by Ben Johnson from NREI

After two years of rising vacancies and slumping rents, apartment owners have reason to be cheerier these days.

According to the latest survey of 169 markets across the U.S. by researcher Reis, the national apartment vacancy rate peaked at a record 8% in the fourth quarter of 2009 and remained unchanged in the first quarter of 2010. Asking rents increased by a scant 0.1% in the first quarter, but that was the first gain since the third quarter of 2008.

When you hear that 1Q 2010 absorption rates were the best the nation has seen in a decade, Portland apartments, Vancouver multifamily…investment properties in the area are looking like better and better deals. 

One economist has opined that he sees cap rates falling as more and more investors return to the market. 

The best way to be a genius in five years is to make wise investments today.  Contact us:  503.577.1034.

Some 20,000 apartment units were absorbed in the first quarter of 2010, which is the strongest first-quarter showing in the past 10 years, according to Victor Calanog, director of research at Reis. “The multifamily market appears to be on the cusp of recovery. If so, pricing and transaction activity will rise and the window of opportunity for landing good deals may close soon,” says Calanog.

Rental demand drove the occupancy rate for downtown Chicago apartments higher in the first quarter, to 93.6% from 91.4% in the fourth quarter of 2009, according to consulting firm Appraisal Research Counselors.

The latest results surprised long-time industry watchers, including Robert Bach, senior vice president and chief economist at Grubb & Ellis. However, Bach is concerned about the abundant supply of empty condos and single-family homes that are entering the rental market in hard-hit areas like South Florida and Phoenix. He believes they are casting a shadow over traditional apartment communities, and siphoning off potential renters.

“I’m surprised the apartment fundamentals have bottomed out this quickly, but as long as there are these shadow units out there, then it’s going to be interesting to see if the apartment market can recover independent of that,” says Bach.

The rest of 2010 will be a telling barometer, notes Calanog. “The next two quarters will offer critical perspective as to whether positive rent growth is sustainable.” Calanog does expect the vacancy rate to improve over the next five years, dropping to 6.6% in 2014.

Unemployment stings young Americans

Certainly one of the most closely watched keys to the short-term apartment market turnaround is the jobs picture. According to the U.S. Bureau of Labor Statistics, the U.S. economy added 290,000 jobs in April, the largest gain since March 2006. That followed a revised 230,000 increase in March. Still, the overall unemployment rate rose from 9.7% in March to 9.9% in April, a sign that more Americans are starting to look for jobs.

According to some observers, danger lurks at the deep end of the renter pool. The primary renter market base, people aged 20-30, comprises 70% of the total U.S. apartment market, and that segment is recovering more slowly than others.

As an example, the unemployment rate among Americans aged 20-24 was 15.8% in March, but jumped to 17.2% in April. “The unemployment rate for young people has climbed faster than it has for the labor market in general,” says Sam Chandan, global chief economist and executive vice present at researcher Real Capital Analytics.

According to Chandan, the rental pool is not being supported by new entrants of young people graduating with jobs. “We need job growth among the younger age groups to drive apartment demand. There’s got to be some replacement there.”

Compounding the situation, one of the biggest challenges to recovery in this market is older, more skilled workers who are willing to take lower paying jobs just to find work. Typically this segment is more inclined to own rather than rent. “This is an issue that’s going to weigh on the performance of the apartment market,” says Chandan.

Savvy like Trump...but better hair!

Having completed over $6 Billion in real estate deals makes Robert Knakal someone to listen to and learn from.  I subscribed: Robert Knakal’s Streetwise.     

Welcome back old friend! Yes, we have seen a re-emergence of the blessed 1031 tax-deferred exchange in recent weeks, and what a welcome sight it is.    

 The opportunity to protect hard earned equity in the sale of an investment has been available to investors since 1921. However, this part of the tax code was so complex that only a small segment of the investment community took advantage of this mechanism.  In 1990, the Omnibus Budget Act provided more widespread access to a broader set of investors as this option was clarified and simplified. Section 1031 exchanges are often mischaracterized as “tax free” when they are actually “tax deferred”.     

Contact the team at Rose City Commercial Real Estate to begin investing in Portland’s future…and your own:  rick@rosecitycre.com or 503.577.1034.     

The theory behind this mechanism is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay taxes. Only the form of investment has changed, therefore, it would be unfair to collect a tax on a “paper” gain.  When an investor utilizes this mechanism, the deferred gain is payable when the replacement property is sold and is not part of yet another exchange. At that point, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.    

