News and Information on Today's Real Estate Investment Market

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Soooooo...............

The Commercial Market is down in 2008.  What Should I Do?

Recently we attended the Distressed Real Estate Summit West and learned a lot about the current state of the market.  Here are some notes from the conference:

The bad news is that deal volume is way down this year because the credit markets make obtaining a loan challenging.   The deal flow fell of the edge of the table at the end of February according to the head of one of the nation's largest commercial brokerages.  The good news is that the commercial market isn't overbuilt and basic fundamentals of occupancy and leasing are holding up pretty good.

There is a tremendous amount of capital waiting on the sidelines looking for the right time to jump in and invest.  There is a lot of conjecture as to when you catch the falling knife (or do you simply pick it up off the floor).  Buyers and sellers have been experiencing a bid-ask spread where sellers have a higher opinion of value than the buyers.  

Regarding distressed assets being held by the banks this bid-ask spread has been moving down a scale as  buyers are willing to pay less and less for assets and banks are not willing to increase their "write-down" of these assets.  The consensus is that the regulators will force this bid-ask spread to close sometime in 2009.  As regulators take over banks such as Indy Mac these distressed assets will be priced appropriately. 

As a review of history - the RTC cycle was 7 years that lasted from 1986 to 1993.  1,043 institutions closed in these years but the "meat" of the bell curve included the closure of 800 institutions from 1988 to 1991.   The assets languished in S&L portfolios because the S&Ls were not willing to devalue the assets.  Eventually the regulators forced the devaluations and sale at fire sale prices.   It is important to note that it took two to three years for the regulators to get this process moving.

The single family market peaked in 1st quarter of 2006.  The fall in values of this market will range from 20% to 50% depending on the market.  South Florida and Las Vegas had a lot of speculative investing so they will fall much farther than most metro markets.  Most metro areas will hold up better than outlying areas because of the infill nature of the market (built our configuration), job creation and price of energy (commuting).   Look for a lot of pain in areas such as the Central Valley of California, Imperial Valley, Victorville/Hesperia and Bakersfield as it will take many years to absorb the excess inventory. 

Single family land is being devalued at a roughly two to one ratio over finished homes so the peak to trough values can fall from 60-80%.  Currently the land being considered for investment is infill metro, finished lots, entry level and near job creation.  The investors are placing all equity and no debt on these projects.  They may try to re-entitle the lots with greater density (change the use to build value).

There will be $700 billion of commercial debt that will roll over in the next two years.  The new reality of the capital markets will force a de-leveraging of this debt.  Where an asset (for example) might have obtained a loan with an 85% LTV and a 200 basis point spread over the 10 year treasury in 2007 that same asset will get a 75% LTV and a 400 basis point spread going forward.   As these loans re-set new equity capital will need to be added.

Some banks are selling performing loans to de-leverage their balance sheets.  These might be purchased at a 20-30% discount and yield a 12-13% IRR.   There is a significant amount of regulatory pressure on these banks.  These investments are very interesting right now while lenders are selling preforming assets.  Call us if you want to know more about these notes.

As the credit crisis continues you will have the opportunity of a lifetime.  Many fortunes were made in the RTC crisis of the early 90's.  We are reviewing opportunities and keeping our fingers on the pulse of this market.  Let us help you take advantage of this huge "fire sale" that is about to occur in excellent real estate assets. 

We are proud members of the Realtors Commercial Alliance.             

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What Asset Classes Will Perform Best in the Next Cycle?

Office, Industrial, Multi-Family and Retail make up the "Four Basic Food Groups" or real estate asset classes.  They don't always follow the same economic cycle plus some are more cyclical than others.  Also, you need to give consideration to important sub-groups such as hotel, self-storage, student housing, senior housing, healthcare and restaurants

If you are an investor that is primarily concerned with durability and consistancy of income you really need to consider the risk/reward profile of potential investments.  Although higher intial cash flow is seductive, make sure you have the right risk tolerance because as Dad told you, "You don't get something for nothing".  

Take a look at the following chart and you will see that the best returns and least cyclical asset class has been multi-family.  The most cyclical asset class has been hotel.  (By the way, see the below article/link on multi-family depreciation to see why apartments have an advantage over the other asset classes)   

We feel that on a risk adjusted basis multi-family and health care are the best bets at the beginning of 2008.  As the economy boomed from 2002 to 2006 office and retail did very well but wee see them at the top of their cycles at this point...................................  Click here for the full article.

