Commercial Real Estate Appraiser - Appraisal Blog

All-

BUSH ADMINISTRATION TO HELP NEARLY ONE-QUARTER OF A MILLION HOMEOWNERS REFINANCE, KEEP THEIR HOMES
FHA to implement new “FHASecure” refinancing product

President George W. Bush today (08/31/07) announced that HUD's Federal Housing Administration (FHA) will help an estimated 240,000 families avoid foreclosure by enhancing its refinancing program effective immediately. Under the new FHASecure plan, FHA will allow families with strong credit histories who had been making timely mortgage payments before their loans reset-but are now in default-to qualify for refinancing…

To read the entire press release, please visit: http://www.hud.gov/news/release.cfm?content=pr07-123.cfm

LENDERS PLEASE NOTE: FHA WILL PUBLISH A NEW MORTGAGEE LETTER WITH GUIDANCE ON THE NEW FHASecure PROGRAM ON OR ABOUT TUESDAY SEPTEMBER 4^th, 2007 at: http://www.hud.gov/offices/hsg/mltrmenu.cfm

AND

FHASecure Initiative information for HUD Housing Counseling Agencies:

The Federal Housing Administration (FHA) is pleased to announce a new initiative that will enable homeowners to refinance various types of adjustable rate mortgages (ARMs) that have recently “reset.” 

Under FHASecure, borrowers that are delinquent on their mortgages as a result of interest rate resets will now be able to refinance using an FHA-insured mortgage.  In many cases homeowners may be permitted to include mortgage payment arrearages into the new loan amount, subject to existing geographical mortgage limits and the loan-to-value limit shown below. Before today, only borrowers who were current on their existing loan were allowed to re-finance into an FHA-insured mortgage. 

Highlights of the FHASecure Initiative:

1. The mortgage being refinanced must be a non-FHA ARM that has reset.

2. The mortgagor’s payment history on the non-FHA ARM must show that, prior to the reset of the mortgage, the mortgagor was current in making the monthly mortgage payments.

3. If there is sufficient equity in the home, under additional eligibility instructions provided below, FHA will insure mortgages that include missed mortgage payments.

4. Under certain conditions explained below, FHA will insure first mortgages where (1) the existing note holder writes off the amount of indebtedness that cannot be refinanced into the FHA insured mortgage; or (2), the FHA-approved lender making the new mortgage or the existing note holder may take back a second lien that includes closing costs, arrearages or previous secondary financing. 

5. Lenders must determine, as part of the underwriting process, that the reset of the non-FHA ARM monthly payments caused the mortgagor’s inability to make the monthly payments and that the mortgagor has sufficient income and resources to make the monthly payments under the new FHA-insured refinancing mortgage.

Additional Information about the FHASecure Initiative:

What May be Included in the FHASecure Mortgage Amount: FHA will permit the inclusion of the existing first lien, any purchase money second mortgage, closing costs, prepaid expenses, discount points, prepayment penalties, and late charges.  FHA will also permit arrearages (principal, interest, taxes and insurance) to be added into the new loan amount.

Subordinate Financing under the FHASecure Initiative: If the new maximum FHA loan is not enough to pay off the existing first lien, closing costs and arrearages, the lender may execute a second lien at closing to pay the difference. The combined amount of the FHASecure first mortgage and any subordinate lien may exceed the applicable FHA loan-to-value ratio and geographical maximum mortgage amount. If payments on the second are required, they must be included in qualifying the borrower. If payments are deferred, they must be so for no less than 36 months to not be considered in the qualifying ratios.

Educate Borrowers Regarding FHASecure: The FHASecure initiative will take effect almost immediately through administrative action.  Counselors should understand this new opportunity and knowledgeably present it as a viable alternative for delinquent borrowers struggling to pay higher interest rates.  HUD will soon publish a Mortgagee Letter providing additional and more detailed information regarding the new initiative.

AND

Implementation of Pay.gov for Upfront MIP Payments

Beginning September 4, 2007, FHA-approved lending institutions may begin submitting upfront mortgage insurance premium (MIP) payments using https://www.pay.gov   Payments may be submitted directly to HUD online via the FHA Connection or through CPU to CPU batch file transmissions.  Between September 4 and September 28, 2007, lenders may submit upfront MIP payments using either the new Pay.gov process or the current Mellon Bank or PNC Bank process.  September 28, 2007 is the last business day that HUD will accept payments made through Mellon Bank or PNC Bank. See Mortgagee Letter 2007-10.

For more information on submitting payments using Pay.gov, see Pay.gov Implementation Information, located on HUD’s Homes & Communities website at: http://www.hud.gov/offices/hsg/comp/premiums/sfpaygov.cfm  

HUD is also providing a training demonstration on submitting and tracking payments via the FHA Connection that consists of short targeted topics that can be selectively viewed and revisited as often as needed. The “Training Demonstration of the Upfront Mortgage Insurance Premium (MIP) Payment Process on the FHA Connection” is accessible on HUD’s Homes & Communities website at:

http://www.hud.gov/offices/hsg/comp/premiums/sfudemo.cfm

Posted by Cochise at 03:25 PM | Permalink | Comments (3)

One of the most useful economic decision-making tools for commercial real estate users and investors is discounted cash flow analysis. The first step in the DCF process is to reduce each alternative being analyzed to the amounts and timing of all the cash flows. Once each of the alternatives has been reduced, the net present value can be calculated. The analysis can be done on a before- or after-tax basis. This article focuses only on the applications of the NPV function, which is a key consideration for determining users’ occupancy costs.

The NPV function has many applications for user and investor decision making. The NPV function simply discounts all cash flows to present values using an appropriate discount rate and totals all of the present values to a single sum. The single sum resulting from performing the NPV function has different meanings and interpretations depending on the application and the decision being made.

The following examples demonstrate the NPV function calculation and how it is used for various real estate decisions. The four user application examples and the two investor application examples that follow are by no means inclusive of all real estate applications of the NPV function for economic decision making. In addition, the use of the NPV function for economic decision making is not limited to real estate — many businesses also use the NPV function to analyze the profitability of potential capital expenditures.

1. Comparative Lease Analysis
The NPV function may be used to compare lease alternatives with the same projected occupancy period using the appropriate discount rate to determine which alternative is the most economically favorable. The largest NPV, which indicates the lowest occupancy cost for the projected occupancy period, is the best economic decision. In most cases, the NPV calculation for each lease alternative results in a negative number, indicating a liability (cost of occupancy). In this case, the largest NPV is the smallest negative number, which indicates the lowest cost of occupancy for the projected occupancy period and the best economic decision. (See Table 1, Comparative Lease Analysis: User Cost of Occupancy.)

2. Lease vs. Purchase Analysis
The NPV function may be used to compare buying versus leasing space for a given time period using the appropriate discount rate to determine the most economically favorable alternative. The purchase alternative may be analyzed with or without using debt financing. The largest NPV, which indicates the lowest occupancy cost for the projected occupancy period, is the best economic decision. The NPV calculation for the lease alternative and the purchase alternative results in negative numbers, indicating that a liability (cost of occupancy) will be incurred for each alternative. In this case, the largest NPV is the smallest negative number, indicating the lowest cost of occupancy for the projected occupancy period. (See Table 2, After-Tax Lease vs. Purchase Analysis.)

3. Sale-Leaseback Analysis
The NPV function may be used to compare the economic impact of a sale-
leaseback decision: determining whether it is more economically sound to continue owning space or to sell and lease back the space. This example illustrates owner alternatives with and without financing. The largest NPV, which indicates the lowest occupancy cost for the projected occupancy period, is the best economic decision. The possible outcomes for the NPV calculations for the sale-leaseback analysis are more complicated than most of the other user NPV applications. The calculations could result in two positive numbers or two negative numbers, or either alternative could be a positive number and the other alternative a negative number. The latter would indicate that either or both alternatives could produce a positive financial benefit (positive NPV) of occupancy or a liability (negative NPV). The multiple results of the NPV calculations largely are due to whether there is debt financing in place on the property, which is illustrated in Table 3, After-Tax Sale-Leaseback Analysis. The best economic decision is still the alternative that produces the largest NPV — regardless of whether the largest NPV is the smallest negative number or the largest positive number.

4. Lease Buyout Analysis
The NPV function may be used to calculate the present value of all lease payments for the remaining lease term using the appropriate discount rate. The discounted value calculated is the maximum price the user should pay to be released from all future lease obligations. There are times when users no longer need the space they currently have leased. The decision these users face is whether to continue to make the periodic lease payments until the lease expires or pay the owner a lump sum to be relieved of all future lease obligations. (See Table 4, User Lease Buyout.)

