The Falbey Report

This Time It Really Is Different

noreply@blogger.com (wayne) — Fri, 28 Mar 2014 16:06:00 +0000

During the last bubble in real estate, I remember speaking with a number of my fellow industry veterans about the dangers of an overheating market. We all had experienced past recessions in the overall economy and the industry in particular. Uniformly, the response was: “It’s a whole different economy this time around. The basic rules have changed.” I’m not sure what they may have been smoking at the time, but, as we all know now, nothing really had changed. Once again, we found out the hard way that there’s truth in the old saw, “The more things change, the more they stay the same”.

No, this isn’t a warning that the market once again has overheated. Personally, I believe we still have a way to go before that happens. For example, financing projects is still challenging. Deals actually have to make sense economically. Lenders haven’t yet started soliciting developers to borrow more money than the project will cost. And, barbers, beauticians, and valets haven’t started flipping pre-constructed condos at a 10% to 20% mark-up. So the current market still appears to have a lot of legs.

But there is something different this time around. In past recoveries, investors and developers quickly picked all the low-hanging fruit. Then, as the demand for developable sites escalated, they began making offers on the not-so-easy-pickin’s. They seemed to realize that the growing demand would justify stepping up their games if they wanted to be in a position to supply that demand. Yes, eventually, they (all of us, really) got caught up in the feeding frenzy and began to throw money into deals that made economic sense only with the continuation of the hyper inflated market of the day. We all were desperate to acquire land to meet the expected demands of the market. We now know, of course, that we should have spent less time hyperventilating over our anticipated profits and more time calmly studying the underpinnings of that surging market.

Again, this is not an admonition that the end is at hand and we need to pull back sharply. To the contrary, absent some economic shock brought on by the political incompetence currently raging on both sides of the aisle, or other unforeseen factors, the market for development in certain areas appears to be quite healthy. Southwest Florida, for example, is booming. Where we only recently had an 88-month inventory of housing, we now have less that one-month’s supply. A recent article in the local newspaper noted that the median home price in Naples was $538,000. In the depths of the recession, it was closer to half that figure.

Commercial, as we all know, follows residential. So it’s no surprise that the commercial market also is showing signs of recovery. It's in the commercial sector that I detect a distinct difference this time around. In the past, the market followed a certain process. Sellers asked a specific price for a property. Buyers, with a specific project in mind, calculated its end value then subtracted the costs of developing it and their profit margin (based on a desired rate of return) to arrive at the cost of the land. This is a simplified statement of a residual land value calculation. Based on this, the developer knew what the land’s value was for the project in mind. If it was well below the asking price, the developer worked to structure the deal to achieve the desired return and get it closer to the asking price. The next step was to make an offer based on that price and structure. Today, this offer probably is in the form of an LOI. If the seller countered, which was not unusual, the developer met with the seller and they worked out a modified price and structure that got both parties what they wanted from the deal. When it comes to real estate investment, there have always been two irrefutable variables for achieving the desired return—price and structure (terms).

That’s what’s not happening today. The low-hanging fruit is gone in areas that have strong markets. Landowners are not pressed to sell. While most of them will negotiate, they don’t need to sell at distress prices. Prospective buyers from outside this area don’t seem to realize that. Often, they appear to lack familiarity with the local market (and ALL real estate is local) and apply factors based on their home markets. That unfamiliarity also causes them to undervalue property based on their undervaluation of the potential income stream. The bottom line: they let the asking prices scare them away.

The solution is simple. Do it the old fashioned way. Suck it up, do your homework and make an offer based on how the deal pencils out for you. When the seller counters, sit down and negotiate a price and structure that works for both sides.

Where Is The Residential Market Today?

noreply@blogger.com (wayne) — Tue, 27 Sep 2011 19:19:00 +0000

Recently, I attended a program on current market trends sponsored by a highly respected and well-known industry organization. It was an annually recurring program. The same speaker has presented this program since its inception more than fifteen years ago. He is an experienced and respected market researcher. His data and observations were accurate and, for the most part, incontrovertible.

There was one area, however, with which I have to take issue. On the subject of the inventory of residential product, the speaker observed that not only was it decreasing, but opined that the glut of foreclosures has run its course. All evidence points to the contrary. Industry and financial publications continue to report that there are mortgages in default that number in the millions. Purportedly, these loans have been kept off the radar screen for a variety of reasons including the lenders’:

· Need to clean up their foreclosure procedures and practices;

· Desire to keep REO off their balance sheets;

· Reluctance to further depress the values of these properties by flooding the market with millions of additional homes.

Laurie S. Goodman, senior managing director of Amherst Securities Group, participated in a Senate subcommittee hearing in Washington on September 20^th, as reported in The Wall Street Journal’s online publication, Developments, on September 22nd:

“Ms. Goodman outlined the size of the foreclosure problem with extensive research behind her well-supported points. There are 4.5 million non-performing loans, of the total 54.9 million nationwide, Ms. Goodman notes, but she emphasized that there are an additional 10.4 million borrowers that are reasonably likely to default.”

If this is true, then the cautious and far-sighted developer isn’t going to be deceived by the appearance of a shrinking inventory of available homes. He will not commit to beefing up both the size of the development organization and the size of current and projected land acquisitions.

It seems safe to say, under these circumstances, that there will be no market for large raw land deals in the Greenfields perhaps for years to come. This means that, in most areas, the land development practice of creating large master-planned communities with the necessary long development time line and commitment of huge amounts of capital at the front end may be years away.

It seems safe to say, then, that the land acquisitions that will be made will be very specific with regard to certain factors:

· They will be relatively small in size. If the market of available housing is flooded with low cost resale product, it’s wise to limit the size of your commitment to the more expensive new product that has to compete with it;

· They will be in A locations. If your new construction product has to compete with lower priced properties that are reasonably new, well-constructed, close to schools, shopping, employment centers, and recreation facilities, and, in many cases, amenitized, your location has to be outstanding. You can’t compete on price, so you must find something else that gives you a competitive advantage.

· They will be entitled. The costs of zoning and, in some areas, growth plan amendments adds too much to the cost of the new product and begs time delays that can eat through the bottom line and destroy the projected return on investment. All other factors being equal, a rezoning may be acceptable, particularly if it is a down zoning procedure.

· They will be infrastructured, or partially so. The cost and delay of putting in the infrastructure can have the same effect on the project’s bottom line and projected return as discussed above regarding entitlements.

· The prices will be discounted. These properties often will be owned by lenders who have acquired them through foreclosure, or deed in lieu of, and are motivated to get them off their balance sheets. I have seen some instances where the acquisition price consisted of an agreed minimum sum per homesite with a possibility of a kicker on the end if certain retail price levels are achieved.

When all these pieces are assembled, they spell out the obvious. For the foreseeable future, most residential developers will focus on infill properties that are in A locations, have entitlements and infrastructure in place, and can be acquired at a discount or through a well-structured acquisition price.

Sustainability: What's The Big Deal?

noreply@blogger.com (wayne) — Mon, 29 Aug 2011 16:38:00 +0000

From time to time, questions are raised about the concept of sustainability. Is it just the current fad? Is there any real substance to the argument in favor of utilizing sustainable development practices? If sustainable development incurs additional costs, why do it?

The real key is to look at the project from the perspective of its life cycle, not merely the cost of developing it. Life cycle costs include operational expenses over the life of the project in addition to development costs.

Hard and soft costs can be 15% to 20% of the overall life cycle costs of the project. Consequently, moving forward from the development stage through the operating stage, lowering the project's operating expenses will enhance the return on investment. Properly done, sustainable development practices will lower the project's OPEX during the operating stage.

Update of Trends in Real Estate Development

noreply@blogger.com (wayne) — Fri, 25 Mar 2011 21:08:00 +0000

A PwC survey reports that real estate investors are optimistic that the recovery is underway in commercial real estate, albeit in fits and starts. As investors strive to deploy capital in anticipation of rising interest rates, core assets are primary targets, although the report says that less attractive properties are beginning to appear on the radar screen. The effect of this interest has been to push cap rates down. The survey reports that cap rates decreased in 27 of the 31 markets surveyed. The expectation is that cap rates will either decline further or hold steady.

Cap rates remember are integral to the pricing of a commercial real estate property. They represent the expected rate of return on capital invested based on the net operating income generated at rent stabilization. As rates decrease and NOI remains consistent, the price rises. IRRs also are lower. Best in class in some markets are showing IRRs in the 8% range.

The CEO of Allianz Real Estate America, the U.S. real estate arm of German insurer Allianz, announced that the company expects to invest between $1 billion and $3 billion in United States real estate over the next few years.

Both PwC and Allianz identified the multifamily sector as currently the most attractive for near-term prospects.

