Doug Marshall's Blog, page 12

3 Steps to Recession-Proof Your Real Estate

SAM ZELL’S ASSESSMENT OF THE R.E. MARKET

Last month real estate magnate Sam Zell stated, “The real estate cycle is nearing its end.”  Mr. Zell is the founder and chairman of Equity International, a private investment firm focused on building real estate-related businesses.  He is a self-made billionaire.  Back in the early 1990s he coined the phrase “Survive til ’95.” You see, there have been other real estate busts.  So when Sam Zell says we are nearing the end of the current real estate cycle we should all take heed.

Does this mean we should start panicking?  Heck no!  As Sam Zell would tell you, there is big money to be made during real estate recessions.  Back in the 90s he was known for buying properties at well below replacement costs and when the market turned he made out like a bandit.  And when this real estate cycle turns we can follow his example.

But before we get to that stage in the real estate cycle where properties are cheap again we need to survive the pending downturn.  As I’ve stated in previous blog posts, I believe that the real estate market in the Pacific Northwest peaked in 2016.  There will likely be a number of years before we reach the bottom of the market and when that happens doom and gloom and gnashing of teeth will be the overriding emotions.  But before that happens there is plenty of time to prepare for the inevitable.  And remember there is money to be made during a recession if we keep our heads when everyone else is losing theirs.

SO HOW DO WE PREPARE?

Buy the right real estate asset classes that are less susceptible to a recession.
Sell the real estate that we don’t want to get stuck with when the next recession happens.
Recession-proof the properties we want to keep in our real estate portfolio.

BUY RECESSION-PROOF REAL ESTATE ASSET CLASSES

Are there really recession proof real estate asset classes?  It depends on what you’re asking.  If you mean, is there such a thing as risk free real estate, the answer is unequivocally, no.  Heck no!  But you already know that, don’t you? However, are there some real estate asset classes that do better in a downturn?  Yes. Absolutely.  I believe there are three asset classes that will do much better during a recession than the overall real estate market.  They are:

Medical Office – Even during a recession, people need healthcare.  It is true that those who end up unemployed are likely to postpone elective procedures.  Some will even forgo life-saving operations though they don’t need to as no one is turned away from a hospital’s emergency room.  Counter balancing this behavior of using less healthcare in a recession are the estimated 10,000 baby boomers that are currently retiring daily.  The Centers for Medicare and Medicaid Services project a 5.8% annual increase in healthcare spending through 2025.  The aging of the Baby Boomer generation makes the medical office asset class almost bullet-proof.
Senior Housing – As the Baby Boom generation continues to age, the need for senior housing will be in greater demand.  We are currently facing a supply shortage of all types of senior housing – independent living, assisted living, memory care and skilled nursing care.  As long as you have an experienced senior housing operator managing your property, this asset class also looks like a sure bet.
Class B & C Apartments – Everyone needs a place to live, but those who become unemployed don’t necessarily need to live in upscale, trendy, Class A apartments.  During the Great Recession, Class A apartments suffered from concessions and higher than normal vacancy.  However, Class B & C apartments did much better weathering the recession.  This will likely be the case this time around as well.

SELL BABY, SELL!

I currently have listed a small apartment that I don’t want to get stuck with when the next recession hits.  Although the property has substantially appreciated in value over the years, it has consistently been a disappointment when it comes to cash flow after debt service.  We have it listed at a “silly-stupid price” and because of the lack of product on the market, we will likely get close to the asking price.

How about you?  Do you have a property that during the good times has at best only limped along?  Now’s the time to get rid of it because you know that during a recession it’s performance will only worsen.  I firmly believe in the Greater Fool Theory.  It’s time to find a greater fool than me to own the property I currently have listed.

3 WAYS TO RECESSION-PROOF YOUR REAL ESTATE PORTFOLIO

I hate to sound like a broken record as I’ve given this advice several times over the years.  It will sound very familiar to those who read my blogs regularly, but it bears repeating.  There are three things you can do to recession-proof your real estate portfolio

Don’t overleverage your properties with debt – Those who overleverage their properties may pay the ultimate price – the loss of their properties through foreclosure.  To avoid that from happening, do a vacancy breakeven analysis.  At what vacancy rate does your property break even?  If the breakeven vacancy rate at your property is lower than the vacancy rate for your asset class during the Great Recession, you have a problem.  Now’s the time to be proactive and pay down the loan, or if necessary, sell the property.
Refinance properties with higher interest rate loans than currently being offered in the market – If it’s been awhile since you financed your property, you need to compare your current interest rate with what you could get today.  Do the math.  If you can lower your monthly debt service by refinancing, now is the time to do so.


Build a rainy-day fund – It’s amazing what cash in the bank will do to save your bacon when the hard times hit.  If you’re currently a bit thin on cash, now’s the time to start setting aside some money to help you weather the economic storm that’s coming.  Be the proverbial ant, not the grasshopper.

Sources: Sam Zell, Wikipedia.org/wiki/Sam_Zell; End of the Current Real Estate Cycle?, blog.thebrokerlist.com, May 22, 2017; What is the Most Recession-Proof Real Estate Asset Class?, by Dave Jacobs, llenrock.com, June 30, 2016;

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Inside the Mind of Donald Trump: What Makes Him Tick

Before I begin, I need to tell you that I didn’t vote for Donald Trump.  By the way, I didn’t vote for Hillary Clinton either.  This article is not my attempt to persuade anyone of the merits or demerits of having voted for Donald Trump.  Sorry, I’m not going to go there.

The purpose of this article is to try to explain to my readers how President Trump thinks.  Now I’m not talking about his policies.  Again, I’m not going there.  No, I’m talking about why he does what he does.  Many in the media like to reference his book, The Art of the Deal written in 1987 as his magnum opus (Latin, for great work).  This makes no sense as it really doesn’t get into how he thinks.

