Real Estate Investment Strategies Part 2

By Bob Nelson Written on 1/1/2010

Part Two: THE REAL ESTATE INVESTMENT MARKET

WHERE ARE WE NOW

As “Part One” summarized, the pre-2009 investment real estate was red hot, but starting to cool at a rapid rate. What had been “too many players with too much credit opportunity were driving prices ever higher. Now things started to change.

The Pre-2009 Real Estate Investment Model is summarized below.

1.The Buyer’s Mantra became “Ready, Fire, Aim”.

Restated: Buy any attractive property, and buy it quickly. The only perceived mistake was not getting involved in the feeding frenzy for good looking real estate.

Frankly, there was a lot of truth involved in that strategy in a run-away market.

The old and wise adage of “look before you leap” turned into “Ready, Fire, Aim”

• Offer quickly or lose the opportunity to buy.
• Once you have it under contract, there will be plenty of time to decide if you really wanted the property.
• If you didn’t like what you had roped, you could cut it loose to another investor who was waiting in line to buy it. Or, hold for a very short period and flip it for a profit.

Real estate brokers became familiar with the buying game.

• If three qualified buyers bid on an available property, there was the buyer would was able to get an accepted offer… he or she was referred to as “The Winner”.
• The person who came in second was referred to as “First Loser”, and the third buyer as “Second Loser”
• You only won as a “Winner”. Loser” didn’t count.

2.The Buyer’s Mantra became “Debt is Your Friend… borrow as much as possible.

The Logic: If you could come in with say 10% down and the property appreciated at 20% per annum, then you had a 200% equity rate of return from appreciation only.

WHAT HAS CHANGED?

The following notable changes have happened that have changed the tried and true Real Estate Investment Model

1.A national and world-wide recession that has continued to deepen at an alarming rate.

2.The US Congress led by President Obama has tried all kinds of stimulus efforts to correct the economic downturn.

• Most of the visible efforts involved throwing previously unimaginable amount of money at the banking industry… unfortunately with no visible results of correcting the primary element that will cure the recession… employment.
• The National Debt has increased greatly in recent months.
  • Someone in the future will have to shoulder the burden of dealing with and reducing that debt.
  • Hope that you don’t live long enough for your grandkids to understand exactly what we have allowed to happen. We have mortgaged their future.
  • Big Moral Question: Maybe we owe it to our heirs to accumulate enough wealth to pass to them so they have a running chance at dealing with the situation. Give them “enough to assist them, but not enough to ruin them” with the concept of “entitlement to wealth”.

3.Unemployment rates continue to rise.

• Consequence on the Real Estate Market:
  • Unemployed people soon lack the financial ability to pay rent or make their mortgage payment.
  • Increasing mortgage defaults mean increasing short sales or foreclosures for those who were not lucky enough to have sold prior to our current “short sale and foreclosure ridden market”.

4.Property values are spiraling downward in the face of competition by low priced short sales and lender resales of properties that they foreclosed upon.

• If you are looking to sell or refinance, then a real estate appraiser will be required by the lender who would make the new loan
• As always, real estate appraisers are required to use the most recent sales that have occurred in the market
• However, a number of the recent sales are short sales or resales of bank-owned property. One low sale influences future sales in the eyes of the lender. The lender is looking for Market Value today as well as the current value trend of the market.
• This adverse impact of short sales and foreclosure sales will continue until the bank-owned properties have mostly all been sold.

5.There is a clear and obvious federal move from capitalism toward socialism.

• The move toward much stronger federal regulation of all financial activities is one that causes great uncertainty concerning important financial relationships.
• The federal government takeovers of General Motors and increasing control of the banking industry causes concerns that additional regulation and new governmental agencies could substantially alter the business models that have caused past stability and long term economic trends.
• The recent success of a nationalized health care program is positive in concept. How can you argue that people should not have some minimum level of health insurance? That would seem un-American! However, the question remains: “At What Cost?”  The cost of the plan stacked upon the financial failures of this recession will cause further stress on a system that is bulging at the seams to hold things together.
  • My friends in the insurance industry appear to be next for strong federal regulation. Anytime the government starts to dictate the “actuarial” statistics, something very strange is about to happen.
  • Who Will Pay The Bill? Guess what? You will be fine ….SO LONG AS YOU DON’T MAKE “TOO MUCH” MONEY!

6.Interest rates have been maintained at very low levels. This is highly unusual in a recessive economic environment.

• The recession of 1980 – 1984 was led by increasing interest rates. First mortgage price hit 21% during the heart of that recession.
• Very low interest rates and the availability of mortgage funding so far has characterized the current recession. This is very unusual.
  • The recession of 1980-85 had first mortgage prime at 21%.  You really needed to borrow money if you agreed to borrow it at that rate.
  • It was high interest rates that led to the recession of 1980-85.

7.A mantra of “tax the rich” is heard at the federal level and at the state of Oregon level. Oregon is known for being one of the “Top 10 Most Taxed State in the Nation”.

