis models once dominated by physical pricing indicators and market momentum.

The August 2009 edition of the Dupre & Scott Apartment Investment Report clearly illustrates the market’s correction to cash flow-driven investing.  According to the report, actual CAP rates for 20+ unit apartment buildings located in the City of Seattle have increased 150 basis points, or 33%, to 6.1% over the last year.  Anticipated, or pro-forma CAP rates have increased 60 basis points, or 10%, to 6.8%, indicating that investors are projecting rising interest rates and nominal appreciation in the foreseeable future.

This story, and the market realities with which investors and speculators alike are now faced, may sound pretty violent and full of doom and gloom. The contrarian chooses to see this for what it is and look for opportunity.  The market correction we are experiencing is a good thing, he concludes.  Objectivity and logic should be at the core of investors’ decision-making processes.  If Benjamin Graham were alive today and investing in commercial real estate, objectivity would drive his decisions and cash-flow would determine his values, eventually moving from a contrarian position to the standard of the day.