Surprisingly, he has co-authored at least eight books.  The book that I think is the most insightful of those he’s co-authored is titled, Think BIG and Kick Ass in Business and Life.  This book was written 20 years later than The Art of the Deal and does a much better job of explaining his philosophy of life and business.  And because it’s written much later in his life, he’s had that much more time perfecting how he thinks and what motivates him.

Based on reading this book, Donald Trump has eight guiding principles that he follows unfailingly.  Yes, I know that defining someone this way is way too simplistic but it’s my attempt at getting a handle on how he thinks.  Below are excerpts from his book.

How to Succeed 

If you want to become successful and stay successful, you must learn to focus. He who focuses the longest wins.  The ultimate winner is the person who has the discipline to focus on their goals every day of their lives, without fail.  Worry destroys focus.  Every successful person sees their problems as a game to be won.  Never give up.  If you want to be successful, you can never, ever quit.  You have to love what you do or you are never going to be successful.  If you want to be successful, you have to handle pressure.

Believe in Yourself

Show by the way you enter the room that you believe in yourself. Whatever you do, do first class with a big attitude.  You are what you think you are.  Most people think too little of themselves and devalue their own abilities.  Reverse this: Give yourself credit for being smarter than most other people.  Let that be reflected in your attitude about yourself.  Give off the attitude that you are important and worth listening to.  Have a big ego, but do not be egotistical.  Ditch your doubts as doubts lead to failure.  Believe in yourself and you will succeed.

Take Action

Once you set your goals, start looking for opportunities to start acting upon them. Get out of your comfort zone.  You have to leave your comfort zone in order to challenge yourself to achieve greater accomplishments.  Don’t hesitate when an opportunity presents itself.  Do not wait for the “right time” or the perfect time.  It will never happen.  Be a doer, not a dreamer.  Good luck happens when opportunity meets preparation.

Trust Your Gut Instincts

President Trump prides himself on using his gut instincts to make important decisions.  After you understand the problem by getting all the facts and asking others their opinions, you then go with your gut. Practice listening to your instincts because they are there to guide you.  Instinct has a lot to do with timing.  Be patient and wait for your instincts to tell you the best time to make your move.

Get Respect

Get people to respect you by knowing your stuff. It is more important to be respected and feared than to be liked by employees.  Don’t give a damn if people like you.  I pride myself on being obstinate, stubborn and tough.  When other people see that you don’t take crap and see you are really going after somebody for wronging you, they will respect you.

Distrust versus Loyalty

As soon as you succeed they (competitors) are coming after you. Lions kills for food, humans kill for sport.  I value loyalty above everything else – more than brains, more than drive, and more than energy.  Forgive people for their first honest mistake.  Never forgive a crook.

Always Get Even

I always get even. When somebody screws you, screw them back in spades.  When somebody hits you, hit’em harder.  If you don’t get even, you are just a schmuck!  When somebody takes a cheap shot at you, do not be afraid to fire back.

Negotiating Agreements 

You hear lots of people say that a great deal is when both sides win. That is a bunch of crap.  In a great deal, you win – not the other side.  You crush the opponent and come away with something better for yourself.

Instead of adding my own commentary to President Trump’s belief system, I will let his words speak for themselves.  For good or ill, this is how he thinks.  So the next time President Trump does something that causes you to wonder what his motivation was for doing what he did, maybe filtering his behavior through the lens of his eight guiding principles will give you a better understanding of what just happened.  Or, maybe not.

If you would like a four-page summary of the book Think BIG and Kick Ass in Business and Life go to my Recommended Reading List on the Marshall Commercial Funding website.  Scroll down to Professional Growth, Business Development.  Find the book title and scroll over to the right side.  There you’ll find a blue page icon which means a summary of the book is available.  Click on this icon to download the summary.

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9 Recession Planning Tips For Investors and CRE Professionals

The April 28th blog post, A Gathering Storm: 8 Indicators a Recession is Looming, must have hit a nerve with my readers. It turns out that this article is my second most read blog post of all time.

In this article I identified four economic indicators suggesting that the American public is tapped out financially and four indicators that business activity is also slowing. I concluded the article by saying the U.S. economy is beginning to slow down and there is nothing the Trump Administration can do to stop it from happening.

The big question is when will it happen? It could happen later this year or it may not happen till next year. It’s anybody’s guess. Understand this important point: Economic expansions don’t die of old age. Typically, a recession is triggered by an adverse event causing panic among the investor class which then sends the market spiraling out of control. Mob psychology takes over. What could be the trigger? It could be a sudden collapse of an overpriced stock market in the United States. Or possibly it could be the collapse of the real estate bubble in China. It could be anything. And until that adverse event happens this economy will continue to limp along.

But the real point of the article was to motivate you to get prepared. We know a recession is going to happen. It’s inevitable. Why not prepare for it while you still have time to maneuver and plan your strategy? Don’t wait until the recession is upon you. There are things you can do now to lessen the negative consequences of a recession.

That’s how I concluded the article. I was purposely vague as to what you could do today to lessen the turmoil from an impending recession. Some of my readers wanted to know my thoughts on this topic. So today I pony up practical suggestions for both investors and commercial real estate professionals that can help all of us to not only survive the next recession, but to thrive when the economy begins growing again.

Recession Planning for CRE Investors

1. Build a cash reserve. Now may be the time to forgo owner distributions to build a cash reserve, also known as a rainy-day fund. One of the biggest mistakes investors make is not having sufficient cash reserves when times get tough. They like the cash flow being generated during the good times and are happy to pocket it for other purposes but they conveniently forget the negative consequences of rising vacancy on the property’s cash flow. Do you have sufficient reserves set aside for tenant improvements and leasing commissions should the downturn cause abnormally high vacancy at your property?

