Investment Analysis - Value Play

By Craig Haskell

May, 2013

Value-oriented real estate investors believe that real estate assets have an underlying intrinsic value that can be determined by analysis and evaluation. Opportunities for profitable investments arise when the asset’s purchase price is below its intrinsic value.

Value investors evaluate an investment’s opportunity by understanding the relationship between value and price. Thus, the essential task of a successful real estate value investor is to determine the intrinsic value to capitalize on inefficient market mispricing.

In determining the intrinsic value of real estate investment assets, value investors use two generally accepted methods: replacement cost and net present value.

Replacement Cost Method

While most commonly recognized by industry professionals, the replacement cost method can be quite complex to calculate. Often used for new developments, it can provide a guideline for existing projects, especially in today’s market where capitalization rates on high-vacancy properties are not useful.

Determining a building’s replacement cost requires gathering construction-related estimates such as:

  • hard costs (site, building, parking),
  • soft costs (third-party consultants, permits, and fees),
  • contingency costs (unforeseen events),
  • fees (developer, construction, profit),
  • marketing and leasing costs, and financing costs.
  • Common practice is to measure the total cost to replace a building using a cost per square foot method. For example, it might cost $90 psf to replace a multifamily property in Tucson, Ariz., or $125 psf to replace an office building in Atlanta. It really depends on the local market and product type.

    When assessing replacement cost on an investment asset, contact two or three reputable developers or contractors who are familiar with your market and product type to obtain replacement cost estimates. Make sure the cost estimates are an apples-to-apples comparison.

    The rule of thumb is to be a buyer of real estate when prices fall below replacement cost, and a builder of real estate when prices rise above replacement cost. Therefore, replacement cost is the line in the sand — the base line to assessing potential value creation opportunities.

    Net Present Value Method

    The NPV method determines a real estate investment asset’s intrinsic value by finding the present value of future cash flows.

    Present value is properly calculated as the sum of current and future cash flows with each dollar of future cash flow appropriately discounted back to take into account the time value of money. Future cash flows are discounted to present values using an interest rate that the investor could earn in the next best alternative investment. This is known as the discount rate.

    For example, an investor buys a property for $950,000 that has a value creation opportunity requiring $50,000 of capital improvements. The investor’s total initial cash investment is $1 million.

    As part of the value creation strategy, the investor plans to renovate the property by painting and landscaping and to upgrade the resident profile by adding some unique services and amenities. With the new look and upgraded resident profile, the investor expects to raise rents.

    It will take 12 months to stabilize the property. So, in year one, there is no cash flow because of expected vacancy and down units during the repositioning process. But in year two, the property is stabilized with higher rents and occupancy; it generates a $50,000 cash flow. In year three, the property continues to remain strong with rents slowly increasing and generates a $60,000 cash flow.

    In year four, the investor receives an unsolicited offer from a real estate agent to buy the property for $2 million. The investor decides to sell the property.

    The net sale proceeds, after paying real estate commissions and closing cost, is $1.75 million. When the sale proceeds are combined with a $50,000 cash flow in year four, the property generates a $1.8 million cash flow in year four.

    The investor finds an alternative investment of similar quality and risk yielding 7 percent, creating the discount rate for the NPV calculation.

    In this simple example, the NPV is $1,465,861. That’s the intrinsic value of this property assuming the investor successfully executed the value creation strategy. So, an investor can buy this property for $1 million knowing it has intrinsic value of $1,465,861.

    Key NPV Factors

    Because NPV involves future cash flow, it is critical to forecast accurate assumptions when modeling a property investment. Here are a few key factors when determining NPV.

    Investment strategy. Modeling a stabilized property versus a high-vacancy property requires different forecasting assumptions. Use worst-case scenarios to offset potential forecasting and assumptions errors, especially on properties without a consistent operating history.

    Discount rate. The discount rate should reflect market conditions. An increase in the discount rate in the example from 7 percent to 13 percent would reduce the NPV to $1,185,000.

    Income and expenses. Forecasted income and expenses should be reasonable and supported by factual data. Forecast lease-up absorption on vacant properties using market standards. Also, use industry standard expense benchmarks in model assumptions.

    Future sales price. Use a capitalization rate appropriate to the asset’s location, class, and product type that conforms to trending market conditions. Forecasts for capital markets, the local economy, and real estate fundamentals should reflect a safe cap rate when modeling future sales prices.

    Make sure the assumptions in your modeling are founded on sound and reasonable data when determining the intrinsic value of a real estate investment. Understanding the investment strategy, proper discount rate, accurate income and expenses, and future sales price will improve the accuracy of the intrinsic value end result. For protection, value-oriented investors insist upon a margin of safety by buying low in case the intrinsic value calculation was too optimistic.

