You hear it all the time? “real estate will recover once property fundamentals improve,” or “property fundamentals continue to reach for the bottom.”  So what are “property fundamentals” and why do they matter so much to market recovery.

The following is an admittedly simplified explanation. Let’s start with some definitions:

Occupancy Rates:  This number represents the percentage of the rentable asset that is occupied by rent paying tenants, or lessees.  The term is sometimes expressed in its negative form ? “vacancy rates”.  The higher the occupancy rate, the more cash is being generated by the asset.

Rental Rates:  This is the average price per square foot per year that tenant-lessees are paying a landlord within a certain asset or market.

Credit Conditions:  Credit conditions are said to be “positive” or “tight” when the banks or lenders are less willing to lend owner-landlords money at an attractive rate, or at all.  They are said to be loosening, or liquid, when creditors make those funds available at competitive rates.

Net Operating Income (NOI): This is the amount of money left over when an asset owner subtracts all of his operating costs, such as heating, cooling, equipment repairs and maintenance, plowing, landscaping, real estate taxes and other related costs from the total rental and service receipts generated by that asset.

Asset Appreciation:  In this case property is the asset and appreciation is the goal for all real estate investors – buy the asset low, watch it appreciate and sell it high.  Asset appreciation is a function of cash flow, (market rates and occupancy less costs), capital improvements and purchase price.  Appreciation usually requires that the occupancy rates increase with the market rates and that costs do not keep pace.

Now that we have command of a few terms, let’s start with a look at Credit.

Credit availability is fundamental to real estate health.  It enables developers to build new assets; owners to purchase new buildings or to make significant capital improvements which, in turn, attract new tenants and maximize occupancy.  Credit conditions tighten when occupancy rates decline or rental rates decrease and an asset is less capable of generating high net operating income.  High unemployment also adversely affects credit conditions since it decreases demand and leaves the market in a pall of no confidence.  Over the past year, NOI fell precipitously as tenants defaulted on their leases, contracted in size, or simply stayed flat.  While some parts of the economy are recovering – employment has not recovered and investors remain skeptical that demand for space will return.  The resulting decrease in NOI is making it difficult for owners to manage their debt service obligations and credit is unavailable to help.

Diminishing fundamentals yield diminishing values.  As property fundamentals decline and with them NOI, the credit market tightens and real estate investors await the Holy Grail known as “the bottom” – that point in market time when the value of real estate assets (defined by operating cash flows) have plummeted so far that current owners can no longer sustain their debt service and are forced into bankruptcy, to hand those assets back to the lender, or to sell them at a “fire sale” price.  When enough current owners are forced into this position, would-be investors line up to buy, competing for these wayward assets.  That point is getting near.  For those with cash or credit available on the sidelines, diminishing values represent a significant opportunity – provided that they believe that the asset they are purchasing can sustain itself (positive NOI) and that its value will increase over time – asset appreciation.

For a long time, owners tried to survive, hoping for that “bottom”.  Some made it through while others foundered. Those with cash tapped those reserves while they attempted to weather the storm.  That hope prevented those owners from liquidating the asset. The economy continues to decline, unemployment is not improving, property fundamentals continue their decline and cash strapped owners are now more willing to sell, are being forced into bankruptcy, or to hand the asset back to lender. Complicated financial gyrations will soon ensue and someone or some group will lose their investment while others will take advantage of that loss and invest – hopefully for them, at that bottom.

Here’s a quick look at some of what’s happening in those markets, evidence that the bottom draws near:

There are signs of life – apparent from the stuttered activity described above. It appears that the market is awaiting the last sign that we’ve hit bottom – job recovery.  Once we see regular employment gains, the market should begin to brighten. Credit will loosen…slowly.  The all important fundamentals, while sputtering, are on the downwind leg, not quiet on final approach, but soon enough they should have their landing gear down.