 1031 exchanges in the investment property market have been growing in popularity since the mid-90s and fueled a majority of transactions in the mid to late 2000s. With falling property values and transaction volumes beginning in late 2007, we saw a significant reduction in 1031 transactions.    

 In previous StreetWise columns, I have gone into detail about the supply / demand imbalance and the fact that the volume of sales was so low due, mainly, to lack of supply as opposed to waning demand. The supply of available properties for sale is generally fed by discretionary sellers. When value falls, as it has done since 2007, discretionary sellers withdraw from the market and the supply is then fed by distressed sellers. Distressed sellers have not fed the supply in numbers which were expected because everything that has occurred from a regulatory perspective has allowed these sellers to avoid dealing with their distressed assets.    

 Recently, we have seen the flow of distressed assets begin to loosen as banks and special servicers are beginning to clean up their balance sheets and portfolios. Simultaneously, we have seen discretionary sellers returning to the market. The tangible evidence that this is actually happening can be seen in the 1031 activity we have seen recently. Distressed sellers are rarely left with any equity to reinvest in the form of a 1031 exchange. Discretionary sellers, on the other hand, often have significant equity to redeploy via this tax-deferred vehicle. We are, once again, seeing sellers ask for flexibility in closing periods to provide them with better chances of being able to effectuate an exchange.    

 During the past 4 weeks alone, we have signed 12 contracts with purchasers who are investing 1031 funds. Moreover, we are receiving multiple calls each day from investors who are looking for properties to complete exchange transactions. This is certainly reminiscent of 2006 and 2007 when so many transactions were motivated by tax-deferment. The demand side has been very strong for quite a while as institutional capital has returned to the market, joining the high-net-worth individuals and families which have dominated the horizon for the past couple of years. Foreign high-net-worth investors are present in rapidly growing numbers and the re-emergence of 1031 capital adds more pressure to already overwhelming demand for investment properties.    

 Don’t mistake my perspective as I am not suggesting that market conditions are back to the go-go, bubble inflating, years of 2005 to 2007. I am, merely, passing along a trend that we are seeing which has, for the most part, been absent for quite a while. It is yet another sign that the recovery is upon us.    

 From an intermediary’s point of view, or anyone’s, who is reliant upon transaction volume for their livelihood, it is positive to see this type of activity returning to the market. To the extent that distressed sellers continue to dispose of assets and discretionary sellers return to the market, transaction volume has no choice but to increase. As sellers with real equity sell, each transaction is likely to stimulate another transaction as a 1031 is contemplated.    

 This trend certainly bodes well for our projection that transaction volume will increase by about 40% this year over last year. Welcome back old friend, indeed!    

 Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career having a market value in excess of $6.2 billion.

Making a difference

Optimizing your investment

 
Cost segregation, though known by many real estate owners, is sometimes overlooked.

It is a methodology used to reallocate certain building costs into separate identifiable components that can be depreciated over shorter lives. The primary purpose of a cost-segregation study is to reallocate as much building costs between land improvements and tangible property. The more costs allocated to tangible property, the greater the desired tax benefit. Tangible property creates tax benefits because it is depreciated over five or seven years while normal building costs are depreciated over 27.5 or 39 years.

A cost-segregation study may be performed for real estate already in service, for new construction and acquisitions. Generally, it is easier to analyze a building’s cost structure during initial construction or expansion since building plans are readily available and can be utilized to identify various components that may qualify as tangible property.

Costs that may be reallocated to land improvements consist of, but are not limited to, certain landscaping, sidewalks and fencing which are depreciated over a 15 year recovery period.

Costs that may be reallocated to tangible property include movable partitions, furniture, removable carpeting and wallpaper, certain fixtures and window treatments. Support systems that are needed to run certain equipment or machinery could be considered tangible property under certain circumstances.

There are several internal levels of cost-segregation studies ranging from a detailed engineering approach through a less formal rule-of-thumb appraisal. The Internal Revenue Service prefers the engineering approach since it will produce the most accurate results.

All businesses that acquire, construct or renovate real property would benefit from a cost-segregation study.

The real benefit of a properly documented cost-segregation study is the enhanced depreciation deductions it yields. A major advantage of the study is not necessarily that it produces more depreciation deductions, but that expenses accelerate more rapidly, producing a greater benefit due to the time value of money.

The ability to write off specific components identified as they are replaced is yet another advantage. For example, when a study is performed, the cost of the roof would be specifically identified. As the roof will eventually be replaced, the remaining cost could be written off.