    Integrating replacement cost and NPV methods into your financial analysis and modeling will help uncover more value-oriented real estate investment opportunities. As the general real estate market improves in the coming years, such opportunities will be harder to pencil out, so take advantage of today’s opportunities using intrinsic valuations as your measurement stick.

    Distressed Decisions - Can you spot a diamond in the rough?

    By Richard Broder, CPM

    March, 2013

    With the real estate collapse several years behind us, the industry has been riding a wave of available distressed commercial properties. But this groundswell of opportunity also brings a groundswell of risk. Knowing what to look for can ensure that a bargain doesn’t become a burden.

    While some analysts believe we may have hit the peak, there are still good deals to be had for savvy investors. Many lenders are still dealing with troubled loans, and while some of them will be worked out with the borrowers, others will make their way to the market.

    The key is to understand the intricacies involved in purchasing a distressed property and do a proper investigation so you — or your clients — don’t end up losing money.

    Complete Due Diligence

    What makes a distressed property attractive is also what makes it a risky opportunity. A property priced below market value means it has issues — delinquent taxes, possible liens, potential tenant issues, and more. You need to identify all the property’s warts before investing. Often the lender may not know or care to know those details, but the buyer doesn’t have that luxury.

    When a property is distressed financially, there’s a good chance that the previous owner has allowed it to fall into disrepair physically. A thorough inspection from the foundation to the roof is imperative in order to understand the actual cost to improve the facility.

    If you’re not familiar with the area, get on the ground and learn the market. Looking at pictures and numbers won’t give you an accurate understanding of what’s going on in the surrounding neighborhood. Identify the demographics and the socioeconomic makeup of the property’s community. Some investors miss out on opportunities to purchase distressed properties in smaller markets because they view them as having less value. But this often is the home of the hidden gem.

    Additionally, find out if the area needs office, retail, or housing. If it is suffering from an overcapacity of active medical offices, strip malls, or industrial parks, then adding similar space with a depressed market value is going to be an uphill battle.

    Use Local Expertise

    Real estate always has been a local product in a local market. Many times out-of-town investors zealously jump into deals with great expectations but shortchange their reconnaissance of the local market. The result is they overpay for a property, then they have to backtrack and bring in a local service provider to make the property profitable or help develop an exit strategy.

    To avoid this trap, identify professional, experienced local service providers upfront. They can help you avoid overpaying as well as identify potential complications, including financial and structural problems — things you’re never going to see in a picture or on a spreadsheet. Local market experts can work to preserve and protect your investment while creating value and cash flow.

    Here are three ways to qualify your provider:

    • Check for professional accreditations, such as the CCIM designation.
    • Ask the tough questions. Determine the firm’s experience in that particular market, ask about their recent successes and failures, find out how they measure results, and look for proof that they pay attention to details.
    • Talk to enough providers to understand the market and average costs for services to avoid overpaying.

    Determine the Price

    There’s as much art as science to determining the appropriate price for a distressed property, especially when there are no recent comparable sales. A conventional model for pricing distressed properties does not exist. It is important that you clearly understand your costs to bring the property back into service and factor that into your calculations when deciding what you are willing to pay. Keep in mind your end goal is to charge the rent you ultimately need to be profitable. If the seller is motivated to get out, you might be able to pay even less for the property.

    In one case where Broder & Sachse recently stepped in, the lender got into a protracted fight with the borrower over a 25-unit overleveraged property in a solid apartment market. The property deteriorated and Broder & Sachse became the receiver. Even though we stabilized the property, the lender wasn’t willing to spend the necessary capital for improvements in order to lease the units. Eventually, a local buyer bought the property for pennies on the dollar and immediately began renovating it. The property now is at full occupancy.

    That’s what can happen when a buyer and lender don’t do their homework on the property. The borrower paid too much and the lender lent too much. The next buyer knew what he was getting — good bones in a good location at a bargain price. He knew exactly what he could do with the property and what it would cost to make it profitable.

    Dealing with troubled or challenged properties is not for the faint of heart or passive investors. Inexperienced investors can often overpay, and in the end, get hurt when they can’t manage the investment. Distressed properties can provide opportunities for new players to enter a market in substantial ways, but the more you know about the property, the better. If you don’t have experience in the arena, be sure to talk to someone who does.

    Taking Credit - Historic preservation tax incentives offer capital solutions.

    By Warren Kirshenbaum

    Jan, 2013

    Taking Credit Historic preservation tax incentives offer capital solutions. by Warren Kirshenbaum

    In the current economic climate, creative thinking is critical when it comes to securing the financing needed to purchase or rehabilitate real estate. With underwriting standards still extremely tight, banks remain less likely to lend, and when they do, loan-to-value ratios are low and collateral requirements are high. This continues to be a major challenge for some businesses.

    In addition, in some highly developed metropolitan areas, it can be difficult to find properties that are financially feasible. However, urban centers that were developed historically as port cities, trading outposts, or early industrialized sites are often rife with turn-of-the-century structures that are well-suited for conversion into apartments, offices, and restaurant spaces.