5. Profitability at a Given Discount Rate
The NPV function may be used to measure the profitability of a potential investment at a given discount rate and/or determine the price adjustment needed to achieve a target yield. When the NPV calculation results in a positive number it means that the investor will achieve a higher yield than required if the investor pays the listed or asking price for the investment. The positive NPV also tells the investor how much more they could pay for the investment and still achieve the target or required yield. When the NPV calculation results in a negative number it means the investor will not achieve the required yield if they pay the listed or asking price. The negative NPV also demonstrates how much less the investor must pay for the investment to achieve the target or required yield. When the NPV calculation results in a zero value it means the investor will achieve exactly the target or required yield if they pay the listed or asking price. In Table 5, Investment Profitability at a Given Discount Rate, the investor could pay $107,148 ($100,000 + the positive NPV of $7,148) and achieve the target or required yield of 9 percent.

6. Investment Value
The NPV function may be used to establish the value of a future income stream for a specific investor with a specific target yield. Investment value is defined as the price a specific investor will pay for a specific investment. Investment value varies from investor to investor based on their individual investment criteria. The NPV function can be used to determine the value of a future income stream (investment value) using the specific investor’s target yield. (See Table 6, Investment Value at a Given Target Yield.)

Robert L. Ward, CCIM, owner of Ward Consulting Services in Oviedo, Fla., is a CCIM Institute senior instructor and consultant to the CCIM curriculum redesign. Contact him at (407) 365-3240 or bowada@bellsouth.net.

Copyright © 2007 CCIM Institute.All rights reserved. For more information call 312.321.4460 or e-mail us.

Posted by Cochise at 09:36 AM | Permalink

The rules for retail are changing across America, almost as quickly as the holiday lights come down and the racks of valentines go up on Jan. 2. Wal-Mart has morphed from the feared competitor into the good neighbor that attracts a slew of national credit tenants that flourish in its demographic pull. The world’s largest retailer also is a pioneer, staking out territory in small markets and moving into inner cities. However, it reported the lowest same-store sales in 10 years last November and ended its fiscal year on Jan. 31 with the lowest annual same-store sales gain in 27 years, according to a Wall Street Journal Online report. As a result, Wal-Mart is slowing expansion plans this year, and when Wal-Mart hiccups, the rest of the retail world scrambles either to gain market share or rewrite pro forma numbers.

The Changing Game
Such dependency on the actions of a single retailer is one of retail’s revised rules. And while Wal-Mart remains every leasing manager’s favorite shopping center anchor, today’s rules question if developers and owners even care about the anchor concept. Investors aren’t too concerned: In Orlando, Fla., a top Southeast retail market, unanchored centers were last year’s most favored retail investment. “Unanchored retail centers are so popular because purchasing one is within reach of a much larger pool of investors,” says Jeffrey Pocklington, director of Investment Services for GVA Advantis and a partner in the company’s Pocklington, Pocklington, and Forster Retail Investment Group in Orlando. “However, in recent years, a few institutional investors have begun to show interest in unanchored retail, causing more competition and increasing prices.”

And that’s a problem for many of today’s smaller, private investors. While the American shopper will have no trouble finding something new to buy this year, those who buy big — in particular retail property investors — may not find the right property at the right price. Competition in hot markets such as Orlando and Fort Lauderdale, Fla., Phoenix, and California’s Orange County has driven prices up and capitalization rates down. Now that real estate investment trusts rule the mall world, institutional and large private investors are amassing portfolios of smaller shopping center properties. The influx of capital chasing core assets is tremendous; but big buyers are very particular, as competition for top-tier assets in top markets is very tight, says Joseph French, CCIM, Sperry Van Ness’ national retail director in White Plains, N.Y. However, in less-stellar markets, cap rates are rising as sellers set more realistic prices. “It’s tough in Bethlehem, Pa., to sell a Big Lots shopping center for a 7 cap rate,” French said in an interview with GlobeStRetail.com. “It may be good credit, but it’s a second-tier center in a tertiary market and it’s not going to command the same price as it would have two years ago.”

Overall, retail sales are expected to grow 4 percent to 4.5 percent this year, still healthy but not as strong as 6 percent and 7 percent in the last two years, according to Marcus & Millichap. In reaction to a slowing housing market, national tenants are pulling back expansion plans, and retail development this year will add about 120 million square feet, approximately 10 million less than last year.

Despite a slower national outlook, retailers still are searching for new markets to enter, but they are not necessarily following traditional rules. For example, Swedish home furnishings giant IKEA opened a store in Austin, Texas, which is much smaller than its usual target market of 2 million people. Whole Foods is settling into a food-filled neighborhood in Jacksonville, Fla., in 2008, across the street from a Publix and within a half-mile of three other grocery stores — despite the fact that nationally it is facing increased competition as traditional grocers beef up their organic offerings. In what some experts see as a defensive move, Whole Foods recently bought its closest natural-foods competitor, Wild Oats, in part to keep the chain out of the hands of traditional grocers.

Such moves indicate the retail industry’s ever-evolving nature. In response, investors seeking retail real estate are looking at alternative opportunities. For example, as proof of today’s reconfigured retail landscape, once-risky projects such as shadow-anchored centers now catch large investors’ attention. A little off the beaten path, power centers are popping up in small markets, as retailers widen demographic rings and seek former competitors as neighbors. Infill projects in secondary markets are under development, as cities such as St. Paul, Minn., try to replicate the new urbanism of major metropolitan areas. And some retailers and developers are pushing into inner cities, which many experts call the next big retail frontier.

For developers, brokers, and investors, retail projects are out there. While they may be a little edgier and riskier than predictable grocery-anchored centers, not even safe bets are safe given retail’s changing rules.

Caption: With stores such as Target competing for food shoppers, grocery-anchored centers look less appetizing to investors.
Credit: Target Corp.

Shadowing the Big Boys
When it comes to leasing retail real estate, there is no bigger guarantee of usual success than Wal-Mart. “Where a Wal-Mart Supercenter goes, so goes about 20,000 sf of tag-along tenants,” says Tom Rohde, CCIM, of Rohde, Ottmers, Siegel Commercial Real Estate in San Antonio. Rohde finds the attraction even in the smallest markets, such as Hondo, Texas, population 5,000. Wal-Mart vacated a 46,000-sf space and built a new 200,000-sf Supercenter right behind it. Rohde listed the former Wal-Mart in early January and had enough leasing prospects to fill it in 30 days. In contrast, he has a listing for a vacant Albertson’s in Victoria, Texas, a town of about 50,000. But “it has sat vacant for three years with few prospects because it is not in the shadow of a major new anchor,” he says.

Investors have traded nearly $2 billion in shadow-anchored space in each of the last four years, according to Real Capital Analytics, indicating both lender and investor acceptance of this once-risky product. Cap rates have dropped to 6.8 percent on the average shadow-anchored transaction, down from an average rate of 9.8 percent five years ago. “The problem was the shadow centers located next to the older, smaller Wal-Marts,” Rohde says. For a number of years Wal-Mart abandoned smaller leased spaces in favor of building larger supercenters. Today, space in the shadows of more than 900 Wal-Mart Supercenters is pretty secure, because Wal-Mart never has relocated a Supercenter, Rohde says. “They can’t find large tracts of land [on which to build].”

But Wal-Mart’s sluggish performance late last year is curtailing its expansion plans, although it is expected to focus on the supercenter format almost exclusively, according to Marcus & Millichap. The retailer blames store remodeling for keeping shoppers away, but retail analysts say Wal-Mart’s entry into markets with stiffer competition may be more the cause for lower sales.

Last April, REIT Kimco Realty Corp. and Michigan-based Schostak Bros. paid more than $100 million for a portfolio of 28 shopping centers shadow-anchored by new Wal-Mart Supercenters. The transaction indicates the range of interest in shadow-anchored centers: Kimco owns more than 1,000 community and neighborhood centers, where as regional Schostak has a portfolio of 50 properties, according to Shopping Centers Today.

Home Depot, Lowe’s, Kohl’s, and JCPenney also are effective shadow anchors. And in Texas markets, HEB Grocery also attracts tag-along tenants, Rohde says, indicating its strength as a regional retailer.

Won’t You Be My Neighbor?
While Wal-Mart is the prime shadow anchor, some retail leasing specialists favor Target as a center anchor because “it attracts a higher-level fashion group of tenants that pay higher rents,” Rohde says. “Most of the apparel stores want to be next to [Target] because it draws women — Ross, T.J. Maxx, and even Penney’s are larger stores from 30,000 to 90,000 sf. You can build a lifestyle center around a Target.” In contrast, a Wal-Mart anchor attracts more service-oriented tenants and lower-priced apparel retailers in smaller stores. “CATO, Dots, Shoe Dept., and Dollar Tree are typical for a Wal-Mart center,” Rohde says.

Wal-Mart remains a prime magnet for new retail development in very small markets. When the retail giant landed in an industrial-zoned corridor outside of Ankeny, Iowa, — population 30,000 — retailers that Barbara K. Hokel, CCIM, had hounded for years suddenly returned her calls. “Every six months I was in touch with Target. I’d call, they’d say no, and that went on for several years.” After Wal-Mart agreed to a location across from Hokel’s property, “I called Target immediately and they said, ‘We think you have an excellent site!’ At that time, they bought enough land to build a Home Depot next to them. From there I asked Target who they liked as neighbors. They said one of them was Kohl’s, so I called Kohl’s and the rest is history.”

