Don’t Wait to Buy Real Estate;
Buy Real Estate and Wait
Commercial Real Estate Outlook
The resulting financial uncertainty left in the wake of this financial meltdown can almost be summed up in one sentence;” What do I do with my money?" If there’s a silver lining in this cloud of confusion that has absorbed our collective attention; it’s that all of us have been forced to take a good hard look at how we invest and hold our money. Hopefully, such scrutiny will open new doors and reveal opportunities that were never before considered.
"Will the capital gains tax be raised?" Currently capital gains taxes are at an historic low, hovering at 15% with the Feds. This may or may not change with a new administration as they take aim at reducing the record deficit and pay the freight for the subprime bailout. Still it might be a good time to sell and lock in the gain. Fortunately, the 1031 Tax Deferred Exchange Option remains a viable alternative for the sale of property held for investment. It continues to remain a reliable and secure vehicle for building wealth. Now may be a good time to evaluate your income to appreciation ratio in property you own and determine how your property's cash flow is actually performing for you. If you’ve owned your property for an extended period of time, you may discover that your property's appreciation is eclipsing the cash flow. Now may be time to consider liquidating that asset in order to find one that creates more income and puts that equity to work for you.
WHY COMMERCIAL REAL ESTATE?
Following are a few reasons you may want to consider commercial real estate for your next investment and some of the advantages and risks associated with them. One tremendous advantage that you receive from investing in commercial real estate is the ability to leverage your money. With a percentage of the total purchase price (usually about 25%-40%) you can expand your range of appreciation potential on the purchase price (not just your cash down payment). Unlike the stock market or residential property; with commercial real estate, you can take advantage of the tax benefits of a depreciation schedule and all the tax write-offs.
In addition to receiving the income stream from your commercial real estate, you have the additional potential to participate in the real estate appreciation
as well. With a commercial real estate investment you are eligible to take advantage of the 1031 Exchange program. This gives you the potential to build up equity and receive the tax advantages of your depreciation schedule while continuing to let your equity build over time without the interruption of “tax bites” out of your principle. What’s the catch? Let’s explore some of the different types of income property currently available.Here, I’m going to highlight three different categories of commercial property and present the basic advantages and disadvantages. Every one of these categories has a proven formula for success.
THE THREE CATEGORIES INCLUDE: (we include apartments as commercial)
1. Multifamily Residential Real Estate/Apartment Buildings: One of the most desirable advantages of buying an apartment building is being able to take advantage of the best financing available in commercial real estate.
Lenders view apartment buildings very favorably.
They are considered low risk because there is little chance for a drastic reduction in income, as all tenants will probably not move at the same time. Apartments are probably the most sought after of all investments because most people inherently understand residential income property (everyone has to have somewhere to live). However, it is almost impossible to find a decent return on a Northern California apartment project. With sparse inventory and high demand, some Investors are willing to sacrifice income to speculate on future appreciation. Local municipalities contribute to this strategy with expensive, cumbersome regulations that make new construction difficult and time consuming; thus creating an artificial value to EXISTING residential income property.
The downside to apartment/multifamily investments are the labor intensive issues you must deal with. There are lots of tenants and often you can be beset with an
ongoing list of repairs and replacements which will significantly interfere with your intended “cashflow expectations”. It’s great to purchase enough units to be able to absorb the expense of a manager who will handle all the day to day problems and annoyances as they occur. Typically, there is usually a strong pool of people who welcome this position in trade for a free apartment unit or one with reduced rent. Retirement communities often have a number of couples that covet this kind of opportunity.
2. NNN Leased Investments: This typically will be
a leased investment that is developed by a substantial corporate client who will find the property, build the building and turn around and market it to the investment community at a certain return on their investment. They are able to construct a scenario
that gives them the ability to just about pay for their new location even before they open. Depending on the financial strength of the organization, the return
on one of these NNN LEASED INVESTMENTS is somewhere between 7-9%.
Some of the more well-known companies using this formula include Chevron gas stations, Walgreen’s, Kragen Auto-Parts, CVC Pharmacies and lots of fast food and restaurant concepts (Denny’s, Taco Bell, Applebee’s, Burger King, TGIF Friday’s are a few that come to mind). The plus side of this type of investment is an absolute no worry investment, (known affectionately as "coupon clipper".) The company assumes all responsibility for the maintenance and repairs or they take care of everything with the exception of the sidewalls and the roof (some will even take care of absolutely everything including the roof
and walls). Typically, you receive a check like clockwork from the parent company. The downside to this investment vehicle is the risk that the company could go bankrupt, that the location could one day become obsolete, or that the tenant may vacate one day and you will be faced with the task of selling or
re- leasing the property (which could be expensive
and time consuming). However, these sites are hand selected to have high visibility, a strong surrounding demographic base and will probably be a desirable location to other retailers seeking a high visibility and convenient site.
