When in Doubt, Use a "Ten Cap"

From Capital Trends Monthly January '09

For decades—before "cap-rate compression" became a catch phrase—yields on commercial property largely averaged between 9% and 10%. In 2009, it is quite possible if not probable that the market will "revert to the mean"—go back to the long term average for the asset class: basically, a ten cap. A 10% cap rate on current income has always been a broad rule of thumb in valuing property for investment, and not only because it simplifies calculations. The logic behind it is that a buyer is assured at least a double-digit return on investment.

As the story goes, Sam Zell's winning strategy in the early 1990s was to buy as much as he could at a 10% cap or better, making sure the price was also below replacement cost. He made billions this way, although correctly timing the exact bottom to buy and top to sell in each cycle also helped.

While this seems simple, it is important to note that the "ten cap" rule applies only to current or in-place income, giving little to no credit for vacant space, iffy tenants or additional development rights. An unleveraged double-digit return expectation is important to capture the attention of potential investors as well as cover any mezzanine debt costs.

In 2002, over a third of all deals traded at a 10% cap rate or higher. By 2007, a 10% cap had become rare, accounting for less than 2% of all transactions.

Are we Going to a "Ten-Cap" Market?

The REIT sector is signaling that 10% cap rates are indeed a real possibility. The implied cap rate of the US REIT industry is now closing in on 10% according to studies published by JP Morgan Chase and Oppenheimer. The conventional wisdom is that public-market pricing leads the private market and there is some empirical evidence to back that up.

Looking at debt costs and doing the math also supports the theory that we could revert to the mean and thus be heading toward a 10% cap rate. Assume the following terms that ballpark the current market: a 7% mortgage rate; an 8% constant (don't forget, there is amortization again!); 60% loan-to-value; debt service coverage ratios of 1.75x to 2.0x. Doing the calculations (8% * 60% * 1.75), the cap rate would have to be at least 8.5% to 9.5%. However, even at that level, the return on equity is a modest 12%, especially compared to mezzanine debt costs that currently are closer to 15% or higher.

Yes, we may be heading to a Ten-Cap market in coming months, but that does not necessarily mean that the market is reverting to the mean for the long term. It can still be argued forcefully that the real estate capital markets have undergone a structural or secular shift toward permanently lower cap rates. After all, another truism is that "the pendulum always swings too far," meaning prices will over-correct to the downside. Thus, even though cap rates of 9% or 10% or more will become common in 2009, a more robust investment market will ultimately push them to a lower level than has historically prevailed but above the 5%-6% levels of the most recent few years.

Article courtesy of Real Capital Analytics Inc.

New One on One episode: Jeff Wandell

SEASON TWO episodes of Alex Ruggieri's One on One

Episode 7, Season 2: Alex's guest is Jeff Wandell, owner and founder of Prairie Gardens and the Jeffrey Allen's chain of retail stores.

Browse all episodes of One on One or Central Illinois Business

American Recovery and Reinvestment Act of 2009

H.R. 1, the American Recovery and Reinvestment Act of 2009, passed the House on February 13, 2009, by a vote of 246 - 184. Later that day, the Senate also passed the bill by a vote of 60 - 38. The President signed the bill on February 17, 2009. The bill is a $780 billion package, with roughly 35% of the package devoted to tax cuts (mostly for 2009) and the rest to spending intended to occur in 2009 and 2010.

View how the U.S. House of Representatives voted
View how the U.S. Senate voted

The mix of provisions of interest to REALTORS® changed frequently throughout the legislative process, with changes continuing to be made just hours before the measure was released prior to the vote. In the end, the elements of NAR¹s housing agenda were included. Congress and the President have announced that a finance and housing package (including tax provisions) will be the next big initiative, so Congress has by no means finished its work as it affects the housing industry and REALTORS®.  

