Updated: Mar 7
As the nation waits tensely to see the impact left by the COVID-19 virus throughout the United States, major capital market players are continuing to do the same. With the months of May & June being highlighted as potentially encompassing the height of the virus’ impact on collection levels, there is no question that markets will remain volatile until uncertainty clears around the spread of COVID-19.
In the following, I’ll walk you through three main topics many real estate investors are focusing on given the current state of our capital markets:
· Should I invest now?
· How would I go about doing so?
· What are some factors a passive investor should be searching for in order to fully analyze the strength of an investment?
I’d like to share with you more info on these factors, and how you can best use them to navigate today’s investment landscape brought on by the impact of COVID-19.
Should I Invest Now?
Many investors may feel that current conditions are not prime for deploying capital towards the commercial real estate asset class. The first issue is that given current market volatility, it’s challenging to determine the correct fair value to set as an offering price for a given investment. Pricing a property is broken down into two factors: Net Operating Income (“NOI”) and the Capitalization (“cap”) Rate. NOI is equal to the property’s NOI less it’s operating expenses (not including mortgage financing and other non-operating costs). Dividing the NOI by the price of the investment will yield the cap rate. The cap rate can be interpreted as the annual rate of return that an investor would be willing to earn per year in exchange for the risk of owning a property at that price.
NOI is currently volatile due to the potential impact of COVID-19 on tenants’ ability to make their rent payments, resulting in high delinquencies. The math is simple: the higher the unpaid rent amount, the lower the NOI, which results in lower property valuation. If NOI drops in the future from vacancies and delinquencies, the resulting fair price to pay for the property would be driven lower as a result. This is where many investors are struggling to discover a fair price to pay for prospective investments: NOI is too speculative to forecast since we don’t really know how much a property can collect in rents in the next several months, due to the Coronavirus.
How can we forecast the right NOI to discount at market consensus cap rates for this area in order to determine the correct price to pay? This would result in assets being offered at below-market prices. The issue of determining price is a very challenging task because we need to understand how much NOI will change in response to the uncertainty of future collections, and how much the fair price would change as a result.
The good news is that April collections turned to be better than expected, with a national average of 93% of March collections. We still need to wait and see what May collections will be to understand how the virus truly impacted a certain property.
Another issue is the relatively unattractive terms at which lenders are structuring their debt. Despite the Fed lowering interest rates, lenders have increased theirs in order to compensate them for lending in such an uncertain environment. Additionally, their required DSCR (debt coverage ratio, which is the ratio of NOI to debt payments) ratio is increased from 1.25x up to 1.35x or even 1.55x. LTV (loan to value) ratios are also being lowered from 75%-80% down to 65% and 55%. All three of these measures result in lower returns and higher upfront capital, which makes it more challenging to find and invest in attractive deals.
The final issue has to do with long-term ramifications of the COVID-19 outbreak. Nobody in the world currently knows when this will end, when we will return to our daily lives, or even whether there will be a secondary outbreak. This is resulting in a wide range of potential opinions, and naturally is sparking uncertainty in buyers, and low d