2. Change the term of your loan. Is your loan coming due within the next couple of years? During the Great Recession, many investors lost their properties, not because they were delinquent on their mortgage payments but because they were unable to refinance their existing loan at the same loan amount. Or it could be that the property owner fails other financial ratios the lender uses to assess an investor’s financial strength and liquidity that prior to the Great Recession they would have had no problem passing with flying colors.

I had a client who built a Class A multi-tenanted office building that at the time of construction was worth about $5 million. The ten-year loan came due at the height of the recession. The property’s vacancy rate at that time was nearly 40%. In order to refinance he needed to pay down the existing loan by about $1 million. But he didn’t have the money to pay down the loan and he couldn’t refinance the property. So even though he had paid every mortgage payment on time for the ten years of the loan, the lender ended up foreclosing on the property.

So how do you avoid that from happening to you? Is your loan coming due during the next few years? If so, you may want to consider refinancing now with a loan term of five years or longer as historically economic downturns don’t last for extended periods of time. If your property’s occupancy rate plummets as a result of the coming recession you won’t have to refinance at the peak of the recession.

3. Another reason to refinance your property is to improve the property’s cash flow. If the last time you financed your property was more than 3 years ago, it is likely the current interest rate is higher than what you could get today. A lower interest rate will reduce the mortgage payment and make your property that much more resilient to a market down turn.

4. Do your capital repairs now. Are there capital repairs that likely need to be completed over the next 3 years at the property? Are you putting off re-painting the exterior, or repairing, resealing and restriping of the parking lot or replacing the roof? Maybe now is the time to make those needed repairs when the property is flush with cash instead of waiting to do the work when the recession hits and cash flow is limited at best.

5. Do a vacancy breakeven analysis on all your properties. Based on your current rent roll and operating expenses, what vacancy rate will result in the property’s cash flow before debt service equaling the mortgage payment? At the height of the Great Recession, apartments averaged a 10% vacancy rate, industrial properties averaged about a 15% vacancy rate and office and retail probably averaged around a 20% vacancy rate. How well does your property do with these vacancy rates? If it can still breakeven with these types of vacancy rates you’re probably okay. If not, now’s the time to make the changes necessary so it can. Do your own breakeven test. If you would like a formula to fill out to accomplish that, let me know.

Recession Planning for CRE Professionals

1. Build a cash reserve – How much? Enough to last at least 12 months without any income. Two years would be better.

2. Forgo expensive and/or questionable purchases. Prior to the Great Recession, I had a friend who was a commercial real estate professional. He lived paycheck to paycheck. When he received a larger than normal commission check, he’d go out and buy the hottest shiny new man toy. The thought of saving money for a rainy day was foreign to him. You see, his spending behavior had a lot to do with his personality which is prevalent among commercial real estate professionals.

Most of us in this business are cock-eyed optimists. We are glass half-full type of people. We have to be in order to succeed and flourish in this business. It requires that type of personality to survive all the negative things that happen until you become a success. But unfortunately, when the Great Recession hit, he wasn’t able to survive the downturn. He lost his job, his house and declared bankruptcy. He currently is out of commercial real estate altogether.

Don’t let that happen to you. Maybe now is not the time to purchase that new car or take that expensive vacation or buy that new house you’ve always dreamed about.

3. Invest in yourself in such a way that potential clients can differentiate you from your competition. Get that CCIM or SIOR designation. Sign up to be coached by a well-respected CRE professional. When the business slows down, be one of the survivors. Make it obvious to potential clients that you have something to offer them that other real estate professionals do not.

4. Stop using the equity in your home as your personal piggy bank. As I mentioned in my last article, consumers have forgotten the lesson from the last recession: Those who borrow end up losing everything. Credit card debt, auto loan debt, student loan debt and home mortgages are collectively at an all-time high. Pay off your consumer debt now. Stop using the equity in your homes as your personal piggy bank. Now is the time to get your financial house in order.

How many properties did investors lose because of the Great Recession that could have been avoided if they had done a bit of recession planning? And how many real estate professionals could have survived the recession if they had done some prudent planning during the good times? Don’t let that happen to you this time around. If you do, I may lose a blog reader and I wouldn’t like that.

A Gathering Storm: 8 Indicators Recession Is Looming

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I hate to be a Debbie Downer to all of you who think things are going well with the U.S. economy.  But there is a stark disconnect these days between consumer confidence and the economic health of the United States.

Last month the Consumer Confidence Index hit its highest level since December 2000.  It dipped a bit in April but it’s still in the stratosphere.  This optimism is baffling to me as economic activity is not keeping pace.  Patrick Moynihan, the former US Senator from New York once said, “Everyone is entitled to his own opinion, but not his own facts.”  And these are the facts:

Consumer Debt is Mounting

Median household income adjusted for inflation is lower today than it was in January 2000. Compounding this problem is real average hourly earnings have actually decreased from February 2016 to February 2017 by 0.3 percent.
As a result, consumers are spending less. Year over year retail sales for the past two quarters are down.  And a substantial decline in auto sales is leading the way.
Even with a slowing of retail spending, consumers are still taking on more debt. Since wages have not kept pace with the cost of inflation, consumers are going into debt to fund the standard of living they are accustomed to.  Credit card debt has ballooned to record highs.  Debt service as a percentage of disposable income is at the highest rate since the beginning of the Great Recession.
Delinquency rates on auto loans, credit cards and student loan debt are all rising at alarming rates. The delinquency rates for subprime auto loans is at the highest level in seven years.  Credit card debt levels are back to where they were prior to the Great Recession.  Student loan debt now totals $1.3 trillion making it the second highest consumer debt category behind only mortgage debt.  The average student loan debt for the Class of 2016 is in excess of $37,000.  Delinquent student loan debt (defined as over 90 days late) totals over $30 billion.

