Steady and Stable... Don't chase quick hits...

Unreasonable Expectations?

We received a phone call the other day that got us thinking. The call came in from a former client who was an acquisitions specialist for a developer. He no longer works for the company that he used to work for ---that developer is still trying to liquidate the surplus of units that they overbuilt in 2005-2009. This person is now working for a “value investor fund”. He called us to tell us about his new job and to solicit our help looking for real estate investments. He engaged us in conversation. He is looking for deals--- he is now what we call a “Scout”.

He outlined what his new company’s investment criteria. “We are ready to buy… We will buy Office, Medical Office, or Retail.” “We have a group of investors that are ready to fund.” “We have promised our investors a 20% return…”

Oh really? I reply… I then wonder; why are you wasting your time and ours? If you are looking for 20+% annual returns from commercial real estate you might as well be buying lottery tickets…

Here is why we believe that. Let’s look at a bit of math… Assume you have a million dollars to invest. If you are seeking a 20% compounded rate of return that means that a million dollars invested for five years with no cash flow for the first five years would have to be sold for and net $2.488 million dollars. So in five years the Asset has to appreciate nearly 2.5 times. But that doesn’t even consider the “value add expenses”. Say the subject property is 10,000 square feet. Assume you do cosmetic and tenant improvements that cost $30 per square foot and leasing commissions that cost $5 per square foot. Initial Investment plus improvements are now $1,350,000. To achieve a 20% return in 5 years, the property now has to be sold for $3.359 million.

To us it is difficult if not impossible to imagine a scenario in which a $1 million dollar property will become worth $3.359 million in five years. The income to justify a $3.359 million dollar sales price at a 9% cap rate 5 years from now would be more than $2.51 per square foot per month triple net.

To imagine a scenario like this occurring we’ll have to go through another cycle—money will freely flow, lending restrictions will ease, prices will increase, more money will come in, and things will get out of control again. It has happened before –and probably will happen again --but we doubt this is the likely scenario any time soon.

Scouts are likely to become frustrated and begin to question whether the chance for quick money and high double digit returns will be attainable at all this time. My gray hair and experience in the commercial real estate business leads me to believe it’s probably more reasonable to expect that a combination of extended consumer de-leveraging and ongoing economic funk will temper lending practices and hamstring demand for years to come. Financial reform will likely bring more restrictions on deal making too. The speculative bubble has burst and very few dollars are going to be made in “distressed real estate” in the short term.

We wish all investors happy hunting and there certainly may be one-off opportunities in the distressed market… We suspect that real estate investors will be better served to stop looking for the distressed quick trading hits. We’re just not going back to the “crazy good old days of 2005” anytime soon. At this point of the real estate cycle we believe that most investors should be focusing on building good core portfolios of well-leased income producing properties, grounded in good fundamentals. Investors should focus on achieving year-in, year out returns in the high single digits where annualized real estate returns historically perform. If values escalate again, these properties will almost certainly jump ahead of the curve so you’ll be in a great position to sell out. That’s why the top properties in the best markets make sense.

People can try to play the yo-yo game of finding rare jewels. But let’s face it--right now the economy and lenders just won’t cooperate. This time around we believe that conventional wisdom may take a lot longer to play out. Steady 8% returns not quick 20% returns is the more likely bet!

If we can be of service reviewing evaluating or finding commercial investment real estate or if you would like to continue the debate over which type of commercial real estate will achieve the best performance please call Jim Gray or Nahz Anvary (916) 375-1500 or at jim&nahz@ctbt.com.

Investment Sales Slow in USA and in Sacramento

Investment sales slow dramatically…

My current line when people ask me “how is the commercial real estate business?” is “It’s fine but I get to sell properties 4 or 5 times before they actually close”. This is because buyers are pickier, sellers are confronted with a changing market and lenders are tougher when it comes to underwriting real estate loans. The indicators are clear and we feel it as active brokers in the business--Investment sales have slowed down considerably. The National Association of Realtors reports that “Investment in commercial real estate during the first 4 months of 2008 was $48.2 billion, down 69.5% from the $157.8 billion for the same period in 2007. More at http://www.realtor.org/press_room/news_releases/2008/commercial_index_contracts

And here in the Sacramento Region, the Sacramento Business Journal reported “Real Estate investment tumbles; sales happening, but at a slower pace.” The Business Journal reports that investment sales are off 2.1 billion or 58% drop for the past 12 months. More at http://sacramento.bizjournals.com/sacramento/stories/2008/08/04/story5.html

Clearly volume is down, but deals are still getting done. For the first 6 months of 2008 14 office investment properties have been sold and that contrasts to 56 transactions for the same period in 2007.

