Wednesday, October 28, 2009

Big Numbers Don’t Tell the Whole Story: Cap Rate Averages

Cap rates are going up nationwide, but accepting this notion as all encompassing does disservice to a market filled with tenant disparity. If one surveyed the nation they would undoubtedly find properties which are suffering, as well as those who continue to prosper. Though the big numbers say cap rates are going up, buyers shouldn’t scoff at properties with low cap rates. They may well deserve them.

Take a case involving an Arby’s (NYSE:WEN) for example. Recent sales have had cap rates as high as 10.07% and 14.85% and Arby’s has posted an average rate of 8.40% over the past six months. So if an owner tried to market one for 7.50% to 7.75%, one would have to wonder what he was thinking, right? But go back to Rules 1-3 of real estate: it’s Location, Location, Location. If that Arby’s happens to be located in the DC metro area surrounded by affluent suburbs, the property would require a much different valuation than the overall numbers would project. A property with the right location can be worth the low cap rates; even if nationwide they are rising.

Real estate is not like an automobile. A car in Washington D.C. is going to be the same as one in Wyoming. However, a property in Washington D.C. will be radically different (value wise) than that of Wyoming. Though the lure of high cap rates may be great, their applicable properties may not be deal they appear to be. Would you rather have a high cap rate property in Wyoming or one with a lower rate in the D.C. area? Certainly it would depend on the investor but it would be prudent to keep in mind the oldest rule of real estate when making deals in this brave new world.

Wednesday, October 21, 2009

Washington DC: An Oasis of Prosperity for Residential and Commercial

There have been many whispers about purported hoards of capital sitting on the sidelines, waiting for the perfect opportunity to spring forth with investment frenzy. The question is when and where? For the answer, go no further than CNN.

What is growing at a never before seen rate?

Where are budgets boldly expanding in the face of economic calamity?

What may be taking over 1/6th of the economy?

Why the Federal Government of course. And its central hub and router, Washington DC, looks to prosper in light of this action.

In-fact, it already has.

As Globe St.’s Erika Morphy reported, Washington DC condo sales are “on a rise after a two year trough”. There were 686 new unit sales in Q3 alone, the highest volume in two years. This represents a greater trend, as sales in the past 12 months increased 45% over the prior 12 month period.

To put Washington DC’s growth in perspective, U.S. foreclosures just went up a record 23% from Q3 of last year and 5% from the previous month. As CNN states “this quarter was the worst 3 month period since the great depression”. To top it all off unemployment has gone up to 9.8% and is expected to hit at least 10.5%.

Washington DC’s unemployment stands at 6.2%, one of the lowest percentages of all U.S. metro areas and was recently named the top magnet city for young professionals. Combine this with its growing employment opportunities through government expansion and it is easy to see why Washington DC is a striking investment opportunity.

Companies are even observing increased sales activity in one of the most bemoaned sectors of the U.S. economy: Commercial Real Estate. The Pitango Gelato, a retail condo building located in Logans Circle, was just reported to have been sold for the highest price per square foot that the selling broker has seen to date. This would seem shocking due to the current state of affairs, but given the context of the building being located in the Washington DC area, the situation makes sense.

As President Reagan once said, “the closest thing to immortality we will ever see is a Government program”. This sentiment rings just as true today as it did all those years ago. In the midst of even the harshest economic turmoil, the one place of unending growth will remain the government and its seat of power, Washington DC.

Wednesday, October 14, 2009

Reversal of Fortunes: Giving Power to the Investor through the 1031 Reverse Exchange

Net Lease Insider sat down for an interview with Stan Freeman, President of Exchange Strategies Corporation, the nation’s only 1031 reverse exchange accommodator dedicated exclusively to providing a full set of reverse exchange processes for all asset categories to qualified intermediaries and sophisticated exchangers. He provided excellent insights into the reverse exchange process, ranging from cost effectiveness to asset security.