The bill includes the following provisions:

Homebuyer Tax Credit
FHA, Fannie Mae and Freddie Mac Loan Limits
Neighborhood Stabilization
Commercial Real Estate
Rural Housing Service
Low Income-Housing Grants
Tax Exempt Housing Bonds
Energy Efficient Housing Tax Credits & Grants
Transportation Investments
Broadband Deployment

 

Homebuyer Tax Credit - The bill provides for a $8,000 tax credit that would be available to first-time home buyers for the purchase of a principal residence on or after January 1, 2009 and before December 1, 2009. The credit does not require repayment. Most of the mechanics of the credit will be the same as under the 2008 rules: the credit will be claimed on a tax return to reduce the purchaser's income tax liability. If any credit amount remains unused, then the unused amount will be refunded as a check to the purchaser.

Chart Highlighting the Major Modifications to the First-Time Homebuyer Tax Credit (PDF: 309K)

NAR's Presentation: The 2009 First-Time Homebuyer Tax Credit  (PDF: 319K)

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FHA, Fannie Mae and Freddie Mac Loan Limits -The bill reinstates last year's 2008 loan limits for FHA, Freddie Mac, and Fannie Mae loans. These limits were equal to the greater of 125% of the 2008 local area median home price or $271,050 for FHA and $417,000 for Fannie and Freddie, with an overall maximum cap of $729,750. For the few areas where the 2009 limits were higher, the higher limits will apply. In addition, the bill includes language providing the HUD Secretary with the discretion, if warranted, to increase the loan limit for any sub-area², i.e.an area smaller than a county. The Secretary's discretion is again limited by the $729,750 cap. These 2009 limits will expire December 31, 2009.

The inclusion of these loan limit provisions in the final bill is a victory for homeowners, buyers and Realtors. While these new limits were included in version of the original stimulus bill approved by the House, the bill first approved by the Senate did not. NAR's Call for Action to both the House and the Senate prior to the final vote advocated strongly for the provisions which were then included in the final bill approved by both Chambers. 

Estimated 2009 FHA, Fannie Mae and Freddie Mac Loan Limits (PDF: 1.3M)

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Neighborhood Stabilization - Division A, Title XII of the bill provides $2,000,000,000 in additional funding for the Neighborhood Stabilization Program (NSP). The NSP was created by the Housing and Economic Recovery Act of 2009 (Public Law 110-289) to provide grants through the Community Development Block Grant program (CDBG) to states and localities to address the problems that can be created when whole neighborhoods are decimated by foreclosures. The funds can be used to purchase, manage, repair and resell foreclosed and abandoned properties. In addition, the funds can also be used by states and localities to establish financing methods for the purchase and redevelopment of foreclosed properties.  After purchase the homes must be used to assist individuals and families with incomes at or below 120% of area median income. Twenty-five percent of funds must be used for households with incomes at or below 50% of area median income. By leveraging their expertise in partnership with others from both the public and private sector, Realtors® in many communities have been making important contributions to their local communities' neighborhood stabilization programs.

How REALTORS® Can Contribute to Local Community (NSP) Efforts

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Commercial Real Estate - Commercial real estate is impacted primarily through those provisions of the bill focused on green building and energy efficiency as well as business tax incentives. H.R. 1 provides significant funds for state energy programs, which could be used to support commerical property owners' investment in energy efficiency upgrades while commercial property owners seeking to invest in alternative energy systems for onsite power generation would benefit from the Department of Energy Renewable Energy Loan Guarantees Program. Of particular benefit to small businesses would be certain provisions of the bill that provide tax relief in the area of bonus depreciation and capital expenditures, as well as the 5-Year carryback of net operating losses for small businesses.

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Rural Housing Service - The bill provides an additional $500 million to existing USDA Rural Housing programs. The RHS provides both a guaranteed loan program and a direct housing loan program for those meeting the program¹s eligibility criteria. The direct loan program will receive $270 million while $230 million will be allocated for unsubsidized guaranteed loans. It has been reported that this level of funding would provide for an additional 192,000 homeowners.

