Market Trends and Volatility on Real Estate Values

Assessing market cycles and risk is a necessary component of any investment strategy. Whether in a positive or negative cycle, there are opportunities in real estate beyond the “buy low; sell high” saying, depending upon long-term goals. However, it is much easier to assess previous trends. It is difficult to predict the future; otherwise, everyone would have predicted the market crash of 2008. To measure performance, we should look at how real estate compares to historical and emerging data, as well as other securities to mitigate risk.

Historical Data

Historical data includes sales information, vacancy rates, and interest rates. Sales data is widely used by the appraisal methods as it gives an indication of where property values have been. The downside is that sales comparables are often lagging and may not keep up with immediate corrections in the marketplace. Vacancy rates can tell us whether there is an surplus of spaces.

A great example is provided by Harvard Market Cycle Quadrants using vacancy and construction to show phases of the market cycle. If an increase in vacancy in a specific market is starting to occur, we may consider this phase to be an indication of an impending downward trend. Often new construction falls behind market phases. Once the market is in an expansion phase, companies look to new construction to capitalize on investment momentum. However, construction often takes time including design, permits and production. By the time the new product hits the market, there could already be a change in the cycle or even cause a change by increasing available units.

 

Another trend to look at is interest rates. When the Federal Open Market Committee raises rates, it affects the housing economy as well as investment properties. Generally as interest rates rise, a negative impact on residential properties will occur. Monthly payments increase and thereby affect affordability. As expected appreciation decreases, the desire to own may also decrease. And of course, interest rates affect investment yields. As the cost of borrowing increases, expected rates of returns must also increase. Recently, we have seen interest rates already increase with anticipated additional rate hikes throughout the year.

Securities

The risk of investing in real estate also must also be compared with returns on other security investments such as bonds, stocks, and treasury bills. Recently, the rates on treasury bills have increased, making those more appealing to more risk adverse investors. T-bill rates impact real estate income yields as investors then expect higher returns when compared to the benchmark of a riskless investment.

REITs are an alternative source of offsetting risk by investing in portfolio holdings and different asset types. Many of our clients are REITs and have positioned their success on the ability to purchase our value-add retail listings thereby increasing yield.

What is the future real estate outlook?

Using some of these indicators we make more informed predictions about the future of expected returns. While purchasing real estate always entails some risk, it also comes with reward. From at least 1985-2009, real estate investments exceeded the rate of inflation and produced investment returns. Increasing returns is also a hedge against concerns about inflation. While uncertainty in the market can be a factor affecting values, knowing how to analyze the trends can help offset volatility.

Our team is uniquely qualified to walk investors through multiple retail assets from single tenant, multi-tenant, to grocery anchored power centers and properly position dispositions ahead of the market curve.

The Real Estate “Occupy Movement” : The Last 10%

The Occupy Movement

The Occupy Movement started in 2011 when an activist blogger in New York started a Tumblr post entitled “We Are The 99 Percent” with a focus on income inequality, among other things, and spawned the Occupy Wall Street and other Occupy events at that time. The blog was inspired in part by economist Joseph Stiglitz’s May 2011 Vanity Fair article “Of the 1%, by the 1%, for the 1%” where he observed that 1% of the US population take home nearly 25% of the nation’s income, and control 40% of the nation’s wealth.

Occupying the Last 10% in Retail Shopping Centers

This blog post is about another Occupy Movement that preoccupies every owner in our industry, and that is the push to get all of the GLA occupied in our centers. Occupancy equals cash flow and value, the end game of the ownership of real estate.

When I worked as a portfolio manager for a shopping center REIT, our COO had a saying that has stuck with me to this day, “Every dollar a day sooner.” He said that to keep everyone’s focus on getting our vacant spaces leased as soon as possible – to limit downtime, and to push for maximum lease dollars. This is the job of every owner.

The Cash Flow Impact

Every square foot of retail space is worth anywhere from $0.50 and $4.00 per square foot per month, depending on the market, and location of the space within the center. So, a 1,000 SF space is worth anywhere between $500 and $4,000 each month. And NOT leasing that space “costs” its owner $500 to $4,000 per month. Adding in NNN charges (typical for most leases), the opportunity cost moves to $950 to $7,300 per month, equating to anywhere from $11,400 and $87,600 per year.

I don’t know many people who would not want the opportunity to have additional cash flow like this!

There are mitigating circumstances that may make it difficult to get every square foot leased, but the goal of every owner is to lease up vacant space.

