The popularity of commercial real estate has exploded in the last few years, and the media is full of war stories from new investors who find themselves in deals with problems.

In almost every case the cause is traceable to a lack of knowledge about a few simple precepts that form the ground rules of successful investments. These are the basic practices that when used correctly will eliminate the most common causes of a bad deal.

My top 5 list of rookie mistakes:

1.     Ignoring local market conditions. There are two levels of due diligence required to evaluate a real estate investment: the market and the property. And of the two, local market conditions trump everything else. A great property in a bad market can be a big loser. A poor property in a great market can be a gold mine. How do you know the difference?

Every market is different, and a deal technique or property type that is profitable in one market it does not mean the same holds true anywhere else.

Analyzing the demographic trends of population growth, income and employment in the local market will tell you where opportunity lies, or not. It will also show which property types are in demand, or oversupply. Those conditions will make or break your investment.

Investing in an area with declining demographic trends is destined for trouble. So learn your market. Then listen as it tells you how, when and where to invest.

2.     Inadequate property due diligence. The second level of due diligence is the property condition, including physical items such as building systems, environmental matters and structural components. Just as important are the intangible items, such as title, survey, and zoning and land-use regulations. Knowledge of contract law, insurance, finance, accounting, and tax law is also critical to doing things right at the beginning to insure success at the end.

If you’ve never done it before, this is not a DIY project. The money you think you’ll save by doing it yourself can cost twice as much to fix, and may jeopardize the entire investment. Red Adair, the famous oil and gas field firefighter, said, “If you think it’s expensive to hire a professional to do the job, wait until you hire an amateur.”

Admit what you don’t know. Approach the property like an open book test. If you don’t know the answer to a question, find an expert who does know to give it to you. Get accurate estimates from professionals of what it will cost to fix what is wrong. The time spent inspecting the components is minimal, and can save thousands of dollars in unexpected repairs.

3.     Botching the math. This is not rocket science, but real estate is a numbers game. Value is dependent on net operating income—gross revenue minus operating expenses.

That’s why it is so important to get the real operating numbers, not a projection of potential gross income and estimated expenses. Confirm and verify every element of income and expense. Value the property based only on present income, not projected income you have to produce.

Your profit is dependent on net income. Net income is the net operating income minus debt service. If you’ve overestimated revenue, underestimated expense, or have too much debt service, your profit will suffer or turn into a loss.

Understand that risk increases with every assumption made. Do not assume you can save expenses by cutting corners, or can raise rents the day after you take possession. Anyone who has ever prepared a projection of operations has realized that by tweaking the assumptions the bottom line can be manipulated into whatever is needed to make the deal work.

The problem comes when its time to make the numbers happen. It’s real cash then—your cash—and when the rents don’t go up or the expenses don’t come down as much as the projection called for, you take the hit. You might tweak the numbers to make it work on paper, but paper won’t pay the bills, and hope is not a plan.

4.     Over-leverage. Borrowing too much money in this business is fatal. Highly leveraged deals do happen, but unless it’s backed up by a solid plan with sufficient capital it can be disastrous. Using 100% financing for entry level deals is like believing gravity doesn’t exist as you jump off a building: you can argue all you want, but you’re going to hit the ground—the only question is how hard.

The proper use of leverage is a function of deal structure and investment strategy. Every investment property should be evaluated in light of the break-even ratio. The break-even ratio is equal to the Operating Expenses plus the Debt Service, divided by the Gross Potential Income. [(OpEx + DS)/ GPI = BE]. When break-even exceeds 80%, the structure depends on perfection, and that’s dangerous territory.

5.     Failure to have an investment plan with multiple exit strategies. An investment plan incorporates all of the due diligence findings and outlines all the possible outcomes of the investment, best case to worst case.

Ask yourself why you think you can do a better job running this property than the seller did. If you can’t answer that with specifics, you won’t do better, and probably not as well.

Your plan should answer the questions of how the property will be managed, what improvements are needed and their cost, how much money might be made (or lost), how long it will take, how to get out if things go wrong, and how to access the profits when it goes right. The answers will reveal a realistic plan to maximize value in the shortest possible time, with the least possible downside.

