With the stock market surging, and economists predicting job increases and a “prolonged recovery,” conventional wisdom provides that happy days may yet be here again. What a relief!

Uh oh… just as we hope to experience the tail end of the residential foreclosure mess, it’s an upsurge in commercial real estate loan failures that could potentially threaten America’s financial system.  Between 2010 and 2014, roughly $1.4 trillion in commercial real estate mortgages will reach the end of their terms. It’s estimated that roughly half of these properties are “underwater,” whereby the borrowers owe the bank more than what the property is worth. Across the country, commercial property values have generally fallen more than 40% since their peak in early 2007. Rising vacancies and decreasing rental rates have exerted a strong downward pressure on how much these properties are worth.

Financial institutions are now facing significant challenges when renegotiating mortgages with commercial real estate borrowers. In cases where these property owners remain creditworthy, a loan workout could be the most constructive solution. One of the keys to a successful workout, is a realistic valuation of the commercial property.

When I first entered the real estate business, I was surprised to see the “old guys” valuing income producing property utilizing a “Cap Rate” instead of a “Discount Rate.”  Fast forward 20 years (did I say 20 years?), and this issue of “Cap Rate” vs. “Discount Rate” has magically reappeared, this time in the form of valuing distressed commercial real estate.

Utilizing the direct capitalization approach, the value of a property is estimated by dividing the projected “stabilized” annual income by a factor called the capitalization rate, or the “cap rate.” This method is appropriate if the current net operating income is typical of future income streams. It is clearly not appropriate for distressed income-producing properties, as current income is “atypical,” or less than what can be projected in healthier future markets.

A “discount rate” is the required rate of return for a typical investor, considering the expected increases in net operating income. This rate is applied to a projected income stream, and it considers the perceived riskiness associated with owning the property. The projected holding period should reflect the period over which a property is expected to achieve stabilized occupancy and rental rates.  A “terminal cap rate” is utilized to project the value of the property at the end of projected cash flow. The longer the period before stabilization, the smaller will be the reversionary value included in the total value estimate.

How risky it is to own commercial real estate today is anyone’s guess. Will there be a double dip recession?… hyperinflation?… are happy days truly here again?… who knows. The fundamentals of real estate valuation provide that in any economic environment, a prudent valuation of a property utilizes a reasonable discount rate, considering all factors that affect the value of the real estate. With more and more banks taking a realistic look at their portfolios of distressed commercial properties, workable solutions to our debt crisis are becoming more likely.

-Jonathan Fischer, MAI

Jonathan Fischer is a Managing Director in NAI Global’s New York City office and a member of the Special Asset Solutions team.