Monday, June 4, 2012

How To Buy an Office Building with Growth Potential

            Some investors buy into an office building for current income and possible long-term appreciation in value, there are also investors who seek out growth situations; i.e., office buildings which for one reason or another are throwing off less than their maximum income.  Such an investor may be interested in increasing the building’s income so that it can be resold at a substantial increase.  Others will want to retain the building for its income.  A syndicator frequently is in the latter position.  He cannot syndicate a building which is already showing its maximum income since the interest he takes in the property (in return for his services) will reduce the return to a point where outside investors will not be interested.  So he must look for a building which can be purchased at a price relatively low in relation to its potential return.  If he then can develop that potential, he will be in a position (and entitled) to take a share of the return himself.

            While in may respects the procedures in buying a property for public syndications are the same as for private investment, there is one significant difference.  The syndicated property must be more salable as an investment, both in terms of lesser risk and a more regular return.  The public will buy such a property much more quickly than one projecting a far-off return (for example, upon refinancing) or depending for its success on special circumstances.

  1. Selecting the Property:  The property to be syndicated should have as many attractive features as possible.  These include large and impressive size, pleasing architectural design, a known name or address, and location on a full block or a corner.  These will make it easier to sell to investors as well as to tenants.\
  2. Figuring the Profit Potential:  In most cases, the property as presently operated will not be able to throw off the rate of distribution which is necessary to make the syndication a success.  It is here that the syndicator earns his pay, for he must think up ways to make the property more profitable.  There are no hard and fast rules for doing this;  it ultimately depends on the experience and imagination of the people involved.  But for illustrative purposes, here is a list of possible approaches for an office building:
    1. Convert the basement -  Man older buildings have extensive basement space which was intended for storage or similar non-income purposes.  Such space can be converted into a restaurant or retail stores.  In one case, a building had a delivery ramp into the basement; it was converted into a garage which returned a sizable annual profit.
    2. Close up an entrance – Many buildings have separate entrances on the main street and on the side street.  Closing up the main entrance creates a valuable commercial space; at the same time, the building retains its address even though its entrance has been changed.
    3. Automate and update – Since the biggest operating expense is payroll, cutting labor costs is an important way to increase the return.  Automate such services as Doorman, Concierge, Security, etc.  if and only if it is possible to do so without diminishing quality of service provided to the tenants.  Update electronics and install technological amenities which are being offered by the majority of competition.
    4. Grant food service concessions – A common sight in many large office buildings is the mobile coffee dispenser which services the tenants.  This and similar concessions can add to the revenue from the building.
    5. Consider an outside cleaning service – In many cases, it will save you money to have the building cleaned and maintained by a professional organization.  Although they must charge you enough to make a profit, they very often are so much more efficient, through the use of mechanical aids and time-saving techniques, that your cleaning bill is substantially reduced.  Even if you do not engage such a service, review you own staff carefully to see if costs can be cut.
    6. Reduce the cost of utilities – In one case, a syndicator purchased three adjoining buildings and was able to have them all serviced by a single electric meter, which saved a considerable amount.  In another case, however, the building owner was realizing profit by paying for electricity at wholesale rates and selling it to his tenants at retail. 
    7. Rent out management office – Very often in a building formerly owned by a small group, the management offices will be quite lavish an sometimes used by the owners for other business purposes.  This space can be converted to rental use, while the management office is put elsewhere.
    8. Modernize the premises – Modernization is an excellent way to increase a building’s profitability since it paves the way to higher rents.  However, never modernize a building located in a deteriorating neighborhood unless you feel sure the trend is being reversed.
    9. Add escalator clauses to renewed leases – Even though the compeititve situation may not permit higher rentals, your bargaining position may be strong enough for you to add escalator clauses for taxes and labor when leases are renewed.  These permit you to recapture such increased costs in the future in the form of additional rent.
    10. Refinance the mortgage – This is a common procedure in syndications.  But you should be absolutely sure you have the fight to prepay the present mortgage.  Also remember than money conditions in the future may not make refinancing as profitable as it now appears.
  3. What to Look Out For:  Assuming the property you have in mind has the necessary profit potential, you must then ascertain the possible risks and verify the historical data that have been presented to you.  In this connection, the following points should be kept in mind:
    1. Length of present tenancies – You will have considerable difficulty in syndicating an office building in which many leases are expiring in the first few years, even though there is every indication that the tenants will renew.  If you are offered such a building, it may be worthwhile for you to buy it personally and hold it for a year of so, until renewals are made.  Before you sign the contract of sale, it is important to check every existing lease to determine that the present tenants are bona fide, to see if any leases have short-term cancellation clauses, and to verify the schedule of renewals.
    2. Length of leasehold – If the proposed syndication is of a leasehold, the term remaining must be sufficiently long to make it salable.  On occasions, a shorter leasehold of, say 35 years is offered, but this will normally interest only the professional investor.
    3. Trend of neighborhood – This is one of the most important factors affecting future projections.  A building with very fine “historical operating costs” can turn out to be a failure due to a shift of the business section or of the particular industry or trade to which the building caters.  And in a smaller community, a shift of only a few blocks can be a disaster.
    4. Taxes  For both of these, it is not sufficient to rely on the historical data alone.  The local tax assessor, reading the purchase price in the newspaper, may check his records and decide his appraisal value is much too low.  This is a particular danger when you purchase from the builder since the original assessment, based on cost, may never have been changed.
    5. Repairs – An understated amount for repairs may indicate a skimping on necessary maintenance, which will mean extra expense in the near future.  An unusually large amount for repairs in the past may indicate that the seller found it necessary to do considerable work in order to make the property salable.  Or it may merely mean that amounts which should have been capitalized were deducted as repairs for tax purposes.
 If you are in the market to purchase an office building or other income producing property do not hesitate to call me.  We provide acquisition, disposition and property management services.  Sims Commercial Real Estate  815-791-7467