The slowdown is attributed to the overall decline in the economy, to a tighter credit market with stricter underwriting in which lenders are requiring higher down payments plus higher interest rates and personal guarantees from buyers. A number of lenders have left the market all together. Also a number of prospective buyers are waiting and assessing what is happening to operating expenses, rental rate growth/decline, and to potentially higher cap rates.

We agree that this market is slowing, but we believe it is not going to be like the savings and loan collapse of the late 80’s. There has not been that much over-building , and most properties are still generating positive income and cash flows for the current owners. Sure, there will be some investors who will get into trouble and will need to dispose of properties that were bought at the top—that haven’t hit their proformas and likely have short term debt or adjustable rate debt who will have a higher sense of urgency. Sellers who want or need to sell will need to be realistic about their price and their deals will attract buyers with more cash seeking higher yields – 7% to 8.5% cap rates on actual Net Operating Income – and underwriting and conditions of financing will make transactions harder to get funded and to actually close.

If you would like to discuss this blog post with us or if we can help you with a commercial or investment real estate transaction please call or email us at Jim Gray (916) 617-4255 jgray@naibt.com or Nahz Anvary (916) 617-4257 nanvary@naibt.com.

There are investments and there are sort of investments...

Can you help me find an investment property? Digging into the details, asking questions and having a good chuckle …

Just the other day my colleague Nahz got an email from a prospect of ours who is looking for an “investment property”. We love those kinds of inquiries. This prospect is a sophisticated and smart individual who lives in our small college town of Davis, California. His profession is in the financial service area and he has a diversified portfolio and has acquired property through our brokerage firm before. We were pleased to have the opportunity to try to be of assistance and potentially make a commission.

So that lead Nahz and I to have a discussion, get busy scanning the market, making a few calls, getting the help from our research and marketing colleagues and having a few laughs about; “What is an investment property?” We are investment brokers and realize that when people seek an investment they are seeking a return on their capital. Also investors want to make sure that they get a return of their capital. We have been trained in calculating yield and returns and we know how to discuss cash flows and the reversion value or the future gain from a sale or disposition. We can build spreadsheets and do discounting and compounding and build 10 year projections to evaluate an investment with our clients. Our discussion turned quickly to what kind of investment. There are the four core investment property types; Retail, Industrial, Office, and Multi-family. Or would the client be interested in a non- core investment like ground lease, hospitality, special use, etc ?

Was this client looking for safe and secure income, institutional quality property and the resulting lower yield and higher price that goes with it? Was he interested in a value added deal? Do you think he wants a mom and pop kind of property with the management responsibility that goes with it? Single tenant or multi-tenant? How much leverage and how much cash? Was his investment being driven by tax shelter /tax deferral like a 1031 exchange requirement?
So we ran through our mental check lists and thought about all commercial properties that we knew were on the market, including our listings. Then we did a search of the commercial databases Loopnet, CoStar, the local MLS and we developed a list and a summary including a picture and a map of each property “listed as an investment property” in these databases.
Now here is where we think it gets funny. As we analyzed the 18 properties and summarized the data into categories we realized that- what is often listed as “an investment property” could in many instances be labeled and described as something quite different as well. In our letter of transmittal to our prospect we said.

Dear Client
Please find attached materials summarizing what is on the market. Two properties are commercial buildings with Net Operating Income. One is a multi-tenant office building at a 7.15% asking cap rate. One is a single tenant specialty/convenience store at a 5% asking cap rate. (Also that retail strip that we previously mentioned that had been on the market at a 6% cap, is not actually on the market anymore. “It has been removed from the market because of disputes amongst the partners and some tenant issues”… but if you want to make an offer we’d love to present it, their broker said.)
There are 3 Multi-family properties on the market, one is a four-plex at nearly $200,000 per door, another is a 13 unit apartment at about $135,000 per unit but no income or expense information is available and please don’t disturb the tenants. The third apartment complex is a nearly 40 year old 200 unit complex at $115,000 per door and a 5.5% cap rate.
Also there are 6 properties on the market – that are land deals—for development – in the People’s Republic of Davis. Those will give you an opportunity to spend money and a lot of time at hearings and meetings. There were two business properties seeking owner users. There were two Farm and Ranch Acreages. And finally there were two properties that we decided to label “Unique Davis Deals”. A campus like setting with living units, a school, an administrative office, a gym, a kitchen, and no income, and no asking price…make offer. And finally there is a remodeled 1917 bungalow with a conditional use permit for a wellness center that has a wheelchair ramp in a residential area but near the commercial center…
Please let us know if any of these are what you had in mind when you said you are looking for an investment property? Please call with questions or concerns.
Best Regards,
Jim and Nahz

