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Could Chicago Property Valuations Drop Further?



Article:
As Chicago's economy sputters along largely supported by very low interest rates many people in the real estate appraisal and commercial banking field are justifiably concerned about commercial real estate values. Commercial and industrial property values have dropped dramatically over the past few years. The Federal Reserve Bank had dropped interest rates to historically low rates to help stimulate the economy. While values appear to have at least partially stabilized, the question Chicago commercial tax appraisers must ask is what happens next? Interest rates will not stay at historically low rates forever.

Investors are becoming increasingly worried about how low interest rates may be propping up values. The question would then become what will be the impact of higher interest rates on industrial and commercial property values?

By utilizing the Band of Investment technique we can mathematically quantify what the impact might be. For the purposes of this analysis I assumed that the typical investment has an 70% loan-to-value ratio and a 25 year amortization on the loan. I also assumed interest rates with no points and that the investor would require a 9% return on their 30% equity position. I am also assuming that our hypothetical property has a net operating income of $100,000.

Interest RateCapitalization RateNet Operating IncomeProperty Value 
5.0%7.6%$100,000$1,315,789
5.5%7.9%$100,000$1,265,823
6.0%8.1%$100,000$1,234,568
6.5%8.4%$100,000$1,190,476
7.0%8.6%$100,000$1,162,791
7.5%8.9%$100,000$1,123,596
8.0%9.2%$100,000$1,086,957
8.5%9.5%$100,000$1,052,632
9.0%9.8%$100,000$1,020,408
9.5%10.0%$100,000$1,000,000
10.0%10.3%$100,000$970,874

It is quite clear that an increase in interest rates could further drive down commercial and industrial property values. Even if the economy overall improves, real estate continues to be at risk. An increase in interest rates from 7% to 8% would theoretically result in a decline in property value of over 7%. Most of us can remember when interest rates for commercial loans were typically around 9 to 9.5%. Should that occur, values might drop by 29% (with loan rates increasing from 5% to 9%). 

We say commercial property values might drop because there is not always a 1:1 relationship between interest rates and capitalization rates. In the mid 2005-2007 period interest rates went up but our commercial tax appraisers saw capitalization rates actually go down. That is because the band of investment technique used above has two variables that must be considered. In that time period Chicago area property investors were willing to accept a progressively lower return on their equity position that offset the interest rate hikes. In our example above we assume a 9% return on the 30% equity position in the property. If an investor would be willing to accept a 6% return then the overall capitalization rate could go down. An investor is normally more willing to accept a lower initial return if they believe property values are rising more quickly. They can make their money on the resale a few years down the road instead of relying on the cash flow that can be generated today.

At this point in the economic cycle we do not believe there are high expectations of substantial property price increases. For the short term we believe that increasing interest rates could threaten commercial property values and limit the upside potential. It is important for Chicago area property owners to monitor their property values to insure that assessment levels are fair and reflect current market conditions. A commercial or industrial property tax assessment appraisal may be required in the Chicago market if you believe your current assessment reflects property values that could not be realized.