One disadvantage of a cost-segregation study is the potential triggering of depreciation recapture and possible understatement penalties a taxpayer could incur for studies that are too aggressive in classifying costs. To avoid penalties and pass IRS scrutiny, the study must be objective and supported by contemporaneous records. Studies supported by an engineering study add credibility and produce the most accurate cost allocations.

Overall, cost-segregation studies can produce tremendous tax savings for those who build, acquire any business that builds, acquires or renovates property. The increased tax savings increase cash flow, which in turn, businesses can reinvest.

Gary Anderson, a certified public accountant and senior manager at Reznick Group P.C. in Baltimore, can be reached at gary.anderson@reznickgroup.com.

Investment Basics

When investors buy any commercial real estate they are acquiring a revenue stream.  Admittedly there are a few signature buildings that are so iconic that they are a ”pride of ownership” acquisition, but most properties are valued solely for their future economic potential.  There are four primary ways in which investors benefit from their acquisitions:

1. Cash Flow

is the sum of:  Cash In - Cash Out.  The primary source of inflow cash is rent.  Pet rent, late fees, laundry and owner contributions are also part of the cash in stream.  Cash Outflows include taxes, expenses and distributions to owners.

Owner types vary widely on the importance they place on distributions:

• Residential Multifamily properties (2 to 4 units) and smaller Commercial Multifamily properties cast off little cash.  Their owners tend to focus more on equity gained at the time of disposition. 
• Investors of larger properties often use cash flows (distributions) as a primary source of spendable income.  They certainly expect gains at sale, but they often will use that gain to step up in basis to acquire a larger asset in the hope of increasing the monthly cash-flow. 
• The bane of all investors is the much dreaded Cash Call.  When cash out ‹ cash in to the extent that operations are impacted, the property owner(s) are forced to add cash to keep expenses current.  Because of their focus on maintaining regular, dependable distributions, the owners of larger properties tend to have lower LTV loans.  This doesn’t eliminate cash calls, but it does make operations inherently more stable, reducing the likelihood of requiring additional cash.

2. Appreciation

is Future Disposition Price - Original Acquisition Price.   A 53 unit complex that is purchased for $3.2 million is 2007 appreciates $700,000 if it is sold for $3.9 million several years down the road. 

• Appreciation gains can occur from (external) market forces such as a downward trend in Cap rates, or from increases in rent relative to expenses due to high demand. 
• Gains can also be “forced” by internal forces.  This occurs when we reposition a property.  Renters will pay more for upscale amenities and newer looking accommodations.  Success requires having the amortized costs of improvements be exceeded by the increased rents.  In some cases we merely seek to raise the rents on the existing renters; other times we are using the upgrades to attract a new tenant profile.

3. Loan Paydown

is determined by subtracting the initial loan amount from the remaining loan balance at any given time.  Suppose a $3,200,000 property is acquired with a roughly 65% LTV loan at 6% with a 30-year amortization.  Day one the beginning loan balance would be $2,000,000.  42 months later (3-1/2 years) the loan balance would be $1,909,649.  The loan paydown amounts to $90,351 for that period.

4. Tax Shelters and Tax Avoidance Benefits

The final benfit to investors is the tax sheltering of income.  Cost Recovery (Depreciation) is the primary example.  Industrial and retail properties are depreciated on a 40-year basis; housing is depreciated using 27.5-years.   Note: Land is not depreciable.  Using our previous example of a $3,200,000 community, let’s assume that land was 25% of the value, leaving a deprecable amount of $2,400,000 to be depreciated over 27.5 years, or $87,27.73 per year.  That will act as a tax deduction to reduce profits by that amount for tax basis purposes. 

A more rapid depreciation methodology is provided by Cost Segmentation, or familiarly, Cost Seg.  This is performed based on findings of a cost engineer during their on-site inspection and review of the property. There is great acceptance of this approach by the IRS, but it is not fully understood by investors and many Tax Accountants.  Cost Seg. on Assets under $1 Million is not always cost effective due to the fixed costs of the on-site inspection.  Savings on multimillion dollar properties are substantial, and can change a 1.1 DSCR property into a 1.25.  That means that Cost Seg utilization can be the difference in some loans being approved!

Duties of Professional Investment Brokers

It is incumbent on the Real Estate Professional assisting a client with a multifamilty acquisition to have an understanding of that client’s risk profile, investment horizon plus target cash flow and appreciation rates.  It is also beneficial to have an awarenes of how important their client deems tax shelter options

Planing Improves Profits!

 Dispositions

The primary reason for starting early is to prepare your Due Diligence Package formatting.  A, well organized complete package will separate your property from others with similar revenues in similar condition.  Buyers and Banks factor for risk.  Key components of risk are items that are unclear or unknown.  By starting your Due Diligence Disposition package early you can instruct your Professional Management company how you want expenses reported. 

