commercial real estate

One of my clients - an investor and owner of a commercial mortgage brokerage business - confessed earlier this week that he was having a chicken little moment.

Offers he’d made earlier in the year to buy product that had been turned down - he’d been third or fourth in the bidding sometimes - were now coming back to him. He had more opportunities than he knew what to do with.

It was exciting at first, until he realized there were no lenders out there to finance the opportunities. Loans offered last week were no longer on the table. Many of his sophisticated equity partners were “on the sideline” for now.

It’s time for brokers and buyers to go where the market is taking them — and that is to distressed assets. My primary focus is on talking to the most motivated sellers: cash hungry sale leaseback prospects, lenders with troubled loans or REO to sell quickly at a discount, troubled owners, and the like.

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A cap rate, or capitalization rate, is an expression of return calculated as follows:

Net Operating Income/Purchase Price = capitalization rate

A cap rate does not take into accout return over time, as it only focuses on one year’s income.

As such, to only evaluate a real estate investment by looking at its cap rate is foolish. What does the 2nd year’s income look like? The 10th year’s income? Where are rental rates in place compared to market? Are you paying more or less than it costs to replace the building? What will cash on cash returns look like after the property is financed? What is the internal rate of return after a 5 or 10 year hold?

It’s your return on an investment over time.  It calculates the present value (ie the value today) of cash coming to you or leaving your pocket in the future.

In the case of evaluating a real estate investment, you have to project cash flow for a period of time into the future to give yourself a series ofcash flows to use in your calculations.

Then, because a dollar today is worth more than a dollar tomorrow, you discount the future dollars. The farther into the future, the bigger the discount.

IRR calculations are subject to big time manipulation in negotiations. By changing the sale price at the end of the analysis you can drive the IRR up or down dramatically.

Take a class from the CCIM Institute — on line or in person — to learn how to calculate an internal rate of return. Or just use Excel…but then you’ll never really understand how it works.

I got the question the other day, “where do I go to raise $50 million to create a distressed properties fund?”

Is may sound snide, but I’m thinking, “if you have to ask…maybe you’re not ready to manage $50 million yet?” My observation is that those who have a track record of success acquiring property, creating value and generating excellent returns for their clients do not have difficulty raising money. Do you have experience buying distressed property and profiting? If not, perhaps you need to look at starting smaller. If you have a modest amount of this experience at a smaller level, a good way to “level jump” is through a one-off joint venture with an equity source on a single larger acquisition. A typical deal structure for these JVs will have you putting up 5% of the equity and the partner putting up the rest. Partner gets a preferred return, you benefit from a large part of the upside. Partner gets control over major decisions, you get to run the asset day-to-day and benefit from associated fees.

Here’s a how-to. Let’s say you’re going to start with duplexes….

I’d pick a particular neighborhood that interests you — or cal it a submarket. I’d build a conclusive database of duplexes and four-plexes in that neighborhood. This will take some driving around. pick small enough a geography to start off with so that you’re not overwhelmed.

For each property I’d track asking rental rates and availability - that will get you a vacancy rate and an understanding of market rents. I’d use tax record data — often search able for free on the internet — to gather comparable sale data and build a list of owners. I’d even take pictures. I’d dump all the information in a contact management program.

I’d start canvassing the owners of the these properties asking them if they’d sell. Phone is best but you start with an introductory letter if you like. Properties not marketed by a broker often sell for less!

Track their responses. Some sellers will be extremely unreasonable! It will take persistent and patient follow up, but I’ve observed new investors have a lot of success with one variation of this method or another.

There’s no magic easy method to finding deals, and focusing only on property listed with brokers is going to give you a lot of heartburn (agents are paid to get sellers the most money possible and most are good at it!)

Are you old? Are you out of depreciation? do you feel like you’re stuck on the real estate roller coaster but can’t get off because of the tax consequences? Talk to your financial advisor about a charitable remainder trust. I don’t give this kind of advice, but here’s how it works:

-Put your building in a trust

-Trust sells the building, gets the cash

-You get a tax deduction

-Trust pays you income as long as you live…you can set the income within limits

-You die, charity gets the cash in the trust

Kids worried about disinheriting the kids? Buy them a life insurance policy!

I know, a dry topic, but if you don’t work for an institutional owner or a national brokerage firm, you may be lacking in access to good analysts for Argus modeling and other financial analysis.