The news on the residential front was not good. The Department of Commerce reported that single-family home sales fell 16.9% from January to February. The seasonally adjusted annualized rate of 250,000 is the lowest on record. Sales fell by 28% year-over-year. Blame was liberally spread around to continuing high unemployment, the seemingly endless supply of foreclosed homes hitting the market, and the Federal Reserve’s stimulus efforts bottoming out.

Real Estate Development Oddity of the Week: Apparently there has been a significant increase in the purchase of survival bunkers. The earthquakes, tsunamis, volcanic action, violent storms, spreading unrest and violence in the Middle East, and various predictions (not the least of which being the Mayan target in December, 2012) are pushing some people into a survival mode.

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For Lenders & Investors With Troubled Assets: There Is A Solution!

noreply@blogger.com (wayne) — Fri, 18 Mar 2011 16:14:00 +0000

GUEST BLOGGER: David Farmer

This week's blog is the first to be written by a guest blogger. David Farmer is a planner, developer, general contractor, licensed real estate broker and professional civil engineer as well as Founder and Managing Principal of Keystone Development Advisors, LLC. He also is a cofounder of Capital Four Advisors, LLC.

"Investors and lenders have a lot in common when it comes to real estate. Both investors and lenders want to minimize risk and optimize prospects for a return on their investment. Investors want to buy low and sell high, and lenders want to fund transactions at low loan-to-value ratios and keep their margins of safety high. The goals of investors and lenders have not changed since the real estate meltdown of 2006-2007. What is different these days is that the roles of investors and lenders have to some extent been switched. Investors are now "lending" their capital to fund purchases of distressed assets from lenders. There is quite a bit that lenders and investors can learn from each other. The present real estate market is making investors a bit more appreciative of underwriting standards and lenders a bit more appreciative of the complexities of owning and selling real estate.

There is always going to be risk for both investors and lenders. Risk is bad because it means there is a real possibility you will not get your money back. The best way to minimize risk is to increase knowledge. If you were going to bet on horses you would be wise to learn everything you can about each horse in the race so you can make the very best choice possible in predicting the winner. Investors need to understand not only the positive attributes of a distressed asset but also the underlying risks of zoning limitations, permit expiration dates, development bond repayment and environmental limitations. Lenders also need to understand these issues if they want to sell their distressed assets for the highest price possible. In a world where doubt equals discount, the more you know and understand the less doubt and hence discount will be applied to a given property.

Informed lenders retain experts in land development, many of whom are experienced, successful developers, to help them understand their assets and maximize their return of capital. Most commercial special assets will benefit from a professional review of the underlying issues and the identification of steps to improve value. Professional investors use teams to investigate potential acquisitions and minimize risk. Some lenders are using the professional review as a basis to give to appraisers so that a more accurate value can be established prior to putting the asset up for sale.

Too many times a lender will order an appraisal where seemingly similar properties are compared to estimate a value, when in fact the compared properties are not similar at all. For example a lender orders an appraisal on a 10-acre industrial property and the appraiser looks up recent sales of industrial property to arrive at a value. What the appraiser is probably not aware of is that any of the comparable properties, or the subject property, may have significant environmental limitations. If the comparable properties have environmental issues then the appraised value of the subject property will be lower. If the subject property has environmental issues, then its appraised value will be higher than what an informed buyer will pay given the environmental issues.

A professional review team also will find items or qualities that add value to a given property. Sometimes a property has impact fee credits or a historic type of zoning that can be vested by filing simple forms both of which can add significant value or capital recovery for the lender.

Uninformed investors and buyers have lost billions since the bursting of the real estate bubble, and one with money is nearly impossible to find these days. Knowledge is power in today's real estate market. Investors and lenders can gain valuable knowledge to help them buy or sell real estate by retaining a professional team, such as Capital Four Advisors, with years of specific knowledge and expertise in the development industry."

Wayne Falbey: Thanks, Dave! Your post is directly on point for the situation many lenders and investors find themselves in today. Projects have gone belly-up and the developer either is gone or no longer performing adequately.

The suppliers of capital for the project usually are not developers. They don't have an experienced understand of the day-to-day challenges that threaten to further devalue the investment they have capitalized. This is the time for them to become very proactive in bringing in a consultant team, such as Capital Four Advisors, to guide them in stemming their losses, restoring value to the investment, and disposing of the asset on optimal price and terms.

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Receiverships: The New Sheriff In Town

noreply@blogger.com (wayne) — Fri, 11 Mar 2011 16:24:00 +0000

Wikipedia, the online encyclopedia, currently defines receiverships as follows:

“In law, receivership is the situation in which an institution or enterprise is being held by a receiver, a person "placed in the custodial responsibility for the property of others, including tangible and intangible assets and rights. Various types of receiver appointments exist:

1. a receiver appointed by a (government) regulator pursuant to a statute;

2. a privately-appointed receiver; and

3. a court-appointed receiver.”

Because of the recent financial meltdown, many loan portfolios, investment portfolios, and development entities and projects contain or are, troubled assets. The classic method for dealing with these has been, and remains, the appointment of a receiver.

Formally speaking, the receiver’s principal duties include:

· Recover and take possession of the books, records and assets 

· Complete a physical and accounting review of the assets 

· Establish/adhere to a budget 

· Stabilize the assets 

· Establish the fair market value of the assets 

· Preserve, conserve and protect assets 

· Operate and maintain property 

· Pay bills 

· Avoid/settle liens and claims 

· Complete the development process, if so directed 

· Otherwise control, oversee, supervise and direct all administrative, personnel, financial, accounting, contractual, legal, and other operational functions involving the assets

In simpler terms, the receiver’s duty is to mitigate as quickly and as completely as possible the lender’s, investor’s, or business owner’s (individuals and shareholders) financial bleeding. This is a two-step process.

First, the receiver must analyze the situation, mitigate costs and determine the intrinsic issues. The receiver also has to value the asset. Real estate valuations generally are thought to be the province of appraisers. But, at the risk of seeming a wag, didn’t the appraisal community contribute substantially to the over-valuing of real estate that led to the meltdown? Also, don’t appraisers generally use recent comparable sales as a method for determining a property’s value? If so, the danger is that recent sales in many cases have been of a distressed nature – short sales, foreclosures, bankruptcies, etc.

The second step is to recommend the optimal course of action designed to cut the bleeding and stop the burn.

In a nutshell, the receiver is operating the business, which, for our purposes, is a real estate development company or project. So why is it that receivers so often are drawn from the disciplines of accounting or lending? It is eminently more reasonable to engage as a receiver someone from the development community. Who knows more about the issues – large and small – involved in the day-to-day operation of a development project or company than an experienced developer? Who is better qualified to:

· Determine actual value,

· Restructure the operation for optimal cash flow,

· Restructure capitalization,

· Reposition the asset for added value, and

· Dispose of the asset on optimal terms?

I’m not suggesting it be the same developer who was involved in creating this troubled asset, although that does sometimes happen. No, I’m talking about the new sheriff in town; the experienced developer who has a track record of successful completion of projects stretching back over past recessionary cycles in the economy. These individuals exist and have experience in successfully cleaning up troubled projects for lenders, investors, and development entities, adding value, and recouping capital.

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Discounted Cash Flow Analysis: Part 3

noreply@blogger.com (wayne) — Fri, 04 Mar 2011 16:35:00 +0000

Part 1 of this discussion of discounted cash flow analysis, or DCF, was a general description of what it is and why it has significance for real estate investment and development. Part 2 discussed Net Present Value. Among other things, NPV provides a means of comparing alternative investment opportunities to determine which one is likely to produce the greatest value or return on dollars invested today given the investor’s desired rate of return.

Part 3 concludes the exploration of DCF with a discussion of the Internal Rate of Return, or IRR. The IRR is the discount rate at which the present worth of future cash flows is exactly equal to the capital invested. It calculates the return earned on the invested capital over the life of the investment, not just during the initial year. The IRR calculations produce a percentage, not a number. The percentage represents the return on each dollar invested from the time it was invested.

In other words, the calculation determines what percentage is necessary to discount cash flows to be produced by the investment in the future years of operation back to the time the investment is made so that the sum of those cash flows, positive and negative, equal zero.

As is true of the NPV calculations, the components of the IRR calculation are:

1. In-place (existing rents)

2. Forecasted (predicted future rent increases)*

3. Terminal or reversion (net sale proceeds)*

*These latter two are highly speculative and shouldn’t be given much weight in today’s calculations.