Hokel, who now does retail leasing with NAI Ruhl & Ruhl Commercial in West Des Moines, Iowa, was working with a local developer when the retail corridor began to develop along Interstate 35. The combination of interstate access and isolation from other retail competition was key to its success, she says. “The power center caught the attention of other big-box retailers who like to neighbor together: Pier 1, Michaels, Dress Barn, Starbucks, and PetSmart. This also sparked the development of a couple of retail strip centers that attracted more national retailers such as Tuesday Morning and Jimmy John’s.”

Making retail connections at International Council of Shopping Centers conventions also proved very beneficial. “In one trip we landed T.J.Maxx, Factory Card & Party Outlet, and Shoe Carnival,” Hokel says. “The conversion from an industrial site to retail was phenomenal and it continues to be a very successful place to shop.”

Rohde sees similar interest from retailers in small Texas markets. Since many retail chains have saturated major markets they are looking at smaller countywide trade areas. Rohde cites a project in Bastrop, Texas, a town of only 6,500. “Being a county seat with many intersecting highways, we are working on a retail project of more than 700,000 sf. The county is over 80,000 in population and the anchor tenants are looking at that countywide trade area because it has become the crossroads of central Texas.”

Caption: Retail space in secondary market urban infill projects such as Straus Building in St. Paul, Minn., faces density and parking challenges.
Credit: Sherman Associates

Small-Scale Mixed-Use
In other parts of the country, infill development and mixed-use are trickling down to secondary and tertiary markets. Retail is a component of these projects, which have had great success in larger metro areas. But it’s not as easy as it looks, says Robert A. Kost, CCIM, commercial leasing manager and project manager for Sherman Associates in Minneapolis. “You have to keep the pro forma rent low and stretch out the leasing schedule to two or three years” in smaller urban markets, he says.

Kost has two projects in downtown St. Paul’s older warehouse district bordering the city’s financial district. Sibley Park Plaza is a new residential building and the Straus Building is an adaptive reuse of a knitting factory. Each project contains about 10,000 sf of first-floor retail that Kost is leasing at $12 to $16 per square foot net.

St. Paul city officials have embraced urban development but Kost says the city lacks the urban density of larger cities and new residential neighborhoods have not reached critical mass. As a result, leasing managers need to be flexible, he says. He has leased part of the Straus Building retail space as headquarters for EQLife, a small Best Buy spin-off company. Now he’s getting more interest from local law firms that are looking for innovative spaces and is advertising the rest of Straus’ space as retail/office.

At Sibley Place Plaza, the end caps leased easily, but in-line space is harder to rent. Kost targets national credit tenants, as well as franchises, which “at least have a business process in place.” The neighborhood residents clamor for local businesses as tenants. “What they don’t understand is that if a local restaurant decides to open another location that’s a huge increase in the overhead; they can’t afford to keep going until the neighborhood picks up.”

Parking is another issue that dogs retail leasing in urban neighborhoods. While there is metered parking in front of Sibley Park Plaza, one of his in-line tenants, Wireless Toyz, complains that on weekends and evenings when the meters don’t need to be fed, residents park in the spaces instead of shoppers. Developers need to work with city planners to provide 30-minute meters or free parking in local garages to alleviate such problems.

While Kost discounts the possibility of leasing to local businesses, Regina Emberton, CCIM, director of corporate services with CB Richard Ellis in South Bend, Ind., is concentrating on them in her attempts to lease retail in a redeveloped industrial building in Benton Harbor, Mich. She also advertises the space as retail/office at a lease rate of $10 psf.

Located in the heart of Benton Harbor’s developing arts district, the building has had several showings for the retail space but no interest from national retailers, she says. “Instead, we have focused on marketing regionally to entrepreneurs and unique niche businesses and that seems to be where the primary interest has come from — arts-related groups, restaurants, caterers, photographers.” Other tenants in the area include a microbrewery, restaurants and bars, a cooperative art studio, a glass-blowing studio and gallery, and a wine-tasting room.

Situated next to twin city St. Joseph, Mich., Benton Harbor is about 90 miles east of Chicago on Lake Michigan in the center of a large tourist and second-home market. Benton Harbor “is really the only city along the lake that has not turned into a tourist community,” Emberton says. However, that is beginning to change now that Whirlpool acquired Maytag and is bringing 400 executive jobs to its Benton Harbor headquarters.

The Final Frontier
Since the 1980s urban planners have promoted inner cities as the most under-retailed U.S. neighborhoods. And it’s true. Inner-city neighborhoods represent more than $85 billion in retail spending per year and contain an average of $76 million retail dollars per square mile, compared with $8 million psm for the rest of metro areas, according to the Initiative for Competitive Inner Cities report. Yet almost 60 percent of those retail needs are unmet in some neighborhoods. In addition, 38 percent of inner-city families fall into the moderate income category with annual incomes between $20,000 and $50,000.

These statistics have caught the eye of national retailers running out of suburban markets. As major retailers have made forays into more upscale urban markets, they have become more familiar with the challenges of urban development. That experience combined with the need for expansion is convincing retailers to explore inner-city locations.

Some pioneers are already there. For its first store in the Pittsburgh market in 2002, Whole Foods settled in the declining East Liberty neighborhood right between the railroad tracks and a taxicab barn. Home Depot followed, and the next year Walgreens and Starbucks also located along the Centre Avenue corridor. This year Trader Joe’s located there. A Borders and Target are on the drawing board, along with multifamily and condominium projects.

A once-thriving neighborhood, East Liberty declined in the 1980s and 1990s after misguided urban renewal attempts cut it off from other parts of Pittsburgh. Surrounded by wealthier neighborhoods, East Liberty has shopper demographics that any suburban mall would envy, and along with national tenants, it supports shops and restaurants that are owned and operated by residents of the largely African-American neighborhood.

Milwaukee boasts a similar success story. The almost-vacant Capitol Court Shopping Center near one of Milwaukee’s poorest neighborhoods generated no interest among local developers and investors. Even when Wal-Mart came to town with the numbers in its back pocket, local lenders still weren’t too interested. But more than 200,000 people with median household incomes of $38,000 live within three miles of the shopping center. They were spending almost $1 billion annually but the nearest mall was seven miles away. Eventually Boulder Ventures LLC with partners bought the mall for $8 million in 2001, demolished it, and built a 454,000-sf open-air center. With Wal-Mart as the first major tenant, the center attracted more than 20 national tenants including Walgreens, Starbucks, and Lowe’s. Boulder sold the nearly fully leased center in 2004 to Inland Western Retail REIT for $53 million — after entertaining 13 offers for the property.

Wal-Mart continues to pursue such opportunities, opening its first Chicago store last September on the economically depressed West Side. Wal-Mart plans to roll out 50 such stores in the next two years and recently announced plans to open inner-city stores in Indianapolis, East Hills, Pa., Cleveland, Decatur, Ga., El Mirage, Ariz., Landover Hills, Md., Portsmouth, Va., and Richmond and Sanger, Calif.

Along with retailers, developers such as General Growth Properties are starting to focus on inner cities. GGP has committed to begin development of two to three $70 to $100 million retail projects annually in under-retailed city neighborhoods, according to Lyneir Richardson, GGP’s executive vice president of urban retail development. Inner-city retail is an “evolutionary process,” Richardson said at last year’s ICSC convention. “First, fast-food eateries got it, then drugstores got it, and now big-box and mass market retailers are getting it.”

Sara Drummond is managing editor of Commercial Investment Real Estate.

Posted by Cochise at 09:26 AM | Permalink | Comments (2)

Although recent media attention has focused on the ups and downs of single-family residential housing, last year's biggest real estate deal - in fact the world's biggest real estate deal to date - actually took place in the multifamily sector. Tishman Speyer offered MetLife $5.4 billion for Manhattan's Stuyvesant Town - an 11,000-unit, 110-building multifamily complex housing about 25,000 people.

Although the multifamily sector often flies beneath the radar of many investors, its combination of stability and upside has made apartment properties one of the best and most tempting real estate investments. And today's combination of high single-family home prices, limited multifamily stock, and burgeoning demand demographics points to improving multifamily fundamentals for many markets.

As an investment, apartment properties have outperformed the stock market for the last five years, according to both the National Association of Real Estate Investment Trusts and the National Council of Real Estate Investment Fiduciaries. In 2005 the apartment sector achieved its best annual return since 1984 - 21.15 percent compared to the market's 20.06 percent. During that same year, $86.9 billion of apartments traded, a 72 percent increase compared to 2004, according to the National Association of Realtors.

Photo caption: The 276-unit Alexan Miramount luxury apartment complex located nine miles southeast of Austin, Texas, was completed last summer.
Photo credit: Opus West Corp.