Now don’t get us wrong every one of these properties has its positive attributes and we hope to be able to sell or lease each and every one of them and to serve the client in meeting their objective. However, I am not sure we would describe many of them as “investment properties”. In closing when describing considering and reviewing an “investment property” remember that there are some investments that have steady and predictable income and returns and there are other real estate opportunities that have attributes for use, development, and speculation. And every investment has potential for risk and rewards and occasionally a chance for some chuckles.

If you would like to discuss this Blog Post with us or if we can answer questions or try to help you search for an investment property or a good chuckle or if we can be of service please contact us. Jim Gray (916) 617-4255 jgray@naibt.com or Nahz Anvary (916) 617-4257 nanvary@naibt.com

Lots of Options --Office Buildings For Sale Sacramento

Office Buildings For Sale in the Sacramento Valley—What Does That Really Mean?
Sifting through Lots of Opportunites...

So you are looking for an office building to buy in the Sacramento area? Or you are thinking about investing in a commercial/office property in the Sacramento area? Well you have plenty to choose from – but you need to refine your search if you want to locate what you really want and you want it to meet your business and investment needs. Office properties are known as one of the four core product types of commercial real estate. Office properties vary greatly in their configuration, style, utility, and economic performance. The “office market” is comprised of many distinct property types. These include modern skyscrapers, medical office, office condos, classes A, B& C, single tenant and multi-tenant, offices for the owner user and offices that are well managed investment properties. There is institutional quality and there are mom and pop offices. Sometimes offices are mixed use with residential or with retail, and there are offices in warehouses and within flex buildings. There are various submarkets and plenty of features that differentiate. Being able to understand these variables and their unique attributes requires a professional focus and asking the right questions.

It is the first of the month and Commercial Brokerage Firms are sending out their “availability lists”. When this occurs, it means that the research staff and the administrative staff are working closely with the Brokers to make sure that an inventory of available property is updated and distributed. When this task is performed by the various offices it also means that the information to the commercial databases such as LoopNet or Costar are also updated. But consistent and uniform information it is not! We thought it would be interesting to review the office market and share some of the findings from our analysis of this imperfect market information.

Here is an effort to describe the current inventory of “office properties” that are “actively on the market”. There are 580 office properties currently offered for sale in the Sacramento Valley. They range in price from $135,000 to $26,500,000. Only 12.5% of the office properties have a quoted cap rate—the other 87.5% are being offered to owner users --or the investment attributes haven’t been provided for their office offering.

To help get our arms around the market we did a few searches in LoopNet to check in on market conditions. The searches included the counties of Sacramento, Placer, El Dorado, Yolo, and Solano. We then looked at the information in these offerings and have the following observations to share:

The first search was for “office properties” less than $1 million dollars. There are 209 separate properties on the market. They range from Victorian houses modified for commercial use to small office condo units. Only 11 of those properties reported a cap rate- ranging from 4% to 9.10%. 198 of the offerings are trying to attract the owner user. Sizes ranged from 384 to 9,600 square feet. Prices varied from $135,000 to $999,999 and from $104 all the way up to $962 per square foot.

The second search was amongst office properties from $1 million to $10,000,000. There are 355 office buildings on the market in that price range. In this category there are properties from $1 million to $9,815,000 on the market. Sizes in this price range from 2,435 to 59,616 square feet and prices per square foot range from $94 to $425 per square foot. Of these offerings, only 55 properties quote a cap rate –ranging from 4.12% to 9.08%. Three hundred of these offerings have no stated income and expenses and are not being offered as an investment.

The third search was for office properties being offered for sale at $10,000,000 or more. In this price category, there were 16 properties on the market. From $10,454,000 to $26,500,000 with more than half of these offerings being “un-priced” and only 6 of these have a quoted cap rate –from 6% to 7.6%. Sizes in these high price offerings range from 34,848 to 153,879 square feet.

There is a lot of inventory; more than 500 buildings being offered to users or being offered without stabilized income --but not a lot of office investment inventory on the market. However, it is worth noting that there are now more than 30 office buildings being offered for sale with cap rates higher than 7%.