Most savvy investors have a hurdle rate or minimum rate of return they desire from any given investment. It generally is equal to or greater than the cost of capital. Therefore, in the IRR calculation:

· If the IRR is greater than desired rate of return, the investment is financially attractive;

· If the IRR is equal to the desired rate of return, the investor is indifferent toward the investment;

· If the IRR is less than the desired rate of return, the investment is not financially attractive;

In days long gone by, discounted cash flow analyses were performed by hand using the Ellwood Tables. It was a laborious task and one fraught with opportunities for errors. Today the calculations are easily made with the use of programmable financial calculators such as the “gold standard” hp12C, or through the use of electronic spreadsheets such as Excel.

For example, suppose an investor has an opportunity to purchase a property that requires an investment today of $750,000 and is expected to produce $100,000 per year in cash flow before taxes. Suppose also that the investor intends to sell the property after five years and expects the sale to net $1,000,000. If these numbers prove accurate, what is the rate of return that the investment will produce?

Visually, the cash flows can be expressed like this:

Cash Flow:

Today: Invested Capital = ($750,000)

Year 1: $100,000

Year 2: $100,000

Year 3: $100,000

Year 4: $100,000

Year 5: $100,000 + Proceeds of Sale: $1,000,000 = $1,100,000

Using the hp12C, the number produced is 17.99% return on the life of the investment. If this exceeds the cost of capital, the investment is attractive.

This is superior to the cash-on-cash or cap rate methods of calculating return, because they focus on a single year only. But is this method perfect? No, for one thing, it relies on assumptions. One of these is that as the cash flows are received, they are reinvested at the discount rate. If this is not the case, the IRR overstates the actual rate of return. In addition, the IRR does not consider the cost of capital involved in the investment. There is a method, the Modified Internal Rate of Return (MIRR), that does this.

Also, a potential investment indicating a higher IRR than an alternative investment actually may not be as attractive. This is because the NPV of the second potential investment may more greatly enhance the investor’s wealth that the first one.

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Discounted Cash Flow Analysis: Part 2 Revised

noreply@blogger.com (wayne) — Tue, 22 Feb 2011 16:59:00 +0000

Part 1 of this discussion of discounted cash flow analysis, or DCF, was a general description of what it is and why it has significance for real estate investment and development. It is a means to measure or assess the present value of cash flows to be generated by the property (investment) in future periods (c.f., years of ownership). Here’s another way of looking at it:

· The initial investment to acquire or develop an income generating property is made today, in today’s dollars

· This property will generate income (primarily from rent) over a multiyear period of development and operation

· The dollars to be generated in these future year cash flows do not have the same value as today’s dollars

· The further out each succeeding year is, the less value the dollars generated in that year have in comparison to today’s dollars

· Therefore, these future cash flows have to be discounted (by some means) in order to determine their real value in today’s dollars

This process is called net present value or NPV. Because any type of investment – real estate or otherwise – is expected to produce cash flow, even if it’s simply a sale in a future year, NPV can be applied. As a consequence, NPV provides a means of comparing alternative investment opportunities to determine which one is likely to produce the greatest value or return on dollars invested today. Therefore, you can compare a real estate investment to an investment in pork belly futures, fine art, precious metals, equities, literally anything.

The components of NPV calculations for real estate are the following cash flows, positive and negative:

· The initial capital invested (negative)

· Subsequent capital investments (negative

· In-place (existing rents - positive)

· Forecasted (predicted future rent increases - positive)*

· Terminal or reversion (net sale proceeds - positive)*

*These latter two are highly speculative and not given much weight in today’s market.

First, let’s clear up any confusion about present value versus net present value. Present Value is a short-form methodology used to evaluate a property using its current-year NOI: Present Value (PV) = NOI ÷ cap rate. This is the essence of the cap rate that was discussed in an earlier posting to this blog.

Net Present Value, as noted above, is the value today of all future cash flows, positive and negative, to be generated by the project as discounted by the required rate of return (i.e., hurdle rate) minus the cost of acquiring the property. The discount or hurdle rate is a rate that reflects opportunity costs, inflation, and risks accompanying the passage of time. It is personal to every investor because each person assesses and weights risks differently.

NPV calculations produce a number, not a percentage. The key to interpreting the results of these calculations is in the nature and amount of the number produced:

· If NPV > 0, the financial value of the invested assets would be increased, (i.e., the return on invested capital is greater than the investor’s hurdle rate)

· If NPV = 0, the financial value of the invested assets would neither increase nor decrease, (i.e., the return on invested capital is equal to the investor’s hurdle rate)

· If NPV < 0, the financial value of the invested assets would be decreased, (i.e., the return on invested capital is less than the investor’s hurdle rate)

For example, suppose an investor is seeking a minimum return on capital invested (hurdle rate) of 15%. He or she has an opportunity to purchase a property that requires an investment $500,000 and will produce $125,000 per year in cash flow before taxes. Suppose also that the investor intends to sell the property after five years and expects the sale to net $1,000,000.

Will the investment produce a return at least equal to 15% under these circumstances? While the calculation requires use of a programmable financial calculator or spreadsheet software, the answer is “yes”. The calculation produces the number 416,196. Because we’re dealing with cash, this number actually is expressed as $416,196 and it’s a positive number. It means that the investment will produce the 15% return AND an additional $416,196. In fact, the actual rate of return (Internal Rate of Return or IRR) is 35.04%.

So, what actually happened here? Each year’s cash flow was discounted from the time it was (will be) generated back to the present using a discount rate of 15% (the investor's hurdle rate). Those respective annual cash flows, as discounted at 15%, have a value today of: $108,696, $94,518, $82,189, $71,469, and $559,324. That’s a total of $916,196. After deducting the initial capital outlay of $500,000, the result (NPV) is $416,196.

The next posting to this blog will discuss the Internal Rate of Return - IRR.

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Return on Investment in Real Estate: Discounted Cash Flow Analysis

noreply@blogger.com (wayne) — Wed, 16 Feb 2011 18:57:00 +0000

In recent posts to this blog, we’ve looked at relatively simple methods for measuring the return on invested funds.

· The cash-on-cash method measures the rate of return, expressed as a percentage, on invested equity only.

· The capitalization rate, or cap rate, measures the rate of return on all capital invested, debt and equity. It also is expressed as a percentage.

While these methods are commonly used in the industry, they leave much to be desired. Primarily, they measure return for a single annual period, whereas most real estate investments or projects experience a multiyear cycle of development and operation. If your capital is at risk for a period of several years, shouldn’t your measure of return reflect this? Can you really understand and measure return on your investment by looking at a single year’s activity, such as the first year at stabilization?

Another issue is the time value of money. Is a dollar received in Year Ten’s cash flow worth as much as a dollar received in Year One’s cash flow? If you invested $100,000 today and received $200,000 within the first year, did you double your money? What if it took five years to get the $200,000? If you fail to see the difference, ask yourself this question: suppose you won $10,000,000 in your state’s lottery, but the state asked you if it could keep the funds for a couple of years then pay you – no interest accrues. Would you say, “Sure!”? Of course you wouldn’t. It’s the “bird in hand theory”. A dollar received today is worth more than a dollar received somewhere down the road, because, among other things, dollars lose purchasing power over time, inflation eats away at it’s value, there is the cost of lost opportunities, and there is the risk of default or nonperformance. This is the essence of the time value of money.

So, the question is: Given the effects of the time value of money, is there a way to measure return on investment over a multiyear period? The answer is yes, using discounted cash flow analysis. It is a means to measure or assess the present value of cash flows to be generated by the property (investment) in future periods (c.f., years of ownership).

There are three principal discounted cash flow methods utilized in real estate:

· Mortgage Amortization: In real estate, this essentially is a sinking fund in which regularly scheduled payments containing principal and interest are made over a specified period of years so that the final payment completely satisfies the mortgage debt.

· Net Present Value (NPV) : Measures and compares the attractiveness of alternative investment opportunities. This actual defies conventional wisdom by proving that you really can compare apples to oranges.

· Internal Rate of Return (IRR): Calculates the return earned on the invested capital over the life of the investment, not just the initial year.

In this discussion, we’ll concentrate on NPV and IRR.

The components of NPV and IRR calculations are the following cash flows, positive and negative:

· The initial capital invested (negative)

· Subsequent capital investments (negative)

· In-place (existing rents - positive)

· Forecasted (predicted future rent increases - positive)*

· Terminal or reversion (net sale proceeds - positive)*

*These latter two are highly speculative. Since the recent financial meltdown, investors and lenders are more conservative in underwriting the forecasted and terminal cash flows. Thus, in-place cash flows are a larger portion of the calculation – meaning cap rates have to rise, which pushes purchase prices (values) down if the investments are going to pencil out.

The next posting to this blog will discuss Net Present Value specifically.

