Modern Portfolio Theory to Succeed in Today’s Markets
Any investor will tell you: the higher the risk, the higher the reward! Yet, when crafting their own investment portfolios, most will look to create some sort of balance between risk and reward.
Acquiring a commercial asset is a complex process, filled with pitfalls that can end the promising career of a novice CRE investor. Without a roadmap to help avoid these hazards, best case scenario you fail to reach your potential, and worst case scenario you take substantial losses. As Benjamin Franklin once said, “By failing to prepare, you are preparing to fail.”
Luckily, you’re here, which means you are preparing to succeed in this space. In another stroke of luck, we happen to have a roadmap you can use to get to a successful commercial acquisition. Let’s get into it.
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Understanding the lingo of the CRE world is integral to acquiring commercial assets effectively. Here are a few terms you should know before buying.
Situs
One of the very unique features of real estate, relative to other asset types, is that it does not move. The term “Situs” is defined by the Oxford Dictionary as: “the place to which, for purposes of legal jurisdiction or taxation, a property belongs.” Put another way- it refers to the near ubiquitous real estate industry colloquialism “location, location, location.”
Fixiti
Closely related to Situs is “Fixiti.” It refers to the fact that buildings are largely immovable, and that the prospects of a property are shaped by its physical location. If you were to try and move a property it would be difficult and expensive- this state of being is referred to as Fixiti.
Heterogeneity
Heterogeneity is another unique characteristic of real estate. Unlike stock equity in a publicly traded company, every building that you look at is different. That means that when you’re going to invest in a building, you have to understand its unique characteristics, its context, its neighboring buildings, its competitive set, because every single building will be different. All these things can be both an advantage and a disadvantage, relative to investing in other asset classes, but it does mean that you tend to get outsized returns with real estate, relative to higher information markets.
Feldman Equities can take underperforming buildings and renovate it into a profitable asset
The first step on your checklist is to decide on a market, or on a few markets. For instance, take Feldman Equities. We focus very specifically on a geographic area, which is Tampa Bay. Our process goes something like this. We start by looking at three or four cities, in our geographic location and eventually winnow it down to one. For the purposes of this example let’s say Sarasota. The next step is to hook up with a knowledgeable broker.
We then connect with a company like JLL or CBRE, or other broker, most of which have investment arms. Feldman’s team gives them a rough description of the kind of property that we’re looking for; for instance a downtown asset. We’ll tell the broker that we want it to be in Tampa Bay and then give them the type of building, and its class, so they are looking for a Class-B office property, or a Class A that might have been neglected or is in need of updating. The class refers to the quality of the building, with A being the highest, and C being the lowest commonly used.
Basically, we are giving the broker the information that he or she needs to get started looking on our behalf. Once the broker is set up and running, we, as the owner don’t sit back complacently and hope the broker will pick everything for us. Some of the best deals we’ve come across are “off- market deals.”
For example, there may be a seller out there, and maybe the broker has a personal relationship with that seller, maybe we do through a tenant or through a friend of the family or through a friend of the company. Buyers can find some deals that are completely off-market and whether or not they use the broker it’s always good to look, as an owner, for new properties, and shake every branch they can and not be dependent entirely on the broker. That said, most of the deals we get done here at Feldman are through a broker whether they initiate the deal for us or not; whether it’s off-market or not.
Brokers are often also the ones going out and helping us secure the debt, or even helping us raise a portion of the equity for the project. Brokers are key in real estate. CRE is one of the industries where middlemen are still very, very important. They have not been disintermediated in every way just yet, and that’s mostly due to the sheer complexity as well as the “in place” nature of real estate and real estate markets.
Brokers are critical to financing a building. They don’t just find the building for you, they can also introduce you to mortgage lenders, to equity sources, mezzanine (mezz) lenders. Mezz lending is a high risk, high return type of debt that goes on top of the main mortgage and above the equity in the capital stack. You can also get preferred equity, which is equity that sits just above common equity and generally comes with some sort of a preferred return.