Friday, January 27, 2012

What Is A Good Real Estate Investment?

A “good real estate investment” can mean different things to different people. For this article, the definition of a good real estate investment is:

“A real estate ownership interest, whether a personal residence or rental property, that increases one’s net wealth by a fair rate of return on their invested cash equity; for the corresponding amount of risk they are taking by owning a relatively high risk asset.”
What that means is that if you are going to put your invested cash equity into real estate, your net worth should improve by a greater amount than if you invested in a similarly risky asset. And “invested cash equity” isn’t the property price; it is how much cash you took from your bank account to acquire the property, which includes your down payment, plus closing costs, plus rehab costs.
Realize a lot of things can go wrong with real estate ownership, so you had better get a fairly high return on your invested cash equity for it to be a “good deal”. So you ask, how would one figure that out?
For investment properties
Your returns are part cash flows and part appreciation in value. For example, if your property rental income minus expenses produced $250 per month positive ($3,000 per year); and your invested cash equity was $50,000, that’s a cash on cash return of 6.00% ($3,000/$50,000). And that is a pretty darn good deal in real estate.
To add to that, let’s say you project net appreciation in value contributing an extra 1.0% or 2.0% return per year (after subtracting your projected estimated costs of capital repairs and improvements). Summing the cash flows and net appreciation could equal about a 8% to 10%+ projected return per year on a long term basis; and if you achieve those numbers….. that is a good real estate investment!
Some investment properties don’t cut it! Most fancy condos or beach houses, where the net rental income is very low compared to the purchase price, usually have projected negative cash on cash returns. So if you buy a fancy property with negative (4.0%) cash on cash returns, even if it appreciates 2.0% per year, you are typically at a 0.0%, or worse, return on your equity cash investment. And that isn’t a deal most experienced investors would take.
For personal residences
You will also be putting down a large amount of cash equity and the calculations are really a little more complicated and difficult because you need to look at how much you are paying in housing expense versus how much that amount would be if you were just renting someone else’s property. So the overall question again is, “Is your wealth going to improve by owning the property?”
Some general guidance herein. As a general rule, if you are not planning to own it for at least five years you will most likely not be adding to your wealth. Any appreciation in value will not compensate for the 8.0% to 10.0% transaction costs on the buying and selling of your property. And even worse, the monthly ownership expense is usually higher than if you just rented a similar property. Therefore, if you don’t plan to own the property a long time, and the longer the better, you will probably do better renting and leaving the hassles and costs of ownership to a landlord.
So a good real estate investment is really one that will increase your net worth over time. The longer you own it, the better the chances for that appreciation in value and wealth building.
As proof positive on this, find someone who has owned real estate for 20, 30, 40 years and ask them what is a good real estate investment? It is generally easy to find them, they are retired, living comfortably, and usually happy to tell you about the properties they bought decades ago.