Last year apartment investors reaped returns at about 17 percent, which was similar to other property types, according to NCREIF. Preliminary reports indicate that far more apartment properties changed hands than any other property type except for office. During the first 10 months of 2006, nearly $70 billion worth of apartment properties traded, with institutional acquisitions already surpassing the total for all of 2005, according to Real Capital Analytics, a New York-based research firm. About 30 institutional investors each acquired $100 million or more in apartment properties in 2006.

Although rental-housing niches such as student and seniors housing continue to grow, few investors are pursuing them. Instead, many traditional multifamily investors are focused on developing mixed-use projects in infill locations and will continue to do so throughout this year. Since some cities make affordable housing a condition of the zoning approval, some of these properties will include an affordable-housing component.

The value-added strategy of acquiring and repositioning class B and class C apartment properties has been extremely popular for the past three years and is not expected to wane this year. However, the condominium conversions that ignited many markets, particularly in Florida, have slowed significantly, and the absence of condo converters has made room for conventional apartment investors in markets such as Tampa and Orlando, Fla., and Miami.

While the conversion slowdown is returning some units to the market, cities with strong population growth will not be affected greatly, according to industry experts. In fact most commercial real estate experts give multifamily a thumbs up for 2007 based on its all-around improving fundamentals. As a result investor interest in apartment assets should continue to grow stronger this year, as the sector benefits from an expanding renter population, strong job growth, and slowdowns in single-family housing.

Improving Fundamentals
Confidence in the current rental market is strong and expectations for this year are even higher, according to the National Association of Home Builders/Fannie Mae Multifamily Rental Market Index released in late November 2006.

More than 60 percent of MRMI respondents said that apartment demand rose during 3Q06, and 70 percent said that effective rental rates increased. Additionally, almost 70 percent of multifamily developers and owners said they felt good about continued demand due to a large volume of calls from prospective renters.

Strong fundamentals are evident in nearly every U.S. apartment market. Out of the 75 markets tracked by the New York-based research company Reis, 60 markets boasted positive absorption and 55 noted falling vacancy rates. A whopping 73 markets recorded effective rent gains.

Vacancy during 3Q06 fell by 20 basis points to 5.4 percent - the lowest level since 4Q01, according to Reis. Vacancies are expected to continue to decrease despite the fact that development has strengthened and condo conversions have slowed.

During 3Q06, 16,300 rental units came online, but all of them and more were absorbed as net absorption reached nearly 22,000 units. During that same period, only 7,400 units were converted to condos, far below the 1Q06 and 2Q06 levels of 29,800 units and 19,300 units, respectively. Further comparison shows that the 3Q06 conversion rate was scant in comparison with the market's peak of 54,700 units in 3Q05, according to Reis.

The decrease in conversions, coupled with a muted development pipeline in comparison to previous development cycles, is impacting asking rents and effective rents. Asking rents and effective rents grew at their fastest rates in 2006 since the national market's peak in 2000, according to Reis. Third-quarter 2006 marked the sector's 18th consecutive quarter of asking rent gains, which rose 1.3 percent, according to Reis, while effective rents climbed 1.4 percent as landlords reduced concessions. Asking rents will increase 3.4 percent and effective rents will grow by 3.6 percent this year, Reis forecasts.

Rendering caption: After slightly more than three years of construction, Scottsdale Waterfront, the first condominium tower in Scottsdale, Ariz., was ready for occupancy in Feburary.
rendering credit: Opus West Corp.

Coastal Markets Attract Investors
Location is a crucial investment factor and continues to be a tricky matter. High-barrier-

to-entry markets such as Baltimore, Boston, Washington, D.C., Fort Lauderdale, Fla., Los Angeles, Long Island, N.Y., Miami, New York, Orange County, Calif., San Diego, Seattle, and San Francisco historically have produced higher rental growth and lower vacancies when compared to low-barrier-to-entry markets such as Atlanta, Dallas, Denver, Phoenix, Raleigh-Durham, N.C., and San Antonio, according to a RREEF study.

From 1990 to 2006, for example, the average vacancy rate for high-barrier markets was just 3.8 percent compared to 6.9 percent for low-barrier markets. Similarly, high-barrier markets achieved rental rate growth of 3.8 percent, while low-barrier markets achieved 3.3 percent, according to RREEF. Capitalization rates in high-barrier markets averaged 5 percent compared to an average cap rate of 5.6 percent in low-barrier markets, the study also shows.

Having four of RREEF's top high-barrier markets located in California provides a reason why the state's cap rates are among the lowest in the country, according to Real Capital Analytics. Apartment transactions that closed during 3Q06 in Orange County, for example, had an average cap rate of 4.9 percent and sold for an average of $195,882 per unit. Farther east toward the desert, the Inland Empire has had an average cap rate of 5.4 percent and an average price per unit of $147,151.

Despite the low cap rates and high unit prices, there's still a lot of upside to be found in Southern California. For example, the Inland Empire's apartment market is expected to see occupancy and rental rate growth increases in 2007 as the population expands by 3.2 percent - the largest amount of all markets evaluated - and job growth will top 3.2 percent according to Sperry Van Ness' multifamily Top 10 Markets to Watch report. Vacancy is predicted to drop to 4.2 percent as rents grow 4.7 percent to reach an average of $1,053 per month.

Orange County's vacancy rate is expected to drop to a countrywide low of 3.2 percent and effective rents are forecast to grow 5.1 percent to $1,481, which is the biggest increase for all markets evaluated in SVN reports. Like the Inland Empire, Orange County will add more than 22,000 jobs and 22,000 new residents. Investors should look to Fullerton, Calif., for significant upside as renters in Buena Park, Calif., and North Anaheim, Calif., are priced out of the market and move to Fullerton.

Northern California's apartment market also has strong momentum. For example, cap rates in both San Francisco and San Jose averaged 5 percent at the end of 3Q06, according to Real Capital Analytics, with an average price psf of $286,867 and $183,715, respectively.

San Jose and San Francisco posted the strongest gains in asking and effective rents for most of 2006, according to Reis. And in terms of asking rents during 3Q06, San Jose led the nation with an increase of 2.6 percent.

Both San Jose and San Francisco's downtowns are undergoing significant revitalization and a number of mixed-use infill projects are under construction. At the same time, job growth has returned to the region. San Jose will add 10,000 new jobs - most of them in the service and professional sectors - and welcome 8,500 new residents, according to SVN. The high cost of living in the Bay Area bodes well for apartment owners. A decreased vacancy of 3.7 percent over the coming months will allow owners to boost asking rents by 4.9 percent, bringing the average rent to $1,380 per month.

San Francisco also has rebounded from the dot-com bust and many people have returned to jobs in the city, seeking homes near transit lines or close to downtown. Rental signs are coming down, as are vacancies and concessions. The city's marketwide occupancy is expected to reach 3.8 percent by mid-2007, while effective rents will jump 5.4 percent to $1,668 per month, according to SVN.

Rendering caption: Edgewater, a San Francisco multifamily property will break ground this spring.
Rendering credit: Michael Sechman and Associates

Investors Warm to Sun Belt Opportunities
Many investors consider the coastal markets, especially those in California and Florida, to be seriously overheated and have gravitated to Las Vegas and Phoenix in hopes of getting quality assets at higher cap rates.

In Las Vegas, for example, the average cap rate for deals closed in 3Q06 was 6 percent, according to Real Capital Analytics, while the price per unit was $94,522. Phoenix's average cap rate was slightly lower at 5.9 percent, with the average price per unit of $89,533.

Las Vegas ranks as No. 3 on SVN's top apartment markets list, while Phoenix and Tucson, Ariz., fill spots nine and 10 on the list. All three markets are appealing because they will continue to experience significant population and job growth. Las Vegas, for one, is expected to add 57,000 new residents over the next six months and lead the nation in employment growth of 3.8 percent. Development in the city is limited primarily to high-rise, high-end condos, but 1,800 new apartment units will come online this year. Therefore, the vacancy rate is forecast to hover right around 4 percent. But new development is not expected to curtail rental rate growth of 3.7 percent.

Other investors are following the demographic shifts that clearly favor Sun Belt markets in Georgia, Texas, and the Carolinas. Some of the fastest-growing metro areas over the past two to three years have been Atlanta, Dallas-Fort Worth, Denver, Phoenix, and Raleigh-Durham, N.C. Without exception, these cities are experiencing strong job growth and population increases as corporations exit expensive locales to take advantage of the quality work force and a low cost of doing business offered in Sun Belt markets. Moreover, these markets will offer better returns to investors in the coming months as fundamentals improve.

For example, in Dallas-Fort Worth cap rates averaged 6.9 percent at the end of 3Q06, and the average price per unit was a real bargain at $67,215. Similarly, Denver's average cap rate was slightly lower at 6.6 percent and the average price per unit was $101,568, according to Real Capital Analytics. Unfortunately, the demand has encouraged developers to start building again. Various sources measure the development pipeline at more than 10,000 units.