For instance, an owner with 5,000 SF of vacancy in his or her portfolio, with rents of $15 PSF annually, and NNN costs of $3 PSF, leasing the vacancy brings in $90,000 extra income. For 20,000 SF of vacancy, and rents of $20 PSF (and NNN costs of $3 PSF as an example), that adds up to $460,000.

The Value Impact

This additional income has a far greater effect on value.

Using a 6% cap rate as the “market” for valuation of a center, the impact of leasing space is as follows (market rents across the top row, GLA leased along the left column):

SF/Mkt Rent $5 $10 $15 $20
5,000 $670,000 $1,080,000 $1,500,000 $1,920,000
10,000 $1,330,000 $2,170,000 $3,000,000 $3,830,000
15,000 $2,000,000 $3,250,000 $4,500,000 $5,750,000
20,000 $2,670,000 $4,330,000 $6,000,000 $7,670,000

As one can see, that additional cash flow has a huge impact beyond the immediate cash flow benefit. This impact is not only affects a sale, but also affects financing proceeds, and in most cases, financing terms. Lingering vacancies can be perceived as market weakness, or a functional problem with a certain space, however it may be perceived as sponsor (borrower) weakness and affect loan terms. Not always the case, but one wants one’s best foot forward at all times.

While some underwriters may still apply a market vacancy factor to a center, beginning at the highest possible number is always the best place to start.

A Solution For The Last 10%

Sometimes it is difficult to get leasing agents to focus on these last spaces in a center. We propose that owners consider contracting a company on a fee basis in order to “stand watch” on these last spaces. This contract amount benefits in several ways:

  1. The amount does not need to be onerously large
  2. The fee could be included in a monthly management fee, to be included in NNN charges
  3. The incentive on the remaining space will be focused on fulfilling the contract obligation and less focused on the leasing fee, which in most cases is small
  4. The leasing firm would welcome the recurring revenue which benefits their EBITDA and value
  5. Having a leasing person paying regular attention to the center may lead to other larger opportunities and will increase ownership’s exposure to market trends

Reach out to our team to discuss your portfolio, including and any lingering vacancy issues so that we can proactively come up with a plan to add cash flow and improve the value to your portfolio.

Top Five Considerations to Make When Purchasing Corporations that Hold Real Estate​

Our team has recently been assigned the task of selling 100% of the shares of an S corporation which holds real estate assets. This opportunity brought up a challenge in assessing the benefits and risks of holding real estate in a corporation as opposed to an LLC or a sole proprietorship, and the tax implications for this transaction.

The motivation for the seller of this corporation is that they inherited their real estate portfolio in a C-corp, and after assessing that situation, elected to convert the C- Corp to an S- Corp. They then faced the issue of selling the assets individually or in bulk, and based on the advice of their legal and tax counselors, elected to opt to sell the S Corp outright.

Advantages and Disadvantages of C-Corporations

Holding real estate in a corporation has various advantages. A C-Corp is a taxable entity, where the corporation itself is taxed on its income (as opposed to other structures which simply pass income along which is subsequently taxed). For those that do not necessarily need to pull all of the net income out of their corporation, the C-Corp provides for keeping cash in the entity. It also provides the benefit of income splitting, where the business’s income is split so that part of it is taxable to the corporation and part of it is taxable to the owners of the corporation. However, C Corp taxation is such that distributions are subject to double taxation, where the corporation is taxed on its income, and the shareholders are taxed on the dividends received.

The Tax Cut And Jobs Act has invoked recent changes to the US tax code, and has reduced the corporate tax rate from 35% to 21% thereby reducing the deductibility of state and local income tax payments in determining federal income. Now that this code has passed into law, the advantages for some Real Estate Investment Trusts (REITs) to convert to C-Corps is starting to have “legs.” Most times, this involves a simple measure of becoming a Real Estate Operating Corporation, or REOC. What this means is that REITs, which ordinarily must distribute 90% of their net income as dividends, may find it advantageous to de-REIT and become a C-Corp. REITs that would benefit from this change would be those that have assets that have lease up/rollover risk, require capital expenditures, and/or need to be redeveloped.

The REIT structure in this instance puts the company at the mercy of the market, and requires the sale of assets to to raise capital. REOCs benefit from this structure as they can self-finance their expansion, and can retain capital and reinvest it in a more tax-efficient way, and in a manner that is consistent with the nature of real estate.

REITs that do not need this structure are those that own triple-net assets, self-storage and, in some cases, health care properties. REITs that would benefit from C-Corp conversion would be those that own malls, large shopping centers with redevelopment needs, and office properties.