Wednesday, January 11, 2012

The Credibility of "I told you so"...

HEADLINE:  Road to Recovery: List of Improving Housing Markets Nearly Doubles in January | RISMedia  

     Being a 20+ year real estate veteran, I have seen my share of market swings.  This most recent downturn which started some time in 2007, seems to have finally bottomed out in 2010 and we are now in to a recovery period.  Having been very active in the last 6 months, my feeling about how the market is moving is more than just a hunch, it is an educated guess fortified with street level activity and hard cash being paid at closing tables.
     During the last 6 months we have seen properties at rock bottom prices.  Not just the newsworthy residential home sales, but also the turnaround of income producing properties.  A "market correction" may be a better term to describe what has just happened in the real estate industry.  Finally we are able to make sensible economic real estate investments.  In retrospect, we have seen inflated property prices, fueled by easy lending underwriting which further skewed the public's perception of what was a good real estate deal and what wasn't.  In the world of income producing properties, I threw in the towel many years ago when I would see people purchasing properties with, dare I say it, negative cash flow.  URGGHH, just the mere thought of it makes my blood curdle.  Vacancy, property taxes, unforeseen tragedy, and the like can never truly be avoided.  But purchasing a building from the onset with negative cash flow never did seem like a prudent investment to me.  Making a profit on all four phases of real estate has always been my goal:  acquisition, cash flow, appreciation/depreciation, and disposition.  The best real estate investments stand solid on all four of these proverbial legs.
    So are what shall we do now?  Good news and bad news.  Good news is that the are still many good acquisition deals to be had.  Properties have been adjusted in price to make economic sense again and give the investor opportunity to make a profit on all 4 phases of a real estate investment.  Bad news:  the "Happy Harry" investors who had dropped out of the market will now be looking for an opportunity to get "back in" the market and create competition for great acquisition deals.  The longer term negative effect is that the increased acquisition competition will again over inflate the expectations of sellers and prices will again climb back to levels of low cap rates and longer term investment holding periods.  
     How will we survive?  Well, when the stock is down BUY MORE!   Real Estate is still one of the best investments around.  This recent wave of foreclosures and loan defaults have humbled many banks and lending institutions to consider work out scenarios before foreclosing and taking title to a real estate asset.  BUY, BUY, BUY and make your decisions wisely (preferably with the help of a professional like myself), so that you can ride the wave of prosperity through this current up swing of the real property marketplace.  Financing is at a reasonable level and cash is king.  Lending institutions are opening their doors again if the numbers make sense.
     BUT MY HEAD STILL HURTS!  Many real estate investors are still feeling the pain of the market downturn and have been "beating their heads against the wall" to try and make the best of declining property values, higher than anticipated vacancies, ever rising property taxes and non-renewal of bank notes.  The obsession of the mind from dealing with this multitude of problems thrust upon them has triggered a proverbial tailspin which they are having trouble pulling out of. Mike Ditka had "mental toughness"  but he never had debt like this!  
     Alas, a light shines upon the horizon!  There are many solutions to the problems some investors are still dealing with.  Mostly it is about letting go.  While we cannot hold on to a dwindling stock, likewise we cannot "fall in love" with a property and hold onto it beyond its investment life cycle.  Like a merchant who must painstakingly throw out perfectly new and good merchandise because it is outdated, so too must the savvy real estate investor dispose of non-performing assets.  In doing so, he clears the runway to set off on a new wave of investment acquisitions by applying age old investment analysis.  The mere action of new blood is invigorating.
     Buy low, sell high is the American way, however in light of some investors holdings, it may be prudent to sell low, in order to ride a better wave of economic growth.