The current unemployment rate is 5.5%. Historically, that’s not a high number. Why all the concern?

The present unemployment rate is historically low. During the past 25 years the unemployment rate has ranged from a high of 9.7% to a low of 4%. It would appear that 5.5% is on the low end. That said, before assuming 5.5% is good news, there are four factors which need to be taken into consideration.

1. Unemployment is a lagging indicator. People are let go from their jobs when business has declined, not before it declines. If business continues to decline, then we will see higher unemployment rates.

2. The unemployment rate is published by the Bureau of Labor Statistics, which is part of the U.S. Department of Labor. The government defines unemployed as people who are jobless, looking for jobs, and available for work. That would include those collecting unemployment insurance. At the same time there are a number of persons who no longer collect unemployment insurance and have simply given up looking for work. The Bureau of Labor Statistics no longer counts them and they fall into the category “Not in the labor force.” Currently, that number totals over 79 million persons. Many within that number are correctly not a part of the work force, but the remainder, if identified, would increase the unemployment rate.

3. The length of time for the unemployed to find a job is taking longer. Recently, unemployment claims lasting more than one week hit a 4½ year high.

4. What is the trend? During the past two years, the unemployment rate has moved steadily from a low of 4.5% to the current 5.5%.

Given these four factors, it would certainly be prudent to use the unemployment rate as a cautionary tool in guiding your investment strategy.

The arrival of $100 crude per barrel is going to jump start and accelerate the growth of e-commerce’s retail growth. The fourth quarter 2007 estimates to be released by the Census Bureau of the Department of Commerce on February 15, 2008 will show this jump and mark the official beginning of the end of retail business as we know it. Office buildings will continue to reallocate their space usage because more employees will be working at home. Residential housing will need to provide a more integrated resident support system. Commute time will become increasingly more important.

The phrase efficient distance cannot be overemphasized enough. Commercial real estate is not like other operating businesses when it comes to location. It can’t be moved to a more convenient location. Thus, the need for responsive, comprehensive due diligence is no longer an option. Future markets will not bail out poorly located income properties purchased with inadequate due diligence.

Today the price for a barrel of crude oil hovers around $140. The causal affect of the higher cost of energy can be summarized by the following changes. The unemployment rate in November 2007 was 4.75%. Today it is 5.5%. The consumer confidence indicator was 88 in November 2007. Today it is at the record low of 50.6.

Those experiencing the current economic environment for the first time feel like it’s the end of the world. They tend to act emotionally, miss opportunities, and avoid the basics. Those who have seen these cycles before know it’s a time when the opportunities prevail. They don’t act emotionally but stick to the basics. In reference to the current phase of the economic cycle, NetGain has recently published the following items:

• Income Property and Buying Right in a Downturn
• A Commercial Real Estate Survival Plan
• 1929 - Can It Happen Again?
• Investment Holding Periods in a Soft Economy
• A Real Estate Investor Plan for a Serious Economic Downturn

NetGain remains committed to providing the most practical, useful, unbiased information for minimizing risk while maximizing return on income property investment.

Recently, one of our visitors questioned what NetGain meant by “taking a fresh look at the business model of income property.” A fresh look means a re-examination of the business model. Income property is an operating business, and the business model for an operating business is descriptively and mathematically summarized within its profit and loss (P&L) statement. In the face of world changing events, the business model for income property has remained unchanged. Space (square feet) is leased and most of the income comes from one source: rent. Operations have become more streamlined, but remain fundamentally the same.

The world is a different place. All the signals are there. Job functions are changing. Consumer buying habits are changing. How business uses its physical space is changing. All of these factors have a profound affect on the business model of today’s income property. To deny these facts would be analogous to the person who still believes there’s a future in manufacturing telephone booths or commercial propeller driven airplanes.

Given a re-examination of the income property’s P&L statement, what are the possibilities for changing the business model?

On the income side, the average income property generates approximately 95% of its revenue from one source: rent. Yet the lessees, whether commercial or residential, spend a much larger amount of their funds on other goods and services. Why isn’t the lessor finding out what those goods and services are, and determining the financial possibilities of providing them.