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What Does the Future Hold for Master-Planned Communities?

noreply@blogger.com (wayne) — Wed, 26 Jan 2011 00:03:00 +0000

According to ULI – The Urban Land Institute, master-planned communities (MPCs) “are usually a product of long-term, multiphase development programs that combine a complimentary mix of land uses…(that) typically occur on ‘greenfields’, that is, tracts of formerly undeveloped land often at or beyond the urban fringes.”¹ The classic MPC is primarily residential in nature with a mix of dwelling units of several different sizes and configurations as well as price points. They often include commercial and recreational components.

In today’s market, MPCs are the redheaded stepchild. The reasons are manifold:

MPCs are usually large-scale developments that have multiyear life cycles which means a commitment of substantial capital at the beginning, and capital is not currently interested in MPC development – too risky, thus too expensive;
With the current huge overhang of residential properties in most areas, there isn’t sufficient demand for more new housing;
The recent plunge in housing prices makes it impossible, in many instances, to build and sell new housing that is priced competitively with existing;
This often produces zero residual land value, and, so far, no one is giving land away;
In addition, in most areas where there might be some demand, the regulatory environment has produced added costs that at the present time eliminate any opportunity for competitive pricing.

That’s the story today, but what about the future? There is a lot of palavering to the effect that the day of the exurbs has passed, and all future development will consist of dense, compact (smaller units), mixed-use, high-rise properties on infill urban parcels. I’m not buying it and here’s why:

The job market will recover eventually;
When it does, the overhang of existing properties will be absorbed, thus creating demand for new;
This will result in an increase in housing starts, and not all of them will be compact urban development;
Why? Because Generation Y will age, and when it does, its members will begin to turn away from the live-work-play in the same place. They will start families and many will want detached single-family residences with yards. That’s not a desire that’s unique only to a particular generation.

Most of the residences in new MPCs undoubtedly will be smaller than in the past for at least two reasons:

The party’s over in the United States. The changes currently occurring in our world as well as our economy are imposing a downward shift in lifestyle affordability, which in turn affects quality of life. We will not see a return of the rising tide that lifted the Boomers’ ships to incredible highs. There will always be an affluent class, but the middle class will be poorer;
Housing costs, including the added costs of ever-increasing regulatory measures, as well as the costs of transportation from the exurbs to workplaces, schools, etc., will eat a greater hole in Generation Y members’ budgets.

These factors and others will be met only by downsizing the residence. But, the good news for the residential development community is that MPCs are not a class of dinosaur.

¹Trends and Innovations in Master-Planned Communities, 1998, Schmitz and Bookout, ULI-the Urban Land Institute, ISBN 0-87420-800-9.

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The Cap Rate – Part 3: What It Is; What It Does

noreply@blogger.com (wayne) — Mon, 17 Jan 2011 20:54:00 +0000

In Parts 1 and 2 on the Capitalization Rate, we discussed how the cap rate is utilized and how it’s calculated. In this final section, we’ll discuss the flaws in the cap rate and what its recent history and usage tell us.

1. What is the basic flaw in the use of the cap rate as a measure of return on a long-term investment?

The basic flaw in the use of the cap rate is its focus on a single year, whereas a typical income property investment is a multi-year proposition. Thus, you have to recalculate the cap rate for every year of the projected life of the investment. You basically are estimating NOI for each of those years as well as the projected value for each year; then, using the IRV formula discussed in Part 2, you calculate the return those numbers indicate by dividing the given year’s NOI by that year’s estimate of value for the property (R=I÷V).

2. In the middle part of the last decade, cap rates compressed to as low as 1% - 2%, while bond rates hovered around 5%. What motivates “sophisticated” investors to settle for such a low rate of return in an investment that’s as high risk as real estate?

To put that into perspective, here’s an example:

· A property is producing NOI of $250,000 and is acquired for a total purchase price of $10,000,000, or a cap rate of 2.5% ($250K ÷ $10M);

· Assume the purchase price represents $500 per square foot;

· The purchaser expects to sell the property within 2 years at a price of $650 per square foot.

Where is the investor’s real profit motivation?

Obviously, it isn’t in the cap rate during the operating years. It’s in the anticipated appreciation of $3,000,000 realized in the resale two years or less down the line. In other words, the investment expectation was to flip the property quickly for a profit sufficient to lift the overall rate of return as measured on the short life of the investment, such as by using a discounted cash flow method like the Internal rate of Return (IRR) method. Discounted cash flow analysis will be a topic of future postings to this blog.

In a red-hot or bubble real estate market like the mid-2000’s, this form of thinking is prevalent.

But then cap rates decompress (rise) back to historic norms, or higher. Why? Because when the bubble bursts, realization sets in that properties were overvalued. The market is uncertain where values will stabilize, so sales are few. Most sales in this situation are short sales or distress sales (bankruptcy, foreclosure), and don’t represent fair market value. Compounding the problem is the rising vacancy rate and increasing concessions to tenants due to business failures and the reduction in space needed by those tenants who survive by eliminating jobs.

The uncertainty revives the awareness of risk inherent in real estate investments, so the required rate of return increases accordingly. The greater the risk, the greater the required rate of return on invested capital.

In this kind of market environment some investors foolishly assume an ability to raise rent levels or cut vacancies or lower operating expenses or some combination thereof, which will increase NOI in future years; thus, increasing the rate of return. That, however, won’t happen because leases are binding contracts that span years regardless of changes in the property’s ownership; thus rents cannot be raised arbitrarily until the lease expires or is breached by the tenant

In the meantime, it’s good to remember that in past recessions the recovery of the commercial real estate sector consistently has lagged that of the larger economy. On a brighter note, effective rent should start to grow once job growth begins. When that occurs, then we should start seeing an easing of vacancies and tenant concessions in the marketplace. With the growth of NOI, values will start to rise, confidence and investor interest will be enhanced, and cap rates will begin to compress again.

At the moment, however, cap rates in the 5% to 5.5% range are seen only where the property is a core asset. These usually are well constructed, well-located, modern buildings enjoying 95% to 98% occupancy on long-term leases with very creditworthy tenants and located in gateway cities.

The Cap Rate - Part 2: What It Is, What It Does

noreply@blogger.com (wayne) — Tue, 11 Jan 2011 19:16:00 +0000

In an earlier posting to this blog, we introduced the concept of the capitalization rate or cap rate, and discussed the basics of it. This discussion will expand on that discussion.

Simply put, the cap rate measures the return on total capital invested in an income-producing property in any given year of operations. Total capital invested means all equity and all debt utilized in the deal. It also can be used to determine the market value of such a property.

There are three components to the cap rate: Income; Rate; and Value, which combine to form the acronym IRV. Income generally is net operating income or NOI. It is derived from Gross Income (expected income from all sources). First, loss of income from vacancies is subtracted, then credit losses are subtracted. This leaves Gross Operating Income (sometimes referred to as Adjusted Gross Income), or the funds generated by the property available for use by the owner.

Operating Expenses, or OPEX, are deducted from Gross Operating Income. This results in Net Operating Income (NOI).

Thus, expressed a little more clearly, the components of IRV are:

I = NOI

R = return on capital invested in any given year of operations, or the hurdle rate sought by investors

V = the market value of the property, given the NOI and hurdle rate

If you know any two of these components, you can calculate the third, as follows:

I = V x R

R = I ÷ V

V = I ÷ R

What’s reflected above is the overall cap rate. But this is a little more complicated than it appears to be at first blush. Because the overall cap rate measures the return on all capital invested, it consists of a lender’s component and an investor’s component. The lender’s component is known as the Lender’s Average Weighted Cost of Capital (WACC). The Investor’s component similarly is known as the Investor’s Average Weighted Cost of Capital.

The lender’s WACC is calculated as follows:

Mortgage Constant, depicted as the Greek letter kappa or К (i.e., Annual Debt Service ÷ Original Principal Balance of the Loan)

x Loan-to-Value Ratio (relationship between total cost and the loan amount, aka LTV)

= Lender’s WACC

Example: LTV = 70%; К = 8.25%, then the Lender’s WACC = .0508 or 5.08%

The investor’s WACC is calculated as follows:

Investors’ % of the investment (the equity portion of the deal)

x Investors’ hurdle rate (investor’s minimum acceptable rate of return)

= Investors’ WACC

Example: Investor contributes 30%; Investor seeks 9% minimum return

Investors’ WACC = .0270 or 2.7%

So the overall cap rate is:

Lender’s WACC (.0508)

Investors’ WACC (.0270)

Cap Rate = .0778 or 7.78%

So, what does all this really mean? The first year’s cap rate has to equal or exceed 7.78% for all parties to achieve their goals. Thus, the current year’s NOI, when divided by the purchase price (value), has to equal or exceed 7.78%.

The third and final installment on cap rates will explore its flaws and what’s been happening to cap rates in recent years.