Business Activity is Slowing

Factory inventories have risen seven out of the past eight months. This does not bode well for future production or employment.
Business investments, measured as new orders for non-defense capital goods excluding aircraft, fell 0.1% in February.
Auto sales declined 1.6% in March. Inventories are at the highest level in a decade.
If the above statistics have not gotten your attention, this will. The Industrial Production Index, published by The Federal Reserve, covers manufacturing, mining, electric and gas utilities.  The two year change in the IP index has been negative for the past 14 consecutive months.  Since 1920 industrial production has been negative 17 times.  Every time it has been negative a recession has occurred shortly thereafter.  A batting average of 17 for 17 suggests that a negative IP index is an accurate predictor of a coming recession.

A Trump Bump Was Unrealistic

When Donald Trump was elected president, the electorate was hopeful that the new administration could drive the economy with tax cuts, infrastructure spending and regulatory reform.  But in my January 19th article about my 2017 forecast for commercial real estate I said the following:

“Many economists will tell you that Trump economic policies will stimulate the economy but also have the potential for generating huge budget deficits.  Let’s for the moment accept this as true.  This assumes two things: 1) that the Trump administration is going to successfully pass through Congress their economic policies without any changes; and 2) that if passed that it will positively influence the U.S. economy this year.

I believe both assumptions are wrong.  Any legislation that passes this year will be watered down either by deficit hawk Republicans or Democrats that team up with Republicans on policies that are deemed to favor the rich at the expense of the poor.  More importantly, even if the Trump economic policies are enacted into law it will take months, possibly years, to feel the positive impact of those policies on the U.S. economy.  It doesn’t happen overnight.”

Unfortunately, my prediction is coming to pass.  During the first 100 days of President Trump’s administration they have not been able to pass any of their legislative agenda.  The overhaul of Obamacare hasn’t even made it through the House yet, let alone the Senate.  Tax reform has been delayed till at least this summer and pundits predict that nothing of substance will happen until next year, possibly later.  Apparently, an infrastructure spending bill is not even on the radar screen.  What happened to bi-partisan support for such a bill?  Unfortunately, the economy needs the benefit of tax reform and infrastructure spending right now.  Today would not be soon enough.

Recession is Looming

Understand this very important fact: The U.S. economy is 72% consumer driven.  If consumer spending is slowing down then this economy is in for a sharp decline.  It’s time to face the music.  After 94 months of economic expansion, the economy is heading towards a slowdown.  I doubt that the Trump administration can do anything to prevent the U.S. economy from sliding into a recession.  I would love to be proven wrong.  I don’t enjoy being the bearer of bad news.  Two questions come to mind:

When does it happen?
Are you prepared?

Make no mistake about it, we are headed for a recession.  When, is still up in the air.  It could happen later this year or it may not happen till next year.  It’s still anybody’s guess.  Typically a recession is triggered by an adverse event that gets everyone’s attention.  In 2008 it was the collapse of Lehman Brothers.  In 2001 it was the sudden collapse of  the dot.com bubble.  What will it be this time?  A sudden collapse of an over priced stock market?  Turmoil in the Middle East?  France voting to leave the European Union?  Who knows?

More importantly as a commercial real estate professional or as an owner of commercial real estate are you prepared?  Don’t stick your head in the sand wishing it would all go away.  There is still time to get yourself ready.  Forewarned is forearmed.

Sources: Student Loan Debt in 2017: A $1.3 Trillion Crisis by Zack Friedman, Forbes, February 21, 2017; Economic Indicators Are Flashing Warning Signs That The Economy Has Stopped – No One is Paying Attention by D. H. Taylor, Seeking Alpha, April 27, 2017; Personal Incomes and Consumptions Are Declining Pointing To A U.S. Economic Slowdown, by D.H. Taylor, Seeking Alpha, April 13, 2017; A Gathering Storm of Recession: Top 5 Indicators, by J.G. Collins, Seeking Alpha, April 21, 2017; Auto Loans and Household Income – Time for A Reality Check!, by Tematica Research, seekingalpha.com, March 28, 2017; Closing In On Zero Growth, by Lawrence Fuller, seekingalpha.com, April 10, 2017; The Last 17 Times This Happened There Was A Recession, by Eric Basmajian, seekingalpha.com, April 18, 2017.

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Got a Full Price Offer. Do You Take It?

You’ve decided its time to sell your property.  You’ve spent the past year doing those things necessary to prepare your property for sale and you’ve consulted with your real estate advisory team to determine your asking price. With that important decision decided you’re ready to list your property.

And let’s say that before too long an investor makes a full price offer!  You’re alternately euphoric about getting a full price offer and wondering whether your asking price was too low? You’ll never really know, but the question you need to answer is, “Do I accept the offer?” It sounds like an easy answer, doesn’t it?  But for several reasons it may not be.  Here’s why:

What is the offer contingent upon?

In other words, what items must be satisfied in order for the sale to occur?  Some contingencies are quite normal to the sales process.  All buyers should request that the sale of the property be contingent upon the buyer getting clear title, that the buyer has a reasonable time period to determine the physical condition of the property and to review the property’s historical operating statements and finally that the buyer has adequate time to get financing.  As long as each of these contingencies come with acceptable time frames then you should accept these contingencies as they are reasonable requests.

But what if the offer is contingent upon the buyer successfully changing the zoning of the property?  Or the offer is contingent upon the buyer selling his property?  Or the offer is contingent upon the seller leasing another space at the property?  Then accepting their offer becomes more problematic.  Doesn’t it?  In fact, for all three of these examples, I would reject these offers without hesitation.