I rarely have less than three exit strategies, and usually a half dozen or more. I’ve learned that if I don’t have a plan to get my money out of a deal, I will soon be out of money.

Learn from those who have paid the price

I just read an article on Wall Street Journal Online about a young Colorado investor who made almost every mistake mentioned above. In 2005 he paid $269,000 for a four-plex, used 100% financing, in a market dependent on the presence of military personnel in the middle of a war with extended deployments. He had no management experience and didn’t screen new tenants, who turned into evictions. He planned (hoped?) to hold the property for cash flow, but over-leverage and inexperience produced average cash flow of only $100 per month.

Now he wants to move to another city, and put the property on the market for $285,000. With no takers he’s reduced the price to $265,000, offering a 3% commission, but not using a listing broker because he thinks he can’t afford it. This is not an isolated case. The dangers of these errors are real, and painful, and none of us have the time or the money to learn all the lessons the hard way.

Roy H. Williams, aka the Wizard of Ads ® from Buda, Texas summed this up. He asks, “Are you smart or are you wise? A smart man makes a mistake, learns from it, and never makes that mistake again. But a wise man finds a smart man and learns from him how to avoid the mistake altogether.”

Office Net Absorption and Vacancy: The national vacancy rate has regressed back to levels unseen since 1993 and remains well above the cyclical low of 12.5% from 2007 before the onset of the recession. A positive absorption rate is encouraging, but indicative of the slow pace of job growth.

“The national vacancy rate fell by 10 basis points, to 17.2% at the end of the first quarter of 2012. The sector absorbed about 6 million SF, the fifth consecutive quarterly gain in occupied stock since the beginning of 2011. Although net absorption levels remain muted, five consecutive quarters of positive net absorption provide fairly consistent evidence that the sector is indeed recovering. “–ReisReports

My own experience mirrors the national data. Rent growth is modest, but pricing power has returned for projects with recent renovations and improvements. While there are fewer large tenants seeking new space, the ones that are will not grind the owner down to the last nickel to make a deal.

However it occurs to me that may be highly personal. I’ve lost patience with the brokers who have used those tactics in the last couple of years. In recent negotiations I’ve just declined to counter to lowball offers. That sends a message–if you want this property be willing to pay what it costs to deliver or don’t waste my time.

That said, I may soften my stance in the latter half f the year. I expect the rampant legislative uncertainty including expiration of seven tax reductions, debt reduction by sequester, an new debt ceiling battle, the outcome of health care expense increases… all on January 1, 2013, tro negatively affect activity in office and retail. Companies are already moving into a hunker-down mode until our can-kicking Congress deals with the freight train headed straight at us.

Retail Net Absorption and Vacancy

The first quarter produced another glimmer of hope that a slow recovery in neighborhood and community shopping was underway. Occupied stock increased by 3.141 million SF in the first quarter. This is the second-largest positive value for net absorption since the sector began losing occupied space in the first quarter of 2008.

Retail continues to be a bifurcated market between STNL (Single-tenant net-lease) and everything else.

I’ve got breakdowns of the aggregated data reported here by sub-type and market that indicates emerging bright spots for well-located, recently built neighborhood centers with strong grocery anchors.

Lease rollovers from the last of the go-go years of 2005-2008 are coming due. Most of the national and regional in-line tenant deals signed then on 5-7 year primary terms. Rent concessions continue to be the order of the day.

However, Reis has more optimism than I do:

“The first quarter produced another glimmer of hope that a slow recovery in neighborhood and community shopping was underway. Occupied stock increased by 3.141 million SF in the first quarter. This is the second-largest positive value for net absorption since the sector began losing occupied space in the first quarter of 2008.”

“Vacancies finally began to fall during the first quarter, declining by 10 bps. This is the first quarterly decline in the vacancy rate since the second quarter of 2005. Since the advent of the recession, supply growth has been virtually non-existent, but negative net absorption drove vacancies upward. With supply growth remaining at minimal levels, the swing back to positive net absorption finally reached tipping point for the vacancy during the first quarter.” –ReisReports

I hope they are right. Retail is my favorite sector and though I am eager to get back in the water, it ain’t summertime yet.