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The Multi-Family Asset Class Offers Significantly Higher Depreciation than Office, Retail and Industrial

Multi-family has the potential to put more after tax money in your pocket.

Multi Family is depreciated over 27.5 years.  Office, Retail and Industrial is depreciated over 39 years.  Therefore Multi-family enjoys approximatley 44% more depreciation and tax shelter than office, retail and industrial (if land valuation and LTV are equal).  Take a look at this link for an example - Depreciation Comparison

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How Bad is it?  Which Way are Cap Rates Headed?  Where do I invest?  What are the "Big Boy" Institutional Investors Thinking?

You can read many different articles and get many different opinions on the direction of Cap Rates.  Everyone agrees that stong capital flows and lower interest rates have brought cap rates down over the last few years.  Is cap rate compression over?  What strategy is best going forward?  What's the best risk-adjusted asset class if we have weaker than expected economic growth?

Read this very interesting article:

How Bad Will the Downturn Be?  Written by Michael Humphrey Managing Principal of Courtland Partners Ltd.

The Institute for Fiduciary Education is a good source of information that is targeted to institutional investors such as pension funds.  Take a look at their Web Site, it's free for you to learn by reading a lot of the same articles and research as the big boys.  www.ifecorp.com

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4 Great Reasons to Invest in Real Estate,

(With a special focus on Depreciation)

1. Cash flow:

This is the cash left after all expenses have been covered: mortgage, vacancy factor, repairs, property management etc.   Most banks will not lend money to buy a property if there is no hope of a cash flow.

2. Appreciation: 

 Appreciation in investment properties is generally dictated by cyclical cap rate fluctuations and increases in rental income.   A lease that has CPI increases built in will help ensure some appreciation.  Shorter leases that can adjust to market rates upon renewal entail more vacancy and market risk but allow for greater appreciation if the market environment is steadily increasing (of course risk also exists that the market will not increase).  

Extra appreciation potential exists, of course, for properties with some type of value added aspect such as excess land for development or re-hab opportunities.

3. Equity build-up:

You reduce your mortgage and increase your equity with every mortgage payment made on underlying debt. A portion of your payment goes toward reducing the principal. The shorter the loan period, the faster the equity builds.

4. Tax savings/Depreciation:

Depreciation is a ''paper loss'' required for estimated wear, tear and obsolescence. However, land value is not depreciable.

Residential income property is depreciated over 27.5 years on a straight-line basis. Commercial property is depreciated over 39 years. Personal property used in operating the property, such as appliances, is depreciated over shorter periods, typically five to 10 years. Even automobiles and trucks used in the investment operation can be depreciated over their useful lives.

Because depreciation is a non-cash deduction, it reduces taxable income from the investment property. But it doesn't require any cash outlay; as do property taxes, mortgage interest, utilities, insurance and repairs. The depreciation expense deduction often turns a positive cash flow property into a tax loss.

Most investment properties appreciate in market value each year, but on paper their value is declining annually. The bookkeeping result is that the book value declines while the market value usually goes up.

The 1997 Taxpayer Relief Act reduced the federal capital gains tax rate to 20 percent. Then the maximum capital gains tax rate was further reduced to 15 percent in 2003 for assets owned more than 12 months. But the special 25 percent depreciation ''recapture'' tax rate remains unchanged. ''Recapture'' means the property is taxed when it is sold.

For example, suppose you bought a small investment property for $300,000 and deducted $100,000 of depreciation during your ownership years. That means your book value (also called ''adjusted cost basis'') declined to $200,000. Then you sold for $450,000. Your capital gain is therefore $250,000 ($450,000 minus $200,000). Of that $250,000 capital gain, the $100,000 depreciation deducted will be ''recaptured'' and taxed at the 25 percent special federal tax rate. The $150,000 remainder of your capital gain will be taxed at the new 15 percent maximum tax rate.

However, a superb way to avoid paying the federal recapture tax is to make a tax-deferred exchange for another investment property, as allowed by Internal Revenue Code 1031.

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