The Cap Rate Part 1: What It Is, What It Does

noreply@blogger.com (wayne) — Wed, 29 Dec 2010 22:29:00 +0000

Again, a reminder that postings on this blog site are sometimes aimed for those who are new to the real estate development industry or who are interested in learning more about it. This is one of those postings.

In an earlier blog, we discussed the concept of cash-on-cash as a means of measuring return on equity capital invested in a real estate project. Most real estate development capitalizations, however, include debt as well as equity.

In the current market, debt often provides 50% to 70% of the development capital needed. The balance generally is raised in the form of equity - money invested by individuals or entities with the expectation of profit or return of, as well as on, the investment. These are financial partners, not lenders who provide debt capital. Some sophisticated forms of debt can be converted to an equity position. Some may require participation in addition to interest on the debt capital. These arrangements sometimes are referred to as “equity Kickers”.

While cash-on-cash is a measure of return on equity, the capitalization rate, or cap rate, measures return on total capital invested: debt as well as equity. So, it is a measure of 100% of the capital utilized to develop or acquire an income producing property. In simple terms, it is the estimated rate of return on the capital invested in an income generating property at the time of its purchase or the initial stabilized year. It is expressed as a percentage.

For example, suppose a property generated net operating income, or NOI, (total income minus vacancies, credit losses, and operating expenses) of $500,000. Suppose also that the total capital (debt and equity) required to acquire the property is $7,500,000. The cap rate is 6.67%.

Cap Rate = $500,000/$7,500,000 = .0667 or 6.67%.

Thus, a common way the cap rate is used is as a means to identify investment properties that meet the investor’s desired rate of return. The investor analyzes the probable purchase prices of various properties and their respective NOIs. Using the formula above, it is easy to determine whether a given property meets the investor’s hurdle rate (minimum acceptable rate of return. In the example above, if the hurdle rate was 6.68% or higher, the investor probably would pass. If the hurdle rate was 6.67% or lower, the investor might be interested.

Instead of purchasing an existing income property, suppose you were going to develop one. If the total cost to develop it, including land, was $7,500,000, and it was expected to generate NOI of $500,000 in the initial year of operating after reaching stabilization (achieving the pro forma rents), the cap rate would be 6.67%, as demonsrated above.

In the next blog on cap rates, we’ll go into more detail.

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Another Way of Looking At Return on Investment in Real Estate

noreply@blogger.com (wayne) — Wed, 22 Dec 2010 23:04:00 +0000

First, a reminder that this blog site is aimed more for those who are new to the real estate development industry or who are interested in learning more about it. Consequently, some of the postings, but not all, will be geared specifically for that audience. This is one of those postings.

Developers, whether newbies or old pros, have to raise the capital required to make the investment in the proposed project. In the current market, debt provides, at best, about 60% to 70% of the development capital needed. The balance generally is raised in the form of equity - money invested by individuals or entities with the expectation of profit or return of, as well as on, the investment. These are financial partners, not lenders.

While there are a number of ways to measure that return on investment - some more sophisticated than others, a classic method is what is called cash-on-cash. It means literally: cash returned on cash invested. It is calculated by dividing the amount of cash returned to an investor in a given year by the total amount of equity invested by that investor to date. The result is expressed as a percentage.

For example, if an investor contributes $100,000 to the project and receives $7,500 during the first year of operations, the cash-on-cash return would be measured as: $7,500/$100,000 or 7.5%.

One of the major flaws in this method is obvious. Investment in real estate projects is a long-term or multi-year proposition; whereas, the cash-on-cash method only expresses return on investment for a single year. Nevertheless, it continues to enjoy widespread usage.

Residual Land Value Analysis: Avoiding Project Failure

noreply@blogger.com (wayne) — Wed, 15 Dec 2010 22:26:00 +0000

As the economy slowly staggers toward recovery, the market will pick up. Deals will began to occur. Existing inventories will be reduced and acquisition for new construction will become viable. When that happens, it is sure to be accompanied by one of the oldest and deadliest mistakes in the real estate development business: overpaying for the land.

This is a mistake that is made by newcomers as well as veterans of the industry with many years and numerous projects under their belts. The only thing that can rescue a deal when the land was overpriced is a bubble in the market. BUT, as we saw with the recent real estate bubble, when it bursts, you are stuck with land on the books that is 50%, 25%, 10% of the purchase price paid for it. Sometimes it actually has a negative value in the sense that the land would have to be given away in order for a project developed on it to make sense financially.

This is why it is critically important for the developer to understand and accurately calculate the residual value of the land. It is simply the maximum amount the developer can pay for the land and still achieve the expected return on the invested capital. In essence, it’s what’s left over after all of the expenses of development and the profit margin have been accounted for. Simply put, it’s a way of backing into the purchase price of the land.

There are a number of formulas designed to determine the residual value of land. Some are relatively simple, some aren’t. One I like utilizes discounted cash flow analysis. This makes sense because real estate developments are long-term.

You start by calculating the total costs of development, which may include any or all of the following:

· Market research fees

· Marketing and advertising costs

· Expenses for demolition, environmental mitigation, and hazardous waste remediation, if necessary

· Entitlement, platting, and permitting expenses

· Engineering and legal fees

· Planning and design expenses

· Infrastructure costs

· Construction costs

· Management fees

· Costs of financing involved in the project

· Sales or leasing commissions

For example, assume you’ve identified a parcel of property on which you want to develop a 30,000 square foot suburban office building that will rent for $25 per square foot with an 8% vacancy factor and OPEX at 35%. The cap rate at sale at the end of the fifth year of operations is estimated to be 7%. There will be a one year build and stabilize period followed by five years of operations. Without rent increases, this scenario produces a present value (PV) of $6,407,153.

Assume also that the permanent loan will be interest only at 70% of PV with developer equity of 30%. The costs of sale will be 3%. The developer’s hurdle rate (desired rate of return) is 10%. For simplicity’s sake, assume the all-in costs of development to be $175 per square foot.

Under this scenario, the net present value of the project is $2,522,107. Minus the developer’s equity, the residual land value is $947,107. If the building will be three stories of 10,000 square feet each and the floor area ratio (FAR) is .25 – meaning the building can cover no more than 25% of the site, the site would have to consist of a minimum of 40,000 square feet. This works out to $23.68 per square foot. If the seller insists that the price is solid at $40 per square foot, pass on this one.

How The "Tax Cuts" Affect Real Estate Development

noreply@blogger.com (wayne) — Fri, 10 Dec 2010 17:50:00 +0000

The current news frenzy concerns the pending legislation to extend the current marginal tax rates for two more years. Is this a silver bullet for the real estate development industry? From a sound economic perspective, it is a good move in a time of high unemployment, stagnant wages for those who are employed, and a very slow and feeble recovery from recession. But you wouldn’t know it from the war of words that surrounds the extension.

· Is it a tax cut for the rich? No, it isn’t a “tax cut” at all. It simply is the extension, for a period of two more years, of the same marginal tax rates we have had for a decade. It’s neither a cut nor an increase for anyone – rich or otherwise.

· Is it a special break for the rich and privileged? No, as Ben Franklin famously observed more than two hundred years ago: “a penny saved is a penny earned” regardless what your income bracket is.

· Does it increase America’s dangerous deficit spending? Yes, for two reasons. One, the continuation of the existing tax rates is not accompanied by mandated and itemized reductions in government spending which is the root cause of the deficit. Somebody wasn’t paying attention when the nation spoke in last month’s elections. Second, there is the inevitable pork packaged in with the legislation extending the current tax rates. This is merely more deficit spending, which effectively increases the size of the national debt, but is not a result of extending the current tax rates.

· Will it help the recovery in the real estate development industry? Probably not. There are a couple of reasons at play here. First, the cause of the slowness of economic recovery overall, and in the development industry in particular, is uncertainty over the nation’s economic future. Extending the so-called Bush tax rates for a mere two years doesn’t do much to alleviate this concern. Only permanent adoption of these rates would accomplish that. Second, as mentioned above, the continual increasing of the nation’s debt through deficit spending further undermines the value of the dollar, and that makes economic recovery impossible.

The Left’s opposes the extension of existing tax rates, rather than increasing them substantially, and screams that this is increasing the deficit. In reality what increases the deficit is creating programs that require spending more money than is available. The Left created these big spending programs on the hope that it could raise taxes to cover them. But the electorate rose up and said, “No, hell no!”.

Here is the danger of spending money on the come. Suppose a real estate salesperson has a prospect who indicates an interest in making an offer on a parcel of property. The salesperson anticipates receiving a sizeable commission on the sale, and buys a brand new luxury automobile. The offer is never made, or, if made, is rejected by the property owner. No sale materializes; thus, no commission is earned and paid. Bottom line: The salesperson does not receive additional income, but now has considerably more debt. This is basic economics to a real estate developer (and most members of the electorate), but seems to be unfathomable by many in Congress.