    But adapting a building to modern usage while preserving and restoring its historic character can be daunting — and expensive. Without the support of historic rehabilitation tax credits, the risk involved would not be worth it for investors and owners.

    Tax Credit Calculations

    Properties listed on the National Register of Historic Places, located within historic districts, or those that can be listed on the National Register are eligible for the historic tax credit at both the state and federal levels. The property’s rehabilitation must meet certain standards that are designated by the National Park Service to maintain the building’s historic character.

    Property owners can use these tax credits to offset federal and state tax liabilities, or they can “sell” the tax credits and use the capital to offset rehabilitation costs. (Although federal historic tax credits are issued to the property owner and are non-transferable, a tax credit investor can be admitted to the property ownership in exchange for a capital contribution in a transaction that has “economic substance” as defined by the Internal Revenue Service.) Add to this the intrinsic value of a historic property — including desirable location and positive sentiment associated with revitalizing a piece of a neighborhood’s history — and historic preservation becomes worth a second look.

    In fact, developers can use historic tax credits as a financing tool. For example, a historic building costs $200,000 to buy and another $800,000 in qualified rehabilitation expenses. The historic tax credit amounts to 20 percent of the QREs on both the state and federal levels, which would be $320,000 in this example. A developer may monetize the federal tax credits and receive a term sheet for the purchase of the state tax credit, thereby raising actual capital (in tranches as construction progresses) for the federal tax credit. This could add $137,600 in construction capital and $275,200 in net monetization proceeds.

    In a situation where the bank is only offering a loan of 60 percent of the cost of the purchase price and QREs, or $600,000, there would be a $400,000 equity requirement to fund the transaction. As mentioned above, the historic tax credit would cover $275,200 (after factoring in transaction costs) of the equity required, leaving slightly less than a $125,000 equity requirement, which is 12.5 percent of the purchase price and QREs.

    Banks financing commercial real estate transactions traditionally require a 20 percent equity contribution by the borrower. By requiring less than the average equity requirement of 20 percent, historic tax credits make such transactions possible. As a result, the historic tax credit program has been one of the nation’s most successful and cost-effective community revitalization programs to date.

    Boston Example

    As developers, owners, and managers look to fill gaps in project funding, state and federal tax credits can make or break the feasibility of resurrecting desired buildings with significant community value. As shown above, these credits on the state and federal level, together with accelerated depreciation, can combine to offset as much as 45 percent (on a gross basis) of a construction project’s budget. Note that with transaction costs, which include the tax credit investor’s purchase discount, the net capital generated may be in the 33 percent range.

    The Fort Point Channel area in South Boston is a good example of an area benefiting from the historic tax credit. This urban area is comprised of several buildings that were owned by the Boston Wharf Co., and previously had been used as warehouse space and for other port and trade-related uses much more prevalent in the early 20th century. Now, these historically significant buildings are being adapted for use as residential apartments, storefronts, restaurants, and office space. Similarly, many other metropolitan areas offer historically valuable buildings in prime locations in need of varying levels of attention.

    Submission Details

    To start the process, the property owner applies to the state historical commission for both federal and state tax credits. In some states, an approved request on the state level is distributed via a competitive allocation process, wherein an owner can request an allocation of the total amount at various points throughout the year. In this scenario, owners may find themselves going back to the state several times as more funding is needed and approved.

    The process of applying for and securing historic tax credits typically requires a development team including a lawyer, a consultant, and a syndicator. Seeking out information about this process before the project commences allows for the potential tax credit equity to be built into a proposed budget or development pro forma, which can lead to even greater control over financing costs.

    Tax incentives such as the historic tax credit manage some of the inherent challenges in preserving a historic building, as well as providing solutions to potential financing conundrums.

    The Lending Landscape

    By Jeffrey Wolfer

    Aug, 2010

    During the first quarter of 2010, four financing sources effectively took control of the lending market. Government-sponsored enterprises, insurance companies, real estate investment trusts, and private situational lenders have money to lend and will finance projects that the national, regional, and community banks won’t touch.

    In a move to target multifamily mortgage refinancing, Freddie Mac has developed mezzanine lending programs, which allows it to partner with experienced players to help borrowers who need to finance or refinance overleveraged and undervalued properties. For example, Prudential Mortgage Capital Co. and Johnson Capital recently joined forces to originate and service multifamily loans for Freddie Mac. This joint venture, Prudential Johnson Apartment Capital Express, will originate multifamily loans starting at $5 million in Arizona, California, Maryland, Virginia, and Washington, D.C.

    Another big player in the multifamily market is insurance companies. After a relatively dormant 2009, life insurance companies are stepping back into this market and filling the pricing gap with the GSEs. Throughout 1Q10, insurance firms such as Prudential, MetLife, and Northwestern Mutual have become more competitive — a direct result of a decrease in cost of capital.

