In talking about economic development the other day we discussed "primary industries". These are businesses that sell their products outside of our trade area, thus bringing new wealth into our community. Among the many "primary industries" I did not mention is the Screen Machine.
Located along Interstate 70 near the State Route 310 exit, Screen Machine Industriesis a welcome addition to Licking County. We will talk more about their story later.
For now, those who think that we don't make anything cool in the United States anymore, watch this.
Capitalization (Cap) Rates have been around investment real estate for a long time. Much longer than me. My teachers taught that the Cap Rate is the key to determining, and understanding, the value of an income producing property. The formula for determining said value is extremely simple, which is probably why I like it so much.
Income divided by Rate equals Value (or using an acronym IRV)
The first key to this equation is knowing that Income means net operating income (NOI). The NOI of a property is found by subtracting from the actual income all of the expenses of property ownership. These expenses include property taxes, insurance, utilities, maintenance, management, cleaning, repairs, snow and ice removal, landscaping, etc. It is important to note that debt service, i.e. mortgage payments, are not part of the equation in determining the NOI.
The not so simple part of this equation is the Rate. It is really Cap Rate not Rate, but we just use the shorthand R for Rate so that our acronym works.
The way I was taught, a cap rate should be an accurate reflection of the amount of risk involved in the investment real estate. The lower the risk, the lower the cap rate. Lower cap rates make the V for Value in our equation higher. The higher the risk, the higher the cap rate. Higher cap rates make the V for Value in our equation lower.
What this means is that all cash flow streams are not created equal.
It all made perfect sense to me. A forty year land lease to McDonald’s has very low risk and thus should have a low cap rate and a higher value in relationship to income. A beat up old house converted to a four unit apartment in a depressing neighborhood may generate lots of income, but it is also fraught with risk and management issues, thus it should have a higher cap rate which lowers the value in relationship to the income stream.
If you have read previous posts, you may suspect that all this verbiage is another attempt to lay out yet another cause of the current mess in the real estate world. You are correct.
For the time period between 2001 and 2005 my business partner and I became very confused by the investment real estate market. We grew up with the idea that an 8% cap rate was low, that a 15% cap rate was high, and that your basic average real estate investment should be capped at 10%. All of a sudden we were seeing cap rates at 7%. What was up with that?
Since investors really make their money when they buy, how were they going to make any money by overpaying so much? For a while, we suspected that these were very smart people who knew something that we did not. When cap rates dropped to 6%, we suspected these were very smart people who did not have a clue what they were doing.
The last two years should give indication about which one of those suspicions was correct. Confirmation arrived via e-mail yesterday.
Morgan Stanley Research, smart people if there ever were, published their Commercial Real Estate 2010 forecast paper back in early January. Such things take their time getting to Newark. In their forecast is the following quote:
“Impact of interest rates on commercial real estate. Commercial property cap rates are benchmarked to spreads over the 10-year Treasuries.”
These are Wall Street people who live in a world that revolves around securities; paper products with widespread market acceptance like stocks, bonds, Treasuries, etc. Using their prism, they have come to see real estate as a “security”. But…..it is not a security. Real estate is bricks and mortar, sticks and steel, concrete and glass, and dirt. It is fixed in place, tied to a geography, subject to all sorts of risks and hazards that it cannot escape from, plus its value is derived by its use over a long period of time. The whole purpose of the cap rate is to judge the risks and hazards over that time period. To benchmark it to anything is to ignore the uniqueness of every real estate investment.
Smart people misjudged risk and thought that buying a real estate investment was like buying a paper product. This led smart people to pay way too much for, and more importantly borrow/lend way too much money on, a whole bunch of real estate. We are enjoying the fruits of those decisions now.
As a side note, in the calculation of value using a cap rate the whole issue of financing is moot. Debt service is not part of that equation, so interest rates and cap rates speak different languages.
We will talk about the impact of low interest rates and easy money at a later date.
But for now, we add the mistaken assumption that real estate can be valued and treated like a security as one of the many paths that have led us to our current economic situation.
I paid some yesterday, visiting the offices of Treasurer Michael L. Smith (a good guy who is good at his job).
I appreciated seeing on the billing how my hard earned money is being distributed between the schools, mental health, and fire/safety. Never noticed that before.
Funny thing about property taxes, when a levy gets approved it establishes a specific amount of money that it will raise annually. No more, no less (well, maybe there is a small fudge factor to attempt to account for projected delinquencies of 5%, but that is beyond my grasp).
Using a complex formula that takes into consideration the total market value of all of the real estate within the taxing district, the County Auditor and the State Department of Taxation figure out the effective tax rate that will generate the prescribed amount of revenue.
The effective tax rate then gets applied to my taxable value (which is 35% of my market value), which gives me my annual gross tax bill. The gross bill gets reduced by rollbacks and reductions, which is why the aforementioned formula is described as complex.
Anyway, the important thing to remember is that if the total of all of the property values in the taxing district increases, then the effective rate becomes lower and maybe my tax bill as well.
It is this balancing act between the total of all property values and the effective rate that makes me want to nominate the Medical Center of Newarkas HERO of the Month.
I love Licking Memorial Hospital. It is a tremendous asset to our community (a later post will detail some of the reasons why this is so). However, as a tax exempt non-profit organization, every time they bought out a doctor's practice and with it the doctor's office building (which they did a lot of), the real estate value of that office building came off the tax rolls.