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Thoughts On The Recovery Of The Real Development Industry

noreply@blogger.com (wayne) — Tue, 07 Dec 2010 22:10:00 +0000

For the real estate development industry to recover, it goes without saying that the overall economy must recover. Is that recovery underway? Let’s take a look. Gold is at $1,400 per troy ounce. If you invested in gold when it was much lower in price, this is good news. Or is it?

The price of gold simply reflects the value of the dollar, real or perceived, but more about that in a moment. So, if gold is $1,400 per ounce, it simply means that the dollar has a value of one 1,400^th of an ounce of gold. If gold was around $800 per ounce two years ago - and it was, this means the dollar has lost significant value as a store of wealth.

What causes the value of the dollar to decline so dramatically? The perception, justified or not, that the dollar is losing purchasing power. In this case, that perception is justified. The dollar, and for that matter the currency of most nations, is controlled by the government acting through a central bank. In the United States, the central bank is the Federal Reserve. The role of the Fed is to stabilize prices (viz., avoid inflation or deflation). When the central bank thinks its task is to stimulate the economy, it necessarily abandons its role as price stabilizer. Thus, if the government, acting through the Federal Reserve, or otherwise, creates more money, it has the effect of devaluing the currency. The brightest member of Congress on economic matters, Representative Paul Ryan says, “It’s a fatal conceit. We’re undermining the precepts of sound money.”

This is because an economy, such as that of the United States, has a finite amount of goods and services available at any specific point in time. Increasing the supply of currency available for circulation in that economy, without a corresponding increase in goods and services available, has the effect of requiring more of these “new” dollars for the purchase of a given good or service. Which is another way of saying that the purchasing power of the dollar has declined. If your earnings or cash flow fail to increase accordingly, you effectively are becoming poorer.

The latest action by the Fed is called quantitative easing, or QE2 because it is the second time in recent months that it has undertaken this action. Simply put, the Fed created $600 billion out of thin air to disburse into the economy by purchasing government IOUs, (i.e., Treasury securities). This added money is not matched by an increased amount of goods and service; thus, it eventually takes more dollars to acquire a given service or good.

This is clear where the price of gold is concerned. In and of itself, it doesn’t grow in value; it’s still just an ounce of gold. Instead, the value of the currency is shrinking so that more dollars are needed to acquire an ounce of gold. This is a means of hedging against anticipated inflation, or the increasing cost of a given good or service because the value of the currency is shrinking. Why does the government create this “funny money” when, among other ills, it has the ultimate effect of eliminating the dollar as the international standard for global commerce? It does it because, more and more, it needs it to finance he rapidly expanding fiscal deficit created by its continual usurping of the activities of the private business sector. It finances this by creating “funny money” ala the Federal Reserve or confiscating it from its citizens – real and corporate – in the form of higher taxes.

The downside of this is more than simply devaluing the currency. It also denies the capital to business people and companies that otherwise would expand existing operations or develop new ones. It also creates uncertainty in the job-creating private sector by raising the specter of higher taxes to cover the deficit. If businesses believe taxes will increase in the future, expansion will not occur and jobs won’t be created. In addition, further worsening America’s status as a debtor nation by borrowing ever greater sums from China, Japan, the Saudis and others, adds to the uncertainty about the strength of the dollar in the future.

The bottom line here is that much needed jobs may not be created for millions of Americans who are out of work. A recent survey of economists predicted that the jobless rate would still be at 9.6% in the summer of next year, and may only reach 7% by year-end 2013.

No less a true Democrat than John F. Kennedy took a risk and lowered tax rates. The resulting expansion of businesses actually increased tax revenues. Ronald Reagan took this same path with the same results. In fact, George W. Bush pushed through lower tax rates to counter the recession in the early years of his first term. Again, business boomed, unemployment shrank to near-historically low levels, and tax revenues actually increased. Tax cuts raise government revenues. History has proven it.

If Democrats fear that revenues won’t be sufficient to finance the trillions of dollars in deficit spending they have created, the simple answer is to trash the giveaway programs and spend only what sound, business stimulating revenues will produce. The United States is not a European socialist nation. In fact, the European socialist nations are beginning to realize the error of their ways and retrench toward a more free enterprise oriented system.

While Obama appears to have caved on extending the Bush-era tax reductions for all taxpayers, including most importantly the higher income ones who make the decisions that lead to job growth, it is only temporary. Successful business people know that we’re facing a long, slow recovery from the Great Recession. They know that that business planning necessarily is a long-term proposition. A two-year reprieve only delays the agony of joblessness and minimal growth.

There are those who would say that the foregoing observations are "Republican talking points". That may be true, but more importantly, they are fiscally sound points for economic recovery and stability. Americans are independent and entrepreneurial by nature. They prefer capitalism and ask only for an opportunity to compete in the marketplace on equal footing. Time and again they have proven to be fully capable of making good decisions for themselves and their families and communities. It's the worst possible ego trip to assume that one is part of an elite class that is intellectually superior to the greater population. And worse, to attempt to force their pseudointellectualist ideals down the throats of an unwilling population.

Is Compact Urban Development Our Only Choice In The Future?

noreply@blogger.com (wayne) — Thu, 02 Dec 2010 18:38:00 +0000

Other than a few metropolitan areas, such as Washington, D.C. or New York City, where unemployment doesn’t seem to be as big an issue as it is in the remainder of the county, there remains a huge housing inventory. With absorption (demand) running about one third of its norm, and the recovery limping slowly along, it will be awhile before that inventory is sufficiently reduced to justify significant new residential development.

When that time comes, however, where will new development and redevelopment occur? The pundits want us to believe that it will take place in the urban core, not in greenfields or suburban areas. Are they right, or is there something wrong with their logic? I believe it’s the latter. Let me explain my heretical view.

· Major metropolitan areas have a distinct, 24/7 “downtown” or urban core. Most other cities and towns, including those with public transit systems, don’t have this type of 24/7 destination center with strong employment opportunities, shopping, and entertainment facilities.

· Humans are not lab mice. We’re like the grains of sand on a beach; no two are exactly the same. You can’t generalize about the behavior of individuals.

o Not all retiring Baby Boomers want to sell the house and cars, move to a high rise downtown, and resort to walking or riding a bike everywhere.

o Not all members of Gen-Y, or Millennials, want to live, work, and play in the same place twenty-four hours a day. Once members of their generation begin having children, many of them will want to move to places where they will have some space around them and less 24/7 activities which aren’t necessarily positive for the wellbeing of the kids.

· Much of the impetus for pushing everyone into residing in the urban core comes from misguided environmentalists who think getting people out of automobiles will save the planet, as well as urban planners who have been brainwashed by the current popular rhetoric. It’s the path of least resistance. It’s also wishful thinking, and it’s very shortsighted.

· It’s also very much about the benjamins. No, not that nice family down the street; the Founding Father whose face adorns the hundred-dollar bill. In other words, money. Compact urban development means putting more in less area. It means, in a phrase, greater density. We’re not talking about public housing. At the end of the day, the development has to prove profitable. The cost of land typically is higher in the urban core. Also, there are the costs of retrofitting frequently inadequate or outdated infrastructure, construction staging in an area that already is developed, and numerous other added expenses. Profitability in this type of milieu requires greater density; sometimes much greater density, and that often is very unpopular.

· Even when public sector planners, appointed planning commission members, and elected officials understand the requirement for greater density, they are aware that the electorate often doesn’t get it. And the public sector necessarily is very sensitive and responsive to the wishes of the electorate regardless whether voters are well informed and can connect the dots between the more efficient use of land which leads to fewer issues relating to sprawl and the resulting need for higher density.

Consequently, I believe it’s clear that demand for suburban and exurban living will remain a viable part of residential development in future.

Density: Good or Evil?

noreply@blogger.com (wayne) — Mon, 22 Nov 2010 20:32:00 +0000

Patrick Phillips, CEO of ULI-The Urban Land Institute, in an article published on GlobeSt.com, addressed the future of real estate development:

“What we learned from this phenomenon (migration back to urban centers) is that there is a market for compact, mixed-use design, smaller housing space, and transit-oriented development that minimizes the need to drive. But perhaps the bigger lesson--one we are still learning how to apply--is that there is a demand for at least some aspects of this type of development that stretches beyond downtown cores and into outlying suburbs” (emphasis supplied).

In addressing the use of land to achieve this development, he added: “Going forward, our decisions on what and where to develop will be guided not by a plentiful supply of land throughout urban regions, but rather how best to use the land that is left.”

The article has been reprinted in Urban Land magazine.