On the expense side, where are the opportunities? According to the U.S. Green Building Council, buildings in the United States account for:

• 70% of electricity consumption
• 39% of energy use
• 39% of all carbon dioxide (CO2) emissions
• 40% of raw materials use
• 30% of waste output (136 million tons annually)
• 12% of potable water consumption

The global warming concept has motivated a multiplicity of methods for reducing the costs of each expense listed above.

By staying with the old business model, can the investment returns of income properties compete against alternative type investments? If not, will income property raise money efficiently for its growth and capital improvement requirements? The present business model for income property’s income, income potential, expenses, expense control, leverage, and current and future capital improvements is limiting, and ultimately it will cause difficulties in competition with the returns of alternative types of investments. Given no change in the present business model of income property, the inevitable consequences would be poorer competitive investment returns, which will reduce the ability to obtain low cost capital, and ultimately result in the deterioration of earnings.

The investment community has finally concluded that the principles underlying a successful investment for income property are the same as those for a non-real estate business. That means if you are considering an income property purchase, you need to realize that tax benefits and replacement costs take a back seat, negative cash flow and guarantees have no seat, and gross rent multipliers and price per unit are all interesting, but are not relevant for determining value. Income property’s bottom line, the net operating income (NOI), is a relationship to yield.

If the tax increase reduces the investor’s return on investment through less cash from the property, then the simple sound bite response would be yes. Our due diligence system regards revenue, sales, and state and local taxes below the national average as a positive factor. However, this is one of those pebble in the pond questions. The amateur investor looks at the first ripple and makes an investment decision. The successful investor looks to the furthest ripple and makes an informed judgment.

To get a better answer to the question, you have to examine the reasoning behind the tax increase. Does it create jobs? Does it build infrastructure near the property? What does it do to the economy? Does it have any affect? The answers to those and other related questions will give you a more thorough answer regarding the impact on property values.

“Is now the time to buy?” That’s the most popular question we receive. Our response is always the same: “If you buy right, it’s always the right time to buy.” There are phases of the economic cycle that place greater importance on buying right. We are in one of those phases. Currently, our economy is in a downtrend, weak and getting weaker. NetGain predicted the turn early on. We thought the economy would improve by year-end. Due to recent events, NetGain now believes the current economic downturn will be longer and deeper than originally anticipated. Not buying right during an economic downtrend punishes an investor more severely than at any other time.

Given the current economy and the media’s propensity to focus on the negative, one could get the feeling we’re heading toward a precipice and about to fall off. If you believe that propaganda, don’t buy! Many industries and companies have come to a precipice and fallen off. Our economy hasn’t. It has maintained a 100% batting average for recovery, and there’s no indication that’s about to change.

Income property also has a 100% batting average for recovery, but not necessarily for investment success. Income property’s continuing recovery from economic downturns is predicated on the fact that it provides non-discretionary products: A place to live, work, and shop. The reason it doesn’t always succeed as an investment is because it’s a business, and as a business, when bought and managed incorrectly, the probabilities are against success. Conversely, because income property offers a 100% recovery rate, it gives you a very high probability for a successful investment.

What does “buying right” mean? Buying right means buying at the right capitalization rate combined with solid due diligence. The result of those actions is the identification and validation of cash flow, line-item operating costs, capital expenditures, and the economic future of the area. This information allows the prospective investor to develop a projected exit strategy and a projected return on investment (ROI). The composite of this information converts emotion into math, and gives the investor a clearer path for a quality decision.

Conclusion

America is founded on and operates as a capitalistic society. Capitalism is an economic system where property is owned by private persons and operated for profit. In a capitalist economy, the market economy decides supply and demand and pricing. As of this date, economic equilibrium remains an unachievable goal. The result: We remain a cyclical economy. Try as it might, government interference will only moderate or exacerbate the cycles. It can’t eliminate them.

Consequently, NetGain regards the number one strategy to buying right to be the due diligence effort. For an example of a comprehensive due diligence effort, review NetGain’s due diligence program: the Economic Valuation System (EVS™). EVS™ identifies the seven critical categories in the due diligence process: Area, location, structural integrity, amenities/functionality, capitalization rate, mortgage, and leverage. These seven categories are supported by 110 key issues which the investor scores and in turn receives a final recommendation. Comprehensive due diligence puts a nice bow around the package for an informed investment decision.