But what if an offer is made and the decision to accept isn’t so obvious?  To help make a well-reasoned decision consider these issues:

What is the buyer’s motivation? 

You may be thinking, “Why do I care?”  You should care because it may reveal the probability of whether the buyer will actually close on the transaction.  Two examples come to mind:

Does the buyer intend to convert your property to a higher and better use? If so, the risk associated with that endeavor is much higher than a buyer who simply wants to own and manage your property in its current use and condition.
Did the buyer give you a full price offer just to get control of your property? This is a tactic used to prevent other buyers, maybe buyers who are more serious about buying your property, the chance to put a more serious offer on the table.  Once he has the property tied up, the buyer then renegotiates the price supposedly because of what was “found” during the due diligence process.  In reality, he intended to low-ball his original offer regardless of what was found.  This tactic can successfully keep your property off the market for 60 days or longer.  By taking it off the market for a period of time, the buyer knows that the seller has to weigh the benefit of closing at a lower price than he wanted with the alternative of turning down the low-ball offer and putting the property back on the market not knowing what another buyer will seriously offer for the property.

What is the buyer’s real estate experience? 

Is he well qualified?  Does he have a good track record with owning and managing this property type?  Or is he new to real estate investing?  Has the buyer even seen the property yet?  Is he local?  Does he have experience in the local market providing him a better understanding of the neighborhood than an out of state investor who doesn’t know the market?   Someone who knows the market has a much higher probability of providing a better offer and a higher probability of closing than an investor who does not.

What is the buyer’s financial strength? 

Does he have the net worth, liquid assets, credit score and annual income that lenders would find more than acceptable?  Or is his financial strength questionable?

What is the buyer’s source of funds?

Is the buyer proposing to buy the property with a sizeable down payment making it easier for him to qualify for a loan?  Or is he requesting from the lender an aggressive loan-to-value ratio?  Is the buyer assembling a group of investors to buy the property?  If so, how far along is he in the process of finding his LLC members?  Does he have experience putting together investor groups?  Or is this his first attempt?

Make an informed decision whether to accept buyer’s offer

As you can see, a full price offer may not be the best offer.  If you are fortunate to have multiple offers on the table take the time to understand their real estate track record, their financial strength and their ability to close.  To make an informed decision about which offer to accept, uncover the buyer’s motivations for wanting to buy your property and their source of funds to do so.  To do otherwise may result in a long drawn out due diligence period that ultimately ends with the buyer unable or unwilling to close on the purchase of your property.

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5 Mistakes to Avoid When Investing in Commercial Real Estate

Shown below are five real estate investing mistakes that I’ve seen committed repeatedly over the years.  Avoid these blunders at all costs.

Mistake #1 – Analysis by Paralysis – Getting bogged down in the minutia.

This type of investor believes that the more information they get on the property, the better will be their purchasing decision. Unfortunately, in most instances, that’s not the case.  As the saying goes these investors, “Can’t see the forest for the trees.”  They are too involved in the details of the purchase that they forget the big picture.  Savvy real estate investors don’t get caught up in the minutia.  They generally focus on a small subset of issues to get comfortable with to determine whether or not they’ll make an offer on a property.

Not only does analysis by paralysis complicate the buying decision, it also lengthens the time necessary to come to a decision.  Many times another buyer comes along while Mr. Analysis-by-Paralysis  continues slogging through his analysis and “steals” the property away from him.  In reality, the seller is tired of all the nitpicky questions the original buyer has bombarded him with.  He is relieved someone else is swooping in to save him from Mr. Analysis-by-Paralysis.

Mistake #2 – Doing only a cursory due diligence on the property.

Opposite of Mr. Analysis-by-Paralysis is the investor who does only a cursory due diligence on the property. This usually takes two forms: the first mistake is not reviewing the historical operating statements and current rent roll carefully.  It’s not uncommon that a property’s Profit and Loss Statement is not transparent to the average reader.  Lots of important information can be hidden in the property’s operating statements.  They need to be teased out by asking the seller good, penetrating questions.  For example:

If it’s not obvious ask the seller what the vacancy rate has been over the last three years?
Why did a particular operating expense increase/decrease dramatically last year compared to previous years?
Are their one-time expenses in the operating expenses that should be removed from the projected operating budget?
Why haven’t the rents increased to market for all the tenants shown on the rent roll?

Those are a few questions that may be appropriate to ask.  The second mistake is only doing a cursory physical inspection of the property.  If you’re buying apartments, you need to have your building inspector inspect every unit, the roofs, the laundry areas, the attics, the crawlspaces, etc.  Don’t cut corners when it comes to the physical inspection of the property.  Find well qualified inspectors to represent you who will provide a detailed report of the physical condition of the property.

Mistake #3 – Not having a consensus among the investors about their investing strategy for the property.

If you are buying a property with a group of investors make sure that those who are in the investor group have the same goals and exit strategy as you do. It’s not uncommon to find out after it’s too late that individuals in the investor group have different motivations for owning the property than you do.

Some may want to fix and flip. Others may want to hold the property long term.
Some may want to have maximum leverage. Others may want to have modest leverage in order to maximize cash flow.
Some may want to refinance at the earliest possible opportunity to take cash out. Others may want to pay down the loan over time.
Some may want to invest more dollars in maintaining or upgrading the property. Others may prefer to do less capital repairs and take more cash out of the property.

Before you decide to be in an investor group that is purchasing a property, have a meeting with the potential investors.  Ask the managing member of the LLC to outline his goals and exit strategy for the property. Also get a feel for whether you would want to be stuck with these investors over the investment life of the property.  If you don’t like what you hear from the managing member of the LLC or your gut tells you not to invest with one of the investors in the group, pass on the opportunity.  It’s better that you pass on the investment opportunity than regret it later.

