Real Estate Investing Fundamentals In Tough Economic Times
By: Scott A. Naugle
In these tough economic times it is back to fundamentals when contemplating real estate investing. Whether investing in commercial properties, defined as office, retail, hotel and industrial property, or in mult-family apartment properties, it is a different time than in the recent past. For the experienced investor, it’s time to get back to fundamental
principles and understand not only the property markets, but just as critical, understanding the capital markets in order to achieve some level of success. This is even more important for the beginning real estate investor. During the heydays of 2002 through 2006, capital was plentiful for all property types. Real estate was easily financed with friendly terms for most buyers. With money looking for opportunities, lenders opened the spigot and investors tapped into a variety of financing sources for an acquisition. The days of lenders’ lending based on a property’s future
potential income and appreciation are gone. As a result, most buyers who sold after the run-up in prices and healthy demand during this time period wound up paying a premium for their acquisition in anticipation of continued property values appreciating at a double digit pace. Their rationale: with a short-term disposition strategy and cheap and plentiful supply of debt, they could realize a very healthy return on investment based on a low equity (leveraged) position.
We are in a totally different environment today. Today it is more important than ever to get back to fundamentals. For investors contemplating an acquisition, there are several property level as well finance level considerations and calculations one needs to perform to assist in properly evaluating a purchase. Qualified and experienced professionals can be invaluable in this area to help insure success.
A necessary first step is to identify goals for each property as it relates to ownership, property operations and management, financing and an eventual exit strategy. The following summary outlines the major considerations that are important to a successful investing program,
whether at the beginner stage or at the level of the more seasoned real estate investor.
Property Type: Different property types require different property
management, marketing and operating considerations as well as have different income and expense profiles. Different property types will experience different vacancy rates, rental rates and expense ratios and these factors will be market driven. All these factors are important when evaluating a purchase. Lenders also rely on historic market metrics and property operating profiles when evaluating their underwriting criteria as a bases for how much they will loan, what level of a property’s net operating
income is required to meet the annual debt service on the loan, to many other property operating, market and management factors. Different property types have different operating and financing considerations that must be thoroughly investigated to achieve success.
Property Location: That old adage in real estate: Location, location,
location is even true in commercial real estate. More importantly, however, cash flow, cash flow, cash flow is more important as it relates to the right market location of the property. A comprehensive analysis of the location factors is crucial for a successful investment program. Due diligence is required and a first step is a geographic analysis that includes such items as the transportation systems, major employment centers, and demographic and economic data to a host of other information useful to assess the broader area where the property is located. A very useful tool to aid in this analysis is GIS, or Geographical Informational System. Once the larger market area is analyzed, a narrower focus on the property market location is necessary to flush-out any particular factor that can add value to the property such as a major employer locating to the market area or any factor subtracting value from the property such as a new zoning ordinance restricting uses and building heights. Once these analyses are done, it is also important to do your due diligence on the specific property under consideration. This ranges from the importance of conducting a structural inspection of the building to environmental/soil studies to all the related legal and physical lot, zoning and other local/state regulatory assessments, as well as the tenant mix to insure no potential problems exist. Legal and Tax Considerations: There are several different ownership
entities that can be used when investing in real estate with their own tax
and legal consequences. It is important to have a fundamental understanding of each ownership type and how each type affects your tax situation. An experienced team of legal and tax professionals are important to assist in navigating these issues. For example, setting up an LLC may not be the best entity for tax implications. LLC’s are a popular vehicle for real estate ownership due to liability reasons, but not necessarily for tax reasons. There are too many issues and potential risks to go it alone. Having a “Team” of professionals to handle all aspects of the proper legal entity and tax considerations is critical.
Financing: Today, more than ever, it is a tough market to access credit. Lenders are not in the lending mood. With the changes in the credit and lending environments it is extremely difficult today to obtain financing for any deal. Gone are the days when lenders would base their decisions on pro-forma estimates for cash flow and property appreciation. Understanding the current capital markets and its impact on the property market is even more important today than it ever has been. Leverage was the name of the game in the recent past. It’s still important, however, any acquisition will require a higher equity position than in the past, which will result in lower returns than with a higher leverage position going into the deal. Some of the questions then are: How will this affect expected returns on the investment? How will this impact money needed for property renovations and other capital reserves for expected or unexpected major repairs? Is the required use of more funds going-in to the deal (equity) and the resulting return on that money to make it profitable better-invested elsewhere? There are a host of other questions and calculations needed to fully assess the feasibility of financing the deal especially given the environment we are in today. For example, is there a strong leasing market today to support higher effective rental rates and rate increases in the future that will more than cover higher debt service requirements today from lenders?
Exit Strategy: How long do you expect to hold the property? What will be the market when its time to sell? What governmental regulations (e.g., zoning and land use) have changed since the acquisition? What will the credit/lending markets look like? What will the demographics and employment projections look like?
These questions require a crystal ball to answer. Of course, no one knows for sure. An exit strategy, preferably formulated before the acquisition, is as important as the decision to purchase. The exit strategy should be the basis for any decision to invest or not. A well thought-out investment program always starts with an exit plan. This is especially true in investment real estate. It is often said that you make your money when you make the purchase. It is also true that you will realize a profit or loss by your exit strategy, or lack of one.
Given today’s economic environment, i.e., recession, it is paramount that investors’ thoroughly investigate and understand the considerations above.
Whether you are an experienced investor with many properties or a beginner contemplating your first deal, understanding all these critical points as well as performing a detailed and comprehensive analysis (due diligence) based on today’s realities will better position you for success.