Before a lynch mob is dispatched…let me clarify: I’m still a huge proponent of real estate investing!  It’s just that residential investments rarely cash flow…you have to wait to make your money at sale from appreciation.  And you can’t afford to have someone else manage the units for you in most cases.  Banks limit you on how many residential investment loans you can have…but they don’t care how many commercial loans you have active.

Take Off Your Training Wheels-

Rumor on the street is that banks are again permitting a prospective borrower to have up to 10 residential loans. Legally you

can have as many as you want of course…its just that lenders won’t underwrite loans past 10 residences. (This is a reversal from a year ago when Freddie Mac tightened up standards to permit only 4 loans.  Fannie Mae adopted the stricter rules shortly thereafter.)

Will the banks  change course again and tighten up standards anew? Rather than shout: “Hurray!” and buy more residential investment properties, I advocate a different strategy.

Convert your multiple residential property equities into a single commercial investment.

Here’s an example:  I have a friend that has 10 single family homes, nine of which are investments. He holds many of them “free and clear” while others have small balances.  He can sell off some of the homes and use a 1031 Exchange to defer taxes, converting the proceeds into equity for a commercial property downpayment.  He can also put new loans on the remaining house to add still more.  Banks are currently writing loans of up to 70 to 80% LTV on investment properties where cash is being taken out at refi.  When this is done my friend will easily be able to acquire sufficient funds ($250-350,000) to buy a commercial property like Heather Joy, currently listed at $779,000.  The advantage of Heather Joy is that he will be able to manage 8 units by going to a single address…a significant improvement in efficiency.

The next step up would be to take an even greater portion of his existing portfolio equity and purchase a larger asset like the 18-Unit South Towne. That $1,150,00 property would require approximately $350-450,000 in equity to purchase.  It has enough units that we could now afford MBO…Management By Others.  That means that my friend would transition from running all over town to manage 9 single family homes to reviewing the results created by the management company.

To take this further…if my friend’s holdings were enough that he could combine equities to add up to $1,200,000…he could purchase Los Verdes, available for $3,200,000.  That property is large enough to not only have management by others…but an on-site manager.  Contrast owning 53 units in one spot that are managed by someone else vs. running all over town to manage and maintain 9 single family homes.

Summary:  You will make more money, receive it earlier, and have fewer headaches…when you transition to Commercial Real Estate Investments.

Call Rick Bean at Rose City Commercial Real Estate for a no cost, no obligation assessment of your investment options.

There are over three dozen metrics for commercial properties that we use to evaluate assets as potential acquisitions, and to gauge their operational performance. Some are relatively intuitive: Rent/Sq. Ft., Cost per Door, Expense Ratio, Gross Income, etc. Commercial investors eschew using GRM (Gross Rent Multiplier) as that measures the income side only.

The first measurement investors look at to see if a potential investment warrants further investigation, is the Capitalization Rate Derivative, or Cap. The Cap is simply the percentage of Net Operating Income to the Purchase Price.

Cap %= Net Operating Income/Price.

As an example, an asset selling for $1,500,000 with $75,000 NOI is at a 5-Cap. ($75,000/$1,500,000 = 5%.) Understanding this ratio and its implications are key to informed investing, as well as managing operations. If you know that assets in a particular area are trading at 7-Caps you have a pretty good idea of what a property is worth if you know its NOI. Before we proceed further it’s important to clarify what NOI is.

Net Operating Income is: Ordinary Revenue – Ordinary Expenses.

The intent with NOI is to evaluate the efficiency of operations exclusive of other factors. On the income side we want to include actual rent, pet rent, late fees and other day to day items. On the expense side we want to include water, sewer, etc…the day to day operation expenses.

Exclude extraordinaryitems from NOI calcs. Examples include revenue (+) from selling timber rights, or the expense (-) of replacing a roof. These are still material when we look at a property in total…but they are not relevant in computing NOI. Also excluded from NOI are finance charges. Why? Because we use NOI to measure the effectiveness of operations. Example: A 3.87% loan with a 35-year amortization would make a poorly managed property look pretty good. Conversely, a well run property with a high interest loan might appear to be poorly operated.

I’ll discuss Net Operating Income Multipliers, the reciprocal of Cap in my next post.

Investors are risk adverse…and “unknown” is synonomous with “high risk.”  Being aware of this, The Client Centric Solution is to reduce the unknowns, reducing the risk…which delivers an increase in value to the client.  (If there are too many unknowns, the potential buyer will make a very low offer…or not bid at all.)