Any combination of those elements can be used to create the capital stack for your acquisition. For commercial real estate, the lenders want to see that you are putting up a substantial amount of equity. You, as the person who will be owning and operating this building, needs to show, to the lender, that you have skin in the game. That’s really key for the lender to get comfortable on the loan. They also tend to want to see some level of real estate experience, which is less true with smaller buildings, but the bigger the building, the more experience the lender is going to want to see.
All of these things can be facilitated by a broker who understands what that lender is looking for and who can explain to you and advise on how to best present yourself. I would recommend anyone who is looking to finance a building, to go out to their local investment broker, explain what they’re trying to do and explain their qualifications – they can get a lot of guidance from a professional like that.
Scope can be a really tough decision. Every building is different, and every building has seen different amounts of love over the years. Some of the buildings, when Feldman Equities first came down to the Tampa area in 2010, for example, hadn’t been renovated in 20 years though since we arrived here that has been the case less frequently as we and other operators have improved the existing stock.
The reality is, if you can afford to renovate, you can afford to invest equity in a project that you plan to see appreciation in over time. However, if you get in at a particularly good basis, as we like to, and you expect the building to be worth three times as much, you’re going be a lot more willing to invest in the building.
Deciding what scale to invest at is also driven by the stage of the cycle you think we’re in. If you think it’s already top of the market, and you bought an asset at a relatively high price, you might be reluctant to invest a ton of cash back into that building because construction costs may also be inflated late on in the cycle and it may not be as economical to conduct renovations.
When contemplating improvements, a seasoned sponsor will focus on what they think will drive leasing at the building as well as what they think will drive tenant retention. These days, that means adding amenities to these projects, and of course making sure that tenants are happy. Sometimes that may be capital improvements to an elevator, sometimes it may be an updated lobby. Every building is different, but it should be very focused on the tenant experience and the leasing experience in particular.
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When you’re out finding buildings to buy and once you’ve found a property, it is time now to find out who it belongs to. Most off-market deals are generally available through pre-existing relationships with building owners. At Feldman, we try to keep good relationships even with our competitors. There are industry events that we always make sure to attend, and meet and mingle with our fellow industry professionals because you never know where the next deal may come from.
Oftentimes, property owners don’t want to go through the long, drawn-out process of doing an open listing or a public listing on a building. If they know you, they trust that you can execute on a deal and that you can get your financing together by the closing date, they may give you a chance rather than going to market to trade a little bit of convenience for what potentially might be a higher price in the public market.
In a listed deal, you’re in a more openly competitive environment, and that’s presumably what the owner is trying to elicit from the bidders. When trying to buy a listed building, you have to be as aggressive as you possibly can be on your initial bid price because you know that two or three or four other bidders are also using similar underwriting numbers and may outbid you. Indeed, some folk don’t like the bid system at all and there are, in fact, buyers out there who simply will not participate in open listing acquisitions. They don’t want to be in that kind of competitive environment and will only do off-market deals.
Most of the owners that we deal with tend to be in a similar position as we are. They’re either a GP/LP structure, where you have an on the ground, day-to-day operator – the General Partner. That operator runs the property management, the leasing, and tends to control a lot of the day-to-day decisions.
Then you have a limited partner who would control perhaps 80-90 percent of the equity and has some input over major decisions for the property. These decision rights may include things like when to sell the building, giant leases, etc. that would have to be approved by the LP. In those situations, as a buyer you’re kind of dealing with two parties on the sell side – you have the GP who has an equity interest but doesn’t necessarily have a controlling interest, and then the LP, who doesn’t have as much information as the GP but owns more of the building. Often, they can have misaligned priorities, so when you’re bidding on that kind of a property, you have to tailor your bid to make sure that both of those owners end up coming out feeling like a winner.
Other times, we’ll deal directly with institutions that own and manage their own property, like an Angelo Gordon, the privately held alternative investment firm, for example. These are groups that invest money globally and have their own management teams and own 100 percent of the equity. They tend to be highly professionalized. You know what you’re getting most of the time, and there’s a lot of trust and faith on both sides of the execution.