The continued strong performance is bringing valuations of existing properties well within the range of replacement cost, which is the benchmark for establishing feasibility of new development.

The chart at left from Reis reflects the trend which began with the rise in rent growth in Q1 2010. As pricing power the rental market strengthened vacancies started falling. They will continue to do so until new development catches up.

However, due to continued tight credit conditions the development pipeline is not filling up as it would in a normal cycle. Multi-family construction starts through March 2012 are at a seasonally adjusted rate of 195,000 units. That’s a 25% year-over-year increase in multi-family construction from March 2011, but a longer view is necessary to put that into proper perspective.

Consider that the average number of multi-family units constructed per year from 1995-2011 is 294,000. Post-recession construction typically rebounds by 50% or more, Last year (2011) saw 167,000 new units constructed, with 165,000 in 2010. The following graph from the St. Louis Fed reflects the data from 1970. Seen in this perspective, the talk of over-development is premature.

As can be seen, we are barely back to 1995 level of 200,000,which was also a post-recession year. This is the basis of my position that the current up-cycle in multi-family will run significantly longer than past cycles.

The following table is the actual annual construction for the previous year since 1990:

Industry projections for 2012 hover around the 200,000 unit level.

My personal projection is for closer to 250,000, based primarily on the stable performance of the architectural billings index, the proclivity of banks to follow the herd into loans for a winning category, and the pent-up demand from developers to build anything that will get things moving again.

Also at work is the the increasing demand from the fallout in single-famly housing. The analysts I read and respect, in particular John Burns and Gary Shilling, are projecting continued rental housing demand of 800,000+ per year for the next several years.  I’ve got a host of data, charts and background on that topic in my new 2012-2013 forecast.

All trends point to a continuation of higher rental demand, still falling house prices, and continued tight credit which affects the single-family buyer as well as developers.

(The new forecast should be posted to the site this week, stay tuned.)

If the is a caveat to the good news in multi-family housing it lies in the falling affordability of houses. The slow development pipeline of multifamily potentially sets up an earlier bottom for single family housing. With rents tight and likely to get tighter, buying becomes a better and better deal (for those who can get a loan), and induces investor demand for purchasing houses out of distress portfolios.

This is good news in a different form. As I have long believed, there is no recovery until housing recovers, and any market-based solution to finding the bottom has my support.

To avoid a too-long post, I will recap the office and retail performance for Q1 2012 in a subsequent post.

FASB sets the standards by which financial institutions must prepare their financial statements. In April of 2011 FASB issued the directive which requires qualifying lenders to mark property values to market if they do a forbearance agreement or loan workout, as defined in the regulations. (The definition of what now qualifies as a workout is as important as the ruling itself. For geeks, the full text is available here.)

This is a 180-degree turnaround of the FASB standard issued in 2009 that suspended “mark-to-market” accounting, which allowed banks and financial institutions (including the GSE’s) to avoid marking down the value of their real estate loans and mortgage securities. Those mark-downs would have devastated the banking sector.

The FASB update means the practice of “amend, extend and pretend” begun in 2009, and morphed into “delay and pray” through 2010-2011, is over. In 2008-2009 the banks tried to do anything to keep a loan from being classified as non-performing.

Aided by the government and the FASB relaxation of the mark-to-market accounting standard, two- and three-year workouts were the norm. They expected that by 2012 things would be better and the problem loans would take care of themselves. It didn’t quite work out that way.

Andy Miller, principal and CEO of Miller-Frishman, a commercial real estate workout firm in Denver CO talked about the state of the distress market for commercial real estate in an interview with Casey Research in February 2012:

One component of our business focuses only on the distressed world, in which we regularly deal with between 50 and 100 banks, from large to small. We’re involved with them in every aspect of distress. We act as receivers, we act as disposition agents, we value the real estate for them and oftentimes I consult with them to just help them understand what they have and what the easiest way is for them to exit while minimizing their losses.