I commented on the original article when it appeared on FaceBook, as follows:

“I agree with Patrick that, going forward, new development and redevelopment will occur in greenfields areas as well as urban ones. The issue I see is that public sector planners, appointed planning commission members, and elected officials frequently don’t get it. Even when they do, they are aware that the electorate largely doesn’t get it. And the public sector necessarily is very sensitive and responsive to the wishes of the electorate regardless whether it is well informed. That is the real challenge for those of us in the land use and development industry.”

The point here, of course, isn’t that public sector officials and members of their staffs, as well as members of the electorate, are dull-witted. It’s that they often don’t easily connect the dots between more efficient use of land with less issues relating to sprawl and the resulting need for higher density.

You can build smaller, more compact residences on a given parcel of land, but only if you can put more of those smaller residences on it than the larger ones contemplated in the original planning and zoning. It’s simply a matter of number$ (if you get my meaning).

Suppose you can build X units on Blackacre (after all, I am an attorney) at a land cost of Y dollars for Blackacre, and sell those finished larger units at a per unit market price that includes an acceptable risk-adjusted rate of return on total investment. Suppose, however, that the market demand changes to smaller, less expensive residences. Now, in order to earn a return on investment, you must be able to build X+ units, assuming the price for Blackacre remains Y dollars.

Otherwise, the residual land value per unit (the percentage of the total cost represented by the land cost) will be too high to produce an acceptable profit, and Blackacre won’t be sold and developed, which means that needed, affordable residential structures (remember those days?) won’t be built. That, in turn causes demand to drive up the price of existing housing, which gives rise to other social, political, and economic issues. Bottom line: density is a positive thing.

Real Estate Factoids, QE2, and Jobs

noreply@blogger.com (wayne) — Fri, 19 Nov 2010 19:48:00 +0000

For starters, here is some of the news behind today’s headlines:

· Mortgage rates have gone up and the number of applications has declined (due in part to expiration of the home purchase-inducing tax credits and continuing uncertainty about the economy and the cost of debt exacerbated by the Fed’s QE2 policy-see below). Not surprisingly, the yield on ten-year Treasury notes has been rising;

· Housing inventories have declined (in theory due in part to frustrated sellers pulling homes off the market and some lenders slowing the sale of foreclosed properties due to irregularities in the foreclosure processes);

· Housing starts have declined, which is understandable in a market where there is a huge overhang of existing inventory and mortgage loans are hard to come by;

· Building permit issuance is relatively unchanged from its current doldrums, also understandable given the situation described in the immediately preceding paragraph.

On Other Subjects:

QE2 or quantitative easing, Round Two. The Federal Reserve has created $600 billion out of thin air ostensibly to buy toxic debt instruments (think residential- or commercial-backed mortgage securities), thus greening the economy. The reality of it? The total of goods and services available in the market at any point in time is a static figure. Simply creating additional dollars only requires the costs of those goods and services to be increased in order to avoid loss of their value.

This is because this “funny money” weakens the value of the currency. It leads, in turn, to higher interest rates in order to adjust for the increased reluctance to invest in dollar-backed securities, such as Treasuries. Ultimately, it disincentivizes investment that would lead to job creation. Higher interest rates on government debt crowds out capital for private investment.

Make no mistake about it. Higher interest rates are part of a zero-sum game. Savvy investors understand that any given asset has a finite value for a desired rate of return on investment in that asset. It’s simple: the more you pay for the cost of the money (debt) used in the acquisition of the asset, the less you can pay for the asset itself. Higher interest rates put downward pressure on asset values.

On their third quarter reports, banks in the U.S. disclosed that they were sitting on more than $1 trillion in excess reserves, that is reserves above and beyond the amount required. Why aren’t the banks lending that money? Could it be that they are afraid of further losses in the real estate sector - residential and, especially, commercial?

Finally, what’s the big deal with extending the Bush tax rates for all those earning less than $250,000 per year and filing jointly ($200,000 for those filing individually)? Just this: who do you think is more likely to have the capital and incentive to invest in business growth and expansion? Right, those who wouldn’t get the benefit of the extension of the Bush rates. And what’s one of the most crucial things needed by our economy today? Right again, jobs. The solution to that problem (there are others that need other solutions to be sure) is to permanently extend the tax rates across the boards. Eliminate the uncertainty looming over future years’ tax rates, including 2011. To accommodate the tax rates, cut government growth and spending. No one ever was entitled to a free lunch in this country.

Is Help On The Way For The Real Estate Development Industry?

noreply@blogger.com (wayne) — Fri, 12 Nov 2010 18:46:00 +0000

Here's what we know:

The overall economy has been slammed harder than at any time since the Great Depression of the 'thirties;
Recovery seems to be imperceptibly slow to the point of stagnation;
Real estate development appears to have suffered more than any of the other industries;
The administration remains unchanged, but, thanks to a majority of the American electorate, the political and fiscal complexion of Congress appears to have moved somewhere to the right of where it has been for several years;
Profligate spending by the administration, as ably assisted by its departing cohort in Congress, has weakened the purchasing power of our currency, thus worsening the situation;
we depend on debt (through the sales of Treasury instruments) to operate our government

The Chinese, Japanese, Saudis and others are the principal purchasers of these obligations, and they have been threatening to slow or stop buying them because of the low rates of interest and the depreciating dollar as a store of wealth.

A proliferation of regulations on businesses and the looming threat of tax increases has created an environment of such uncertainty that the needed expansion of business, and the resulting creation of jobs, has not occurred;
This has aggravated the reluctance of lenders to provide the needed debt capital;
This uncertainty, high unemployment, and absence of debt capital dampen demand and make it difficult both to reduce the huge overhang of residential units and refinance much of the $1.4 billion in commercial real estate loans maturing over the next few years.
And, this doesn't even touch on the potential economic disaster represented by apparent irregularities in the mortgage-backed securities industry.

Here's what we need:

The Republican majority in the House to display some genuine grit for a change and dispel the uncertainty by:

Rolling back the plethora of centralized power-grabbing regulatory schemes enacted in the past few years - simply unfunding them if all else fails;

If lenders had clear regulations regarding reserve accounts and other matters jumbled by the Dodd-Frank bill and other legislation, they would be far less reluctant to lend.

Initiating permanent tax cuts - temporary ones or ones that benefit only the lower bracket taxpayers who don't create jobs - do nothing to dispel the uncertainty concerning the economic future;

permanently quash the death tax and the oft-proposed tax on carried interests;
lower the capital gains tax and the corporate tax rate;
create tax incentives that encourage investment and expansion.

These are but a few of the positive actions that could be taken to jump-start the economy. We'll discuss more in a future blog entry.

Efforts to Limit Growth and Development

noreply@blogger.com (wayne) — Thu, 11 Nov 2010 21:26:00 +0000

Over the past decade or so, several states have seen efforts by special interest groups to try to place constitutional limitations on development activity. The method used generally is to try to put a referendum on the ballot during statewide elections, such as the recent mid-term elections. The sponsors of these initiatives are those, who for various reasons, steadfastly oppose any further growth in communities. Never mind the tragic consequences that may have on the economy in that community. St. Pete Beach, Florida is a good case in point.

The goal is to force all new development proposals to be placed on the ballot for electorate in the affected jurisdiction - usually a city or county - to cast their respective votes for or against the proposal. In other words, what ordinarily is a task for the municipality's elected officials to decide becomes a matter for decision by the entire electorate.

These efforts often have compelling titles. For example, in Florida, the most recent effort was called "Home Town Democracy", also known by a more plebeian name, Amendment 4. The proposal was defeated by a significant majority of the voters in Florida, as has been the case in other states, so far. But the people sponsoring these proposals will continue to try to press their will on the public.

So, how exactly would this limitation work? If, for example, the one in Florida had succeeded, it would have required most proposed amendments to a municipality's comprehensive growth plan to be placed on the ballot at the next general election. Comprehensive growth plans (GMPs) are maps outlining in general terms how a city's or county's growth and development should occur over time. The principal idea is to insure that capital facilities, such as roads, schools, sewer and water, are in place to accommodate the growth rather than resulting in overburdened infrastructure and the resulting negative impact on the quality of life of the citizenry. Because these guidelines necessarily are general in nature and require flexibility to accommodate the unforeseeable changes and developments that are sure to arise over time, there usually is some process for amending the GMP.

As a general example, if a land owner wanted to change the land use designation for a parcel of property she owned from commercial to residential, she would seek an amendment to the GMP. Her proposal would be reviewed by the municipality's planning staff and sent to the governing body of elected officials with a recommendation for or against the proposal. The city council or county commission, with input from state agencies and after notification to affected landowners, would determine whether to grant or deny the proposal in a public hearing. It's worth noting that in areas where growth is occurring, it is conceivable that hundreds of these proposed amendments could be on the ballot in any given election. Are individual voters going to take time to study each proposal and give its due? It's very doubtful. The voting process involves lengthy lines and long ballots as it is.

