Opinion

Over the past few years rents on commercial properties have increased significantly, leading to concern that rent levels in some markets may be reaching their peak. It is now economically feasible to build new buildings in several markets, and whenever lease payments reach such levels, it serves to limit or decrease current market rents. The methodology for determining when markets are considered to have reached unsustainable rent levels will be discussed in this report, along with the impact it will have on CMBS analysis.

For those markets where construction is taking place, especially at a pace faster than demand,(1) Moody's will pay close attention to the sustainability of rents. However, even in those markets with limited construction, rents may have reached or passed the level where construction is feasible, signaling cause for concern.

The Concept of Rent Sustainability

A key component of Moody's analysis of a given property is to determine sustainable cash flow. An important consideration is to know whether rents are above, at, or below market, as well as the degree to which market rent is at a cyclical high, low, or midpoint.

Moody's makes downward adjustments to the rent of tenants who pay above-market rents based on the premise that such rents are not sustainable. Following the expiration of the lease or default under the lease, the rent could revert to a market level.

The interrelationship of sustainable market rent and the economics of new construction is evident in an analysis of the U.S. office market from 1993 to the present. From 1993 through 1997, new construction of office space was sparse, because replacement costs often exceeded asset values as determined by capitalizing then current rents. Vacant space was gradually absorbed, dropping from 16.7% in 1993 to 9.8% in 1998, with rents increasing approximately 40%.(2) In 1998, the growth rate of office supply was 2.4%, which matched the growth rate of office employment on a national basis - the first time in more than 15 years that new office supply and demand were in balance.

The report focuses on measuring sustainability by calculating whether capitalized rent levels yield prices either above or below replacement cost. This methodology is more precise and predictable than the alternative (i.e., looking at historical rent levels and comparing them to current levels).

Moody's Approach To Determining

Feasibility of New Construction

An accurate method of measuring the sustainability of market rents is to determine whether the capitalizing of a net rent level yields a price either above or below replacement cost - a procedure often used by developers and construction lenders.

Moody's basic formula for calculating economic feasibility to build new product is as follows:

Step One: Value A = Total Replacement Cost + Land Value

Step Two: Value B = (Market Rent - Vacancy & Credit Loss - Operating Expenses - Capital Costs)/Capitalization Rate

Step Three: If Value B > Than Value A, Then New Construction Is Economically Feasible

Step One: Calculate Value A

To determine Value A, the replacement cost of a given property type in a specific market is first calculated. The figures can be obtained from a cost estimator service or from a local contractor/developer. After calculating replacement cost,(3) entrepreneurial profit is then added to obtain a total replacement cost figure. Entrepreneurial profit is a market-derived figure that represents the amount an entrepreneur expects to receive for contributing to a project.(4)

Land value can be determined by using comparable sales for the property under consideration. Several other methods can be used to determine land value, including allocation.(5) After land value(6) is determined, it is added to the total replacement cost resulting in Value A.

Step Two: Calculate Value B

Value B is determined by capitalizing the market rent after deducting appropriate costs. All parameters used are consistent with Moody's approach to cash flow and value. Vacancy and credit loss are determined both according to the prevailing availability rate in the subject market and Moody's guidelines. The vacancy and credit loss figure is deducted from the market rent number, the result of which is effective gross income (EGI).

Operating expenses based on market operating expense ratios (OER)(7) or per square foot levels are then subtracted from EGI. After capital items, such as leasing commissions, tenant improvements, and reserves, are deducted from net operating income, the resulting net cash flow is capitalized at an appropriate rate of return. Capital items are estimated from market data and from Moody's parameters.

In practice, the capitalization rate is determined by reviewing actual sales and by interviewing investors. For the purpose of the report, Moody's capitalization rates are based on those used in its rating approach, which includes an element of stress. Value B is represented by the capitalized net cash flow.

Step Three: Compare Value A to Value B

When Value A and Value B have been determined, they are compared. If Value A - the replacement cost number - is higher than Value B - the value derived using market rent - there is then room for growth in rent, and near-term construction is unlikely. If the replacement cost number is lower than the value derived by capitalizing market rent, it is then likely that new construction will occur and that current rent levels may have reached their peak.

Demand for new space is a variable, which is treated as a constant in this analysis. If indicators point to a sufficient increase in demand, a reduction in rents may not then be appropriate. If, however, Moody's considers demand unlikely to keep up with new supply, a reduction in contract rent to a level at which new construction is not feasible will then be considered.

An important factor in the analysis is the iterative relationship between land values and market rents. When market rents increase, land values rise - a relationship that is a major consideration when analyzing sustainability.

