Consider the above graph. As you can see the historical spread between the 10-yr. T-bill and CAP rates is in the area of 400 basis points. Late in 2003 CAP rates broke through to the down-side and finally came to a low point of 180 basis points in 2006. From there you can see where CAP rates leveled off while T-Bills turned lower. This phenomena was a result of several factors coming together including ample liquidity in the market, Wall Street's hunger for new profits in the CMBS market and a good fundamental environment which allowed for very loose underwriting criteria. I am of the opinion that the most likely scenario over the next few years will be a severe retracement to higher CAP rates as T-Bills retrace to more historical norms. This will happen, in my opinion due to one or more reasons. First, the real return on T-bills is currently negative based on future inflation expectations. Demand should be lower (which was seen today) and there will be pressure on yields to rise. Secondly, the FED will probably turn more attention to inflation fighting at some point over the next few years as the economy emerges from it's sluggishness.
With there being absolutely no chance of further compression, Some retracement is guaranteed and should t-bills return to 6% and the spread to CAP rates return to 400 basis points then the same asset that was worth a 6.8 CAP in 2006 will be worth a 10 CAP.
To see this impact on a property see the graph below, which shows only a 200 basis point move in a CAP rate:
As you can see the equity value shrinks considerably on a 200 basis point cap rate move. In this example it shrinks from $3,000,000 to $500K Many owners who benefited from nothing more than cap rate compression will be feeling this pain.
So what is an owner to do: Here are the options
Hold property and ride out the downtrend
•Advantages
–Easiest approach in the near term
–Might Capitalize if surprise market recovery
•Disadvantages
–Significant short term equity loss
–Significant short term cash-flow challenges
- No Equity for redeployment at bottom
•Considerations:
–Plan on a 4-5 Year minimum hold
–Assess if projects ability to cover debt and capital requirements over hold period?
–Assess partner/investors tolerance for reduced cash flows and capital calls if required?
–Will a debt or capital restructure be required during the hold?
–Increase management focus to optimize income over hold period
•Considerations:
–Plan on a 4-5 Year minimum hold
–Assess if projects ability to cover debt and capital requirements over hold period?
–Assess partner/investors tolerance for reduced cash flows and capital calls if required?
–Will a debt or capital restructure be required during the hold?
–Increase management focus to optimize income over hold period
Sell one or more properties
•Advantages
–Reduces investor/partners exposure to major equity loss
–Preserves maximum capital for purchasing after market bottom
–Increases investor liquidity to service other investments
•Disadvantages
–Difficult to sell in a down-trending market
–Must be willing to price at or below the market
–Will likely see loss of equity from peak market pricing
•Considerations
–Get realistic pricing assessment before making decision
–Consider benefits of paying capital gains taxes now?
–Consider Structured Sale or Deferred Sales Trust options
–Selling sooner is better than later
–Choose a Brokerage Firm with widest marketing reach
With capital gains rates at historic lows as well, now still may be a good time to sell, pay the tax and hold the cash safely until you see a return to more historic T-Bill levels and spreads to CAP rates. As a broker, I would love to sell your property and earn a single commission, but more than that I would like to be an advisor to you that can help you build wealth through Real Estate over the long term. For this reason, I would recommend a thorough assessment of your property and situation before recommending any specific strategy. Do not hesitate to contact me if I can provide that service.