Mistake #4 – Lack of cash reserves for unexpected expenses.

One of the biggest mistakes investors make is not having sufficient cash reserves available for unexpected expenses. This is especially true for multi-tenanted office and retail properties.  For example, a short-sighted investor owns a multi-tenanted office building.  He’s owned the building for years and it has cash flowed beautifully.  But instead of putting some of the positive cash flow into a reserve account for future needs he puts it all into his back pocket.

Then one day one of his larger tenants moves out and the property no longer cash flows like it once did.  Now the owner has to contribute his own cash to keep the mortgage current.  He would like to get the vacant space market ready but to do the generic tenant improvements and pay a leasing commission will cost him more money than he has in his savings.  The space remains vacant because he tries to do the leasing himself to avoid paying a leasing commission.

The property slowly deteriorates because he can’t afford to maintain the property.  Years go by and the loan comes due.  Because the property no longer cash flows, the owner has three choices, none of which he wants to do: 1) he can pay down the loan so the property can achieve the lender’s minimum debt coverage requirement; 2) sell the property at a discount because no one will buy a non-performing property at a reasonable price; or 3) he can give the property back to the lender.

Am I being too pessimistic?  No, not hardly.  This scenario happened over and over again during the Great Recession.  And the sad thing is, it didn’t need to. If owners had established a reserve account for the eventual cost of tenant improvements and leasing commissions they would have had the funds to get their properties re-tenanted.

Mistake #5 – Paying more than the property is worth to avoid capital gains taxes.

A 1031 exchange allows investors to defer their capital gains tax when they reinvest their equity into a like kind-exchange.  Deferring the payment of your capital gains taxes to a later date is a HUGE advantage to real estate investors.  But sometimes investors are so eager to not pay their capital gains taxes that they pay way too much for their exchange property.

If you can find an exchange property at a market price then do a 1031 exchange.  But first find out what the capital gains taxes would be if you didn’t do a 1031 exchange.  No one likes to pay the IRS if they don’t have to.  I get that.  But don’t get silly-stupid about the price of the exchange property.  Sometimes it is better to pay your capital gains tax than to get stuck with a property that will never be a good investment because you paid too much for it.

How about you?  When it comes to investing in commercial real estate, what types of mistakes have you made?  I am interested in hearing your stories.

Source: Investor Mistakes from A to Z, Dale Osborn, Bigger Pockets, https://www.biggerpockets.com/article...

 

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Warren Buffett’s Surprising Approach to Real Estate Investing

As you already know, Warren Buffett, the CEO of Berkshire Hathaway, made his considerable fortune investing in the stock market.  Last year Fortune magazine ranked him as the third wealthiest person on the planet with a net worth approaching $80 billion.  Not too shabby!

But unknown to most people are Mr. Buffett’s two small real estate investments that he made long ago that have amply rewarded him for his willingness to invest outside his area of expertise.  And far more important than their profitability were the five common sense principles he learned from his real estate investments.

REAL ESTATE INVESTMENT #1

In 1986, he purchased a 400-acre farm located outside of Omaha, Nebraska.  He purchased the farm from the Federal Deposit Insurance Corporation (FDIC) who had inherited it from a bank that failed.  Mr. Buffett admits that he knows nothing about farming but he has a son who loves to farm so he turned the day-to-day operations over to him.

Although Mr. Buffett admits his lack of farming acumen he could easily recognize that purchasing the farm was a good investment decision.  As he said, “I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside.”  Three decades later, the farm has tripled its earnings and is now worth five times what he paid for it.

REAL ESTATE INVESTMENT #2

In 1993, he purchased a retail property located adjacent to New York University that the Resolution Trust Corporation (RTC) was selling.   A real estate bubble had popped and the RTC had been created to dispose of assets of failed savings institutions.  His investment analysis was very rudimentary.  The property had been poorly managed by the previous owner and then by the RTC.  The vacancy at the property was well above the market’s vacancy rate for no apparent reason.  The largest tenant’s rent was $5.00 per square foot compared to all the other tenants’ rent averaging $70.00 per square foot.   He realized that when the current lease term expired for this tenant that the new rent on this space would improve the property’s cash flow dramatically.

And like the time he purchased the farm, he realized that he needed to turn the management of the property over to an experienced property manager, which he did.  Over a relatively short period of time, the new property manager was able to lease the vacant space and to raise to market the rent on building’s largest tenant.  As a result, the property’s net cash flow tripled and annual distributions currently exceed 35 percent of his original investment.

LESSONS BUFFETT LEARNED FROM INVESTING IN REAL ESTATE

So what has Mr. Buffett learned from his two real estate investments?

Notice that he bought both properties out of foreclosure when the real estate market was at the bottom of the cycle.  “I will tell you how to become wealthy,” Mr. Buffett once said. “Be fearful when others are greedy.  Be greedy when others are fearful.”  When he bought these two properties most investors were out of the market, fearful that real estate wasn’t ever going to turn around.  Mr. Buffett knew differently and acted upon it.
You don’t have to be a real estate expert to achieve satisfactory investment returns.  But you do need to turn over management of the property to someone who is well qualified to manage the property for you.
You don’t need to do a sophisticated investment analysis to determine whether to purchase a property.  Many times a common sense look at the property will do.  Ask yourself, “What is holding this property back from operating well?”  If you can answer this question and you’re confident that you can correct the problem, then buy the property.
Investing over the long term will eventually solve most problems.  Notice he still owns these two properties, one he bought in 1986 and the other he bought in 1993.  As he likes to say, “Our favorite holding period is forever.”
He didn’t concern himself about their daily valuations.  He understood that he bought the properties at bargain prices and that overtime they would make good investments.  “Games are won by players who focus on the playing field,” he quipped, “not by those whose eyes are glued to the scoreboard.”