Farther east, Raleigh-Durham offers such impressive growth opportunities that it nabbed the No. 8 position on SVN's top apartment market list. Almost 18,000 new jobs are forecast for the coming year for the metro area, and 38,000 people are expected to move to the city.

A large student population and a growing employment base have created significant demand in Raleigh-Durham, pushing vacancy to 7.5 percent and driving rental rate growth of 3.4 percent. The city has absorbed 2,000 units over the past two years, but there is concern that the 3,000-unit development pipeline is a little pudgy.

Even the amount of new development that is planned nationwide for 2007 can't cast too large a shadow on the apartment market's future. About 92,000 units are expected to be completed this year, 2,000 more than last year. Although condo conversions reverting to rentals may add to that total, completions still will fall short of 1990s' levels.

David Baird is senior vice president and national director of multifamily for Sperry Van Ness in Las Vegas. Contact him at (702) 765-6005 or bairdd@svn.com.

What's Driving the Apartment Sector?
Demand for rental housing is showing no signs of slowing. The United States is projected to add 11.6 million new households between 2007 and 2015, an average of roughly 1.5 million new households each year. This rate is 15 percent higher than the 1.3 million new households created each year since 2001. Most of the growth in household formation can be attributed to the echo-boomer generation, who range in age from 20 to 24 years, and strong immigration, which both positively impact the apartment sector, according to a RREEF report.

Echo boomers account for around 30 percent of the U.S. population or 76.3 million. This group is critically important to the apartment market: Roughly 75 percent of this age group calls an apartment home and historically has lived in apartments. In the 1990s, this age cohort shrunk significantly but started to grow again in 2001 as echo boomers - children of the baby boomers - came of age.

Similarly, immigrants make up a large portion of the renter population. Roughly 4 million immigrant households live in apartments today, and immigrant households are expected to contribute a greater proportion to future apartment demand, according to the National Multi-Housing Council. By 2010, another 500,000 immigrant households are expected to live in rental units.

In addition to echo boomers and immigrants, many Americans may end up in apartments as the cost of homeownership increases. Homeownership costs about 30 percent more a month than renting, according to the NMHC. That affordability gap plus high housing prices are causing fewer apartment residents to become homeowners.

In addition, many existing homeowners have mortgage payments that grow as short-term interest rates increase. The impact of the interest rate hikes already is apparent: The number of foreclosures during the first 10 months of 2006 (766,058 properties) was 19.6 percent more than the number of foreclosures for all of 2005, according to Foreclosures.com, a California-based real estate investment advisory firm and publisher of property foreclosure information.

While foreclosures and weak home sales aren't anything to cheer about from an economic perspective, the multifamily sector certainly will benefit, and those rewards will be passed on to investors.

Posted by Cochise at 09:23 AM | Permalink

Much of the real estate finance industry operates on dogma, most of which is grounded in sound theory about the factors that drive commercial real estate markets and risk pricing. During the past 15 years there have been significant advances in methods for assessing and quantifying risk, which contribute to more disciplined debt and equity investors.

However, many of the risk models and decisions taking place in commercial real estate today are based on assumptions that are questionable. Understanding the reality behind some of these myths is important when making commercial real estate financing decisions.

Myth No. 1: Real estate equity currently is a safe haven for investors. In the long term, well-located real estate is a solid investment. However, the short and intermediate outlooks are somewhat more clouded. The idea that today’s valuations will be maintained is a risky proposition. Since 1993 real estate values in this country have performed well in most markets due to a confluence of factors that have made real estate a favorable asset class. This long bull market must end at some point.

For instance, if a property owner places two advertisements for the same property -- one for lease and the other for sale -- there might be a deluge of interested buyers, but far fewer potential tenants. Something is wrong with this phenomenon, since investors buy real estate for its long-term cash flow potential. If interest rates rise, values will decline, with much of the downward pressure being caused by floating rate loans that cannot be refinanced or cannot carry their debt service. And, inevitably, capitalization rates will rise back to historical levels.

Myth No. 2: Spreads on commercial mortgages are too low. Many commercial mortgage debt investors are complaining that they are not being fairly compensated for risk. But this is only partially true. Investors that receive 90 basis points over U.S. Treasuries for a truly conservative mortgage are being fairly compensated, since many of those loans have an extremely low probability of ever defaulting. In actuality, 90 basis points is a fair yield as it is a 22 percent yield increase over a 4.1 percent treasury. When bonds were 8.82 percent on average in 1988 and low leverage spreads were at 90 basis points, the reward for investing in a mortgage was a 10.2 percent premium over the risk-free rate. Note that 80 percent loan-to-value loans were between Treasury plus 175 and 200 basis points in 1988; now they are Treasury plus 110 to 140 basis points for most properties.

Complaints regarding spreads for highly leveraged loans, where debt investors are attempting to get an additional 30 or 40 basis points of yield, are justified. In these instances, the lender is taking on an inordinate amount of risk for the incremental yield offered in today's market.

Myth No. 3: Mortgage debt is a solid investment right now. While lower leverage loans are just fine in the current market, higher leverage mortgages are mispricing risk. A commonly used term these days is debt cap rate, which generally refers to the mortgage amount as a function of the cash flow. Often times the debt cap rate reflects a loan amount that is more than the property would have sold for a few years ago. In many cases, traditional lending tenets are being tossed aside.

Experts know that studying real estate markets’ history is a poor way to predict future performance. Subordination levels are in sharp contrast compared to levels a few years ago. Commercial mortgage-backed securities originators are touting the new "super senior structures" of their issues. This structure carves out a junior piece of AAA bonds backed by mortgages that are subordinate to the rest of the AAA tranches. In theory, the balance of the AAAs is safer. However, this thinking would be sound if AAAs didn't continue to take a growing share of the entire mortgage pool; all this does is recover some of the ground lost by more-lenient subordination levels. The rating agencies and many bond buyers are confusing theory with reality, causing errors in judgment.

Myth No. 4: Liquidity will continue to exist. Many investors wrongly assume that capital, both debt and equity, will continue to be consistently available. More typical credit cycles have longer periods where liquidity is scarce, such as the cycle that occurred between 1990 and 1993.

Real estate fundamentals are stronger now than in 1988-1989, which greatly reduces the chance of a near-term liquidity squeeze. It is likely, however, that in a few years there will be a lower supply of available credit, especially for leveraged transactions. Refinance risk for loans originated now is higher than at any time since 1986-1989. This is true for leveraged fixed rates as well as interest-only floating rates.

Collateralized debt obligations, or CDOs, which have continued their transformation into a core asset class in the fixed-income markets, currently incorporate pooled B financing pieces from CMBS into their offerings. CDOs are complex securities, even for bond investors, as they contain numerous types of credits including home equities, corporate credits, and high-yield loans. Since CMBS B pieces comprised only 6.98 percent of total 2004 collateralized debt issuances, it is possible that the risk inherent in B pieces is not fully understood. There is a trend towards dedicated real estate CDOs comprised of aggregated subordinate debt and mezzanine investments. The idea that pools of unrated securities can have investment-grade tranches seems counterintuitive despite the fact that diversification of the pooled B pieces somewhat neutralizes their risk. Many of the buyers of B pieces are now less concerned about risk so long as they can transfer it to collateralized debt buyers. If B piece liquidity through collateralized debt originations diminishes, then leveraged loan supply will follow suit.

Myth No. 5: All conduits are the same. Many investors believe that all conduit financing is similar in price and structure, but this is not true. In case you haven't noticed, conduits are staffed by people, and so are the rating agencies and bond buyers. This means that anyone originating or selling mortgages has their own subset of experiences from which to draw upon. There are startling differences between securitized lenders in how risk is viewed, structured, and priced. One needs to truly understand what is happening with numerous players in this market to achieve efficient execution.

Myth No. 6: Interest rates must rise soon. This is not as certain as some people seem to think. A popular belief among economists and others is that we have been living off the dole of the Federal Reserve Board for too long. The U.S. economy has yet to establish the kind of job growth that drives gross domestic product to levels that cause the Fed to raise rates dramatically. Hurricane Katrina may also have an impact on federal policy in the near term, causing them to pause in their current round of rate increases.

Inflation appears to be in check assuming that recent oil spikes do not contribute to a spiral of price increases the way they did in the 1970s. The largest financiers of the federal deficit, Japan and China, which hold more than $1.2 trillion of U.S. debt, cannot liquidate their positions without experiencing an enormous bond value loss. This is because the market likely would panic if the industry suspected that either entity wanted to reduce its U.S. Treasury holdings. The Fed also should realize that disastrous consequences could occur if it raises rates too fast. Consumers are financing much of their spending through home equity borrowing. This would collapse if rates rose quickly, which also would deflate home prices to the extent that the solvency of Fannie Mae and other large investors in adjustable rate residential and commercial mortgages would be at risk.