Global warming has had no direct affect on income property values. Indirectly, the affect has been momentous. The concept of global warming has started a revolution. Developers and owners are seeking more efficient ways to build and maintain their properties to conform to the concept of global warming. To accomplish this they are finding new ways to reduce heating and cooling costs, provide clean air, reduce noise, minimize energy output, streamline employee transportation, and pursue like initiatives.

Buildings with characteristics that respond to global warming have lower operating expenses, higher net operating income (NOI), more cash flow, and better liquidity than competitive properties without the global warming initiatives. Each global warming investment can project the savings affect and add on to NOI. Given a reasonable capitalization rate, the new NOI will contribute to the value equation to achieve an amount above and beyond the global warming investments. As demand increases from investors for more efficiently run buildings, there will also be an added bump in the property’s value through a lower capitalization rate.

The answer to timing your vacation home purchase is the same as in all real estate purchases. If you buy right, the timing is right. The characteristics that determine the value of a vacation home differ only in emphasis from those in the standard principles for buying real estate. Egress and ingress (leaving from and coming to) are more important to a vacation home. Given the high cost of gasoline, distance has become an important issue. Vacation homes are supposed to provide and support certain passions (golf, hiking, boating, etc.). Are the amenities to support the desired activities available, and what is their long-term outlook (cost and availability)? The cost of construction and comparable sales prices should provide the rest of the information necessary.

Additionally, vacation homeownership and usage comes in several different forms: (1) 15 days to 100% of the time occupied by the owner, (2) less than 15 days owner occupied and the rest rented, and (3) rented less than 15 days.

Number one has the tax advantages of homeownership. Remember, for mortgage deduction purposes, you can’t use more than two homes and a mortgage(s) outstanding of more than one million dollars. Number two is treated as an income property (a business) with depreciation, rent as additional income, and operating expenses. Number three offers an interesting feature. When a home is rented for less than 15 days, the rent is not considered income. An effective way to take advantage of number three is as follows: Buy a second home near an annual popular event, and rent the home for two weeks. That’s two weeks of tax free income.

All the instances above provide general tax information. For more precise tax information suitable to your needs, please check with a Certified Public Accountant.

On June 26th The General Motors Corporation (GM) common stock closed at approximately $11 per share. That’s the same price (adjusting for splits and dividends) that it closed on in December 1986, 22 years ago. GM has gone from being the largest market capitalized company in the Dow Jones Industrial Average to the smallest. What sound bites for the media. But the media missed the real story, which is in the why. NetGain believes GM has been the victim of some of the poorest management decisions in American history.

It is management’s responsibility to design a responsive business model, and then supervise the execution of that model. The post World War II era left GM in a strong financial condition combined with the largest and most productive factories anywhere. The world was in post war rubbles, leaving GM with a virtual monopoly on automobile production and sales. They built and sold record numbers of cars.

During the 1950s and 1960s, the rest of world started to rebuild itself. GM changed nothing and stayed the course with the same business model. The believed they could decide the design and quality, and the consumer would buy it. The company was not driven to relate to or respond to the consumer (their customers). The result of this static business model was that GM customers found other companies that were responsive to their desires, and started buying their cars from them. Honda and Toyota, which were non-existent in the 1950s and 1960s, now have market capitalizations of $124 and $149 billion respectively. GM’s market capitalization today is $6.4 billion.

During these same recent decades General Electric under Welch exploded in growth. Citicorp under Weil became a powerhouse. Apple under Jobs reinvented itself with huge profits. Each leader designed a responsive business model and successfully supervised it.

NetGain believes that the management mistakes of GM are an important wake-up call for the commercial real estate industry. The reasons behind GM’s failure are centered on the fact that management didn’t change their business model in the face of significant international business changes.

Today, the combinations of globalization, emerging countries, fanaticism, a technical revolution, energy demands, and energy costs are driving significant social and economic changes. America is changing from a manufacturing based economy to a service oriented economy, competing internationally, concerned about security, creating new industries while increasing mobility, and incurring higher energy costs. All of these changes cry for the investors of commercial real estate to take a fresh look at their business model.