If we can assist you with your search for an office for your business or an office as an investment please contact us to see if we can be of service and bring professionalism and value as you sift through and consider available options. If you have questions or comments about this post or if we can assist you with your commercial and investment real estate needs please call Jim Gray at (916) 617-4255 or Nahz Anvary at (916) 617-4257.

To Sell or Not to Sell? Capital Gains Considerations is that the Question?

To sell…. or not to sell? That is the question.

If you have been following the presidential race as closely as we have, one question may be at the forefront of your mind—to sell…or not to sell? Borrowing William Shakespeare’s famous line and applying it to the world of commercial and investment real estate has made us wonder about the role capital gains tax and the outcome of the upcoming election may play in our disposition decisions and what the best avenue may be to reinvest our proceeds from investment property sales.

The volume of 1031 tax-deferred exchanges has dropped dramatically, approximately 30-50% in the last year, especially in properties less than $5 million, according to Boulder Net Lease Funds. One explanation may be that investors who once never dreamed of paying Uncle Sam are now deciding to lock in their gains, as no one is really sure when capital gains rates may ever be this low.

Regardless of whoever takes the White House in November, it seems to be a matter of time until the very favorable capital gains tax rate of 15% is set to increase.

So…if you have been philosophizing about the big question “to sell…or not to sell” you may have just found your answer. Or at least you are asking the right question along with many other investors.

For more, read the article in the Wall Street Journal, June 18th, 2008, Your Tax Bill How McCain and Obama Differ; Capital Gains Rates are likely to Rise, No matter Who Wins.
http://online.wsj.com/article/SB121374794468982701.html

National Real Estate Investor, June 2008, Taking a Direct Hit.
http://nreionline.com/finance/investors/real_estate_taking_direct_hit_0601/index.html

If we can answer questions about this posting or help you with a real estate question or decision please feel free to call Jim Gray or Nahz Anvary at NAIBT Commercial Real Estate at (916) 617-4255 or (916) 617-4257.

A return to fundamentals in commercial loan availability and underwriting…

This afternoon, I had lunch with John DiMichele, the CEO of Community Business Bank, a local bank less than 3 years old with nearly $150,000,000 in assets that focuses on relationships with small and medium sized businesses and non-profits in Sacramento, San Joaquin, Placer, Yolo, and Solano counties. John is a veteran of the banking industry and has more than 30 years in banking and has been the CEO at four financial institutions. (So here is the disclaimer, Jim Gray has been on the board of two different banks that John has led – but none the less John D. is a smart guy who we are proud to say is our friend and banker.)

Over lunch John said; “In my career I have never seen it change so quickly. There are still good customers out there and there are still plenty of good loans to be made—but we need to do a much better job of underwriting and we just have to say ‘no’ to some loans that we would have made just a few months ago. We don’t have to say we won’t make commercial loans or that we won’t make construction loans, but we do need to be more cautious and more thorough as we underwrite those loans. We must make sure that we underwrite not only the asset but also the cash flow and secondary sources of repayment.”

John is not alone in making these kinds of observations … Prudent lenders and the market place have tightened up their underwriting standards. Here are some ways that Commercial Real Estate Investors need to think about the implications of better underwriting. (And I do mean better.)

Six months ago you could get a commercial loan with a 75% to 85% Loan to Value Ratio- LTV. Now maximum LTV ratios are more like 65% to 70%. On a $5,000,000 acquisition 6 months ago you could have borrowed $4,250,000. Today you would be fortunate to borrow $3,250,000. In other words, you would need an additional million dollars in down payment for a total of $1,750,000.

The other underwriting ratio is the one that evaluates cash flow and it is known as Debt Coverage Ratio. DSCR . Six months ago you probably could have gotten a loan with a 1.10 or 1.15 DSCR. Now it is probably more like 1.25 to 1.30 DSCR.

The debt service coverage ratio is the ratio of net operating income to debt payments on a piece of investment real estate. It is a benchmark used in the measurement of an income-producing property's ability to produce enough revenue to cover its monthly mortgage payments. The higher this ratio is, the easier it is to borrow money for the property. In general, it is calculated by: DSCR = Net Operating Income / Total Debt Service

To determine the DSCR one needs to determine the Net Operating Income, NOI. In this $5,000,000 property example, let’s assume it was acquired at a 7% Cap rate, = $350,000 NOI. Then let’s assume that one could find a market interest rate of 7% and a 25 year amortization for the $3,250,000 loan balance, that would mean a monthly debt service of $22,837 or $274,045 per year. The DSCR is the annual Net Operating Income divided by the Debt Service which in this case is 1.28. In other words the cash flow after paying expenses and debt service is $75,955. The banker or the investor in the mortgage debt are now comfortable and feels that their risk of default is “covered”. The bank underwriter has returned to “tried and true” underwriting standards. And they have changed quickly.