Myth No. 7: The real estate bubble will burst soon. It is possible, but not if rates stay close to current levels. Since rents in many markets have been somewhat depressed for a while, it is possible that rent inflation will increase as some markets reach equilibrium. For instance, it is hard to imagine that class A suburban office rents can drop much more than current levels. Very little supply has been added in areas that are supply constrained due to lack of available land or soft leasing. Better information flow regarding absorption has enabled construction lenders to enforce greater supply financing restrictions. If rents recover in certain areas, there is upside value potential.

To navigate the current market, equity investors should tread water carefully and debt investors need to be wary of leveraged loans based upon inflated asset values. Existing borrowers should lock in as much money as their investments can support for as long as possible -- more than 10 years is preferable. If owners have another method of deploying capital outside of real estate, it is time to sell, but not to buy more real estate at inflated values.

Andrew Stewart is chief operating officer of David Cronheim Mortgage Corporation in Chatham, N.J. Contact him at (973) 635-6800 or andrew@cronheimmort.com.

Posted by Cochise at 09:14 AM | Permalink | Comments (1)

Taxpayers planning to sell, purchase, or construct real property should review the possibility of conducting an Internal Revenue Code Section 1031 like-kind exchange to defer the incurrence of federal and general state income taxes on the capital gain. To qualify, property owners must exchange real or personal property (relinquished property) for other property of a like-kind (replacement property).

For example, Javier Cortez owns an apartment building valued at $500,000. He wants to sell the building to purchase another investment property but avoid incurring capital gains taxes. Following detailed IRC rules, he can accomplish this through a 1031 exchange.

Defining Like-Kind Property
The definition of like-kind real property is very broad; the replacement property does not have to be the same type as the relinquished property. For example, Javier could exchange his multifamily building for an office or retail property or for a tenancy-in-common or fee interest. Also, the replacement property is not limited to a single building; Javier could purchase a portfolio of three small buildings.

Personal property may be exchanged for other like-kind or like-class property, but the definition of like-kind personal property is more restrictive than that applied to real property. For example, the exchange of a truck for a car likely would not be allowed, while the exchange of one car for another car or a computer for a printer is treated as an exchange of like-kind property.

Real property is not like-kind to personal property, but combinations of the two may qualify under Section 1031 rules. For instance, Javier could not exchange his multifamily building and its furnishings solely for real or personal property in a completely tax-free exchange, but he could exchange the property for a combination of real and personal property, such as a restaurant and its furnishings and equipment. However, exchanges involving both real and personal property may result in the recognition of some gain as it is unlikely that equal values of personal property of a like-kind are exchanged. This form of multiple property exchange is subject to specific rules and can result in the recognition of gain even in the absence of any money transfer.

Not allowed are transfers of certain property inventory or other property held primarily for sale, such as subdivided lots held for sale, and interests in partnerships or real estate investment trusts.

Use Requirements and Holding Period
Taxpayers must have held the relinquished property for use in a trade or business or for investment. Under this requirement, personal residences are not eligible. Vacation homes may qualify as investment property if the taxpayer's personal use is limited or the home has been rented. Since Javier's multifamily building is an investment property, it is eligible for an exchange so long as he selects a replacement property to hold as an investment.

While no formal rule exists, the Internal Revenue Service historically has taken the position that the taxpayer must hold both the relinquished and replacement properties in a qualified use for a certain time period. Thus, the IRS might challenge the exchange if Javier sold the replacement property shortly after the exchange. Taxpayers should consult with a tax adviser concerning the appropriate holding period for property.

Recognition of Gain or Loss
To defer total gain, both the value and net equity of the taxpayer's replacement property must equal or be greater than the value and net equity of the relinquished property at the time of the exchange. In Javier's case, the replacement property must have a value of at least $500,000 and the value must exceed by $300,000 (net equity) any debt assumed in connection with the replacement property.

If the value of the replacement property is less than $500,000 or the net equity is less than $300,000, Javier would be taxed on the greater of the trade down in value or equity, limited to the gain he would have recognized if the property simply had been sold for its fair market value.

The Qualified Intermediary
Most like-kind exchanges are deferred exchanges. To complete a deferred exchange, the taxpayer must transfer the relinquished property for other like-kind property and not for money. Therefore, the taxpayer cannot gain actual or constructive receipt of the relinquished property's proceeds before purchasing the qualifying replacement property. Tax regulations impose strict limitations on the taxpayer's access or control over the proceeds and expressly limit the right to receive, pledge, borrow, or otherwise obtain the benefits of the money.

Thus, deferred exchanges require the use of a qualified intermediary to hold the sale proceeds and acquire the replacement property. Certain persons that provide other services on behalf of the taxpayer are disqualified to act as a qualified intermediary. Many companies specialize in acting as a qualified intermediary for a fee. Consult a tax adviser to make certain that a qualified person is acting as the intermediary in the case of a deferred exchange.

For example, Javier chooses an acquaintance, Robert, as the qualified intermediary. He assigns his rights under the relinquished property sales agreement to Robert who holds the sale proceeds in an account or in a qualifying escrow until purchasing the replacement property on Javier's behalf.

Deferred Exchange Timing
Strict timing rules apply to deferred exchanges. Generally, the taxpayer must identify the replacement property or properties in writing to the intermediary within 45 days of the relinquished property's sale. Within 180 days of the transfer of the relinquished property, the taxpayer must receive the replacement property. The 180-day period is limited to the due date of the taxpayer's tax return unless that return is extended.

Tax rules also place restrictions on the taxpayer's right to use or pledge the relinquished property sale proceeds during the 180-day exchange period. In Javier's situation, he sold the multifamily property to another investor for $500,000 and placed the proceeds in an escrow account held by Robert. Within a month he identified in writing two small medical office buildings as the replacement property. Two weeks later, Robert purchased the medical office buildings for $500,000 using the relinquished property sale proceeds and transferred the title to Javier. By following the guidelines, Javier successfully completed a deferred exchange and avoided incurring federal and state taxes.

Consult a tax professional for more information about Section 1031 tax-deferred exchanges.

Thayne Needles is a senior manager in the McLean, Va., office of Ernst & Young. Contact him at (703) 747-1000 or thayne.needles@ey.com.

Posted by Cochise at 09:12 AM | Permalink | Comments (2)

Many real estate investors think nothing could be simpler than an investment in a triple-net-leased (also known as NNN) property. Some liken it to buying a bond. While straightforward to own and operate, triple-net-leased properties can be the most challenging type of real estate investment for advisers to structure or — if the lease already exists — to understand. With lease terms as long as 50 or more years when options are taken into account, due diligence is critical, as changes usually cannot be made later on.

To prevent costly mistakes during the lease term, investment advisers must completely master all critical components of the transaction early in the negotiations. These include the client’s objectives for the investment, the lease document, the type of tenant, the physical real estate, and the type of seller.

The Client’s Objective
Investors considering triple-net-leased properties usually have certain objectives in mind that might not be met by typical real estate investments. These may include relief from management obligations, assured income, pride of ownership, and preservation of capital.

Many investors seek a suitable replacement property to complete a tax-deferred exchange. Having sold a management-intensive property such as a multifamily building, they must reinvest in real estate to take advantage of the exchange provisions. They still need the income, but they no longer want a landlord’s responsibilities. In addition, many take pride in having a well-known and respected company as a tenant. Others are most interested in providing an estate for their heirs, and they prefer to have less current income with the highest possible tax deductions from interest and depreciation.

Although all of these objectives can be met through triple-net-leased investments, the variations in different triple-net-leased properties need to be considered as well.

A Lease Primer
Unlike typical commercial real estate transactions, approach the analysis of a triple-net-leased investment with the idea that it is the lease, rather than the building and land, that the investor is purchasing.

Because definitions of triple-net leases differ, be certain that you understand your client’s concept of what the lease should and should not include. You may discover that a triple-net lease does not meet the client’s objectives after all. Also, be aware that the term is widely misused in brokers’ marketing materials.

After finding a potential property, obtain a copy of the lease and analyze it first. Otherwise you can waste time and money on market studies, inspections, and contract negotiations only to find during due diligence that one paragraph in the lease knocks the property out of consideration.

Generally a net lease refers to the arrangement where the tenant pays all or some of a property’s operating costs in addition to rent. Several general gradations of net leases have evolved over the years. These are summarized here, ranked from strongest to weakest, beginning with the lease that gives the tenant absolute responsibility for the real estate in exchange for absolute control.

Bond Lease. The tenant is fully responsible for operating expenses, maintenance, repairs, and replacements for the entire building and site, without limitation.

NNN Lease. These leases follow the bond lease definition except that capital expenditures are limited, usually in the final months of the lease. The lessee is liable for all of the property’s expenses, both fixed and operating.

NN Lease. This lease follows the NNN, except the landlord is responsible for structural components, such as the roof, bearing walls, and foundation.