How about you?  What common sense principles have you learned from investing in real estate?  I would be interested in hearing from you.

Sources: Buffett’s annual letter: What you can learn from my real estate investments by Warren Buffett, Fortune magazine, February 24, 2014; The World’s Most Powerful People, 2016 Ranking – #15 Warren Buffett, Fortune magazine, September 2016

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Finding “the Hook” – What gets commercial real estate financed

As a commercial mortgage broker I find it fascinating to go through the process of identifying worthy loan opportunities. It’s not always obvious picking the winners from the losers. A mortgage broker/loan officer can waste a lot of time if he/she doesn’t choose wisely which deals to work on.  Stating the obvious, we don’t get paid unless the loan closes.  Therefore it’s critical to our financial well being to focus on those loan opportunities that have the highest probability of closing.

I have seen my peers waste several weeks if not months on loan requests that I could tell up front had little or no chance of closing.  It’s painful to watch and it’s even more painful to experience first hand.  Over the years, successful mortgage professionals acquire a sixth sense about which commercial real estate loan requests can ultimately be financed.

The Initial Steps in Separating the Winners from the Losers

For most mortgage brokers/loan officers the process of finding properties that have a high probability of getting financed goes something like this:

It usually begins with a telephone call, many times from a person I’ve never met who has been referred to me.

I try my best to patiently listen to their request.  I ask probing questions to draw out the issues that will make or break this deal. Usually the deal ends with this first conversation as typically I identify a significant flaw in the deal.  I try my best to tell them as gently as possible that I’m not the right mortgage broker for their loan request.  If possible I then refer them to someone I think can help them.

But sometimes, usually about 1 in 6 conversations, I end the conversation requesting their documentation so I can get a better look at the deal.

Once I get their documentation I underwrite the property and the borrower.  I use the metrics that the typical lender will use to evaluate the loan opportunity.

I then visit the property to see first-hand its condition and its neighborhood

Once I’ve completed this process my deal radar kicks into overdrive.  I try my best to discover what makes this deal a truly good opportunity so that lenders will have no choice but to say “yes.”

Not that I’m telling you anything you don’t already know, but lenders as a rule are very conservative when it comes to risk taking. They have what some people call a “belt and suspenders” approach to lending. To avoid risk they look at the loan through redundant safety procedures, like a man who wears both a belt and suspenders.

Finding “the Hook”

Another word for “safety procedures” is what I call finding “the hook.” I politely ignore the sales pitch that the prospective borrower makes about why this is such a good loan opportunity. Instead I go fishing for “the hook” that I believe will snare the lender’s interest. Shown below are several examples of finding “the hook.” The borrower:

Agrees to sign personal recourse.  He has a strong personal financial statement with substantial liquidity in proportion to the financing request.


Is willing to put in all or a majority of the cash/equity required in the deal instead of a group of passive investors with minimal real estate experience.


Has an excellent track record owning and managing that particular property type with decades of experience.


Is requesting a very low leveraged loan.

These are just a few “hooks” and the more obvious ones. A good mortgage professional has the uncanny ability of finding the less obvious hooks that can change the outcome of a loan request from “no” to “yes.”  They are the unsung heroes of our business. Many times the borrowers don’t even realize what a service they’ve provided to them.

Good Mortgage Professionals Are Hook Finders!

It’s not uncommon for a client to request a loan with all the “bells and whistles” that they heard one of their peers just received. Many times they say it with something of an attitude like, “If you don’t get me these incredibly good loan terms I’ll go to your competition who’ll get it for me.” What they don’t realize is for their friend to have received such a “smokin’ deal” the lender was able to identify “the hook” that made those rates and terms possible.

It is not enough to say that the commercial real estate market is “hot” or a specific property type “can’t miss.”  We need a hook! And that is what I do for a living. I’m a professional hook finder!

Source: What is it that gets real estate deals financed today?; Kevan McCormack; Metropolitan Capital Advisors; April 24, 2013

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My 2017 Forecast for Commercial Real Estate

Recently I heard a humorous quip that is appropriate for the moment we are in: “If you are not confused, it’s because you haven’t been paying attention.”  In preparation for writing this blog post I’ve read several 2017 forecasts from well-meaning and well-qualified economists and political commentators.  Their opinions vary widely as to what this year is going to bring, much more so than you normally see.   Economists usually succumb to the herd mentality.  They don’t want to be wrong so they more or less follow what everyone else is saying.  Not this year.  There are many contradictory opinions about 2017.

Before I give you my thoughts, let me start by saying that the most important events of 2016 were not anticipated.  No one predicted that:

The United Kingdom would vote last June to the leave the European Union.
Donald Trump would be the Republican presidential nominee, let alone win the presidential election.

And I’m confident there will be other important events in 2017 that no one, not the most seasoned prognosticators, will anticipate.  That said, there are really two questions that need to be answered in order to make accurate predictions about commercial real estate in 2017.

What is the health of the U.S. economy?
What phase is the real estate market cycle currently in?

Answering these two questions will go a long way in predicting the health of the commercial real estate market in the Pacific Northwest and beyond.

To help understand where the U.S. economy is headed four questions need to be addressed.

What impact will Trump economic policies have on the U.S. economy?
Will the U.S. dollar continue to appreciate?
Where is the stock market headed?
Will U.S. bond yields move permanently above 3.0%?


What impact will Trump economic policies have on the U.S. economy?