    In addition to working alongside GSEs, some insurance companies have found opportunities in areas where GSEs are less inclined to lend, such as new properties still in lease-up and properties in pre-review markets. Life insurance companies are poised to thrive in today’s revolutionized lending market as they have an exceptional amount of flexibility in their underwriting.

    Private equity funds, such as REITs and situational lenders, are starting to take the lead with distressed and rehab properties. Private equity funds have become an increasingly popular option because they generally finance the riskiest part of the capital structure — sometimes as much as 100 percent of the capital requirements — and often seek returns greater than 20 percent.

    REITs recently have started to pick up steam again because of the broad-based opportunities available in distressed asset acquisitions. Commercial mortgage REITs typically originate or invest in the debt used to finance the purchases of specific properties such as office towers, hotels, and shopping centers.

    The appeal of commercial mortgage REITs is that they usually rebound strongly after difficult times — as seen in the previous commercial real estate crisis back in the 1990s. So far this year, commercial mortgage REITs are up 9.6 percent compared to 2009 when they were down 8.0 percent. An up-and-coming firm in this market is Ladder Capital Finance, which had its initial public offering in late 2009. So far this year, Ladder Capital has completed four commercial real estate transactions totaling $40 million, including a nearly $8 million refinance loan for a retail building in Aventura, Fla.

    Many borrowers looking for safe, reliable sources of financing with attention to time and special circumstances continue to turn to situational lenders. Essentially, situational lenders provide borrowers with hard money or bridge loans to keep their existing projects going until they can refinance. A hard money loan, which strictly deals with the value of the borrower’s assets, is based on an agreed-upon loan-to-value ratio and a collateral piece that is not fundable by conventional lending firms. A bridge loan, on the other hand, deals primarily with providing funding from one lending source to another. Bridge loans generally have lower interest rates than hard money loans.

    Situational lenders have become attractive sources of financing in today’s economy mainly due to their attention to speed, but also because their loans are tailored to the value of the collateral property and the overall risk level of the collateral. A good example of situational lending in action was a $3 million dollar luxury residential development loan that Kennedy Funding extended to M Group Resorts S.A. to finance the construction of the Jalousie Enclave in St. Lucia, West Indies.

    Despite the restricted market, borrowers still face many decisions when it comes to securing capital for commercial real estate projects. However, these modern traditional lenders have gained increased popularity because of their handling of deals in the midst of the economic crisis. Their attraction to borrowers will continue once the eventual recovery occurs.

    Courtesy of: CCIM Education Report

    Community Banks Step Into a New Role

    By David C. Hannah

    Aug, 2010

    Because of the existing credit crunch, community bankers now have the opportunity to look at good loan deals with high-profile companies willing to consider a banking relationship with a small community bank. With the lure of highly leveraged, low-cost, non-recourse debt no longer in play, community banks’ more-traditional approach to lending (lower loan-to-value ratios, proven debt service coverage capability, recourse debt) is not the competitive disadvantage it was a few years ago. Many national banks simply have no appetite for additional commercial mortgage loans — despite long-time pre-existing client relationships — and often are unwilling to issue commercially viable term sheets on new deals. Community bank lending officers recognize these deals are tremendous opportunities to bring larger business clients to the bank, establish meaningful deposit relationships, and, most importantly, create solid loan assets for the bank’s commercial real estate portfolio.

    However, there is a catch. Unfortunately, many community banks cannot meet the total funding requirements for the deals. They are constrained by either their legal lending limits or their own policy decisions and simply cannot do the deals on their own.

    The solution? Banks can band together with other similarly situated community banks to share the credit risk through a loan participation or syndication arrangement. In its simplest terms, Bank A is presented with a rock-solid $20 million commercial mortgage loan opportunity, but has a $5 million loan limit, so it partners with Banks B, C, and D via a loan participation or syndication arrangement to make the deal. 

    Borrowers (and even some lenders) often use the terms participation and syndication as synonyms, meaning any type of loan facility that is shared by multiple lenders; but there is a legal distinction. In a participation arrangement the borrower only deals with the lead lender as they are the only parties to the loan agreement and related loan documents. The borrower can look only to the lead lender for funding, and only the lead lender can deal with the borrower with regard to default or other compliance issues. The participant lenders own portions of the loan purchased from the lead lender, with all of the rights and obligations between them specified in a separate participation agreement. The borrower may not even know of the existence of the participation agreement or the identity of any participant lenders.

    In a syndicated loan, two or more lenders agree to jointly make a loan to the borrower. Each syndicate lender is a party to the loan agreement and receives a separate promissory note in the amount of its funding commitment. Likewise, the borrower only can look to each syndicate lender for funding of its portion of the loan facility. The loan agreement in a syndicated arrangement actually serves both the traditional function of establishing the terms and conditions imposed on the borrower for the credit facility and the additional function of spelling out the rules of engagement among the various syndicate lenders. Day-to-day decision making with respect to the administration of the loan is handled by an administrative agent.