The Medical Center of Newark is not a tax exempt non-profit organization. If I am reading the public records correctly, their medical complex on the east side of Tamarack at West Main Street created over $10,000,000 in real estate valuation. That real estate will generate around $175,000 in property taxes this year.
Next time you drive by Medical Center of Newark complex, honk your horn and send them some love.
Four or five years ago Cheri Hottingerasked me to chair the economic development committee of the Licking County Chamber of Commerce. It is easy to say yes to Cheri. The harder part was figuring out what “economic development” is. There are lots of good definitions that are really not all that helpful, because they don’t tell you what your committee is supposed to do that will actually benefit the community.
A good analogy for a local economy is provided by Bill Fruth of Policom. (Fruth just made an interesting career/life path change here)
“..imagine that all the wealth of an area is contained in a bucket. It swirls around and around…..It goes from person to person, business to business, person to business, and is constantly moving….But, there is a hole in the bucket, and all the wealth in the community is leaking out….money leaves the community and goes to the area in which the purchased product was made or the service was performed…..Money is continuously leaving the community through the hole in the bucket….There is nothing that can be done to stop it….So what can be done? A community needs to add money to the bucket, replenishing its supply…with fresh rejuvenating wealth.”
Money is added to Fruth’s bucket by the business activity of “primary” industries. “A primary industry is one that sells its goods or services outside of the geography of the local economy, importing money to the local economy.” Owens Corning, Dow Chemical, THK, Longaberger, Kaiser, Boeing, Park National Corporation, the State Farm Insurance operations office, and OSUN/COTC are a few examples of our “primary” industries.
The good news is that economics is not a zero sum game. A community can trade in its current leaky bucket for a bigger one. Bigger buckets will hold ever increasing amounts of wealth. To do that however, the community needs to be canny about its economic development.
The bad news is that much of what has passed for economic development in our community over the past ten years is based on the growth of retailing. It is nice to have two Wal-Marts and a Kohls and all the newer strip centers (disclaimer: we developed two of them), but the retail segment of the economy puts the largest hole in the bucket, sending ever more money out of the community in exchange for only a fair amount of property taxes and some low wage jobs. An economy based on consuming does just that, it eats up wealth.
So, if one wants to be smart about economic development, one should seek to grow the manufacturing side of the local economy. Farming and wholesaling are primary as well, but are clearly not as impactful as manufacturing.
This is not earth shattering news. Just watch the various States ferociously compete for large automobile or steel plants and you will know they understand the long term value added-ness of manufacturing jobs.
There is more good news. Licking County is well positioned to grow its manufacturing side. There is available and affordable land with utilities and proper zoning. We have skilled workforce and the ability to train and educate for specific employer needs. The County government, the Chamber of Commerce, the Port Authority, the Workenomics group, and private developers (Southgate, Mid-Ohio Development, etc.) are all working together on multiple levels. The teamwork is actually impressive.
It is a process that takes time and focus, but it feels like a lot of local energy is being directed at the right target- on building us a bigger bucket.
About eight years ago, the Heath-Newark-Licking County Port Authorityacquired 300 acres contiguous to the south of the former Newark Air Force Station. To make the acquisition the Port Authority mortgaged the land and borrowed $4,500,000.
Our intention was to protect the Base, preserve industrial zoned land for future industrial development, and to be able to improve traffic flows in the neighborhood.
Occasionally a plan does come together. Boeing and its partners at the Base continue to do important work in an excellent manner. A new building was built for a new-to-Licking County industrial company that now employs about 100 folks. We still have several hundred acres of rail served land ready for development for manufacturing uses. The former James Parkway cul-de-sac now connects to both S.R. 79 and Irving Wick Drive.
As of today the loan is paid off and the land is free and clear. Feels good.
Robert Frost is my favorite poet, and his Two Tramps at Mudtime my favorite poem,
especially the last verse.
"But yield who will to their separation,
My object in living is to unite
My avocation and my vocation
As my two eyes make one in sight.
Only where love and need are one,
And the work is play for mortal stakes,
Is the deed ever really done
For Heaven and the future's sakes."
The Realtors Political Action Committee (RPAC) is a fine group of people. Their mission in life is to support, on the political front, both Realtors and private property rights. They are effective.
For years I sent them money. After all, they had the ear of legislators, and were speaking into those ears on my behalf as a Realtor. Seemed like a win-win to me.
I no longer send them money (although they don’t seem to have missed it).
Like all special interest groups, we Realtors have a sacred cow. Ours is the Mortgage Interest Deduction.
It is our industry’s belief that the deductibility of mortgage interest from taxable income adds significant value to home ownership, and in fact adds to property values. It, therefore, must and will be defended to the death.
Sacred cows abound. AARP has them, doctors and lawyers have them, media folks have them, the NRA has them, banks and insurers have them, Wall Street has them, unions have them, the citizens of Nebraska almost became one. You get the picture.
It is easy and fashionable to disparage “special interest groups”, but our reality today is that most of us belong to more than one.
The complex web of pressure we have constructed for the purpose of defending our sacred cows seems to be making sensible governing (if that is not an oxymoron) difficult and making change nigh unto impossible. Making change hard is often not a bad thing. However, if we are on a path that is not sustainable, change will come. Our choice is whether we do it or whether it gets done to us.
If I want your sacred cow to become negotiable, I must be willing to let mine be too.