Lastly, we have occasionally, dealt with non-professional real estate owners. This might be someone who maybe made a lot of money in technology, decided to invest a lot in real estate and then over five to six years, they’ve mismanaged the property. They don’t necessarily understand how to maximize the value. That is often a good opportunity for us to come in and improve building value by improving management expertise.
Need help making a profit in the commercial real estate market? Feldman Equities can make that happen for you
There are a few different ways to value a property. Generally, the first valuation we’ll do is a cap rate methodology. We’ll take that first year’s net operating income, and we’ll come up with a cap rate, which is essentially the inverse of a multiple. If you’re familiar with multiples and stock terminology, it’s basically the opposite of a stock multiple. Don’t ask me why we use cap rate versus multiples in real estate, it is just the way things are done in the industry.
Cap rate are generally derived by looking at comparable buildings. It gives you a valuation based off NOI, which is otherwise known as a yield. A cap rate can be used as kind of a quick and dirty way to look at how much money you’ll make at acquisition as a percentage of the purchase price, unlevered.
However, the problem with the cap rate valuation is it doesn’t forward look. When using cap rates, you tend to be looking at trailing one-year NOI and it can miss a lot of detail on the potential for cash flow in future years. This is especially true if the NOI that you’re using takes into account a one-time increase in revenue or a one-time increase in expenses – that could really distort the valuation if you’re only using a single year.
The more advanced methodology that we use in every building before closing, is discounted cash flow. Essentially, what we’re doing is we’re looking at all the cash flows projected out 10 years into the future. We are estimating, how many expenses, how much CapEx, we’ll put into the building. This includes the cost of leasing, brokerage commissions, paying our own fees out of the building, consolidating all the projected expenses and revenue items over many years into the future, and then applying a discounting factor onto those cash flows.
That discounting factor can be defined as our cost of capital. How much does buying a building cost us in combined equity and debt? We then apply a projected cap rate, assuming a sale of the property in something like year five or ten from the day we purchase the building to estimate a terminal value. What we’re doing is taking the value of that cap rate sale, adding all the values of the cash flows in between and applying a discount rate to give us a net present value of what we can afford to pay for the building today.
After coming to a decision about an acquisition, it’s time to have the property inspected.
Unfortunately, this can be a very time consuming, costly and tedious process. On the plus side, we have trained engineers who are specialists in commercial office building. Most lenders insist that a buyer conduct a property condition report where a third party engineer or surveyor is hired to look at the HVAC system, the chillers, the electrics, the electrical, all the major engineering components of the building and come up with a projected useful life.
Another big thing to check is the roof. What was the last time the roof was resealed? A leaking building is very difficult to lease. With the windows, you have to make sure that windows are sealed and sealed regularly, particularly with buildings that are closer to saltwater. A lot of these issues can come up even with a thorough review but, unfortunately, others may not show up until a few years later. You really do need to be diligent on this and make sure there are no landmines hidden that could be expensive to fix and that went unbudgeted for at acquisition.
It is also important to conduct an environmental check, which will also be required by the lender. The environmental issues are very important because maybe there used to be a military depot on the site or something like that, and there are chemicals in the ground that could severely impair the value of the site. There’s a lot of different boxes to check with environmental studies and it is critical to bring on third party experts to provide thorough inspections.
Your next step is to study the property deeds and titles related to the property in question. A deed is the recording instrument that shows ownership of a piece of property. Most real estate transactions in the US are formalized by transferring a deed from one party to another. A lot of the time in some states, including Florida, it might be advantageous to avoid a transfer of deed because there is a tax associated with the deed transfer. That can be avoided by keeping the entity that owns the deed intact. Instead of transferring the property to a new owner in a sale, you instead transfer ownership of the ownership entity. This is a common practice though the tradeoff is that if you do not extinguish the owning entity and transfer the deed, you can, in some cases, take on the liabilities of that existing entity. It’s a tradeoff between saving on the transfer taxes and taking on unknown liabilities.