    There is a perception among borrowers that a syndication confers more rights upon the lenders and, therefore, is riskier than a participation loan. But with properly drafted agreements there is very little practical difference in the customer’s borrowing experience under either format. Ideally, the cooperative effort will be seamless to the borrower.

    In addition to lending limit concerns, participant and syndicate banks may be motivated by a lack of loan origination capability with certain types of customers or transactions and the desire to leverage their lending partner’s competence in these areas. Depending on the bank’s willingness to rely on the lead lender’s transaction screening and credit analysis of the borrower, the participant or syndicate bank may acquire new loan assets in areas where they do not have expertise at significantly lower internal costs. 

    Borrowers and lead lenders alike fear that the participant or syndicate banks will not rely on the lead lender’s underwriting, due diligence, or legal documentation efforts, but will want to conduct their own independent review and negotiation processes, thereby adding layers of complexity, cost, and closing risk to each proposed transaction.

    Because of the potential for the “too many cooks in the kitchen” problems associated with lender club deals, many borrowers maintain a high degree of skepticism about the chances for actually closing the loan when told by their relationship bank of the need to bring in additional lenders. In one recent $10 million loan transaction to refinance a maturing CMBS loan on a multitenanted office building, the borrower gave instructions to the loan broker to deal only with lenders able to close on its own account because of fears that multiple lenders would equal trouble. However, after many futile months of false promises and false starts by the national banks and other large lenders, it was a combination of two small Northern Virginia community banks, neither of which had the ability to close the deal without the other, working under a participation arrangement, which put together the winning loan package. The loan was full recourse, with a parent guaranty, approximately 55 percent LTV, and relatively high DSC covenants, but it had a very competitive interest rate and fee structure and provided the borrower a performing loan with cost certainty for the term. 

    We have closed several community bank participation/syndication commercial mortgage loans in the past six months, representing both real estate owners and lenders in the process, and have seen firsthand the impact these community banking “strange bedfellows” can make by working together.

    The good news for community banks is that many real estate owners and developers have long memories. If the community banks are willing to put aside their competitive differences and step into the current real estate lending breach to make these much-needed commercial mortgage loans, then they will earn the gratitude and loyalty of a group of strong, high-profile customers they would never have reached in different market circumstances.

    Courtesy of: CCIM Education Report

    Buying Into Distress

    Don’t discount due diligence when purchasing troubled loans.

    By Monica Cunill-Fals and James W. Shindell

    Aug, 2010

    A struggling commercial real estate market has led to unprecedented levels of nonperforming commercial mortgage loans. While lenders weigh their options, investors with capital are contemplating where and how to invest. This article discusses the typical loan purchase process and some of the advantages and disadvantages of buying nonperforming commercial real estate loans.

    The principal parties involved in a loan sale are the owner of the loan — the lender or its assignee — and the buyer. If the loan has been securitized, the buyer likely will need to negotiate with the master servicer or special servicer for the loan. In some cases, a loan sale adviser or broker is hired by the lender to manage the marketing and bidding process.

    Due Diligence Process

    Careful due diligence of the loan and collateral property will help buyers decide whether to bid and at what price. Unfortunately, due diligence periods are brief. Generally, buyers have 10 to 30 days to conduct due diligence prior to bidding or entering into a written agreement for the sale and purchase of loans. Prior to receiving any documents and information from the lender, prospective buyers must sign a confidentiality agreement. Most agreements prohibit prospective buyers from contacting the borrower or any guarantor, indemnitor, tenant, or property manager.

    In carefully reviewing the loan documents, buyers should confirm, among other things, the financial terms of the loan including the amount, the interest rate, the monthly debt service, and the monthly escrow and reserve requirements. Buyers also should check the loan documents for unusual provisions or future funding requirements, full or limited guaranty, or an environmental indemnity.

    Buyers should confirm that the owner of the loan is in possession of the original loan documents, has the authority to transfer and assign the loan documents, and that no third party has a right to purchase the loan.

    Buyers should obtain the following items from the owner for review:

    •    chain of allonges to the promissory note and assignments to loan documents;
    •    existing loan title insurance policy;
    •    most recent property survey;
    •    inspection, environmental, and other reports relating to the collateral property;
    •    property rent roll and financial information; 
    •    financial information of borrower and guarantors/indemnitors; and
    •    property insurance certificates.

    Buyers also should review:

    •    a title update to ascertain, among other things, whether real estate tax assessments have been paid and if there are any liens; 
    •    an assignment endorsement with respect to the existing title policy; and
    •    Uniform Commercial Code, judgment, bankruptcy, and municipal lien search results with respect to the borrower, any guarantors or indemnitors, major tenants, and the collateral property.