We want costs shown as Operational Expenses only if they are indeed directly related to operations.  The same is true of revenues.  Instruct your manager to keep all extraordinary and capital expenses accounted for separately.  It’s simple:  building a new parking lot is cap-ex; stripping the old parking lot is operations.  The reason that’s important?  Take the case of a 53 unit apartment that spent $68,000 switching out their single paned aluminum windows and sliders for Argon filled vinyl.  The individual heat bills dropped by $15/month, the appearance was upgraded, and the units are less drafty…clearly improvements.  But poor reporting of expenses would reduce the value when evaluated by Cap Rate by inflating the expenses by $68,000:

Imagine improvements to your property reducingits value! A good broker would likely have figured this out during due diligence once the property was under contract…but it would not have become obvious until then.  Prospective buyers wouldn’t have stopped to give your (apparently) under-performing property a second look. 

 A free meeting saves a million bucks.  Now that’s what I call a high yield investment! 

 Want to increase your yields?  Contact Rick Bean or Robert Poe at 503.577.1034 or rick@rosecitycre.com

The Northwest Real Estate Investor’s Association has a Multifamily Focus Group that meets the third Tuesday of each month.  I’ll be co-moderating this month’s meeting with Doug Foley of the Pro Real Estate Team.  Check out the video for details!  See you there!

Many thanks-

Rick Bean, Rose City Commercial Real Estate.  503.577.1034 or, rick@rosecitycre.com

We need more financing professionals like Holly Bray!

I have previously saluted Holly Bray of Love Funding as a real commercial lending pro.  Below is an article that she wrote describing one of the most liberal multifamily loans on the market today…and with rates in the mid to upper five percent range.  These are non recourse loans. 

Submitted by Holly Bray: 

With many lenders on hold, the topic of the day has been FHA. 

The FHA multifamily loan programs have been in place for over thirty years.  They continue to be used regularly and have closed as much as $8 billion a year in new business.  With commercial lenders on hold there has been renewed interest in these valuable HUD multifamily programs.  The following summarizes the 223(f) program. 

The 223(f) program provides high-leverage long-term permanent debt to refinance, purchase, or moderately renovate existing apartment communities on a fixed-rate, non-recourse, assumable basis.  The loan size is relatively unlimited and the properties can be located in any state, Puerto Rico, Guam, and the US Virgin Islands. 

The property must contain five or more  units and be at least three years old based on the final certificate of occupancy.  (HUD recently granted waiver authority to the field offices through September 2009  to refinance younger properties that have stabilized.)  Commercial space cannot exceed 20% of the total net rentable floor area or 20% of effective gross income, including a 10% vacancy allowance.  Repair cost are limited to 1) $15,000 per unit in Portland, as adjusted to FHA’s high-cost factor for the area; 2) a maximum 15% of “as-improved” market value; and 3) cannot involve replacing more than one major building component. 

Borrower Advantages:  35-year amortization period; eligibility for both market rate, subsidized, and LIHTC properties; NO rent control restrictions, rental subsidies, or limitations on owner return; non-recourse; AAA credit enhancement with Ginnie Mae securitization. 

Guidelines: 

Term:  Up to 35 years fully amortizing with level payments. 

Loan Size:  Unlimited, nationwide. 

Loan Amount:  Maximum 85% LTV for refinance and 85% loan-to-cost for purchase transactions.   Maximum of 80% LTV for refinancings involving equity take-out. 

DSCR:  1.17:1 

Occupancy:  Underwritten up to a maximum of 95%. 

Interest Rate:  Rate is locked with borrower’s approval after issuance and acceptance of FHA Firm Commitment.  Current interest rates are in the 5.50% range! 

Prepayment:  Negotiable.  Typically a two year lock followed by 8% declining 1% per year thereafter.  No prepayment penalty after the 10th year.  No defeasance.  No yield maintenance. 

Escrows:  Tax, hazard insurance and mortgage insurance premium escrows are required, as is a replacement reserve.  If repairs are required, a completion escrow in the form of cash or a letter of credit may be required. 

Other Features:  The traditional sources of income such as laundry, parking and storage now include ancillary income such as forfeited deposits, pet fees, and the like.   FHA requires an annual project audit.  Surplus cash, as determined by audit, may be distributed up to twice a year.  Davis Bacon wage rates do not apply.  Critical repairs (life and safety) must be completed prior to closing.  Non-critical repairs must be completed within 12 months of closing.  Draws to cover reimbursement of cost of repairs are subject to a 10% retainage. 