Exceptions to the Rule

Barriers To Entry

In certain markets rent can continue to rise for a time, even though it is economically feasible to build new product. Such markets have regulatory and logistical "barriers to entry." A good example of such a market San Francisco, a city where legal constraints and geographic barriers limit growth.

Nevertheless, even in markets with barriers to entry, new construction will eventually occur.

There is hardly a market where, at the right price, new construction will not occur even in the face of regulatory or physical constraints. Even if land is scarce, redevelopment or demolition in order to build new will ensue.

Competing markets are another factor that can keep rents from increasing in a market with barriers to entry. For example, if rents become prohibitively expensive in the CBD as a result of barriers to entry, it will then be realistic to consider lower-cost suburban alternatives. The lower rents of the suburbs can have an adverse effect on the CBD rents even if no new development is occurring in the CBD.

Government Incentives

Tax benefits and other government incentives can spur development before it is otherwise economically feasible. If developers in certain districts or zones are given tax breaks to construct facilities, it becomes economically feasible to build in that area before it is in other districts. For example, if a tax abatement of $3.00 per square foot is allowed, the break-even rent to justify construction may be reduced by an equivalent amount.

Building can also occur if a local municipality is giving zoning incentives to build in certain districts for a limited time. As a result, building, which otherwise is not economically feasible and which is more than that normally allowed, will be achieved. The situation that existed in the Midtown West district of Manhattan during the early 1980s, which facilitated lower-cost development, illustrates that point.

Functional Obsolescence

Another exception is that in which existing facilities do not meet current standards. Although a replacement cost analysis will reveal that it is not currently feasible to build new facilities, renovations can still occur that increase the stock of desirable space. A prime example is class B and class C buildings being renovated with technologically advanced wiring to accommodate hi-tech tenants.

Older buildings can sometimes be retrofitted at a lower cost than that involved in building new ones given the existing shell. Even if it is uneconomical to build new product, competition can still arise in the form of a retrofitted older building.

Land Banking

During down markets, developers may purchase land at low prices in anticipation of better times. Commonly known as "land banking," the practice can affect the replacement cost formula. If developers have land they have purchased at low prices, they can then develop it before it would otherwise become economically feasible. Their "Value A" will be significantly lower than buildings constructed on land purchased in the more expensive market. If enough developers decide to build using low-cost, land-banked parcels and charge lower rents, it could have an adverse effect on overall market rents.

Rent Spikes Can Be Misleading

Some cities have recently experienced or are currently experiencing sharp increases in office rents. In similar circumstances in the 1980s, rent spikes were followed by a take-back, in which real rents (i.e., rents adjusted for inflation) ended up at or below the pre-spike level, or, in other words, "what goes up must come down." As a result, when assessing sustainable rents for office properties in CMBS pools, we cannot assume that rents caused by a spike are sustainable at the current levels. The misleading market signals inherent in rent spikes can trigger excess construction.

The two kinds of rent spikes are those that lead to excessive or unsustainable rents and those that actually are "normalizing" rents from sub-par or depressed levels. The former is the focus of our analysis.

Moody's Approach to Sustainable Rents and Values

Moody's generally reduces the rents of tenants in properties who pay above market rents to market rents, based on the premise that above-market rent is not sustainable. With the expiration of the lease or default under the lease, the rent could revert to a market level.

However, if the above-market rent is that of an investment-grade tenant and the lease under which the tenant is obligated to pay rent extends beyond the maturity date of the debt, Moody's may consider the above-market rent to the extent that it supports buildup of loan amortization, based on the premise that the risk of a lease default is low and that a takeout lender or buyer may value remaining above-market rent.

In the context of the replacement cost analysis Moody's will also consider rents that justify construction as a limit on sustainability; therefore, in some cases even rents at market may be considered too high.

(1) See "CMBS: If You Build It, Will They Come?" Potential Supply and Demand Imbalances in Selected Real Estate Markets, Moody's Special Report, February 18, 2000.

(2) Torto Wheaton Research, Office Outlook, Spring 1999.

(3) Includes "hard" costs for materials and "soft" costs for interest and fees.

(4) The Dictionary of Real Estate Appraisal, Third Edition, Appraisal Institute

(5) Allocation is a method of estimating land value in which sales of improved properties are analyzed to establish a typical ratio of site value to total property value and this ratio is applied to the property being appraised or the comparable sale being analyzed. The Dictionary of Real Estate Appraisal, Third Edition, Appraisal Institute

(6) Land value represents an option to build and rises rapidly when construction becomes at or near feasible levels and is lower when construction is a remote prospect.

(7) The operating expense ratio represents operating expenses divided by effective gross income.

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