    Buyers must find out if foreclosure or receivership proceedings have been filed and the status of the proceedings. The buyer should understand the foreclosure process in the jurisdiction where the property is located and know whether and to what extent any encumbrances, such as ad valorem taxes or construction liens, have priority over the mortgage lien.

    Loan Documentation

    In a typical loan purchase transaction, the owner of the loan and the buyer enter into a loan sale agreement in which the owner agrees to transfer and assign the loan and the loan documents to buyer in as-is, where-is condition, without recourse, and with only limited representations and warranties from the owner. The representations and warranties provided by the owner in a loan sale agreement vary, but they generally are minimal, especially if the loan has been securitized. Typical representations and warranties relate to the outstanding principal balance, escrow and reserve balances, and ownership of the loan. Buyers often must provide an indemnity releasing and holding the owner harmless from any and all claims with respect to the loan and the loan documents and an agreement that the owner will have no further servicing obligations. At the closing of the loan purchase, the owner will assign and deliver the loan documents to the buyer.

    Pros and Cons

    A principal advantage of a loan purchase is that a loan may be purchased at a discount and provides an opportunity to acquire title to the collateral property (scrubbed of subordinate liens) through the foreclosure process. In some states and under certain circumstances, a buyer could reduce or eliminate the transfer taxes normally due on a property sale.

    Among the chief disadvantages of a loan purchase are the limited due diligence opportunity, which makes it necessary for the buyer to factor unknown risks into pricing, and the limited representations and warranties, which often leave a buyer without meaningful recourse. Additionally, lender liability issues may travel with the ownership of the loan. The buyer also bears the risk of the foreclosure process and borrower bankruptcy that would not be present in a purchase of the property itself. Since state laws governing loan purchase transactions vary, buyers should consult legal counsel with loan purchase experience.

    Courtesy of: CCIM Education Report

    Lease Leverage

    How can creditworthy tenants maximize their bargaining advantage?

    By Steven D. Sallen and Kasturi Bagchi

    Aug, 2010

    Many property owners continue to be weakened by the languishing commercial real estate market. Falling rental values, declining occupancy rates, and maturing loans with no readily available replacement financing all are affecting landlords’ bottom lines and eroding their equity.

    For tenants, however, this creates an opportunity, especially for those that are fiscally stable and have short lease terms remaining or other circumstances that make viable a threat to vacate. These tenants are in a position to use their leverage to renegotiate their existing leases. Here are some negotiating points that tenants should consider — and to which landlords must be prepared to respond.

    Quid pro Quo

    Tenants who demand lower rental rates should be prepared to offer something of value in return. Most landlords cannot afford to reduce their rental income with no quid pro quo. They have mortgages to pay, and their lenders are unlikely to offer concessions in this climate.

    Tenants have several options to propose to landlords in return for rent concessions, including offering to extend their lease terms. It will be far easier for a landlord to justify a rental reduction in the short term if the contracted rental stream continues beyond its original term. Another option is timed rent escalations, perhaps even returning to pre-concession levels.

    Operating expenses is another area for negotiation. Many landlords may want or need the added certainty that operating expenses will not increase; therefore, changing a gross lease to a triple net lease — which assigns to tenants responsibility for operating costs — may give a landlord confidence that it won’t be damaged on the back end by operating expense inflation.

    Tenants also can offer a personal or affiliate guaranty, sometimes known as a good-guy guaranty, which ensures rent payment if the tenant defaults and fails to immediately yield possession of the leased premises.

    Landlord Finances

    Tenant improvements usually are a part of new leases or lease amendments, but in today’s economy, tenants may wonder if the landlord can afford to pay for promised improvements. In such instances, tenants may need to examine a landlord’s financial statements. In the old economy, such financial analysis always was downstream and almost never upstream to the landlord. But a landlord may be a mere shell for a limited liability company whose only asset is the building. Add to that the likelihood that the building’s equity is probably eroded, and tenants may have little recourse if the landlord cannot perform a TI build-out.

    Depending on the bargaining strength of the parties, a tenant may demand certain protections. For example, the landlord could commit TI dollars in advance by depositing funds in escrow, or obtain a letter of credit naming the tenant as the beneficiary. However, a letter of credit or escrow may be considered part of a debtor’s estate and could be seized if the landlord files for bankruptcy.

    Another option is to establish a right of offset against rent if the landlord fails to complete the improvements. Parties also could agree to a reduced rent upfront and make the tenant responsible for the improvements. In such cases, landlords must make sure tenants do not take advantage of the rental reduction and do nothing to better the space.

    A landlord’s failing financial strength also may lead to deterioration in building and common area maintenance. Tenants concerned about a landlord’s ability to maintain and make timely repairs may want a self-help right to maintain and offset costs against rent to cover the incurred expenses. Tenants also may need to consider what levels of building maintenance and other services will be continued if the building winds up in foreclosure and/or receivership.