After execution of engagment letter, professionals will work closely with the client to expedite the application process and achieve MAP timeframes.  An appraisal, Phase I Environmental, and Engineer’s report are needed.  

This is an excellent program and although it takes longer to process than either a conduit loan or a Fannie/Freddie loan the generous loan parameters make this the best long term financing in the industry. 

To find more about this product call: Holly Bray – Love Funding – 202-887-1849.  To learn about local area properties that this would be a good finance solution for…contact Rick Bean: 503.577.1034, or rick@rosecitycre.com.

I can't believe he did that!

I am a huge proponent of specialization. I focus on Portland multifamily assets ranging from 8 to 80 units.  Have I worked on leasing, single family homes, larger commercial properties or deals in other states?  Sure!  Probably will again, too!  But I feel that Robert Redford got it right when he said to Paul Newman:  “Keep thinkin’ Butch…and go with what you’re good at!”  Similarly, I feel we owe a debt of gratitude to our doctors because they are models of specialization.  There’s so much to know that docs must specialize in order to competently provide critical services.

I was reminded of this recently when an investor told me that one of his partners was insisting that his nephew get the listing on a Portland multifamily complex.  I’m not a great loser, but I know in life if you don’t strike out occaisionaly you’re not getting enough trips to the batter’s box.  What I find amazing is that the nephew has no business experience, no real estate experience, no relevant sphere of influence…but he did get his license last month and some business new cards.

Be aware that in Portland there are many commercial brokers that haven’t sold an asset yet this year.  To move product requires knowing Cap Rate trends…but I jokingly suggest this respective agent thinks a Cap Rate is the maximum value an adjustable mortgage can reset to.  He does not have an awareness of full recourse clauses, understand terms such as: “jointly and severally” has no idea of the minimum hold time for capital gains versus ordinary gains, or that a reverse exchange is not a football play.  In short, this new agent is exposing his relatives and unaware principal broker to huge risks and not delivering all of the available upside.  Vegas odds are he is a matter of months from being mentioned in the paper.  Once again…the case is made for specialization!

When you’re ready to work with an investment specialist…contact Rick Bean at 503.577.1034 or: rick@rosecitycre.com.

Preparing To Sell!

While we focus on NOI and Cap Rates when buying apartment investment properties…we still pay close attention to curb appeal…that’s part of what attracts potential tenants. With that in mind, when preparing to sell a multifamily property we want the grounds to look the best they can without breaking the maintenance budget.  If you can’t afford to do everything, do everything you can.

PHASE ONE:  Before listing a multifamily property take a walk around it with a different focus. Try to looking at it as you would a plane when you board. The psychology of safety is that when things look messy, ill planned or in disrepair, we perceive that higher risks are present.   To ease traveler’s fears airlines strive to have passengers enter a clean and neat plane.  The multifamily analog is we stripe the parking lot so it looks sharp, prune tall bushes….particularly those near buildings.  Mowing the lawn is a must. Adding colorful flowers to the landscaping is a good idea. 

Create scenes, viewpoints that best displays the pluses of the property.  The marketing photos and videos will use those to attract attention to the property.  The financials will be what ultimately sell an investor…but the marketing images increase the odds of a buyer taking the time to look close enough to view the financials.

PHASE TWO:   The first items that any investor or buyer’s broker will ask for is a Rent Roll and Profit and Loss Statement.  Those need to be  current and readily available upon request in electronic format.  In this climate actual results must be delivered.  Proformas…”the art of the possible” are acceptable…but only if real numbers are shown as well.  That may be enough information for a potential buyer to submit a Letter of Intent (LOI), but that is only the tip of the research iceberg.  In order to be ready to go to market, Sellers need to have the entire Due Diligence Package complete and ready for submission to the Buyer.   Imagine that you are an interested investor that requests a complete package…only to be told that will be sent in a few days or weeks. 

The best time to forward information requested in the initial interest phase is immediately.  Delays create the impression of increased risk…higher perceived risk inherently reduces perceived value.  Contrastingly, Sellers and Seller’s agents that anticipate questions and answer them in advance of their being asked create trust and value.

In my next article I’ll discuss everything that belongs in competent Due Diligence Packages…and how that package will vary based on the size of property.

Free Offer:  I will give you up to two hours of my time without cost or obligation.  That includes reviewing wealth building strategies, tax deferral opportunities, disposition/acquisition tactics, equity analysis, etc. 

The fine print:  You pay for the coffee.  Contact me at: 503.577.1034 or rick@rosecitycre.com.