Bricks & Sticks

Buying Markets

2005-07-29T00:56:00.000-04:00

“I never buy markets, I buy properties” - Sam Zell Spring, 1988

Legendary real estate mogul Sam Zell was commenting about how he had purchased a building in Houston. At the time, the Houston market was in a depression. The twin effects of the oil bust and the tax law changes of the mid-80’s had turned the Houston real estate market into a mess. There were a number of “see-thru” buildings. Yet, due to construction and tax shelter commitments, there were still cranes in the air building more office buildings. Properties were selling below original construction cost, jobs were radically cut as “Big Oil” restructured to cope with oil at sub $10 per barrel (remember that???). It seemed dire and the whole country knew it.

Meanwhile, Sam Zell was telling a few University of Michigan MBA students about his decision to purchase a large office building in this horrible market. But he bought a building, not a market. The building had a long-term AAA rated tenant (a true S&P AAA credit rating). Zell capitalized on the panic to make a great deal. He noted that the purchase was at a great price and that with the rent increases and the stability of the tenant he had made a good deal.

The market today

Recently, I watched some talking heads on a televised business show opine about the expected returns for real estate versus mutual fund investments over the next 12 months. They were trying to tell the audience where to invest. As usual, nobody made any strong recommendations, which helps them avoid accountability. Oddly, they were comparing the market for luxury homes in places like Florida and New York against the market for corporate control (a fancy term for stocks). This comparison is silly.

But if we take a cue from Sam Zell, we won’t buy a real estate market, we buy an investment property. Despite all this “bubble” talk, the fundamentals of real estate investing have not changed. A solid building in a good location with a good tenant will make money. If you don’t have these, you are speculating. Speculators get hurt by market shifts, Investors don’t.

Back to the talking heads for a moment…Is there a market bubble in luxury homes in some parts of the United States? YES! For example, the Florida residential market is showing the classic signs of a bubble when prices go up 30% in one quarter. Are people likely to get hurt? YES! Are there investment bargains in Florida? YES, but probably not in new luxury homes.

So how does this apply to West Michigan?

We have a lot of corporate downsizing, many local companies are moving production offshore. With 20 million square feet of vacant industrial space the local industrial property market is weak. Most industrial buildings are selling below replacement cost. The changes in our economy and at our large manufacturing base are causing tremendous shifts in employment (this sounds like the Houston office market in the late 1980’s).

While we don’t need production space and production workers like we have in the past, we are seriously short on medical workers. I know a local entrepreneur who is setting up a nursing import company to bring in nurses from overseas. Think about that, we are sending production jobs overseas and at the same time importing knowledge workers to fill empty jobs here. This shift in our employment is also being played out in the local real estate market. We have less need for large manufacturing plants and more need for retail, medical/professional office, and urban residential. These are the areas where our development community is concentrating.

From an investment perspective, the fundamentals still apply in West Michigan. Location, structure, tenant, price, terms, & financing all factor in to the investment decision. Even if you are looking at investing in manufacturing space in West Michigan, don’t buy the market, buy the property.

Purchase or Lease?

2005-06-09T11:26:00.000-04:00

Should my business purchase a building? Should my business continue to lease? There comes a point time in which every business is curious whether it is more beneficial to purchase real estate or to lease. Unfortunately, the answer is not the same for every company. There are advantages and disadvantages to either scenario. To accurately assess the best situation, it is important to look at both the quantitative as well as the qualitative aspects of the decision.

Quantitative Analysis

The best way to financially compare the value of owning real estate versus leasing is to create an after-tax cash flow analysis for a given period of time. On the purchase side, it is necessary to consider the initial cash outlay, the yearly debt service and the residual value of the property. As far as leasing, the yearly lease payments and operating costs constitute the majority of the cash flow outlays. Once you determine the cash flows from owning and leasing, they can be analyzed on a Net Present Value (the value of a series of cash flows in today’s dollar) basis. The lowest Net Present Value (NPV) provides the business with lowest cost solution. These cash flows need to be discounted at a rate that best represents the business’s opportunity cost.

When considering a range of discount rates, there is a point when the best decision crosses over from purchasing as the best option to leasing. If a company can achieve a higher return from its operations than from its real estate, it is prudent to lease commercial space. This is one of the main reason why companies like Walgreen’s owns very few of their stores. They achieve a higher return by investing capital into their business rather than into real estate.

Qualitative Analysis

The decision to purchase real estate must also consider advantages other than strictly the financial aspects of a specific space. A company may decide to own a larger building and lease out portions of it to other tenants. This can create an alternative income stream for the business and also allow for future expansion. Owning real estate also provides for diversification of the company assets. In addition, purchasing a building creates a predictable expense stream over the long term because it is not susceptible to fluctuations of the rental market or changing demands of landlords.

Alternatively, the decision to lease can offer many qualitative advantages over purchasing. The initial capital outlay to purchase a building is a major obstacle. Many companies either do not have the capital readily available or will choose to use this capital in a more productive manner in their business operations. The debt of purchasing a building can also reduce the company’s borrowing capacity for other capital expenditures. There is also a risk in the relative illiquidity of owning real estate versus leasing. Leasing a building also removes your business from the maintenance and management of the facility. Finally, one of the main advantages in leasing is the mobility and flexibility. Many growing companies find it difficult to determine the exact amount of space that will be needed over the long haul.

Although the decision to lease or purchase is ultimately your decision, having the assistance and advice from a commercial real estate professional who is actively involved in the business on a day to day basis can arm you with the best information to make a wise decision.

Cap Rates

2005-05-15T23:23:00.000-04:00

So what is the deal with Cap rates? I have noticed a growing number of NNN buildings with capitalization rates below 8%. So ask yourself, would you buy a piece of investment real estate at a rate below 8%? How about a Walgreen store at sub 7% for 25 years?

Don't people realize that at these rates there is no upside? Unless there are serious rent bumps, there are likely few buyers in the future for a 6.5% cap investment. Never mind that when interest rates rise (notice that I did not say "IF" but "When") the investments will not provide a market yield. So what happens, the price of the building goes down - just like a bond, these things react inversely to the rate.

When rates go up the investor has a bad choice, hold the investment that yields a below market rate, or take a capital loss. Maybe this is the problem, with CD rates at such lows, people are unwittingly stretching up the risk curve for a higher yield. However, they are locking in rates at historic lows. This is a great strategy for your home mortgage but not for an investment.

Personally, I think people should be looking at 8% and above. Based on historical returns, this should be safe. But, it is hard to find quality at this time at those rates. So, invest carefully.

What do you think?

Welcome

2005-05-03T00:11:00.000-04:00

Welcome to Bricks and Sticks. This Blog is a dedicated to the commerical real estate market in the Greater Grand Rapids, Michigan area (this can include Holland, Kalamazoo, and Lansing). Topics include issues that relate to the market in general or specific investment types.

For the purposes of full disclosure, I am a commercial real estate agent and a developer. My employing Broker is S.J.Wisinksi & Company I am not an attorney and I won't engage in or provide legal advice. Need legal advice, hire a lawyer!

Best Regards,

Dave