    Default Issues

    Tenants should confirm if the landlord has a mortgage and if there is a current or potential likelihood of mortgage default. If yes, tenants should review lease terms to determine if a nondisturbance agreement in favor of the tenant is in place or can be obtained from the lender. A nondisturbance agreement assures that the lease stays in place (so long as no default exists) even if the lender forecloses its mortgage. Lenders typically are receptive to such agreements because they help ensure that the tenant will pay rent directly to the mortgagee after a loan default. Tenants also should ask the lender to provide a duplicate notice of mortgage default, and, in certain cases, such as a single-tenant building, a right to make direct payments to the mortgagee, with a corresponding credit against the rent.

    Typical loan documents prohibit landlords from amending leases (especially for a rental concession) or entering into new leases without a lender’s consent. Thus, in assessing leverage, tenants should determine ahead of time how many parties will be sitting at the bargaining table and be aware that dealing with lenders on these issues can take time, patience, and sometimes money.

    Tenants negotiating new leases or amendments to existing leases for single-tenant buildings might ask for an option to purchase the leased premises. However, lenders often consider such options as an impediment to their foreclosure rights. Therefore, lenders may withhold their consent to purchase options within a lease without additional provisions. Often the option specifically must provide that it cannot be exercised against a successor landlord such as a lender after foreclosure or, at a minimum, that the purchase price must pay off the mortgage in full.

    As with any negotiation, leverage points can be anticipated by being prepared. Tenants — as well as landlords — should plan a strategy for success in advance, indentifying all the players involved and the potential obstacles. In today’s climate both parties must be creative, and above all, make the deal a win-win for all concerned.

    Courtesy of: CCIM Education Report

    Commercial Insight

    New Rules, New Fears, New Opportunity

    July, 2010

    While media attention has focused on residential real estate over the past few years, concerns over commercial property are just beginning to hit the spotlight. Savvy short sale investors and veteran real estate entrepreneurs have long recognized the buying opportunity presented from troubled assets, restrictive lending practices and high vacancy rates...however, a new set of rules associated with the financial reform bill threatens to further impact an already unstable commercial market.

    Currently, American companies often list a lease in the footnotes of the financial statement rather than treating it as a primary expense. Under the new accounting rules, corporations will be forced to record the full rent on their balance sheet as a liability...potentially impacting their bottom line in a dramatic fashion. No grandfather clause will be forthcoming; all active leases will be declared as a liability with the potential to reduce credit ratings and weaken the financial standing of any given company as soon as it goes into effect. For example, a company that signs a 10 year lease will be forced to account for the entire term of the lease as a liability; if the same company wants to put an option for renewal into the contract in order to hold down costs and secure long term positioning, the original lease plus the entire option period will be treated as a debt on the balance sheet.

    As if the above wasn't difficult enough, industries that utilize contingency leases (based upon a percentage of sales) will be forced to estimate those sales numbers for the entire term of the lease in order to fill in the appropriate estimate on the balance sheet. Revisions will be required to keep the data up to date. Needless to say, it's an accounting nightmare in the making.

    On the other hand, the new accounting rules are expected to dramatically alter the desirability of commercial ownership of a property rather than leasing. The bottom rules are leading to new fears, a great deal of confusion and a growing opportunity for those that position themselves to provide the solutions in the near future.

    Courtesy of: CCIM Education Report

    Retail Details

    Renegotiating leases requires attention to each tenant’s circumstances.

    By Bridget Grams and Ben LaForest

    April, 2010

    Due to the economic downturn, property owners and real estate companies that work with retailers and restaurants have seen a record number of requests for restructured leases or renegotiated rental agreements. According to real estate industry experts, the trend is likely to continue until 2012.

    Until there is a full economic recovery, lease and rent negotiations will remain a necessary strategy for maintaining the viability of shopping centers and malls. In some instances, it even can provide a win-win situation for riding out the financial crisis. But with requests coming from every direction, it’s not always easy for landlords to identify the ideal situations for restructuring or renegotiating retail tenant lease terms. In addition, not all tenants are alike; in fact, most bring unique circumstances to the table that landlords must consider individually. Looking at tenants in terms of their financial health, leverage, and what they bring to the shopping center mix may help landlords and property owners determine the best course of action in retail lease restructuring.

    Read the full story
    Courtesy of: CCIM Institute

    Engineering Value

    Fine-tuning building performance can boost asset strength.

    By Arkady Siterman

    April, 2010

    It seems like only yesterday that real estate investors and developers breezily talked about easy exit strategies and double-digit internal rates of return. When lenders and investors were eager, winning at real estate was more about managing the capital stack than fixing the smokestack.

    Times have changed. In this new reality, the development, acquisition, and management of major properties often have extended horizons. This longer-term investment strategy may be the default choice, but right now it’s the only choice.