Here are some folks who have expressed interest in doing this kind of work, or do it for a living:

rebackoffice. http://www.rebackoffice.com/analyticsResearch/investmentAnalysis.html. $250 plus $10/tenant and $25/assumption. rebackoffice has a wide range of real estate outsourcing solutions. Overseas solution.

Cherie M. Hardgrove, MAI, CCIM. chgrove@columbus.rr.com. $90/hour.

Global Realty Outsourcing, Inc. T: (212) 209-0772. Wide range of pricing depending on format of data provided. Can do lease abstracting and other due diligence projects. Overseas solution.

Carey Guiberson. Carey [carey@ont.com]. Will refer assignments to his graduate students. $50/hour.

Market rent growth is as important, if not more important, than in-place cash flow. Novice buyers focus solely on barometers of the “here and now,” e.g. capitalization rates and in-place returns. Learn to make cash flow projections and calculate an internal rate of return. You can buy a fancy program from Argus or you can do it in Excel. Don’t know where to start? Take the ccim 101 class. Take all their classes for that matter. They will pay for themselves many times over if you are making a career in real estate. Doesn’t matter if you’re flipping houses or buying million square foot warehouses, it’s a great program.

With all the hype of flipping houses for profit, think about the tax consequences.

You suffer ordinary income tax treatment on your gain if you sell less than 12 months after acquisition.

Hold for a year and a day and save yourself potentially 25-35% of your profit!

In these leaner times, might make more sense to collect a year of rental income before you pull the trigger.

They never appreciate in value. Never never never. Research research research. buyer beware.

1. Find a tenant that needs space. Find a building to buy. Contract to buy the building, write the lease. Finance based on the credit of the tenant and the cash flow.

2. Buy Veterans Administration homes which can be bought by investors with 5% to 10% down.

3. Get a real estate license. Find a niche with little competition (car washes? Mobile home parks? small multi-family buildings? little strip centers) and excel.

4. Think big. Find a bigger opportunity. Joint venture partners will contribute 95% of the equity required if the deal is a good one and give you much of the upside. It takes as much work to do a big deal as a small one. You do have to bring some expertise to the table to pull this off.

5. Be contrarian. Now that everyone is down on real estate, start thinking about buying it.

6. Look for sale leasebacks: an owner and occupant of a building who wants out but will continue to occupy the building and rent from you.

I sell warehouses for a living, so I think a lot about roofs.

When I’m underwriting a warehouse, I use these rules of thumb:

-flat roofs generally last around 15 years. You might get more out of a particularly well maintained one, and you might get less if the job was poorly done…particularly if the new roof was laid over the old.

-It’s costing about $3 to $4 per square foot right now in my area to rip off an existing roof to the deck and replace it with a new rubber membrane roof.

I would never select one through any manner other than a referral. It’s too big a task to be carried out by someone you’ve found in the yellow pages, a google or yahoo search, or by responding to mass mailer. Whether it be residential or commercial. Ask a friend.

If your mortgage broker extols the virtues of a “conduit loan,” i.e., lower rates, longer amortization, and so forth, be wary. I’m not telling you to avoid conduit loans, but if you’re accustomed to dealing with banks, say farewell to a customer service-oriented experience. Also beware of

-Lengthy prepayment lockouts

-Arduous reporting requirements

-Prepayment penalties (called defeasance) that make prepayment unfeasible

If you want to sell your building in the next year or two, I would discourage you from using this sort of debt.

If you and your business own and occupy a commercial property and need commercial financing, do yourself a favor and look beyond your bank and talk to life insurance companies and conduit lenders.

Higher loan amounts, lower rates, better terms and a structure that includes little to no recourse (ie lender cant seize your personal property) are often available depending on the credit of the occupant.

Hire a good mortgage broker — one who has been referred to you — to handle the process. They will charge you a fee (a point or less) but will earn it back many times over if they are good at what they do.

Loan constant = annual debt service ÷ loan amount.

So for example, $100,000 annual debt service ÷ $1,000,000 loan = 10% loan constant.

Who cares?

If I’m buying a property at a 11% return before the debt, the debt is improving my return.

If I’m buying a property at a 9% return before the debt, the debt is worsening my return.

Use a loan constant to quickly evaluate the impact of a loan on your return.

We use this calculation more often on the commercial side of the real estate business because commercial loans are often locked out from prepayment or expensive to prepay.