3. Mini-storage facilities: These can be extremely hard to find as these cash cows have a very loyal following of investors. Mini-storages offer the investor extremely low-maintenance requirements for personnel, have a multi-demographic customer base and give an investor a superior return on the investment dollar.
The downside is increased competition. Developers are always looking for new sites and increased competition can create market saturation that can eventually impact the occupancy rate. Keep in mind that many cities have an aversion to these bland structures and can be extremely hesitant in allowing more to be built.
Sales Leasing Investments
Annette Cooper
Commercial Real Estate
KEEGAN & COPPIN COMPANY, INC.
ONCOR INTERNATIONAL
Established 1976: Celebrating 32 Years of Service
Phone: 707.528.1400
LEVERAGE INVESTING: “FRED AND FRIDA”
If Fred and Frida have $1,500,000.00 in cash, and invest it in a $1,500,000.00 NNN property
with an Annual Cap Rate of 8%, they will have an annual income on their investment of $120,000.00
$1,500,000.00 NNN Investment (All cash)
with an annual cap rate of 8% = an annual income of $120,000.00
Annual Income:
$120,000.00
$120,000.00However, if Fred and Frida take the same $1,500,000.00 and borrow an additional $3,000,000.00 and invest all of the money in a $4,500,000.00 NNN property with an
Annual Cap Rate of 8%, they end up with an Annual Income of $360,000.00.
Out of these funds, they can make the $270,000.00 in loan payments
and still have $90,000.00 in annual income.
8% Cash-on-Cash Return
$1,500,000.00 and Borrow $3,000,000.00
Buys $4,500,000.00 NNN at 8% Cap =
$360,000 Income
$270,000 Loan Payments
$ 90,000 Annual Income
Annual Income $90,000.00 + New Depreciation Schedule and equity accumulation
on $4,500,000 (as opposed to $1,500,000)
PROJECTED APPRECIATION OVER FIVE YEAR TERM
What would happen to Fred and Frida in each different scenario? If they purchase the one
with their original $1,500,000, or the second option for the $4,500,000 which the loan would
give them, and then assume those properties would appreciate over 5 years at a rate of
3% per annum.
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Forbes Magazine conducts an annual survey that evaluates the Best 200 Places to live and do business in the country. In this year’s survey, no city in California surfaces until number 85 (Sacramento).There are other areas of our country that are absorbing this financial calamity better then we are here in California. Now may be a time to consider finding income property in one of those other areas for diversification, stability and growth. A legitimate strategy to consider when you decide to invest out of the area is an NNN Leased Investment. It is a reasonable hedge for securing cash flow and still allows for the tax and appreciation benefits of owning real estate. NNN Leased Investments obligate the tenant to pay all the expenses associated with owning that property (taxes, insurance and common area maintenance). They are sometimes known as “coupon clippers” because they require minimal management and can be comfortably owned from a far.
Other investment real estate products worth considering are mobile home parks, self storage facilities and ground leases. All have income in place and typically require less intensive management then multi-tenant investments such as apartments, retail and office complexes.
Ultimately, the thing to remember is that real estate will not evaporate. It is remains a tangible commodity and will not disappear in a Wall Street shell game. It has the potential to offer prudent leverage and remains the most prevalent wealth building mechanism our financial system has to offer. Market fluctuations can be “waited out" and the risk to reward potential is substantial, yet secure. 90% of self-made wealth in this country has been generated through real estate investments held over time. It is impossible to perfectly time the market, but now may be the time to do some inquiry and take advantage of new opportunities.
PURCHASE PRICE
$1,500,000.00
$4,500,000.00
3% Per Annum
Appreciation Price
$1,688,263.00
$5,064,789.00
NET Appreciation
Amount
$188,263.00
$564,789.00
Additional
Comments
Plus $150,000 in
income over 5 yrs
Lots of accumulated equity in paying
down the debt
CAP RATES vs. CASH
ON CASH RETURNS
There appears to be a lot of speculation everywhere today about what is going to happen to cap rates and interest rates in the near future. A flat economy, burgeoning deficits, the costs of the Iraq war, election uncertainty, oil prices, energy costs, health care chaos, "baby boomers" tapping into an already stressed Social Security system and Alan Greenspan's hints of interest hikes have taken their toll on the investment community's perspective.
A capitalization rate is the percentage of retum from
an investment when you divide the Net Operating
Income (NOI) by the price you are paying for the
property (e.g. you buy an investment for $1,000,000
and the NOI is $100,000 annually - the cap rate on this investment is 10%).
Cap rates do not consider the costs of financing into
the investment equation. Instead of buying into cap rate mania, a more important question to ask is: "What will be the actual "cash on cash" return on your investment dollar?" Before I launch into this, let me warn you that there are two things not factored into today's equations. One is the obvious tax advantages of commercial investments such as depreciation, loan fees, interest,
and other related tax benefits. These write-offs are very important, and extremely valuable. There are times when specific tax strategies may be the only reason to purchase investment real estate, but that's not what I want to discuss here. The other really important topic I'm not going to discuss is real estate appreciation. This is extremely important in the overall return evaluation, but impossible to calculate at this stage.