    In this climate, value engineers have much to offer private equity and institutional property investors. With their help, developers, investors, and owners can reduce the cost of constructing and operating properties and eventually achieve higher resale values.

    Read the full story
    Courtesy of: CCIM Institute

    Bridging the Gap

    A new breed of lenders is providing capital in today’s market.

    By Jerry Dunn

    April, 2010

    The credit crisis has had a significant impact on commercial real estate and the availability of financing. Most lenders have reduced maximum loan-to-value thresholds to 65 percent and increased debt service coverage ratio minimums. Life insurance lenders are cherry picking only the highest quality properties, and banks are retaining only their best relationships. In addition, many institutions are deleveraging their balance sheets. As a result, a precipitous reduction in commercial real estate originations has occurred. According to data from the Mortgage Bankers Association, origination volumes for banks, life companies, and conduits have declined 86 percent, 62 percent, and 90 percent respectively from the market’s peak to trough.

    Read the full story
    Courtesy of: CCIM Institute

    Default Decisions

    What are the options when a tenant files for bankruptcy?

    By Alan M. Burger, JD, and Nancy Nicole Workman, JD

    Jan, 2010

    In the current market environment, commercial property landlords are experiencing an increase in the number of tenants that are party to U.S. Bankruptcy Code Chapter 7 and Chapter 11 proceedings. Landlords should have a basic understanding of their rights when tenants seek bankruptcy protection.

    Lease Options
    Under the Bankruptcy Code, when a debtor-tenant files a petition in bankruptcy, the filing generally acts as an automatic stay on all actions of all of the debtor-tenant’s creditors, including the landlord. However, the filing generally does not prevent a landlord from obtaining stay relief and recovering possession of the leased premises if the lease terminated before the filing or the term expires during the bankruptcy proceedings.

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    Courtesy of: CCIM Institute

    Revenue Recovery

    Lease audits can reveal hidden income potential.

    By Susan H. Nadler, CPA

    Jan, 2010

    With the commercial real estate industry still in an economic tailspin, now is the time for property owners to look at their existing portfolios and monetize any untapped opportunities. In addition, the new year presents the perfect opportunity for landlords to review lease terms and billing procedures and begin asking the right tough questions — questions that can mean the difference between positive cash flow and money left on the table.

    Landlords cannot afford to forgo revenue at any time. However, revenue opportunities often hide in complex lease terms, elude inexperienced staff, or fall through the cracks due to communication and coordination gaps. In other instances, revenue opportunities may not be negotiated into leases, although they should be.

    Read the full story
    Courtesy of: CCIM Institute

    Betting On Troubled Assets

    CCIMs share creative strategies for playing in this high-risk market.

    By Jennifer Norbut

    Nov. 05, 2009

    Today’s $108 billion of distressed commercial real estate reported by Real Capital Analytics has created an opening for risk-takers of all sizes. Weak properties are prime targets for small to midsize investor-owners who have enough cash and market savvy to know when to roll the dice. Meanwhile, larger vulture capital funds circle the action, waiting patiently to pick up troubled assets at deep discounts. For these and other players, the jackpot is growing: Commercial loan delinquencies reached 4.5 percent and construction loans topped out at 17.1 percent in 2009, according to Foresight Analytics, an Oakland, Calif.-based commercial real estate research group.

    Before playing the odds, investors must think strategically about the risks and rewards associated with this high-stakes market. Therein lies the challenge: “Each [distressed] transaction has its own strategy that needs to be unveiled,” says Beau Beery, CCIM, director of commercial brokerage and asset management for AMJ of Gainesville, Fla. “It is up to us as investors to discover what that strategy is.”

    Though setting your sights on distressed properties may seem like betting against the house, CCIMs are uncovering successful strategies for working with troubled assets. From understanding the distressed property buyer pool to examining regional disposition trends to tailoring creative financing sources for these deals, CCIMs have identified proven methods for winning a share of the troubled asset market.

    Read the full story
    Courtesy of: CCIM Institute

    Cost-Segregation Solutions

    These studies can provide tax advantages even after property sales.

    By Harvey Berenson

    Nov. 05, 2009

    Cost segregation is an accepted Internal Revenue Service method of allocating the purchase price paid for real estate property. Generally, cost segregation enables owners to increase the depreciation deductions from their properties, providing substantial present value benefits by reducing income taxes during the initial years of ownership.

    Although most cost-segregation studies are completed when the taxpayer acquires or constructs a building, the IRS allows owners to complete cost-segregation studies for buildings they have sold. This can generate significant tax savings in the year of sale — and owners do not need to amend prior tax returns.

    A cost-segregation analysis breaks down construction and acquisition costs, allocating the costs to specific categories: tangible personal property, land improvements, and real property. Under the applicable tax rules, a substantial percentage of a typical building’s cost often qualifies for shorter cost recovery periods, generating tax savings from accelerated depreciation. 

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    Courtesy of: CCIM Institute