That said, the most typical transfer is the deed transfer where a title company will always play a role because it is important to make sure to have a clean title on a building before taking ownership. Additionally, you want to run something called a UCC check, which will look through public records to make sure that there are no contractors or lenders or anyone else with a lien or other encumbrance on the property. The last thing you want to have happen is to close on an acquisition, front a whole bunch of money, and then find out that there are four or five people who also are contesting ownership. This is why title is very important to clear and working with a title company or law firm can help you with that.
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After ensuring a clean title, it is time for the property appraisal. As I mentioned earlier, we have our own internal valuation techniques using discounted cash flow and cap rates, but a lender will want to see a third party appraisal to help validate the loan proceeds that they’re willing to extend. A lender will not go above a certain loan-to-value ratio, just like with a standard home mortgage, to offer a reference point.
Of course, every lender is different, and every property is different, but they will effectively only look at the appraised value from a third party, rather than the value that you, as a buyer, come up with. There are obvious reasons for that. You could, as a buyer, inflate what you think the value of the building is which could leave the lender at a lot of risk because their loan to value ratio could be off.
Compliance and zoning are also mission-critical items to attend to. You always want to make sure that your building is conforming to the existing zoning. It doesn’t always matter if your building is grandfathered in to zoning or if it is not. For example, sometimes you can purchase a property that is in an area and that is now zoned for residences, but your office building is there.
They’re not going to make you tear down the building, but zoning may come into play if you want to expand or if you want to renovate the building substantially. You may find that you are not be in the correct zoning area for what you want to do to the building, and you may have to go through what’s called a ‘variance process.’
This process takes the form of asking the local authorities to grant an exception to the local zoning so that you can proceed with your business plan. You don’t want to deal with variances as part of a business plan because there are landmines left and right on a process like that. It is much better to purchase a building with conforming zoning that allows for whatever use you want. That way you can be sure to keep the property in tip-top shape, and be certain you can do whatever renovation programs you have planned in the future.
You might be wondering, what does the landscape look like for lenders? There are a few key criteria that we, as a borrower, look for. The big one is recourse. We tend to be able to find lenders that do not insist on personal recourse in the event we don’t repay the loan. That’s called a non-recourse loan. There are exceptions to non-recourse loans that are called “bad boy” carve-outs. These kick in if a borrower commits fraud, intentionally deceives the lender, or otherwise is dishonest and under these circumstances, the lender could come after them personally.
However, for regular commercial reasons of default, a non-recourse loan is highly desirable for any borrower. Another big condition is what’s called interest-only periods. You can have a loan where you’re paying down the interest and the amortization at the same time, like a traditional 30-year mortgage for a home. In commercial real estate, you can often get one, two, even up to five years of interest-only period – or even up to 10 years if you’re willing to go with a CMBS lender. Interest only loans mean that your overall debt burden for most of the project life span will be very low and later you have a balloon payment of the amortization at the end.
That is very desirable because it helps your cash flow and helps you on cash-on-cash basis also. Obviously, the rate on the loan is very important, or whether it is a fixed-rate loan or a floating-rate loan. If you have a lot of risk tolerance right now, you might be interested in a floating rate loan because rates are almost at historic lows. We prefer to look for fixed-rate loans or to buy a floating rate loan and then purchase in a swaps market a cap on that rate so we can only go up to a certain level and keep our interest payments relatively in check.
Feldman Equities Renovate buildings through cosmetic and structural strategies coupled with a targeted marketing approach
The steps we’ve just gone over are not optional. You may get away with one or two profitable deals by cutting corners or taking shortcuts, but that is not a recipe for long-term success in the commercial property markets. A small issue with the title or zoning requirements can be devastating, and nobody likes losing time and money for a stupid mistake. While you’re in the acquisition process you can refer back to this checklist to ensure you’re hitting all the right notes and keep an eye on how we put together our next deal – you’ll see we keep this list close to everything we do.
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