 This segment was very busy in 2009. We did many receiverships all over the country, and we were busy into 2010. In about the third quarter of 2010, it completely ground to a halt. We saw no distress. We saw no hysteria. It was as if within a span of 90 or 120 days the entire world righted itself. It was one of the weirdest things I’ve ever seen, and it lasted for an entire year. Our business in the distress world was totally dead around here from about October of 2010 to November of 2011. Dead. I don’t think we picked up a single property.

 All of a sudden, right after Thanksgiving in 2011, the floodgates opened again. In the last six weeks we probably picked up seven or eight receiverships – and we’re now seeing some really big-ticket properties with major loans on them that have gone into distress, and they’re all sharing some characteristics in common. In 2008 and 2009, these borrowers were put on a workout or had a forbearance agreement put into place with their lenders.

Most banks have repaired their balance sheets, and now have an incentive to liquidate problem loans and OREO’s. This sets the stage is set for higher transaction volume in distress property this year, as well as in non-performing notes.

In recent weeks I’ve had calls from three of my banks with notes for sale, secured by properties they do not want to foreclose on because they know there is a huge loss waiting on the auction block.

The bank’s best prospects are the bank’s customers who have weathered the downturn and have an appetite for acquisitions. The bank would sell the note at a discount—even if they have to finance the purchase—and minimize the loss. Buyers then deal with the borrower on whatever terms can be negotiated. The deal I looked at this week is leased with a long-term tenant paying above market rent, the note is in default and can be foreclosed immediately, and the bank is willing to finance the purchase. We could use the property if it were to become vacant, so I’m tempted.

Brokers I talk to around the country are getting lots of calls from banks looking for non-performing note buyers. I expect the volume to increase significantly, especially around the end of each quarter when financial statements must be filed and reserves recalculated.

If you haven’t heard from your bankers lately, give them a call and ask the question, “What’s the biggest problem on your list you would like to get rid of today?” You may be the best call that banker gets all week. Happy hunting!

The Department Of Numbers is a blog with data sets for national employment statistics derived from the monthly BLS reports. The data is organized by state and metro areas. The site also has data on household income by metro. This is another level of “granularity” as the biz speak gurus put it, also known as “details” to dirt merchants.

I was tipped to the site by a report from a local economic development organization I belong to, the New River Valley Economic Development Alliance

The director,  Aric Bopp, sent the data for my hometown metro, Blacksburg VA. Aric was spreading the word that our corner of the world has been on a job creation roll the past year. During the calendar year of 2011, the Blacksburg/Christiansburg/Radford MSA (aka the New River Valley) ranked 3^rd (out of 363 MSA’s) for “1 Year CES Jobs Percent Change”.

I love news like that, because on a percentage basis our little metro can compete with the big guys. (The nominal increase was 3,600 jobs. But you gotta admit,  “3rd in the nation for percent job change” has a better spin!)

Combined with the county data available from the BLS site you can get a pretty good handle on local employment conditions for any given market. If your county is not part of an MSA (Metropolitan Statistical Area), contact your state or local economic development folks. They are usually sitting on a trove of data available for the asking.

The image at left is a screenshot from the website. This is an interactive map showing job growth by industry at the county level. Go to the site, roll your cursor over the map and you will see the breakdown of job growth stats for the county. Click on the county and the table at bottom will give even greater detail.

I spent over an hour checking out my home markets, other markets I’ve targeted for expansion, and those where friends and colleagues live… but then I’m pretty much a data geek, which means give me a dataset I can manipulate and I’ll be entertained for hours! An advantage to looking at a composite of 5 years of data is that it smooths seasonal fluctuations, however it does have one major drawback. (more on that in a moment)

The NewGeography site also has an index for the 2018 Best Cities for Job Growth. (To sort the data, copy the chart into Excel and use the Data | Sort function.)

As to the drawback of the 5-year data, this has been the most turbulent 5 year period for employment changes since the 1980’s. So while I love the quick fix of information on an interactive tool, I will also go to the Bureau of Labor Standards site to get the most current data.