Many economists will tell you that Trump economic policies will stimulate the economy but also have the potential for generating huge budget deficits (related article: 3 Likely Outcomes of a Trump Administration on Commercial Real Estate) Let’s for the moment accept this is as true.  This assumes two things: 1) that the Trump administration is going to successfully pass through Congress their economic policies without any changes; and 2) that if passed that it will positively influence the U.S. economy this year.  I believe both assumptions are wrong.  Any legislation that passes this year will be watered down either by deficit hawk Republicans or Democrats that team up with Republicans on policies that are deemed to favor the rich at the expense of the poor.  More importantly, even if the Trump economic policies are enacted into law it will take months, possibly years, to feel the positive impact of those policies on the U.S. economy.  It doesn’t happen overnight.

Will the U.S. dollar continue to appreciate?

The short answer is yes.  There are too many global influences coalescing together to stop the appreciation of the dollar.  Is this a good or bad for the U.S. economy?  It generally is a bad thing.  U.S. exports become less and less competitive compared to their foreign competitors as U.S. products become more expensive.  It’s a good thing for U.S. consumers who buy foreign goods that are imported into the U.S.  And if you like traveling abroad this is great news.  Travel costs are becoming much less expensive.

Where is the stock market headed?

My track record predicting where the stock market is heading is abysmal.  It’s embarrassingly bad.  So doing the opposite of what I say will likely have a higher probability of being right.   Markets have rallied since November on the expectations that Trump and the Republicans will quickly enact a growth-oriented economic agenda, including tax cuts, regulatory relief and targeted economic stimulus projects.  If my 2017 forecast is right, that Trump economic policies, even if enacted, will have no positive influence on the economy this year, then the strong stock market rally that we’ve experienced since November is unwarranted.

And if you believe that the Price/Earnings ratio is an accurate indicator for valuing the stock market then you have to believe the stock market is overpriced.   Since 2014, the S&P 500 P/E ratio has been increasing at an accelerated rate at a time when company revenues have been declining.  It defies logic.  This recent run up in the stock market only exacerbates this disparity (related article: A Bubble in Search of a Pin – The Unintended Consequences of Low Interest Rates).

Will U.S. bond yields move above 3.0%?

The ten-year bond yields jumped overnight with the election of Donald Trump.  Yields jumped from 1.79% on election day to 2.60% by mid-December.  They have since moderated to 2.34% but they are still well above were they were on election day.  The rationale is that Trump’s economic policies will jump start the American economy allowing The Federal Reserve to raise short term interest rates leading to higher inflation.  That may be a correct interpretation of a Trump election but I’m skeptical.

The world has been fighting disinflation for several years and is losing the battle as evidenced by the negative interest rates in Japan and Europe.  I don’t believe one man can reverse this trend.  My 2017 forecast predicts that once the market realizes this to be true treasury yields will slowly subside.  Treasury rates may not return to where they were pre-Trump but they should trend down this year.

What will be the health of the American economy in 2017?

If my 2017 forecast is correct then I think it is likely that the economy will limp along like it has for the past several years with one exception: The stock market is heading for a correction. When? It’s hard to say.  Can I tell you emphatically that 2017 will be the year?  Heck no.  No one has that ability.  At a day and time unknown to all, some event will occur that will send a tremor through the economy (think Lehman Brothers in 2008).

This event will trigger a series of cataclysmic shock waves resulting in the stock market turning over night.  It won’t be gradual.  It will turn on a dime.  And when that happens the economy will likely dip into a recession as well.  But if there is no adverse triggering event in 2017 we should skate along with the economy continuing as it has for the past several years.

Where are we on the real estate market cycle?

The Pacific Northwest has experienced a strong rental market since coming out of the Great Recession.  The chart below shows the four phases of the real estate market cycle.

My 2017 forecast for commercial real estate

So where do you think we are on this chart?  I believe that rent growth for 2017 will begin to moderate.  Instead of the strong rental growth of the past two or three years we will begin to see rental rates that are much more modest.  If true, then the real estate market cycle is at the beginning of Phase III – the Hypersupply Phase.  And as more product comes on line, vacancy rates will gradually increase.

So how should we respond?  First of all, there is no need to panic.  The world is not coming to an end.  I believe a future economic slowdown is likely but it may be a year or two away.   I believe the real estate market will continue to be strong although at a more moderate pace.   And if treasury rates decrease as predicted then interest rates will continue to foster a healthy commercial real estate market.  While the real estate market is still doing well, now is the time to prepare for a future slowdown in the economy.

3 steps to prepare for an economic slowdown

If my 2017 forecast is right, now’s the time to sell that property you don’t want to get stuck with during the next economic cycle. You know the property.  In spite of a hot real estate market, for whatever reason, it’s not really performing as well as it should be.  It’s time to unload that albatross around your neck.  I believe in the Greater Fool Theory.  Sell that loser of a property to an investor who is a greater fool than you are.J  Now’s the time.  Prices are fantastic.
If you haven’t done so already, it’s time to refinance your properties with modestly leveraged debt at a good interest rate. Call me today (503) 614-1808 for a free no-obligation loan quote.
And finally, if my 2017 forecast is right now’s the time to sock away some additional cash to help you through the slowdown. Cash in the bank solves all sorts of problems and makes life a whole lot easier.

Sources: 5 Trends That Will Impact Your Real Estate Investments, by Doug Marshall, Marshall Commercial Funding, May 16, 2016; A Bubble in Search of a Pine – The Unintended Consequences of Low Interest Rates by Doug Marshall, Marshall Commercial Funding, October 31, 2016; Toronto Real Estate Forum: The Ying and the Yang?, by Robin White, blog.avisonyoung.com, December 29, 2016; Forecasting with Friends, by John Mauldin, Thoughts from the Frontline, January 14, 2017; 2017 Forecast: Skeptically Optimistic by John Mauldin, Thoughts from the Frontline, January 8, 2017

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