S-Corporations Versus LLC Ownership

The S-Corp holding manner has some tax savings as profits from the S-Corp are not subject to self-employment tax. However, the S-Corp still must pay any owner-employee a reasonable salary which is subject to Social Security and Medicare taxes. S-Corps are significantly more complicated than LLCs and require more professional input, meaning billable hours for accountants and attorneys.

Ownership as an LLC has no tax advantages or disadvantages. In California, LLCs are subject to franchise taxes in addition to typical income taxes. LLCs, particularly single-purpose LLCs, are also the preferred method of ownership for lenders, and in some cases absolutely required.

Purchasing a Corporation

In purchasing a corporation for the purpose of controlling the underlying real estate assets, one must understand that this transaction differs significantly from a straight real estate transaction in many ways; namely, taxes, financing, and ultimately, value.

  1.  The purchase of the corporation does not qualify for a tax deferred exchange. Trade dollars can be used, but the purchase would not qualify for a 1031 tax deferred exchange. This does not affect value directly, but limits the utility of the transaction for the buyer.
  2.  The sale is, in effect, a change of control, which may trigger issues with loan covenants (if there is debt on the portfolio) and in California, reassessment of real estate property taxes.
  3. The purchase of the corporation can be financed as a corporation purchase which may or may not have the same metrics as financing for straight real estate purchases. Overall loan dollars will be affected by the valuation of the corporation itself, which may or may not follow the underlying real estate assets. Some lenders may only offer credit lines for these transactions, and some lenders limit the loan dollars to a lower loan-to-value ration on the purchase. However, some lenders offer more dollars on a refinance, so structuring a transaction with bridge financing to be taken out as a refinance later may be beneficial in this instance.
  4. The basis by which capital gains are computed does not change in the sale of the holding corporation. This means that there is no “step up” in basis, and the original basis follows. Also, depreciation is inherited as well, and does not re-set. This must be properly reviewed by one’s tax and legal professionals.
  5. The acquisition of the corporation will put you in the place of the former principals, including responsibility for liabilities. One must fully explore the potential liabilities that might be inherited. If the corporation has been carrying “per occurrence” insurance, that insurance is supposed to cover claims made in the future for anything alleged from the past. This should be carefully reviewed with the insurance carrier during due diligence, as well as legal counsel. Also, full due diligence on all prior activities should be done, and as an additional measure of safety, an umbrella liability policy might be in order. This is the stuff that makes careers for insurance and legal professionals, and definitely consult both to fully understand the issues.

Purchasing a corporation has benefits and risks. Carefully explore both before launching into the venture. Please also feel free to reach out to a team member to discuss further.

Assessing the Risk of Commercial Cannabis and Real Estate

2018 brought about the legalization of recreational cannabis to California, providing a wealth of opportunities. Many of these opportunities, however, translate to risk. This new industry, in its wild west phase, has created a wave of disruption and is even effecting today’s commercial real estate landscape. Join us as we discuss title, debt, appraisals,leasing and how the cannabis industry could potentially influence a purchase or sale transaction.

There will undoubtedly be a real estate boom fueled by the cannabis industry, and transaction services will either be built around the industry, or existing companies will need to find a way to meet the demand. Properties have already hit the CA market and there are very limited services available for those trying to find their own point of entry into the cannabis industry.

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Don’t Be a Lone Wolf: How leveraging Your Team’s Strengths Can Increase Your Deal Flow.

Growing your commercial real estate business can seem overwhelming within the dynamic and entrepreneurial environment. Many young brokers come into the business with the dream of making their dent, often never realizing that the cornerstone to progress is surrounding yourself with the proper support and team.

I learned that in order to multiply my results as an individual broker, I had to team up with people that complemented my skill set. I researched various resources and found the most success with the Strategic Coaching program, Kolbe Index, and Market Force.

This trifecta not only exposed my strengths, but also my weaknesses. It showed me where I needed the most help and helped me find people that would be able to fill those weaknesses with their individual strengths.

In this article, I will walk you through how I surround myself with complementary team members and the results of a strength-focused team. I will expand on how the aforementioned trifecta helped me identify potential team members, how I help my team, and how working with a team is the only way to truly progress in commercial brokerage.

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Bringing Technology To Market

Baking a pie takes precision and strategy, a careful measure of all the ingredients creating the perfect formula. The pie crust needs to be the right consistency and bake to support the filling. Timing becomes the catalyst to perfection. Thankfully, today’s modern technology has supplied digital scales, timers, and thermometers that have taken away most of the guess work, providing many with the tools needed to achieve culinary success.