This image from BLS depicts unemployment rate by county for the past 12 months. The raw data is available on the same page downloadable in an Excel spreadsheet. As you can see, there are some differences between the color coding of the two maps.

By the way, the BLS site has enough employment and labor market data to make your eyes bleed.  While you’re there take the tour of the datasets. I get the data for any market I’m invested in on a quarterly basis to keep a weather eye on market conditions.

In choosing real estate markets to invest in there is no such thing as too much information about the local employment conditions. Jobs and HH income levels affect consumer spending in retail stores, demand for office space, rent growth and occupancy for apartments, and ultimately the tax base for the community. This determines the quality of schools, public services and overall quality of life. In sum, everything that is important to real estate values and performance.

In a recent American Express Open Forum interview, the noted business guru Jim Collins made a great  point about preparing your business for all conditions:

“As soon as you can—before you grow really big—your first priority is to have enough cash that you could go a whole year without revenues if you had to,” says Collins. “Because someday, you might have to.”

In other words, plan for zero.

In practice that’s the type of advice that most people hear, nod their head yes, and then promptly ignore.  We know it makes imminent sense, but carrying it out is hard. When  revenue grows to exceed the immediate demands  of the moment the natural instinct is to use it for growth, or more investments, or a vacation.

The thought of hoarding cash for bad times is a downer by nature, mostly because we delude ourselves into thinking there won’t be any bad times now that we’ve “mastered” the business. Please observe that the road to bankruptcy court is paved with delusions.

How does this apply to real estate? For many years I’ve used a “worst-case break-even” as the deciding factor in valuation calculations, and to devise appropriate deal structures.

To explain, when I look at a property for acquisition I must have the most recent 12 months operating statement available, preferably a trailing twelve from the most recently completed month, along with the current rent roll.

Multiple Projections for Multiple Uses

I normalize the NOI by removing (or adding) anything from the historical statement that is not property related, or adjust for how I will operate the property, and my proposed deal structure. Using the current rent roll and appropriate expense inflators I construct a baseline projection of the first year of operation. This is the “do nothing” scenario. (It’s also the basis for valuation, but that’s another post.)

Then I do a “best case” projection, which includes improvements from the property investment plan, expansion, new lease-up, whatever… with the assumption that everything goes right.  I know it won’t, but I want to know what it looks like.

Last is the “worst case” projection. This reflect is if all hell breaks loose, e.g. higher than normal tenant turnover; long re-leasing periods with heavy TI expense ( very common in retail and office properties);, improvements come in late and over budget; and any other possible problems for the project.

That third scenario becomes the litmus test as to whether I do the deal. What I’m looking for is what I call a “worst-case break-even” projection. That means just what it says… if all hell does break loose, then my worst case is I don’t make money that year, but any losses should be minor.

Reserves are the Key to Survival

This is the only way to play intelligently in the distressed property space and maintain a margin of safety to avoid excessive risk. I’ve acquired numerous properties purposely structured on a break-even scenario when the due diligence supports an investment plan that meets my 3-year return criteria. Using the “plan for zero” mindset, I budget for the improvements and reserves up front, and avoid the nasty surprises that sink projects.

How cool is that! I want one! But with one small change… when Colbert refers to election law, I substitute “Tax code”.

Since its tax season, this is a great idea for dealing with my tax lawyer & accountant, John Hyre –aka Dictator-in-Chief at Real Estate Tax Accounting LP. Our conversations become Socratic exercises, in which I keep changing the facts until I get the answer I want. I don’t just visit the gray areas, I live there.

John would have to add his fallback answer to every question, “anything is okay until you get audited. The real question is whether I’ll be there.”

Common work-arounds include reception areas with glass walls to the corridor, designing the interior work area with perimeter offices with glass half-walls, liberal use of artwork and  and interior-scapes.

However, as any office-manager will tell you, suites with no outside view can affect staff morale, and the business owner will use the perception to negotiate the rental rate. The landlord is often predisposed to accept the offer, knowing from experience the lack of windows hurts the appeal.