Let me explain what I mean by "cash on cash return."
First example: You have $500,000 in cash. What are some of your commercial investment options? Let's
use a maximum leverage strategy for this example.
This concept is usually best suited to the multiresidential sector. Lenders have a soft spot for residential properties. Consequently, the loans available for apartments and multifamily properties have lower
interest rates, and allow for a minimum down payment. Let's assume your broker finds what appears to be
a great investment for 52,500,000 with a 7.5% cap rate.
Your income on this investment is estimated to be
$189,600 annually.
A loan of $2,000,000 at 6.5% (amortized over thirty (30)
years, due in ten (10) years), would cost about $151,000
annually. You would net approximately $38,600 per year. Your cash on cash return on this investment would be in the 7%+ range ($38,600 divided by $500,000:
7 .72%) with a very attractive leverage position. The principle on the loan amount is also reducing every year and building more equity. The reason this investment makes so much sense is that the income is greater than the financing costs.
Here is another example: Using the same $500,000,
your broker finds you a beautiful Class A building. The purchase price is the same $2,500,000, but the cap rate is 5.5%, and the lower available financing is 6.5% for this property type. The 5.5% income is estimated at $137,500, but the annual loan payments are still going to be in the $151,000 range. Your cash on cash return is
-$13,500 annually. You are still paying down the loan and building equity, but there simply is no cash on cash return on this investment. The spread between the financing costs and the NOI is a negative.
There may be good reasons to buy a 5.5% cap rate
investment, but if the underlying financing isn't in line with the annual income, you may want to think twice about what you expect from your overall return. When I started in this business, cap rates were a lot higher than they are now. The overall returns were probably about the same, because cap rates seemed to move up to accommodate higher interest rates. If interest rates move up again,
I would anticipate that same phenomenon to hold true.
In any event, the typical anemic investment cap rates
offered in most of the major California metropolitan
areas are driving investors and 1031 Exchange buyers to search the Central Valley, as well as other states around the country that can produce more attractive returns.
The ability to communicate information through the internet has facilitated this exodus and I think the phenomenon are here to stay. Through this fairly new "lightning fast" communication medium, buyers now
have instant access to investments that may yield a 7-8% cap rate and have an underlying financing potential of
6-7%. This creates an attractive yield, as well as tax benefits and appreciation potential.
INVESTMENT CATEGORIES
Shopping Center
Strip Center
Retail Project
INVESTMENT TYPE
WHY TO BUY
WHY NOT TO BUY
Apartment Complex
Multifamily Units
NNN Leased
Investments
"Coupon clipper" investment;
no hassle.
Check arrives each month.
No expenses.
Depreciation potential.
Hedge against inflation.
Best financing options
Maximum leverage.
Less tenant loss.
Good opportunities to
purchase nationwide.
Office Complex
Office Building
Multi-Tenant
Less tenant loss.
Typically tenants pay
reimbursements = more
cash in your pocket.
Ability to pass through most
expenses.
Ability to raise rents & catch
appreciation wave
Demographics important
Stable tenant base.
Hedge on income loss
w/multi-tentant building.
Downtown locations offer
great depreciation (high
improvement to land ratio)
Can be a money pit.
Multitude of tenant problems.
Management is critical
Buy newer & bigger if possible
May require large down payment
Tenant goes bankrupt
Anchor tenant in a center relocates
No ability to aggressively raise
rents and catch periodic
appreciation waves
Expensive tenant improvement
Exposure to expense hikes may be buried in full service leases; may take longer to recoup added costs,
e.g. utilities
Ground Leases
Industrial Facilities
Mobile Home Parks
Mini-Storage Facilities
Tenant loss impacts cash flow
Broker expenses to lease Vacancy in a recession
Management intensive
Tenants expect tenant
improvement money.
No hassles.
Long term hold (20 years)
Hold can reap $$ bonanza
No depreciation.
No ability to raise rents
Higher down payment & less
leverage possibilities
Low maintenance tenants.
Low cost tenant improvements
Long term leases
May convert to retail and/or
housing zoning to benefit
from "obsolescence" over
time as a city grows
May have to wait for new tenant
during a recession
Residential environment issues
Less depreciation (more land)
Lower improvement to land ratio
Cash cows.
Easy to find managers.
Potential to improve by upgrading "coaches"
Government interference in the form of rent control (senior
issues)
Little to do depreciation potential.
Cash cows
Little maintenance overhead
Easy to find managers
Hard to find
High desirability
Subject to development
saturation
Little depreciation
Prepared by Annette Cooper, Senior Real Estate Advisor
"The greatest amount of wasted time is the time not getting started."
- Dawson Trotman
"You've worked hard for your money.
Make sure your money is working hard for you."
- Annette Cooper
Northern California