Modified Net (or Modified Gross) Lease. The tenant pays its own utilities, interior maintenance and repairs, and insurance. The landlord pays everything else, including real estate property taxes.

Regardless of the type of net lease, many fluctuations, such as increasing utility costs and changes in government regulations, cause problems under rigid lease terms over time. Investors must be aware of lease nuances that may seem innocuous but require knowledge and planning in order to avoid future disappointments or disasters. Two such examples are the inflation trap and the taxation burden.

The Inflation Trap. At one time, single-tenant leases were structured with flat income for 25 or 30 years, and then had a series of options at drastically reduced rent, such as 2 percent of the property’s value. The theory was that the loan would be paid off by then, so the landlord’s spendable income would not be reduced. But inflation made this a nightmare for owners. When income was compared to current rent schedules, properties only could be sold at tremendous price reductions.

Today new leases take this possibility into account by specifying periodic rent increases, with options, if any, pegged to "fair market rent" or other indicators that preserve the income level.

Taxation Burden. Local laws and customs also may affect leases. For example, because triple-net tenants are responsible for real estate taxes, including any future increases, a unique situation developed in California with "Proposition 13" in 1978. It established a new base tax amount of 1 percent of the then value and limited tax increases to 2 percent each year until the property sold. Upon sale, taxes would be recalculated to 1 percent of the new purchase price. This formula, combined with soaring real estate values, meant that tenants were faced with wild leaps in rental rates due solely to changes of ownership, which in no way benefited the tenant.

Today tenants and landlords still are hamstrung over this issue. Tenants generally agree to an allowance for pass-throughs of increases except in the event of a sale. Owners reject these lease provisions, correctly noting that the impact on the net income to a future buyer results in a reduced market value of the real estate.

Triple-Net Tenants
After mastering the lease, the next factor to evaluate is the tenant.

Credit Worthiness. From an investor’s perspective, a triple-net-leased property’s price should reflect the tenant’s ability to meet the terms of the lease. The capitalization rate indicates this variable risk factor, because it directly represents the relationship of the stipulated net income to the price a knowledgeable investor is willing to pay. The higher the risk that a tenant may not be solvent over the long term, the higher the cap rate should be.

A tremendous amount of information is available to assist in evaluating the current and future financial strength of a tenant. If it is a public company, the credit rating is fairly easy to determine through a number of sources, including sites available on the Internet such as http://www.companysleuth.com/, http://www.zacks.com/, and http://www.freeedgar.com/.

The trend toward mergers and divestments adds another dimension to credit reviews. Even though the resulting entity usually is stronger than the original company, the risk of the unknown can be perceived as a negative factor.

If the business is complex or privately held, contact a fee-based tenant underwriting service for added assistance.

Type of Use. Even if the credit rating is substantial, the type of business may affect investment value. From an investment standpoint, a general-purpose use, where tenant improvements easily are convertible to another tenant’s needs, is more desirable than a special-use project. In many special-use cases, the seller passes along the costs of highly specialized improvements to the buyer, who may be unable to recover that portion of the investment over the lease term. Fast-food outlets are a prime example of this problem, but certainly not the only one.

The Physical Real Estate
After reviewing the lease and tenant/landlord compatibility, investors then should evaluate the physical real estate. All categories of office, industrial, retail, multifamily, and hotel properties, and even undeveloped land, can be sold on a triple-net-lease basis, without regard for size, design, or location. However, retail, office, and industrial most often are available in the marketplace.

Businesses that typically lease rather than own their real estate are those that achieve a business-income yield that is substantially higher than the typical real estate yield of 8 percent to 10 percent pre-tax. High-volume retail operations are probably most prevalent. But each investment must be considered individually. For instance, if an investor purchases a special-purpose building with a "theme" construction, the net worth of the company is of prime importance. On the other hand, a food market in a good neighborhood shopping center most likely can withstand even a change of tenancy without significant loss of income.

Similarly, industrial buildings can be classified as warehouse, manufacturing, or research and development space. They come with and without substantial office space and range in size from 10,000 square feet to 500,000 sf. Even warehouse space can be highly specialized today, including high-cube to accommodate the new storage technology, or dock-high local storage for lower volume distribution.

Manufacturing facilities usually have the greatest number of special-purpose characteristics, such as drainage wells, overhead cranes, two-foot-thick concrete floors, and special lighting and exhaust systems that preclude their use by other businesses. The possibility of hazardous materials in any manufacturing process may require consultation with experts who can advise on ways to minimize the landlord’s liability for adverse consequences.

Office buildings, even though they come in all sizes and styles — from free-standing, one-room buildings to lush garden complexes to high-rise palatial headquarters — are easiest to evaluate because they are the most closely tied to location as an indicator.

The purchase price should take into account replacement costs and comparable sales, but be wary of an overmarket rent that cannot be achieved with another tenant in the future. Inflated rents may make the investment return appear desirable. However, if market rents and prices of comparable buildings in the area are substantially lower, the resale value may be less than what the investor paid for the property and the actual yield probably will be lower than other alternative opportunities in the marketplace.

Analyze the effect of overmarket rents on investments by generating a range of internal rate of return calculations, incorporating these assumptions that might impact resale values:

• The tenant renews at a consistent rental rate in the year of sale.
• The property must be released at projected market rent in the year of sale for the same type of use.
• The property must be released for a different use.

Comparing these IRRs demonstrates the marginal value attributed to the current tenant, over and above the demonstrated investment value. Whether or not it is in line with reality can be a subjective call based largely on a client’s "feel" for the company. Quite often, buyers will ignore the importance of the type and location of the real estate when evaluating a triple-net investment. It is not unusual for a fast-food facility to sell at four or five times the replacement value, because the investor is satisfied with the projected return based on the tenant’s strength and length of the lease. But brokers must educate buyers as to the potential problems if such tenants were to go out of business.

Furthermore, if the triple-net facility is located in a shopping center, the owner also must consider the effect of a possible failure of the business location, even if the tenant "goes dark" but continues to pay rent. The loss of traffic, which the credit tenant might have drawn, can impact the sales volumes of every other tenant in the center and destroy the synergism of a previously well-constructed retail mix.

Triple-Net Sellers
Triple-net-leased property sellers fall into three categories: investor/owners of leased properties; owner/users creating sale/leasebacks; and build-to-suit developers.

Investor/Owner. This type of seller presents a known entity for an investor’s analysis. The lease may be a true triple net but with a short remaining primary lease term, requiring either re-leasing or a series of short-term options. Investors can evaluate base rent and expense payment history and may have access to historical sales volumes to assist in determining the likelihood of future income.

Even after the prospective purchaser has analyzed and approved the lease, stipulate a review of an estoppel as a contingency of closing. Many sellers only are willing to involve a tenant during the final stages of the transaction, when they are assured of a sale. However consider what may happen if the estoppel comes back a week before closing and it differs in some way from what the seller’s documents had shown, or worse yet, presents an addendum granting a first right of refusal to purchase the property. Have a clear understanding as to when the seller is willing to submit the form, take note of the response time agreed to by the tenant in the lease, and build this into your contingency timeline.

Owner/User. The triple-net lease is well suited to sale/leasebacks as a way to transition the selling company from having absolute control over its surroundings to a situation where it merely is a "lessee." Despite the emotional response that may be generated by the change in status, the sale/leaseback provides a number of advantages to both seller and buyer. The seller frees up capital, often 100 percent of the equity in the real estate, to expand or enhance the business. Since a business return, generally speaking, is higher than the typical 8 percent to 10 percent real estate return, the seller can benefit from the lower cost of investment capital.

Sellers and buyers also benefit by being able to customize a transaction, negotiating sale and lease terms that reflect unique landlord and tenant needs. Investors, for example, may agree to a higher purchase price in exchange for stipulated rent increases, rather than taking the risk of cost-of-living increases. They may trade a short initial term for a series of 10-year rather than five-year options. Tenants may feel comfortable with the obligations of a bond-type lease because they know the property.

One potential negative is the possibility that the seller overimproved the physical plant to enhance the company’s image and expects the buyer to cover overmarket amenities. This occurs most often with office buildings, but overimproved industrial facilities can be even more difficult to evaluate since the perception of overimprovement is related to the location as well as to the building itself.

Developer. From a logistics standpoint, developers are relatively straightforward, since they are professionals who will have the information you need readily available. As always, consider the seller’s motivations. The developer’s first objective is to build. With a lease in hand, the developer can get construction financing and create the product. The second objective is to sell at a profit, so it is necessary to build a return into the transaction. However, the developer’s costs may be relatively low because of economies of scale in creating a large amount of product. One of the benefits is that the lease is already drawn, and a meticulous analysis of the terms virtually can eliminate the chance of contractual surprises during your client’s ownership.

The main potential downside is that there is no performance history for the site. Second, even experienced developers sometimes give in to a strong tenant’s demands, even though the terms may be detrimental to the property’s investment value.