• This is a dangerous theme. New employment is required to lead us out of the recession. Oregon has lost much of its appeal to those companies who could help the quickest. Small business is the major source of jobs that will create local stability. However, a number of small businesses failed in 2008 and 2009.
• Interesting Issue: People with money have the capacity to maneuver their money to avoid taxation. The big problem with “soak the rich” is that sooner or later you run out of “rich companies” and “rich people” to tax. Then what do we do?

WHAT IS THE CURRENT REAL ESTATE INVESTMENT ENVIRONMENT?

– or –

WHAT DO WE HAVE TO WORK WITH?

Put the above in a blender and put it on “whirl” for about 30 seconds. Then, pour it out and evaluate what we have to work with.

1.Cheap Mortgage Money: At this time, there is an availability of “cheap” mortgage money for:

• Those who can afford to make a 30% to 40% down (depending upon the property type) and as little as 25% down on other asset types.
• Contact me for some hints of some that I have discovered.

2.Increasing Debt Coverage Ratios: The lender’s Debt Coverage Ratio (“DCR”) has replaced the Loan to Value Ratio (“LVR”) as the standard for gauging maximum loan amount for income producing properties.

• Range of DCR: As the recession started to develop, the DCR was increased from 1.10 to 1.25 and 1.30.
• Restated: The amount of a new loan has been reduced rather substantially as the recession continued to progress.
• How the DCR Works:
  • Start with the Net Operating Income of the property and divide it by the Debt Coverage Ratio. This will define the maximum allowed annual principal and interest (P&I) payment.
  • Next, divide that by 12 to identify the maximum allowed monthly P&I payment.
  • Using a “present value” calculator, input that maximum monthly P&I payment in with the lender’s allowed loan amortization term and the lender’s required interest rate.
  • The result is the maximum amount of loan that the lender will permit on that property using that DCR.

3. Uncertainty of the tenant’s ability to pay rent.

Here is where the real estate market has been shaken to the core.

• Retail: A number of national credit tenants (Linen & Things, etc. etc,) have failed during the recession.
  • Past Observation: The retail triple net lease has been valued highly on the pecking order of desirable “institutional quality” investments. Cap rates were relatively low to reflect the low risk faced with national credit tenants.
  • The Problem: As some of the “big names” started to fold, the risk rating sky rockets. It would be logical that the cap rates would also increase to recognize that increased risk
  • Conclusion: The retail triple net credit tenant lease has started to pick up a bad name. Flip on the Red Stop Light.

• Commercial Office: An interesting observation has been made about office tenants. They are starting to contract in amount of space needed. They are also attempting to renegotiate their leases for lower rents. Several of my commercial broker friends are starting to make a special practice in serving tenants as they negotiate against their landlord,

• Commercial Medical: I have had several conversations with skilled doctors concerning the potential impact upon their career and their ability to generate income. They have expressed a deep concern about their continued ability to make good money.
  • Some might say that they earn too much to begin with. Maybe so, but if they have less income, then they can’t pay as much rent for leased medical space. Medical building landlords… are you listening.
  • Lower rents would mean lower values for leased medical buildings

• Residential Income: You have heard the adage… “Everyone needs a place to live”. That is true, but watch the “trickle down effect” take an interesting gyration during a heavy recession.
  • Vacancy factors has started to increase.
    • However, in the Eugene-Springfield apartment market, the vacancy factor has increased from about 2% to about 4%. That is a rate that can very well be tolerated.
    • My friend Brian Miles, CCIM of SMI Commercial Real Estate in Salem has observed that vacancy factors for apartment units has doubled over the past six months in the greater Salem apartment market.
    • The commercial appraisers who appraise apartments are the best source of current vacancy rate and rent level information.
      • The problem is there are few that are generating published vacancy and rent reports any more. Rick Duncan MAI and owner of Duncan Brown Appraisers in Eugene stated that he grew tired of his competition using his reports in their appraisal reports.
      • Rick Duncan and several of the larger apartment complex property managers are the best source for vacancy factors in the Eugene-Springfield area. Rick is my “go to” guy when I need to get a quick and accurate temperature check of the apartment market in the Eugene-Springfield area.

My Caveat To You

Concerning “Real Estate Market Information”

Be very cautious when accepting information as “fact” concerning the “real estate market”.

The “real estate market” consists of a number of localized sub-markets based upon:

1.Type of property

2.Type of tenant;

3.Location; and,

4.Quality of the information source.

Often I real articles in the local newspaper claiming that “real estate is a total train wreck”. Then check the source. It is an article written in very generic terms about the “housing market” is some region far form the I-5 Corridor between The California border and the Canadian Border.

My Observation Concerning the I-5 Corridor (Oregon and Washington): to date

1.Property values for most types of tenant occupied real estate have held up rather nicely compared to other parts of the nation.

2.Mortgage funding is available to those qualified to purchase.

3.Occupancy levels are showing strains of a recession, but this is where the product types would be anticipated to have recessive problems

Read part three