Commercial Lending

Condo Investment - I Would Be Careful

In many parts of the country, residential condominiums are very inexpensive. Even here in the San Francisco Bay Area, some condominiums can be purchased for under $100,000.

While the condos may appear inexpensive, condo ownership is filled with hazards.

Many people forget that when buying a condo, you get the condo association too. Some associations are better than others. You may run into the unfortunate situation of a poorly run association that has not set aside sufficient funds for reserves. In this case, escalating home owner's dues can quickly erode any cash flow.

It is wise to thoroughly review any and all documents relating to a home owner's association. Read the meeting minutes, budgets, and bylaws before jumping in.

Also attempt to determine the percentage of owner occupied properties. Some lenders will not finance condos that belong to an association that have a majority of units leased to tenants.

If you want more information about investing in real estate, head over to http://www.maclennaninvestments.com/blog/. Or give me a call at (925) 385-8798.

Should a Young Professional Buy a Single Family Residence

Saturday's Wall Street Journal had an interesting article about the growing ranks of single female homeowners. The author quotes a letter from her father about some of the pros and cons of homeownership for a single female.

Buying offers "the ineffable qualities of ownership"—that is, presumed emotional rewards—but at the cost of immobility, lost investment returns and continuing expenses (taxes, insurance, repairs, maintenance), which, for a $300,000 house in Newburyport, add up to $18,000 a year, or $1,500 a month. That is for a single-family residence bought for cash. Condos, in his opinion, are merely "buying into trouble; just one difficult owner can be a costly misery" (though he concedes that large complexes with professional management have much less potential for problems).
Renting, by contrast, offers more pros than cons: greater mobility, no continuing costs, no maintenance responsibilities and investment returns on money not spent on ownership—which, in Norma's case at least, could likely cover her rent. He cites the downsides as "no ineffable qualities of homeownership" and "other tenants." (The mortgage tax deduction gives a slight break to homeowners, but not so much as to make a real difference, and generally only those with high incomes itemize their deductions anyhow.)

I have written a post on why I would not recommend that young professionals buy a single family residence as their first property.

In many areas a duplex or triplex is marginally more expensive than a decent single family residence. As well, properties that have 1-4 residential units are more readily financed as an owner-occupied dwelling. Some properties would allow the owner to rent out the units at a rate that would allow them to live almost rent free.

If you are contemplating your first real estate investment as a single person, a duplex, triplex, or fourplex as an owner-occupant is an excellent way to go.

Using Warren Buffett's Principles for Real Estate Investors

From my blog at MaclennanInvestments.com:

View Your Investment as Ownership of a Business
Warren Buffett writes in his 2008 letter to Berkshire Hathaway owners:
We like buying underpriced securities, but we like buying fairly-priced operating businesses even more.
In his 2007 letter to investors Buffett writes:
Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.
A real estate investor must realize that they are buying a business when they buy rental property. Businesses must market and sell a product to customers that are ready, willing, and able to buy in order to make a profit.

Becoming an Equity Investor

Many established investors as they reach retirement age may be transitioning from a "hands on" investing style to a more passive investment approach. They may be looking to do less work and yet put some of their capital to work in other properties.

Minority Equity Investor

The current market provides a unique situation where investors with capital can make investments in existing commercial properties and reap large rewards by becoming a minority equity investor.

Many properties that were bought in 2006 and 2007 will not be refinanceable in today's market. This means that if their loan comes due more equity will be required to finance the property or the loan will be in default.

Backed Into a Corner

Many commercial property owners do not have enough cash to pay down the mortgage out of pocket.

Equity investors can leverage this situation to their advantage by providing the necessary capital in return for an equity stake in the deal.

The equity investor is providing the only alternative that some property owners will have to foreclosure.

Don't Get Greedy

Equity investors need to walk a fine line between asking for too much and giving away the farm.

If an equity investor asks for an exorbinant return, the current owner may be offended and walk away from the deal. At the same time the equity investor needs to safe guard their investment.

Commercial real estate investors should look for opportunities to provide this type of equity investment.

Medical Office a Bright Spot for Commercial Real Estate

Yesterday I spoke with a developer selling medical/dental office. He told me that despite the lack of financing in general, doctors and dentists were still able to find financing through SBA loans.

This is confirmed by an article from NREI Online:

While office building transactions have fallen off a cliff in recent months, one bright spot many industry analysts point to is the medical office building market, where sales typically range from $10 million to $30 million. According to the latest data from Real Capital Analytics, sales of medical office properties totaled $3.3 billion in the first nine months of 2008, a 13% drop compared with the same period a year earlier. But that dip pales in comparison to the 62% dive in property sales for the entire office market in the third quarter.

Vacancy and Rental Rates Affect Commercial Value

Imagine that little retail center near your house.You know the one.

It has your favorite coffee shop, the weird home decor shop, a woman’s clothing boutique, the nail shop, and the national auto parts store.

Over the years you’ve seen the stores change. Different shop owners have come and gone. The coffee shop has been there for a while. The woman’s clothing store is only a year old.

As you drive by you notice a “Going Out of Business” sale going on in the home decor shop. You’ve talked with the owner of the woman’s boutique and she is having a rough time making a profit.

If these two stores close their doors, you wonder who is going to fill this space. What is going to happen to the owner of that little retail center? Where will he find tenants?

The Plight of Retail Stores

Americans are spending less money these days. We built our economy upon the model of consumption and borrowed to fuel that consumption.

With the well of cheap financing depleted, spending has come to a screeching halt. Retailers nationwide are taking a hit. The recent headlines have featured the likes of Circuit City, Mervyn’s, Shoe Pavilion, and Linens ‘n Things.

The Pain on Retail Center Owners

When a retail store closes or “goes dark” the landlord will feel the pain of having a vacant store. (Some leases do have a provision that stores can close but while the tenant continues to pay rent.) This means that she does not have as much rental income to pay the bills she faces for owning the property.

How Vacancy and Rental Rates Affect Value

I shared here the most common method to value income producing property. The most important numbers to determine value are Net Operating Income (NOI) and the Capitalization (Cap) Rate.

Rental rates and the assumed vacancy rate will affect the NOI. NOI is then used to calculate the value of the property based on an expected return to the investor, the Cap Rate.

Slight Changes with Devastating Effects

So how would a 10% decrease in rents, a 5% increase in vacancy, and a 1% increase in Cap Rate affect a properties value?

Notice that the value decreases by 26%.

Also notice that the change in the maximum loan amount decreases by $1.08 million. If the borrower needs to refinance under these new assumptions, the borrower will need to come up with over a $1 million to close the loan. The foreclosure process and bankruptcy are not far away.

The Current Credit Crisis

Currently, some institutional lenders have begun to underwrite retail loans along the lines of this scenario. They are forecasting decreasing rents and higher vacancy rates.

Some lenders are incorporating a higher cap rate as well. (One developer I know said that he hasn’t started a retail project unless it underwrote at a 8% cap rate or higher because of historical cap rates, even during the boom times.)

Unless, a retail property absolutely must be refinanced now, the wise real estate investor would be best served to hold off until cooler heads prevail.