Friday, June 19, 2009

Commercial Real Estate's Problem: Down and Dirty

With all of the talk about commercial real estate, a.k.a the next shoe to drop, we thought we'd share some actual revenue projections that are used to assess the financial viability of a deal at its infancy. The blue line above represents actual base rental revenue projections for a large, well known office building. These figures are typically projected out ten years into the future. As is evident by the slope of the blue line, the assumption is that, generally, rental revenue will always go up. The red line represents what we would call a "mild recession scenario", where rental revenue drops 5%/year for three years, at which point it stops declining and begins increasing, at the rate of 5%/year for the remainder of the 10 year projection. As you can see, the red line is unable to surpass the blue line - despite the fact that the growth of the blue line slows significantly around the 7th year. Based on these numbers, a building that follows the path of the red line will collect rental revenues that total $31.6M or ~11% less than a building following the blue line's path. While this isn't necessarily a good thing, it probably doesn't mean the project will fail outright. Don't forget however, that the red line corresponds to a recession much milder than we are experiencing, and the blue line projections (forecast circa 2000) are not nearly as optimistic as the CRE projections going on in 2007. At a certain point, a building is simply unable to service its debt and operational costs with a dwindling revenue stream. That reality is certain to transpire for many of the commercial mortgages written on buildings at or near the peak of the CRE cycle. Sphere: Related Content

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