The Problem…

A colleague had a client that was looking to invest in quads and smaller commercial multifamily properties. One opportunity that caught the investors’s eye was a fully occupied plex that had upgraded units and an assumable loan with stated payments and interest rate.  The owner of the property was loathe to have multiple agents and investors traipse through the units on short notice and upset the tenants.  He was so concerned about losing tenants, that he instructed his agent that potential buyers could only view the inside of a unit after the owner had accepted their offer.  While this is somewhat common, without being able to view the property the investor could not verify the condition of the units, if they had a desirable layout, if they were upgraded, or if they were “repositionable” for increased income.  The potential buyer didn’t know how much time was remaining on the loan.  If it was a 30-year amortization loan with only 1-year left of the 10 year term he wasn’t interested.

The Solution…

I suggested to my friend that he contact the Listing Agent to find out how much time was left on the loan. He did, and found out that there was over 7-years left on the term and the bank was amenable to extending it on a qualifying assumption.  That eliminated one form of risk for the buyer.

Second, I suggested giving the tenants a weeks notice that each unit would be filmed for insurance reduction reasons.  About 1 minute is sufficient per unit. (I would also used that video to see if the insurance company would reduce premiums, so it is not a lie.)  Being able to view the video permitted the potential client to make an informed offer with far fewer unknowns, and less risk.  Should his offer not be sufficient, the owner had something to show future offerers.  

I think my buddy owes me a lunch!  What do you think?

The concept of eliminating unknowns to improve results applies to many aspects of business and life.  I learned this years ago when I watched a co-worker answer the President’s question with:  “I don’t know, and I don’t know when I will know.”  That co-worker was permitted to seek opportunities elsewhere.

If you would prefer Client Centric Service, you can contact me at rick@rosecitycre.com

Summary:  Cost Seg. is an underutilized strategy that commercial real estate investors can employ to reduce their taxes, improve their ability to fund new properties and increase their purchases.  Below I have adapted information provided me by one of the nation’s leading authorities on Cost Segmentation Studies.

As we all have enjoyed our Holiday Season, sadly the next event we face involves the perennial tax deadlines.  This year you could apply cost segregation and save considerable money. Cost Segregation is the least utilized and most cost efficient way to save tens and even hundreds of thousands of tax dollars on the commercial properties that you own, represent or manage. Unless you take action soon, you will forgo these tax deductions.

Reasons why you should learn more about Cost Segregation: Cost segregation is the spigot that taps the hidden “cash flow” in every commercial property, including apartments. Less than 10% of all commercial property owners have utilized cost segregation. The reasons vary but in general it is due to a lack of awareness and because the 1997 Supreme Court ruling requires than the cost segregation be prepared by an independent cost-engineer – not an accountant. In addition up until 2001, the cost of cost segregation services were prohibitive – this is no longer true.

Recent court rulings and changes in IRS filing procedures make this tax savings benefit fully accessible to owners of any size commercial property.

Property owners now need only file a single form accompanied by a cost seg report prepared by an independent cost engineer — no costly, formal, multi-stage appeal process is required. You can even file for a previous year’s reduction in Federal and state taxes. All these funds are “hidden cash flow” for the business owner. These monies become a new source of investment capital. In addition to these Federal tax benefits there are other significant monetary gains.

Big Dollar Returns – TRIFECTA of Cost Seg

Read more

One strategy of acquiring investment properties is to pool individual owner’s equity stakes and take title as Tenants In Common or a TIC.  TICs feature an undivided unity of possession, but they may, or may not have unities of percentage of ownership, title, or time of acquisition and disposition.  Upon the demise of a co-tenant their interest passes to their devisees/heirs, not the co-tenants.

It is critical that an executed Operating Agreement be in place to define critical items including:

*Ownership percentage
*Conditions underwhich the property will be sold
*How distributions from operations will be made
*Rights and responsibilities of each investor

STRENGTHS INCLUDE:

1. Pooling resources may permit the ownership of far larger assets than could be acquired individually, resulting in economies of scale for  management and maintenance.
2. Overall flexibility. TICs permit owners to sell,  encumber, or convey their interest without permission of their co-tennants.
3. Depending on the structure of the Operating Agreement, TICs may permit General Partners to run the asset, allowing investors to have the benefits of owning an asset without having to be involved in routine operations.

WEAKNESSES INCLUDE:

1. Litigation is more likely.
2. Closings are more cumbersome.
3. Coordinating items that require input from the co-tenants is more involved.

Note:  The information contained herein is deemed accurate and reliable, but is not guaranteed.  To assess applicabilty to individual situations please consult your legal proffesional.