February 28, 2024

Fryer And Brown

Creating Your Dream Home

Real Estate Investing Fundamentals in Tough Economic Times

In these tough economic times it is back to fundamentals when contemplating real estate investing. Whether investing in commercial properties, defined as office, retail, hotel and industrial property, or in multi-family residential property, it is a different time than in recent past. For the experienced investor it’s time to get back to fundamental principles and understand not only the property market, but just as critical, understanding the capital market in order to achieve some level of success. This is even more important for the beginning real estate investor.

During the heydays of 2002 through the first half of 2006, capital was plentiful for all property types. Most property types were easily financed with easy terms. With amble money looking for opportunities, lenders opened the spigot and investors could tap into a variety of sources to finance an acquisition. The days of lenders lending based on future potential income of the property and appreciation is gone. As a result, most buyers during this time period wound up paying a premium for their acquisition in anticipation of continued property values appreciating at a double digit pace as had been the case during much of this time.

We are in a totally different environment today. Today it is more important than ever to get back to fundamentals. For investors contemplating an acquisition, there are several property level as well finance level considerations and calculations one needs to perform to assist in properly evaluating a purchase. Qualified and experienced professionals can be invaluable in this area to help insure success.

A necessary first step is to identify goals for each property as it relates to ownership, property operations and management, and an eventual exit strategy. The following summary outlines the major considerations that are important to a successful investing program, whether at the beginner stage or at the level of the more seasoned real estate investor.

Property Types: Different property types require different property management and operating considerations as well as have different income and expense profiles. An example is a full-service office building where the owner pays all building operating expenses and up keep with no pass-through to the user. Granted, the rental rate the office user pays reflects the operating expenses, however, there may be expense stops in the leases prohibiting any amount over a certain dollar amount per square foot that can be passed-on to the user of the space. In that case, the owner will have to absorb the amount over the stop amount of the increase in expenses. Conversely, a retail shopping center owner typically will pass-on all property expenses to the user without offsets or expense stops. Therefore, the retail center operating expenses will typically be less of an expense burden for the retail owner than for the office building owner due to the contractual (lease) ability to pass-on all expenses to the tenants. This is just one major consideration when contemplating investing in the office building versus the retail center example used here. Different property types will experience different vacancy rates, rental rates and expense ratios and will be market driven. All these factors are important when evaluating a purchase. Lenders also rely on historic market metrics and property operating profiles when evaluating their underwriting criteria as a bases for how much they will loan, what level of income is required to meet the annual debt service on the loan, to many other property operating, market and management factors. Different property types have different operating and expense as well financing considerations that must be thoroughly investigated to achieve success.

Property Location: That old adage in real estate: Location, Location, Location. Yes, it is even true in commercial real estate. A comprehensive analysis of the location factors is crucial for a successful investment program. Due diligence is required and a first step is a geographic analysis that includes such items as the transportation systems, major employment centers, and demographic and economic data to a host of other information useful to assess the broader area where the property is located. A very useful tool to aid in this analysis is GIS, or Geographical Informational System. Once the larger market area is analyzed, a narrower focus on the property market location is necessary to flush-out any particular factor that can add value to the property such as a major employer locating to the market area or any factor subtracting value from the property such as a new zoning ordinance restricting uses and building heights. Once these analyses are done, it is also important to do your due diligence on the specific property under consideration. This ranges from the importance of conducting a structure inspection to environmental/soil studies to all the related legal and physical lot and zoning and other local regulatory assessments to insure no problems or potential problems exist.

Legal and Tax Considerations: There are several different ownership entities that can be used when investing in real estate with their own tax and legal consequences. It is important to have a fundamental understanding of each type and how each type affects you and your tax situation. An experienced team of legal and tax professionals are important to assist in navigating these issues. For example, setting up a LLC may not be the best entity for tax implications. LLCs are a popular vehicle for real estate ownership due to liability reasons, but not necessarily for tax reasons. For example, operating a real estate investment business and having employees may require a different business entity such as a sub-chapter S corporation instead of operating as an LLC. There are too many issues and potential risks to go it alone. Having a team of professionals to handle all aspects of the legal and tax considerations is critical. This can also be said for having real estate professionals who understand not only the property market, but also the capital market, as well as experienced negotiators working on your behalf. Having a team of experienced professionals in your corner is always prudent.

Financing: Today, more than ever, it is a tough credit market. Lenders are not in the lending mood. With the changes in the credit and lending environments it is extremely difficult today to obtain financing for any deal. Gone are the days when lenders would base their decisions on pro-forma estimates for cash flow and property appreciation. Understanding the current situation is not only important, but it is even more so today, crucial for anyone to have a chance for a successful investment program. Leverage was the name of the game in the recent past. It is still important, however, any acquisition will require a higher equity position than in the past, which will result in lower returns than with a higher leverage position going into the deal. Some of the questions then are: How will this affect expected returns on the investment? How will this impact money needed for property renovations and other capital reserves for expected or unexpected major repairs? Is the required use of more funds going-in to the deal (equity) and the resulting return on that money to make it profitable better-invested elsewhere? There are a host of other questions and calculations needed to fully assess the feasibility of financing the deal especially given the environment we are in today. For example, is there a strong leasing market to support asking rental rates and rate increases in the future that will more than cover higher debt service requirements from lenders? Again, having a team of professionals working for you to help evaluate and advise on such issues is an important part of the process and overall analysis.

Exit Strategy: How long do you expect to hold the property? What will be the market when its time to sell? What governmental regulations (e.g., zoning and land use) have changed since the acquisition? What is the credit/lending markets like? What will the demographics and employment projections look like? These questions require a crystal ball to answer. Of course, no one knows for sure. An exit strategy, preferably formulated before the acquisition, is as important as the decision to purchase. The exit strategy should be the basis for any decision to invest or not. The above questions along with a host of other property specific, legal, tax and financing considerations will help to formulate the investment program and its likelihood for success; success here meaning making a profit. Why else would an investor partake in an endeavor without the possibility of a profit? A well thought-out investment program always starts with an exit plan. This is especially true in investment real estate. It is often said that you make your money when you make the purchase. It is also true that you will realize a profit or loss by your exit strategy, or lack of one.

Whether you are an experienced investor with many properties or a beginner contemplating your first deal, understanding and performing due diligence with attention to details of the more important real estate investing processes and engaging in the necessary analysis will go along way toward any successful investment program. Particularly given today’s economic environment, is paramount that investors thoroughly vet-out all issues a property may represent along with understanding financing considerations and the legal and tax considerations to owning investment real estate.