Finally, let’s now look at the return that the buyer/ property investor receives in a $5 million dollar property with these more conservative underwriting standards. The Investor increases their down payment—investment -- to $1,750,000 and receives $75,955 in annual cash flow after paying expenses and servicing the mortgage debt, that equates to a 4.34% cash on cash return. In addition, after paying 12 monthly payments- interest and principal - there would be $48,069 in principal reduction which is 2.75% additional return on the initial investment.
In this new, more normal, lender /borrower relationship, the bank is “covered” and receives a 7% return on their mortgage debt and the buyer receives a cash flow of 4.34% and a total return including principal reduction of 7.1%.

Clearly what this means to a community banker is there remains a willingness to take a risk so long as it is coupled with a reasonable return for the risk and a requirement that the investor has a sound investment. How can one argue with these fundamentals? A borrower is going to have to have more cash, stronger collateral, and outstanding credit to achieve approval in this return to underwriting fundamentals.

The Denominator Effect

The Denominator Effect…

No, it is not just a test of your recollection of long division, fractions, or high school algebra. The denominator effect is is a term that describes a phenomenon that is finding its way –unfortunately--into the commercial and investment real estate communities right now, and might lead to more pressure to sell and less capital to buy.

So here is how it works and what the implications are. An Institutional investor, pension plan, investment fund, or insurance company manages a portion of their risk by diversifying their portfolio. In broad terms they set guidelines for themselves on how much money to put into various asset classes and then they either quarterly or annually check their investment percentages against their guidelines. They do this not only amongst individual stocks, bonds and other individual assets but also amongst all asset classes. Commercial Real Estate and Commercial Mortgages are usually a small percentage of many investors’ portfolio diversification strategies. (5% to 15%)

As institutional investors have taken recent losses and declines in the Stock and Bond Markets, combined with the fact that much of their real estate investments had double digit growth over the past 5 years, some now find themselves “over-weighted” with commercial real estate. Now, many of them need to “rebalance” their portfolio by reducing their commitment to commercial real estate. Here is an example of how this works. Let’s say the investor has a $10,000,000 portfolio comprised of 60% stocks, 30% bonds, 10% Real Estate. Let’s say that the stocks perform like my IRA and lose 15% of their value in the last quarter. Let’s also say that long term interest rates rise by 1% or credit quality comes into question and you lose 10% of your bond’s value. (You have a good investment advisor and he didn’t let you buy any mortgage backed securities or auction rate notes so you have only lost 10%) The portfolio is now “marked to market” at a value of $8,800,000. The Plan should now allocate only $880,000 to real estate not $1,000,000. Funds available for real estate just went down by 12%. Investors either reduce their appetite for buying or they need to sell to reduce the size of their actual real estate holdings.

So what does this mean in the near term? First, several quarters of poor performance in the equities and, to a lesser extent, the bond market have had an impact on the denominator of plan assets and have increased the relative weighting of real estate. Secondly, strong performance over the past five +- years in the real estate sector has led to imbalances in sector weightings within the real estate portfolio. And thirdly, many experts have “expectations of moderating performance” including slower rent growth, potentially higher expenses, and likely rising cap rates and these factors are leading investors to reduce exposure to real estate as they consider new strategies in their real estate portfolios. It means less money for purchasing real estate and some pressure to sell commercial real estate so that funds can be reallocated.

This phenomenon is really happening and it is happening right here in northern California. Recently the City and County of San Francisco Employees’ Retirement System (SFER) reduced its target allocation to real estate by 73%, from $750 million to only $200 million in its next fiscal year beginning in July. Here is a link to that article from May 27, 2008. http://www.globest.com/news/1166_1166/sanfrancisco/171096-1.html

Keep your eye on the impact of this denominator effect and its implications for your particular portfolio or any purchase opportunities that may arise because of it.

If we can answer questions about this posting or help you with a real estate question or decision please feel free to call Jim Gray or Nahz Anvary at NAIBT Commercial Real Estate at (916) 617-4255 or (916) 617-4257.