Cash Flow Duration And The Term Structure Of Equity Returns Real Estate Investing Fundamentals in Tough Economic Times

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Real Estate Investing Fundamentals in Tough Economic Times

In these tough economic times, real estate investment thinking is going back to basics. Whether investing in commercial real estate, defined as office, retail, hotel and industrial real estate, or in multifamily real estate, times are different than in the recent past. For the seasoned investor, it is time to go back to fundamentals and understand not only the real estate market, but also a critical understanding of the capital market to achieve some level of success. This is even more important for novice real estate investors.

During the boom period from 2002 to the first half of 2006, capital was abundant for all types of real estate. Most property types were easy to finance on favorable terms. With ambitious money looking for opportunities, lenders opened the tap and investors were able to tap into a variety of sources to finance the purchase. Gone are the days when lenders lent based on a property’s future potential income and appreciation. As a result, most buyers during this time period paid a premium for their acquisition in anticipation of property values ​​continuing to rise at a double-digit rate, as has been the case for most of this time.

Today we are in a completely different environment. Today, more than ever, it’s important to get back to basics. For investors considering a purchase, there are several considerations and calculations at the property and financial level that need to be made to help properly evaluate the purchase. Qualified and experienced professionals can be invaluable in this field and help ensure success.

A necessary first step is to define the goals for each property, which relate to the ownership, operation and management of the property and a possible exit strategy. The following summary describes the main aspects that are important to a successful investment program, whether at the entry level or at the level of a more experienced real estate investor.

Types of real estate: Different types of properties require different aspects of property management and operations and have different income and expense profiles. An example is a full-service office building where the owner pays all building operating costs and maintenance without passing it on to the user. It is true that the rent paid by the office occupier reflects operating expenses, but leases may contain cost freezes that prohibit any amount above a certain dollar amount per square foot that can be passed on to the occupier of the space. In this case, the owner will have to absorb an amount that exceeds the amount of the stoppage of cost increases. In contrast, the owner of a retail shopping center will usually pass all the costs of the property on to the user without compensation or stop costs. Therefore, the operating costs of a shopping center will usually be less of a cost burden for the retail owner than for the commercial building owner due to the contractual (lease) option to pass all the costs on to the tenants. This is just one of the main factors when considering investing in an office building compared to the retail center example used here. Different property types will have different vacancy rates, rents and expense ratios and will be market oriented. All of these factors are important when evaluating a purchase. Lenders also rely on historical market metrics and property performance profiles when assessing their buyout criteria as a basis for how much they will lend, what level of income is required to meet the annual loan debt, for many other properties that are performing, market and management factors. Different types of properties have different operating and costing and financing aspects that must be thoroughly studied in order to achieve success.

Property location: That old real estate adage: location, location, location. Yes, this even applies to commercial real estate. A comprehensive analysis of location factors is crucial for a successful investment program. Due diligence is required and the first step is a geographic analysis that includes elements such as transportation systems, major employment centers, and demographic and economic data, as well as a host of other information useful in assessing the wider area where the property is located. A very useful tool to help with this analysis is a GIS or geographic information system. When a larger market area is analyzed, it is necessary to focus more narrowly on the location of the real estate market to eliminate any special factors that may add value to the property, such as a major employer located in the market area, or any factor that deducts the value from the property. such as a new zoning ordinance that limits the use and height of buildings. Once these analyzes are done, it is also important to conduct due diligence on the particular property being considered. This ranges from the importance of carrying out a structural inspection to environmental/soil studies to all associated legal and physical land and site assessments and other local regulatory assessments to ensure there are no problems or potential problems.

Legal and tax aspects: There are several different ownership entities that can be used in real estate investing with their own tax and legal implications. It is important that you have a good understanding of each type and how each type affects you and your tax situation. An experienced team of legal and tax professionals is important in solving these issues. For example, forming an LLC may not be the best entity for tax consequences. LLCs are a popular vehicle for owning real estate for liability, but not necessarily for tax reasons. For example, operating a real estate investment and employment business may require another business entity, such as a Subchapter S corporation, rather than operating as an LLC. There are too many problems and potential risks to tackle alone. Having a team of experts to handle all aspects of legal and tax matters is critical. The same can be said for real estate professionals who understand not only the real estate market, but also the capital market, and experienced negotiators who work on your behalf. Having a team of seasoned professionals in your corner is always prudent.

Financing: Today, the credit market is more difficult than ever. Lenders are not in a lending mood. Due to changes in the credit and lending environment, it is extremely difficult to obtain financing for any business today. Gone are the days when lenders based their decisions on pro-forma estimates of cash flow and property appreciation. Understanding the current situation is not only important, but today it is even more crucial for everyone to have a chance for a successful investment program. Leverage was the name of the game in the recent past. Still, importantly, any acquisition will require a higher equity position than in the past, resulting in lower returns than with the higher leverage involved in the deal. So some questions are: How will this affect the expected returns on the investment? How will this affect the money needed for property renovations and other capital reserves for expected or unexpected major repairs? Is the required use of more funds going into the business (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 a deal, especially given the environment we’re in today. For example, is there a strong leasing market to support the asking rents and future rate increases that will more than cover lenders’ higher debt service requirements? An important part of the process and overall analysis is also a team of experts who help you assess and advise on such issues.

Exit Strategy: How long do you expect to own the property? What will the market be like when it’s time to sell? What government regulations (eg zoning and land use) have changed since the acquisition? What are the credit/loan markets like? What will the demographic projections and employment forecasts be? A crystal ball is needed to answer these questions. Of course, no one knows for sure. An exit strategy, preferably formulated before the purchase, is as important as the decision to purchase. An exit strategy should be the basis for any decision to invest or not. The above questions along with many other ownership, legal, tax and financial considerations will help shape the investment program and its likelihood of success; success here means making a profit. Why else would an investor participate in a venture with no chance of profit? A well thought out investment program always starts with an exit plan. This is especially true for investment properties. It is often said that you earn money when you make a purchase. It is also true that you will make a profit or a loss with or without your exit strategy.

Whether you are a seasoned investor with many properties or a beginner considering your first deal, understanding and performing due diligence with attention to detail of the important real estate investment processes and engaging in the necessary analysis will contribute to a successful investment program. Especially in today’s economic environment, it is critical that investors thoroughly research all the issues that real estate may present, along with understanding the financial considerations and legal and tax aspects of owning investment properties.

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