Under this scenario, which exists in many states, these decisions are made by the public's elected representatives after various open public hearings, notifications mailed to affected parties, and input from a number of sources including the individual members of the public. Some jurisdictions even solicit public opinion surveys and questionnaires, as well as public hearings in various specific locations within the community. Sure sounds like representative democracy at work.

So, what is it the proponents of these ballot initiatives seek to achieve by taking land use decisions out of the hands of duly elected public officials and requiring the entire electorate to make decisions? Just this; they don't like a process that gives each proposed development activity an opportunity to stand on its own. By moving the decision making to a laborious and demanding process for each individual elector, it almost assures that the mass of proposals will fail. Other than Congressmen, voters rarely vote in favor of something complex that they haven't had time to sufficiently understand.

It is certain that these initiatives will continue to appear on ballots at the state and local levels anywhere there is healthy development activity. Just remember: when you stop growth, you impair economic activity, which in turn leads to decline and higher taxes to cover the resulting shortfall.

Reflections On The Election: Moving Forward

noreply@blogger.com (wayne) — Wed, 03 Nov 2010 20:00:00 +0000

What messages does the recent mid-term election send, and to whom are they sent? The answers seem simple enough on the surface. The principal message was aimed at the Democrats: The majority of the American electorate “does not want to be governed from the Far Left”.

There were other messages to be sure. The election of a Republican to fill Obama’s former Senate seat appears to be the people of Illinois saying to Obama, “Goodbye,…and don’t come back.” So much for favored son status.

But the main message clearly was the reflection of the anger, mistrust, and disappointment the electorate has with the direction of the Obama policies. Much of that anger springs from the perception of having been duped by him in the 2008 presidential election.

There is evidence that in any election of national consequence 30% of the electorate consists of loonies, misfits, and sociopaths slavishly devoted to the Far Left’s promises of a statist nirvana where they are rewarded for their singular lack of talent and ability. That percentage is much higher in California, as was proved by the elections of those clueless twins, Brown and Boxer. Add to this, in 2008, the disgust with the ineffective fiscal and immigration policies – or nonpolicies – of the Bush administration, which drove the mass of voters in the center to buy into the Obama message of Hope and Change. The country thought it was ready for any change. It took Obama less than two years to disabuse the majority of the electorate of that notion.

The mean of the electorate is often said to be center-right. That certainly appeared to be true in the recent election, if not somewhat farther to the right. Remember, the Republicans recently held both houses of Congress and the White House, but lost it all through poor governance. It appears that the electorate, in desperation, is turning back to them principally through the efforts of the Tea Party and similar movements. The challenge now for the Republicans is to accurately take the pulse of the electorate and respond accordingly.

The message appears clear enough, as evidenced by the victories of Marco Rubio and other Reagan-style conservatives. The majority of voting Americans do not want big government, deficit spending, and the proliferation of regulations and bureaucrats. They want jobs, fiscal responsibility from their elected representatives, jobs, small government, jobs, a playing field on which entrepreneurial talents can take the shot at the brass ring, and…,oh yes, jobs.

More From The ULI Fall MeetingIn Washington, D.C.

noreply@blogger.com (wayne) — Mon, 25 Oct 2010 21:47:00 +0000

This is Part 2 of notes I took at the latest annual fall meeting of ULI - the Urban Land Institute. The meeting was held in Washington, D.C. from October 11 to the 15th.

From Distressed Loans/Deals:

· 5,200 CRE loans are in special servicers’ hands representing $94 billion in distressed debt

· Lenders are holding 1,100 REO properties having a value of $10.7 billion

· 73% of all outstanding CRE loans will mature over the next 6 years

· There are 4.8 workers for every job in the USA, up from 1.8 workers per job

· The he run-up was caused by investor demand that was fueled by Wall Street quant jocks who didn’t understand the cyclicalities in the economy

· There is a correlation between high unemployment rates and the rate of defaults on indebtedness

· Troubled loan goes from the master servicer to a special servicer at even the threat of imminent default, such as when someone has had a receiver appointed

· Workout techniques:

o Subordinate some portion of the debt to fresh equity – this creates the A note, B note situation

o Restructure if you can get a higher NPV by doing so as opposed to the NPV on foreclosure and the issues of REO

§ The hurdle rate for the NPV is the interest rate on the note

o Because of REMIC requirements, a special servicer who sells the asset has to do so on an all-cash basis. BUT if they get a court appointed receiver to sell it, the receiver can sell it as a structured deal

§ Also, the receiver insulates the lender from liability and becomes the manager of the asset once it goes into foreclosure

· CMBS trusts can’t hold REO more than 5 years

From Larry Sabado: What the Elections Mean for the Economy:

· It will take a decade to recover from the recession in the USA

· Republicans will win control of the House with at least 226 seats and probably more

o 30 to 40 of these will be Tea Partiers, who will not compromise

· Republicans will get 7 to 9 new seats in the Senate but will not get enough to prevent filibuster

· Thus, gridlock will reign on Capitol Hill

noreply@blogger.com (wayne) — Fri, 22 Oct 2010 20:45:00 +0000

I attended and participated in the ULI Fall Meeting in Washington, D.C. last week. It was the usual track meet environment - too many activities going on from dawn to late into the evening for 4 or 5 days with a great deal of concurrency and overlapping. Much of my time was spent in my Product Council activities, District Council activities, and presenting or moderating sessions, but I did get to attend some of the most interesting sessions. Here, in bullet point fashion, are the take-home comments that resonated with me.

From Certainty in Uncertain Times

What is certain?

· Demographics

· Trends (urban infill)

· Green

· Differentiation and disparity - not everyone wants the same thing

· Economy – will improve, but slowly

Demographics

· Housing starts currently are at ¼ what’s needed for expected population growth

· Gen Y is 30% unemployed, in debt, ambivalent about owning versus renting (will rent for years to come), urban oriented, will move a lot

· Immigration is 50% what it has been, but immigrants and their descendants will drive 82% of the population growth

· Homeownership will settle at 62-64%; the rest will rent

· Much housing will be urban infill which will put upward pressure on prices

· Going forward, emphasis will be on smaller, affordable, compact housing

Green

· 870,000 sf are being LEED certified everyday despite the recession

· Gen Y is environmentally sensitive and aware

From Council Day: Taxation:

· NPV with a discount rate of 10% indicates you should accelerate planned 2011 sales into 2010

· Sell securities in 2010 and buy them back in 2011

· When buying distressed debt, get the lender to write it down before you buy it or you may recognize ordinary gain

From Global Capital Markets:

· Never forget: real estate is a yield instrument (not sticks and bricks)

· Emerging countries are riding high on $86 oil, but Western nations are floundering under unsustainable debt

· China has $700 billion to invest in stabilized real estate assets;

o Looking for long-term value, not quick profits

o But very risk-sensitive and carefully analytical

· If the USA pushes China to revalue the Yuan, they may stop buying our treasuries, which would push up interest rates

· Consensus is interest rates could go anywhere – who knows in this environment?

o So, if rates go up, today’s 4.5% (on quality core assets) is an argument against delevering

o The market currently expects quantitative easing (QE), but fears the consequences because QE is treating the symptoms and not the disease

o What is needed is not QE; it’s:

§ real jobs (not road-paving)

§ spending cuts and the reduction in the spread of government centralized power

· Corporate bonds are safer and have a better return than treasuries

· Today’s low interest rates are propping up property prices

· Today, a fair return on core assets with 50% equity is about 8%

· Global gateway cities are where the current action is:

o The market is very narrow and very deep

o Foreigners are bullish on the long-term USA economic growth prospects

§ They are used to low yields (i.e., a 5 cap)

o The Euro is stronger than the dollar because the EU doesn’t print money to solve financial crises

· Difficult to find equity for construction because return is 3 years away (when stabilization is reached)

· Lower unemployment rates would encourage investment because of the expected effect n the economy

· Hedge funds have a better model than Wall Street because they don’t pay preferred returns (“prefs”), so they collect 20% from the first dollar of return

· Higher risk mezzanine debt returns are being compressed

· Real estate taxes are going up, so expenses will increase and NOI will go down, negatively affecting cap rates and values

· Banks are lending today only on core assets with strong cash flow

· Moratoriums on foreclosures because of bad documents could result in all mortgages being decertified for foreclosure action, not just the ones with bad documentation. This would be a disaster because it means no one has to pay mortgage payments and lenders cannot do anything about it.

There is more to follow in a subsequent posting.