Marketing for commercial real estate has also experienced similar advances in technology that measure campaign metrics and provide the data to help perfect one’s marketing methodology.

Our team has learned to lean on much of this technology to build our marketing process and ensure both precision and efficiency.

Digitize all Materials

Most of our materials are now digital.  Although we do make printed collateral for our team marketing, we always accompany each piece with a digital version.

Digital Materials not only help track open rates and additional metrics, it also allows for incorporating interactive elements that are not traditionally utilized in the industry. As a marketer for Lagos Shopping Center Advisers, I push our team to breathe new technological innovations into our campaigns. No longer are the days of printed collateral, mailers, and faxing. Everything needs to be instant and easy to access.

Our team utilizes a few platforms to ensure investors can access the property marketing materials immediately – our go-to being Real Capital Markets (RCM). Their user friendly interface not only allows for immediate access, its aesthetics are sharp and the platform is easy to use. RCM also provides our team with real time alerts letting us know when someone has accessed the marketing materials.

Drone Videos have also been a great way to bridge the gap between antiquated marketing campaigns and innovation. Our team creates a video for every property we market and we make sure to utilize the newest trends in video editing and animation.

Tracking Metrics

Tracking the effectiveness of marketing campaigns is one of the most distinct benefits of leveraging technology for commercial real estate marketing campaigns. Metrics are essential to any marketing campaign because they show whether your marketing efforts resonate with your target audiences.​ This not only helps us make adjustments to current campaigns, it also helps us streamline future campaigns.

With every new campaign innovation there is a huge curve for learning. A wonderful example of this was our team figuring out the appropriate length for a property video. Metrics helped us find that most videos should be no longer than one minute and ten seconds. We learned an important behavioral pattern, specifically how much time our audience wants to spend watching a property video.

Not only are metrics important to us, they are important to our clients. And, technology allows us to accurately provide that information. Our clients want to know that we are correctly positioning their properties by showing them how many people watched the property video, how many people opened up an email from our marketing campaign, as well as how many people downloaded marketing materials throughout the campaign. These metrics provide valuable benchmarks and also help us re-assess a marketing campaign if the numbers just aren’t reaching our expectations.

Timing Is Everything

Timing really is everything with commercial real estate marketing campaigns and technology is a wonderful tool in helping our team find a campaign’s rhythm.

Because most of the platforms we use give us detailed metrics, we are able to see what time of the day works best for sending email campaigns, and even if a campaign is losing steam.

Technology goes hand in hand with all of our marketing campaigns and we are always looking for new ways to provide our clients with the highest quality possible and the most effective marketing campaigns.

ARGUS Enterprise: Warp Speed Ahead

While change can sometimes be worrisome, ultimately, newer software models have proven to be helpful. For instance, can you imagine being stuck using Windows 2000 in today’s world and having data storage in MB rather than in GB or TB (as is the case of my external hard-drive)? Or imagine hiring a programmer who only knew C++.

The latest software upgrade to the ARGUS platform is entering into the repertoire of commercial real estate professionals, known as Enterprise. While many companies have been hesitant to switch over right away in favor of keeping the older DCF model, the latest announcement from ARGUS includes ending its support of DCF licenses on June 30, 2017. Also, since I began teaching the program at UCLA Extension in 2015, many universities including UCLA Extension have no longer provided instruction in DCF. Although ARGUS has stated it is “committed to working with [customers] to ensure a smooth transition” many professionals have been concerned about how this shift will impact the commercial real estate arena.

In order to help better prepare you for ARGUS Enterprise, here are a few key changes:.

User Interface

The first notable change is the user interface within Enterprise. The look and feel of Enterprise are meant to be intuitive for Microsoft Office users, with some semblance to Excel. Many of the entries, like in the Rent Roll tab, populate various rows, tabs, and drop-down options. You are also able to scroll and create multiple row entries. The language and terminology between DCF and Enterprise in many situations remain relatively unchanged; however, the method of entry provides more options, easier flow, especially for more complex modeling situations.

Reporting Options

In the DCF model a user can export the entire file into an excel document. With Enterprise, this feature has been modified. There are now many reporting options in Enterprise – more than even one user may even need, so the ability to export everything into Excel is a bit more difficult. Valuation Reports alone has eight options, and Tenant Reports has nine. Instead, you can export an individual report to an Excel or PDF file. Some users have the option of creating “Report Packages,” depending upon the license, which combines several different options together into a customized Excel or PDF file.