In all business types, though certain characteristics may be different, the principles behind investment success are the same. The mistake too many commercial real estate investors make is that they don’t understand or believe income property is a business and has to be acquired and managed accordingly. The product of the income property business is square feet. The clients are the lessees, and the value today and tomorrow will be determined by the quantity and quality of the bottom line. GM’s mistake was a business model that didn’t relate to or respond to the consumer (their customers). Commercial real estate investors can’t afford to make that same mistake.

If an investor wants to buy residential property right now, should they opt for private houses, condominiums or multifamily? Each one has a good news/bad news list of characteristics. Which is best for the investor depends on finances, emotional preferences, and time. Following are summaries of the advantages and disadvantages of each.

From a management perspective, as a general rule, unless you own a total of ten private homes and/or condominiums, the economics don’t work for hiring a management company. For multihousing, fifteen units is the threshold for hiring outside management. Managing on your own real estate means collecting rents, keeping books, taking calls in the middle of the night and leasing on the weekends. There is nothing wrong with this approach, except that you need the skill, temperament and time to do it.

From an economic perspective, when a condominium or private home is occupied, it is 100% occupied. Conversely, when either is vacant, they are 100% vacant. Condominiums have covenants, conditions and restrictions (CC&Rs) which govern the community. The condominium owners elect directors to manage and oversee the property. The directors’ skills and abilities will reflect on the condominium’s value. Lawsuits can arise that will affect the value of the condominium. Multihousing offers a diversified source of revenue and has less of the financial complications presented by private housing and condominiums.

Whichever you buy, it has to start with cash flow and grow from there. In the final analysis, that’s what is going to determine value.

The Royal Bank of Scotland (RBS) has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks.

“A very nasty period is soon to be upon us — be prepared,” said Bob Janjuah, the bank’s credit strategist. The same person that warned of the credit crunch.

A report by Morgan Stanley’s European experts stated “We see striking similarities between the transatlantic tensions that built up in the early 1990s and those that are accumulating again today. The outcome of the 1992 deadlock was a major currency crisis and a recession in Europe.”

The European Central Bank and the US Federal Reserve are going in different directions over monetary strategy. This is overtaxing the global financial system and could cause a rate crisis.

Could the RBS be right? NetGain believes we have gone from a serious recession being impossible to it being possible. This change has been caused by the higher cost of energy coming on top of the credit crunch. If a serious recession is possible, when would it happen?

The effects of higher crude oil prices and subsequent gasoline costs are happening in two waves. The first wave hit the business community and is having a serious impact on the earnings of any business that uses transportation and energy, which is just about every business. Unemployment is a lagging indicator and increased unemployment is in the beginning stage. The second wave has just hit the consumer, who is in the confounded stage. They can’t believe this is happening.

Within the next six months, two changes could take place to provide the perfect storm for a serious recession: A sharp increase in unemployment and a major decline in consumer spending and travel.

Could a serious recession be avoided? Not when we get responses from our leaders like the following: 45 nuclear power plants by 2030, a windfall profits tax on oil companies, remove the speculators from the futures markets, etc. Those are feel-good political solutions whose results will be somewhere between neutral and harmful. Until there is a comprehensive bi-partisan energy plan, the income property investor needs three essential items when buying property.

1) A comprehensive due diligence analysis. That would include the seven critical areas identified in NetGain’s Economic Valuation System (EVS): Area, Location, Structural Integrity, Amenity/ Functionality, Capitalization Rate, Mortgage, and Leverage.

2) A real capitalization rate of at least 7%. Real means numbers that are supported by an operating history and rents that are comparable to the verified rental market.

3) Cash flow that is not subsidized and starts at the close of escrow.

NetGain adheres to strategies that maximize ROI while minimizing risk. Consistent with that approach, if the property doesn’t meet the three criteria listed above, don’t buy the property.

What if there is no recession? Then you bought a property after performing a comprehensive due diligence at a 7% capitalization rate with a real cash flow. The result is, while minimizing your risk, you have positioned yourself for an attractive ROI.