The Greater Recession – Black Mountain Investment Group

But where do cap rates come from? Comparable transactions. These transactions are usually very opaque in the world of commercial real estate anyway, but because of this massive tug of war happening across all markets, especially the already illiquid commercial real estate markets, even less transitions are happening- and those that are transacting are often being kept under wraps.  

In the above example, if the cap rate of that building increased 3%, which would be a very dramatic occurrence, the building’s value (according to the above formula) would be reduced to ~1m, a 38% reduction in value from the 5% cap rate value.  

A more realistic example would be the cap rate rising to 6.5%, resulting in a ~$1.23m value and ~23% reduction from the 5% cap rate value. I think we are going to start to see more of these sort of price reductions happen once sellers start to wake up to the reality of “higher for longer” as for the most part buyers have more leverage or buying power than sellers in most markets since a lot of the bubble that was created had to do with owners (current sellers) putting insane amounts of debt onto their buildings without considering scenarios of interest rate increases… 

Although cap rates do not necessarily have to do with debt in terms of the formula, they tend to move in tandem as both valuation and debt payments are a matter of liquidity- or how much money is available to transact in any given marketplace. 

I think people are slowly but surely waking up to this but that most people are genuinely terrified to admit just how big of a problem it is. Things have not been transacting for a reason, and it’s because not only are buyers and sellers in trouble, but banks too. Banks don’t necessarily want to repossess assets with bad debt, and refinancing at lower valuations isn’t good for anybody.  

A very dramatic recent example of this is an office building in St. Louis that was transacted for $205M in 2006 just this month being sold for $3.6M. Once again, we are in an unprecedented time of price discovery and it’s essentially a massive game of poker. I couldn’t be more excited about it but I also understand how potentially dangerous it is on a global scale. Conflict is destroying value- dollars, to be exact, which means that the “price discovery” of what that value truly is needs to be discovered at some point. What will that be?  

Of course, it will depend on the market and the liquidity found within each of those markets. For example, Dubai has 10-20x the buildings of Baltimore but only 5x the population. Is there over building? Could Dubai be an example of ghost cities in tertiary markets in China? I personally don’t think so but it’s not impossible. 

In the last year and a half, I’ve visited Singapore, LA, Salt Lake City, San Fransisco, Baltimore, New York, Washington DC, Philadelphia, Park City, Sun Valley, Miami, and probably a few other cities. In almost all of them, there has been under-building to the point where people are willing to pay more for renting and owning living spaces because there are so few.  

There are some exceptions to this, however, such as Baltimore and San Francisco, and to a much smaller degree, Philadelphia- where I have been living on and off for the last ~6 years. The interesting thing is though, even though they are in the same country (on opposite ends, fairly), SF and Baltimore have an unbelievable price disparity.

For example, a two bedroom townhome in Baltimore is going for $200-300k, even if not in the worst of areas. In San Francisco, most two bedrooms are well over $1.2m despite both cities being perceived as very dangerous and for the most part, empty. There is clearly a big difference in what people are willing to pay for. Is this location, is this quality of asset- and if neither of these things, what is it? I think it’s landmass, liquidity, quality of life, talent and opportunity, similar-minded people, and more- among other things.  

Something big is happening in terms of global liquidity, what that means for prices, I don’t think anybody really has any idea- other than maybe the largest companies with the best and most comprehensive models, but even those guys really don’t know. That means what every deal will come down to is how much the other side is willing to settle on.  

This will be inconsistent across asset class, across geographies, and across time. But one thing is for certain, higher interests are going to cause prices to come down, across the board, and we are just starting to see this happen. Who will be the winners? Read the next article in this series to see how “REITs” might be the industries’ saving grace in these wildly exciting times. 

Best, 

Elijah and The Black Mountain Team