Complex Recovery Structures

While creating complex recovery structures isn’t new, Enterprise has made it a bit easier to see what exact expenses have been included into the expense pools, as well as if there are any detailed items such as administrative fees, or capped costs individually by the tenant.

IRR Matrix

One of my favorite updates to Enterprise is with the IRR Matrix table, found under Valuation Reports. After basic inputs are made, such as purchase price and entry and terminal cap rates, a user can easily see the IRR table for the analysis period and also make immediate adjustments if necessary.

File Exporting

Enterprise allows the ability to export the property file to a DCF file format, which is “.sf,” so even though you may be working off Enterprise, a group still using DCF can review your file. Keep in mind, however, that due to it being simply a different program, there may be variations in the cash flow and valuation results. A warning message will typically pop-up requiring the user to agree to this.

Automatic Saving

Unlike DCF, Enterprise doesn’t automatically save every change you make, which can be both a positive and a negative. One of the biggest complaints of the DCF format was trying to model different scenarios: you would have to save the original file separately. In Enterprise, you can make changes to the scenarios (such as changing the entry CAP Rate or Analysis Period) to see how this would affect the model, without having to keep the change if you didn’t want it hard-coded. This is a great way to see the updates in a live setting.

While migrating or changing to a new platform is never without trials or errors, many groups have already been making the switch or are at least easing into the new model. And, Enterprise has already made a variety of software updates. When I first started teaching at UCLA Extension, we used 10.0. The latest model version 11.6 was released in April 2017.

Of course, at Shopping Center Advisers we are here to help with your commercial real estate modeling needs and are equipped to handle any complex scenario using the latest and greatest technology.

Contact us here: http://shoppingcenteradvisers.com/contact/

Shopping Center Advisers | The Lagos Team | Top 5 Underwriting Mistakes in Commercial Property Transactions

Top 5 Underwriting Mistakes in Commercial Property Transactions

Shopping Center Advisers | The Lagos Team | Top 5 Underwriting Mistakes in Commercial Property Transactions

We’ve all been there, staring at an offering memorandum or Excel Spreadsheet wondering why the numbers aren’t matching exactly. Or somehow a tenant’s actual base rent doesn’t quite match the Rent Roll. Many underwriting mistakes happen not intentionally, but rather through a variety of distribution channels. Understanding the economics of the real estate transaction is an essential part of the deal for all parties involved including, buyers, sellers, and agents and brokers. And when there are mistakes in the underwriting, it can affect pricing as well as the smoothness of the transaction. Even with a well-trained eye, mistakes do happen.
There are five common mistakes than can be alleviated to help your next transaction process with ease.

1. Valuation Timing Doesn’t Match Current Rents

As tenancies often have rental escalators the current rent maybe slightly higher or different than when the property was first placed on the market, or when the Rent Roll was prepared. Shopping Center Advisers (SCA) tip: ask for a current and updated Rent Roll to verify rents.

2. Property Taxes Aren’t Updated

There are many states that reassess the property taxes upon the sale of the property (such as California). However, the operating expenses can sometimes reflect the ownership’s current property tax amount, which can be lower especially if the property has not traded for many years. SCA tip: recalculate the property taxes as needed and verify the percentage rate.

3. Not Getting Leasing Updates

There are often moving parts with tenant leases, for instance, a tenant may be in the process of exercising an option (extending). Or, a vacant space may have an offer to lease. These timely updates can significantly impact the valuation of the property. SCA tip: inquire about any and all leasing updates.

4. Assuming ARGUS is Flawless

We would all like to think that technology is perfect; however, like most programs, the information exported is only as good as the information inputted. ARGUS is an intricate platform and one minor change can trigger a wrong calculation. For instance, having the rent show as $/Month (amount per month) instead of $/SF/Month (amount per square foot per month). SCA tip: check the ARGUS run against the Rent Roll.

5. Not Reviewing Specific Lease Clauses

One paragraph can change the entire economics of the deal. For instance, if a Big Box retailer has the right to terminate the lease early or is not responsible for paying their portion of the property taxes. SCA tip: ensure that the entire lease and any subsequent amendments are read in its entirety.

Paying close attention to these five underwriting mistakes will help you analyze the deal while minimizing some risk. With especially large transactions, it is helpful to have many eyes looking at the deal and determining appropriate procedures. As such, besides having an in-place analyst and acquisitions team, ask your real estate professional as well as third party vendors for a review. The more thorough the underwriting review process, the less likely to have avoidable errors.