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Low Income Housing Grants - Allow states to trade in a portion of their 2009 low-income housing tax credits for Treasury grants to finance the construction or acquisition and rehabilitation of low-income housing, including those with or without tax credit allocations.

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Tax-Exempt Housing Bonds - Tax-exempt interest earned on specified state and local bonds issued during 2009 and 2010 will not be subject to the Alternative Minimum Tax (AMT). In addition, financial institutions will have greater capacity to purchase tax-exempt state and local bonds.

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Energy Efficient Housing Tax Credits & Grants - To promote green jobs and energy independence, ARRA invests significantly in efforts to make homes and buildings more energy efficient. The bill provides state and local governments with $6 billion in energy efficiency and conservation grants for energy audits, retrofits and financial incentives. Through 2010, homeowners will be able to claim a 30% tax credit (up from 10%) for purchases of new furnaces, windows and insulation. Another $5 billion will be available to modernize the nation¹s electricity grid and install smart meters on homes that help to save consumers money. There is also $5 billion for weatherization assistance for low income households and $2 billion for federally assisted housing (section 8) efficiency efforts.

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Transportation Investments - The bill provides $46.7 billion to states and localities for capital investment for surface transportation projects including highways, bridges, transit, and rail projects. NAR policy supports increased spending on the types of transportation infrastructure addressed in the bill with the exception of Amtrak and high-speed inter-city rail where NAR has no policy. These investments will tend to moderate traffic congestion and support a variety of transportation alternatives which will improve the quality of life of American communities and bolster the value of real estate.

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Broadband Deployment - The bill creates $7.2 billion in grants to promote broadband deployment in unserved and underserved areas and for mapping the availability of broadband service in the U.S. Any entity is eligible to apply for a grant including municipalities, public/private partnerships and private companies as long as they comply with the grant conditions. The grants are subject to network neutrality requirements to ensure that broadband networks be free of restrictions on content, sites, or platforms, on the kinds of equipment that may be attached, and on the modes of communication allowed. 

The bill also charges the FCC is with developing a national broadband plan that shall seek to ensure that all Americans have access to broadband capability and shall establish benchmarks for meeting that goal.

These provisions are important victories for REALTORS because increased broadband access promotes economic growth and expands opportunities for home sales. A 2006 Commerce Department report determined that property values are 6% higher in communities where broadband is available.

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Just announced, first-time homebuyer $8000 tax credit

PRINTABLE VERSION

What you should know about the

First-Time Homebuyer
Tax Credit

 

The American Recovery and Reinvestment Act of 2009 features an $8,000 tax credit for first-time buyers who purchase a home on or after Jan. 1, 2009 and before Dec. 1, 2009.

Details of the tax credit include:

• Eligible properties include anything that will be used as a principal single-family residence—including condos and townhouses.
• There are income guidelines on the credit. Individuals with an adjusted gross income up to $75,000 (or $150,000 if filing jointly) are eligible for the full tax credit. The credit is phased down for those earning more and is not available for those with an income above $95,000 (or $170,000 if filing jointly).
• The new tax credit does not have to be repaid if the buyer stays in the home at least three years. But if the home is sold before that, the entire amount of the credit is recaptured on the sale.
• People who purchased homes under the 2008 $7,500 tax credit program will still be required to repay that credit to the government over a 15-year period.

• The temporary credit is only available for home purchases made from Jan. 1, 2009 to before Dec. 1, 2009 and is equal to 10 percent of the cost of the home, up to a maximum credit of $8,000.
• Buyers claim the credit on their federal tax return to reduce their tax liability. If the credit is more their total tax liability that year, the buyer will get a refund check for the balance.
• Only first-time homebuyers can take advantage of the tax credit. A first-time buyer is defined under the tax credit as an individual who has not owned a home in the last three years. For married joint filers, both must meet the first-time homebuyer test to take the credit on a joint return.

Contact one of our Realtors® for more information at (217) 359-6400.