In the current market, should a potential seller hold or fold? For real estate companies, one of the biggest challenges is deciding whether to hand on to a money-losing commercial property or to sell it at a deeply discounted price.
The decision is risky, nerve-wracking and complex. Methodical analysis is called for, requiring robust financial modeling and realistic market knowledge. The current and future cash position of the company must be determined. The company needs to understand its level of debt, when it comes due and what it costs. Most difficult for the company will be to try to determine the value of each asset. Critically, the company must consider its entire real estate portfolio—not just look at a single property.
Despite signs of a nascent macroeconomic rebound, the commercial real estate sector still faces tremendous obstacles to its own sustained recovery. The only properties being sold now are those purchases with nonperforming loans and high-end, one-of-a-kind trophy or foreclosed properties. While differences between buyers and sellers are becoming less pronounced than they were at the peak of the global crisis, the sides are still far apart. Buyers, expecting a rash of commercial properties to flood the market, await a further fall in prices.
Given buyers' market power, how should a potential seller think though the exit decision? Ultimately, the purpose of the sale will be to raise cash, so it's important to clearly understand the company's cash needs. The potential seller must assess not only the future cash projection of a distressed property or even each property in the portfolio but also the company's cash position as a whole on both an operating and an asset level. To that end, the company should utilize a rolling 120-day cash-flow budget that will illustrate its actual liquidity position every month.
When determining cash flow, potential sellers need to find the cash shortfalls and understand their negative impact. Which properties are sucking the most cash out of the company and dragging down the good assets? After identifying those vampire assets, owners should work through various possible options. Leasing is one option, for example, but many markets have 20 percent vacancy rates, making new leases difficult. Only when such options are exhausted can the verdict to sell be appropriately reached.
Key to assessing cash needs is identifying the level of debt to be serviced for each asset, when it is coming due and the cost. The more equity a company has in an asset, the better the owner's ability to weather today's market conditions. With greater equity, the cash the asset throws off can be used to meet unexpected capital expenditures.
Another consideration is the type of outstanding loan on the property. A recourse loan allows the lender to legally pursue the property owner for the amount owed even after taking the collateral for a property. A non-recourse loan only allows the lender to collect the collateral. While a property owner would certainly want to work with the lender in either case, the incentive to create a schedule to pay off a recourse loan is greater since more is at stake.
Key to determining whether and what to sell is the worth of one's assets. But when valuing property in today's volatile market, appraisals done even 6 months ago are of little use. Every element that goes into a financial model must be assessed more closely than every before.
The goal for the owner is to determine whether the asset's value during a specific time period will likely be greater than the cost of holding it. To get there, owners must attempt to calculate net income for the property during the next few years to see how long it will take for the property to bounce back.
With highly leveraged assets, when the property is worth less than the debt, the owner needs to consider the current cap and occupancy rates and what a buyer would pay for the cash-flow stream. While the property may be throwing off cash, it may still be worth less than the debt, and the owner will have problems if the lender comes to remargin a loan that was bought at the peak of the market cycle.
In such an uncertain environment, property owners need robust analysis and modeling to be able to make sound decisions. Having the greatest possible market knowledge is a critical factor in deciding whether to hold or fold.
— Mike Straneva works in Ernst & Young's Phoenix office.