Armchair Investments
Carefully structured and underwritten, a triple-net-leased real estate investment can be an armchair type of investment. However, before an investor commits capital to such a long-term investment vehicle, pre-acquisition due diligence is paramount. Real estate advisers must ascertain the degree to which the lease is, in fact, a triple-net, the likelihood that the tenant will succeed, and the suitability of the real estate itself for the proposed and subsequent use. Finally, match all of these components to the unique characteristics and goals of the investor to determine if this type of property is a right fit.

Letty M. Bierschenk, CCIM, Kurt R. Bierschenk, CCIM, and William C. Bierschenk, CCIM, are members of the Bierschenk Group in Los Angeles. They provide brokerage, advisory, and capital services to individual and corporate clients. Contact them at (310) 573-3615 or tbg.inc@ix.netcom.com.

Posted by Cochise at 09:11 AM | Permalink

Editor’s note: While industry trends come and go, some investment principles remain infinitely valuable for commercial real estate professionals. A version of this article, originally published in the September/October 2000 issue, is the most viewed article on Commercial Investment Real Estate’s Web site, www.ciremagazine.com, which contains articles dating back to 1994. Although the concepts explained here are not new, they represent some of today’s most frequently used commercial real estate investment calculations. The content has been updated to reflect the terminology and concepts presented in the CCIM Institute’s educational courses. All calculations are performed using Microsoft Excel 2003. Visit www.cire magazine.com for additional financial analysis articles as well as all of CIRE’s previously published material.

While many financial analysis software programs are available today, solving the time-value-of-money problems commonly encountered in commercial real estate can be accomplished quickly and accurately with spreadsheet software such as Microsoft Excel. Specifically, Excel can calculate discounted cash flow measures of value and return such as net present value, internal rate of return, and modified internal rate of return, which provide the foundation for many commercial real estate investment principles.

Some commercial real estate practitioners consider the DCF analysis for valuing income-producing property to be superior to single-period ratio analysis. One principal advantage is that DCF analysis allows consideration of both the amount and the timing of the cash flows (including capital expenditures) from operations as well as from property disposition. Moreover, once the pro forma cash flows are developed, practitioners can assess the risk associated with investments by performing a sensitivity analysis. This allows experimentation with a range of uncertain variables such as interest rates, vacancy and rental rates, and appreciation rates to determine their effects on NPV, IRR, and MIRR.

IRR is perhaps the most popular measure of yield or return in analyzing income-producing real estate. Despite the many technical problems associated with its use, IRR generally is considered the standard measure of return in evaluating commercial investment real estate.

The following examples are designed to facilitate the process of calculating NPV, IRR, and MIRR using Excel. Unlike calculators, Excel allows users to print out their calculations. Familiarity with the process of compounding and discounting as well as with basic spreadsheet calculations is assumed.

Calculating Net Present Value
NPV is the sum of the present values of an investment’s positive cash flows and the present values of its negative cash flows. This calculation results in a single sum that can be positive or negative. Investors generally specify a required or target rate of return for investing capital; it is an “opportunity cost” concept.

The general rule for considering an investment is if the NPV is greater than or equal to zero, the investment should be accepted; if the NPV is greater than or equal to zero, an investor must be earning at least the required rate of return. In fact, if the NPV is equal to zero, the rate of return being earned on the investment is exactly equal to the specified required rate of return. If the NPV is negative or less than zero, the investment should be rejected because the investor is not earning the required rate of return.

To calculate NPV, assume an investor makes a $100,000 investment today to receive the following annual after-tax cash flows: $9,000 at the end of year one, $10,000 at the end of year two, $11,000 at the end of year three, ($3,000) at the end of year four, $12,000 at the end of year five, and $180,000 at the end of year six. The investor’s required rate of return on equity is 12 percent. Enter the assumptions into a template. (See table, Net Present Value.) The shaded cell, B11, is left blank; this is where the answer will appear. The NPV of $19,933 in cell B11 is calculated as follows:

1. Move the cursor to cell B11, where the answer will be displayed.

2. Click on the Paste Function icon (fx). A box of available options appears. (If the box obscures the data, click on the title bar, drag the box out of the way, and release the mouse.)

3. In the box directly under the title “Search for a function,” delete the highlighted narrative content, type NPV, and click Go.

4. Click OK to continue. A box appears to guide users through the calculation.

5. At the Rate prompt, click on cell B9, which specifies the cell containing the requested information.

6. Press Tab to move to the next prompt.

7. At the Value1 prompt, select cells B3:B8, which specifies the cells containing the requested information.

8. Click OK, which closes the box. The investment’s present value of $119,933 is displayed in cell B11.

9. To calculate NPV, type +B2 at the end of the NPV formula in the formula bar near the top of the screen and press Enter. The NPV of $19,933 is displayed in cell B11.

10. Move the cursor back to cell B11. Click on the Increase Decimal icon or Decrease Decimal icon to display additional or fewer decimal places.

Calculating Internal Rate of Return
IRR equates the present value of the positive cash flows and the present value of the negative cash flows. The decision rule for IRR is if the IRR is greater than or equal to an investor’s required rate of return, the investment should be accepted; otherwise it should be rejected.

Using the same investment assumptions, what IRR is earned on the initial $100,000 investment? Start with the same template for the NPV problem, making changes as necessary. (See table, Internal Rate of Return.) The yield of 16 percent in cell B10 is calculated as follows:

1. Move the cursor to cell B10, where the answer will be displayed.

2. Click on the Paste Function icon (fx). A box of available options appears.

3. In the box directly under the title “Search for a function,” delete the highlighted narrative content, type IRR, and click Go.

4. Click OK to continue. A box appears to guide users through the calculation.

5. At the Values prompt, select cells B2:B8, which specifies the cells containing the requested information.

6. Press Tab to move to the next prompt.

7. Leave the Guess prompt blank. (In most cases users do not need to provide a guess for the IRR calculation. If the guess is omitted, it is assumed to be 10 percent.)

8. Click OK to close the box. The yield (IRR) of 16 percent is displayed in cell B10.

9. Click on the Increase Decimal icon or Decrease Decimal icon to display additional or fewer decimal places.

Calculating Modified Internal Rate of Return
MIRR is an alternative to the traditional calculation of the IRR in that it computes an IRR with an explicit reinvestment rate assumption. MIRR has several versions; the Excel version uses the following rates: Finance_rate is the interest rate used to discount all negative cash flows to the beginning of the holding period; Reinvest_rate is the rate used to compound all positive cash flows to the end of the holding period.

The discount rate that equates the present value of all negative cash flows (including the down payment) to the future or terminal value of all the positive cash flows is the MIRR.

To calculate, assume the same cash flow assumptions used in the previous examples. In addition, assume negative cash flows will be discounted at an interest rate of 6 percent and positive cash flows will be compounded at an interest rate of 10 percent.

What annual MIRR would be earned on the initial $100,000 investment? Enter the assumptions into the template. (See table, Modified Internal Rate of Return.) The MIRR of 15 percent in cell B12 is calculated as
follows:

1. Move the cursor to cell B12, where the answer will be displayed.

2. Click on the Paste Function icon (fx). A box of available options appears.

3. In the box directly under the title “Search for a function,” delete the highlighted narrative content, type MIRR, and click Go.

4. Click OK to continue. A box appears to guide users through the calculation.

5. At the Values prompt, select cells B2:B8, which specifies the cells containing the requested information.

6. Press Tab to move to the next prompt.

7. At the Finance_rate prompt, click on cell B9, which specifies the interest rate used to discount any negative cash flows to the beginning of the holding period.

8. Press Tab to move to the next prompt.

9. At the Reinvest_rate prompt, click on cell B10, which specifies the required rate of return, which is the interest rate received on the positive cash flows that are reinvested for the duration of the project.

10. Click OK to close the box. The yield (MIRR) of 15 percent is displayed in cell B12.

11. Click on the Increase Decimal icon or Decrease Decimal icon to display additional or fewer decimal places.

More to Explore
These examples illustrate the simplicity of using spreadsheet programs such as Excel to make a variety of basic time-value-of-money calculations. These examples do not, of course, demonstrate the full range of options and computing power available with the software.

Donald J. Valachi is a clinical professor of real estate and co-director of the Real Estate and Land Use Institute at California State University, Fullerton. Contact him at (949) 936-1796 or dvalachi@fullerton.edu.

Posted by Cochise at 09:10 AM | Permalink

Economic, demographic, and psychographic changes affecting the demand for commercial real estate product types continue to present new and exciting opportunities for developers, municipalities, users, investors, and citizens alike. These changes, combined with the natural evolution of cities and other markets, also present new and unique challenges.

Like politics, commercial real estate is still a local business in many ways. Understanding local dynamics and disseminating the components into manageable pieces that can be further analyzed are critical steps to the success of every real estate project.

Despite the location, some problem solving methods are universal for most real estate projects, such as performing site analyses and market studies or conducting highest-and-best-use, adap