The idea that everyone is on average approximately six steps away from any other person on earth, is known as six degrees of separation – such that a chain of “friend of a friends” will connect any two people in the world within six steps or fewer. In Hollywood, this small world phenomenon is embodied by Kevin Bacon, where any actor can be linked to Mr. Bacon within six film roles or less – or so goes the theory.
Translating this “small world phenomenon” to the ”small market phenomenon” of real estate – every facet of the market is on average approximately six or less steps away from effecting any other facet of the market – positively or negatively. It’s my theory that home sales and housing starts are the Kevin Bacon of real estate value.
Let’s start with capitalization rate – the true expression of real estate value in the distant realm of commercial real estate. A “cap rate” is the mathematical relationship between net operating income (“NOI” – all revenues derived from a real estate asset less the costs of maintaining that asset) and asset value. It is a historical value – extracted from sales of real estate of a particular class within a market place and derived from the formula – NOI ¸ Value = Cap Rate. To simplify the concept, let’s assume that an asset throws off $25,000 per year and is valued at $350,000 – it has a cap rate of slightly more than 7%. So NOI, Value and Cap Rate lie in close proximity to each other with a change in one, certainly affecting the other.
Add to this mix the fact that Net Operating Income includes rental income from commercial leases. The 2008 financial meltdown forced massive layoffs as companies struggled to repair their balance sheets. Fewer jobs meant fewer dollars available to pay home mortgages. This fact, combined with plummeting home values caused home buyers to balk, homeowners to default and the overall economy to hiccup. Commercial financing became impossible to find, driving down asset values and destabilizing commercial rents. Hence a decline in home sales, (1) caused by depressed home values and home owner to default, (3) made financing impossible to find, (4) resulting in massive layoffs, (5) declining net operating income, and (6) the consequential compression of capitalization rates.
As a trailing indicator, real estate activity is the last to emerge from a financial decline. With new home prices starting to plummet once again and mortgage interest rates rising, there is little hope for the housing market to pick up in the near term, despite a correcting economy. This spells trouble for the commercial real estate sector with home sales and housing at the center of the real estate value fray. Bad news, like water, finds its way through everything – even bricks and mortar. I wonder if Kevin Bacon is selling.