Enter Winscape, the technological solution to the fluorescent-soaked cube farm. The video below will make you go “wow”. I sent this to a good friend, Eric at Capital Thinking, , and he  emailed me back a one-sentence comment, “I want one.”

This is a work-in-progress. Rational Craft, developed and sells the software it calls Winscape, to run the screens. The user supplies the plasma displays and a Mac computer to run the program. Total costs are estimated to be about $2500-$3000. Their website has several videos documenting some of the installation challenges (e.g. portrait/landscape orientation, cables, heat, etc.).

We’ve got several suites in our inventory that could use this, and we’re contemplating the added marketing exposure that may be generated with a well-placed press release.

The new regulations affect virtually every commercial building open to the public, including establishments that were exempted in the original 1991 act, and facilities such as office buildings, factories and warehouses that do not provide goods or services directly to the public are subject to the ADA’s requirements for new construction and alterations. The new act was passed by Congress in 2010, and phased the enactment of the anti-discriminatory hiring sections for March 15, 2011, and the building accessibility standards for this year.

Most importantly, the new act eliminates the “grandfather” or “safe harbor” provision that exempted buildings constructed prior to 1991 from compliance with ADA unless significant alterations or new construction occurs. After March 15, 2012 all buildings must comply with the 2010 standards when making improvements previously considered normal maintenance or replacement.

Quoting from the ADA Small Business Primer:

“When a small business undertakes an alteration to any of its facilities, it must, to the maximum extent feasible, make the alteration accessible. An alteration is defined as remodeling, renovating, rehabilitating, reconstructing, changing or rearranging structural parts or elements, changing or rearranging plan configuration of walls and full-height partitions, or making other changes that affect (or could affect) the usability of the facility.”

“Examples include restriping a parking lot, moving walls, moving a fixed ATM to another location, installing a new sales counter or display shelves, changing a doorway entrance, replacing fixtures, flooring or carpeting. Normal maintenance, such as reroofing, painting, or wallpapering, is not an alteration.”

The one that got our attention was the classification of flooring and carpeting, and parking lot restriping as alterations that require compliance with new standards.

The new act requires 1 van accessible space per 6 required handicapped spaces, a change from 1 per 8 spaces previously required. This affects parking lots with 151 or more spaces. A van space requires 11′ wide parking space adjacent to an 5′ wide access aisle, or an 8′ wide space if the access aisle is 8′ wide, as depicted below.

In practice, assuming the typical requirement for 1 parking pace per 200 sq. ft. (5 per 1,000 sf) for retail uses, this will affect retail centers of 30,000 square feet and up.  This is an important consideration when assessing needed capital expenditures during acquisition due diligence, or in budgeting for existing properties. Essentially every parking lot over this size is now non-compliant, as all local building codes are written in compliance with the 1991 act. Unless sufficient space is available to accommodate additional  van spaces the center could be unable to get a certificate of occupancy for new tenants after improvements are made. Typical office parking requirements are 1 space per 400 sq. ft., so the new requirement will kick in for buildings over 60,000 sq. ft.

New carpeting or flooring can trigger requirements for a minimum 3′ wide accessible route through public space (e.g. retail display shelving, showrooms, office areas, etc.), heights of counters and light switches.

The new standards still contain the “readily achievable” language of the original act. This is a subjective judgment made by a local building official which is supposed to take into account business size,  relative affordability, and the nature of the barrier or non-accessible feature in determining whether the new requirement can be met.

The act does provide that compliance costs are tax deductible. Section 190 of the IRS Code provides a tax deduction for businesses of all sizes for costs incurred in removing architectural barriers in existing facilities or alterations. The maximum deduction is $15,000 per year. For businesses with less than $1 million in revenue and fewer than 30 employees, all costs of compliance are deductible.

However, the tax deduction is going to be cold comfort for building owners struggling to maintain rent rolls. Office and retail tenants routinely demand new carpeting for renewals, some leases require it every few years. And parking lot striping is a recurring maintenance expense every five years or so. You may want to take a look at your parking lots now, and if they are close to needing sealing get it done now. Ditto with lease renewals requiring improvements.