1. How do investors take advantage of reverse 1031 exchanges in today’s difficult investment real estate market?

First, it is unfortunately true that many investors’ gains have been seriously eroded over the last 18 months. 1031 exchanges have fewer benefits for these folks. If someone does have potential benefits from a 1031 (either the deferral of gains or renewed depreciation potential), then the issue with making a new acquisition in the context of an exchange will likely be finding a buyer for the old asset.

To that end, reverse exchanges have been used for years by investors to better control the outcome of their investment strategies. At no time in recent memory has this been more important. Using a reverse exchange, an investor can acquire what they really want without the pressure of the standard 45 and 180 day deadlines applied to new assets. Most investors would rather be under pressure to sell what they have and not under pressure to buy something they might really not want. Furthermore, in many situations, reverses can be structured to provide more time – up to a year or perhaps more – to a accomplish a particular strategy. In today’ market, this can make all the difference.

2. How do you use a reverse exchange to get more time?

There are various ways to combine exchanges to get up to two 180-day periods. Generally, this is done when there are multiple properties to sell or buy. As an example, suppose you have an older apartment building to sell and you want to buy two new net-lease properties. If you start a reverse with the first of the new properties, then you have up to 180 days to sell the old property. Once it gets sold, in the context of a forward exchange, you have another period of 180 days to acquire the second new property. This type of strategy can also work if you have multiple old properties and a single new property to acquire.

There are also forms of reverse exchange that allow a new property to be improved prior to title being transferred to its ultimate buyer, thereby increasing its value for purposes of deferring more gain. This can also work with leaseholds. Both forms allow the investor more time to make improvements that bring a property to a full income producing condition.

In addition, there exist non-safe-harbor structures that require a great deal more care to implement. They are more complex and expensive and should be considered when the gains from the sale of an old property are substantial and there is real potential based on a either a series of new property acquisitions over a period of time or a construction project that will require a lot more than 180 days to complete. There are situations in which these structures make a great deal of sense.

3. But, I have the impression that reverse exchanges are very expensive. Isn’t that an impediment to using them as you suggest?

Investors with properties that produce healthy income will almost always find that a reverse is economically sound. The investor can earn the rents from both the old and new properties for up to 180 days if they are using a reverse exchange. So, if this income is greater than the reverse exchange fee plus the cost of funds needed to acquire the new property, the economics are significantly better than in a delayed exchange. Of course, a detailed analysis of the exchange economics for a specific situation is probably more complex than this. But it is always worth doing and we help our clients through the analysis on a regular basis.

4. These days, many investors are hesitant to use 1031 exchanges at all because of the numerous instances of theft and bankruptcy. Is there a reason to be nervous?

A reverse exchange is a title-parking arrangement. There is no cash, per se. And, there are well established methods of insulating assets from liability, bankruptcy and failure to execute. There is really no asset risk in a reverse exchange if it is structured properly.

Regarding the spate of QI failures, it is the accumulation of a large amount of cash proceeds – often following the acquisition of one QI by another – that has proved too tempting for some. The exception to this was the situation involving a large title-company-subsidiary in which securities were purchased with exchanger funds that became illiquid. The motivation was to increase the earnings on the cash it held. When selecting a QI for a delayed exchange it’s important to use one that allows you select the bank where proceeds are parked and is bonded and insured.

None of these issues pertain to reverse exchanges.

Perhaps choosing your accommodator for a reverse exchange requires some additional care in light of these cash-drive failures. If the QI you choose is heavily dependent on delayed exchanges and if their business is under stress because of the decline in exchange activity, then you should make sure that the LLC they form to hold your assets is fully protected from a decision they’d make to seek protection from a bankruptcy court. The entanglement that can occur if the LLCs are not structured right can be lengthy and difficult.

Wednesday, October 7, 2009

S&P and Moody’s Put on the Defensive:
Rating Agencies to Share Liability under New Bill

From Merriam-Webster:

Conflict of Interest
Date: 1843
: A conflict between the private interests and the official responsibilities of a person in a position of trust.

To most, AAA investments are as good as gold and function as a secure reference point with which to steer portfolios. However, they recently served as a false beacon, leading thousands onto the jagged rocks of financial peril, causing billions of dollars to be lost forever. The credit ratings agencies responsible for these guiding lights are supposed to have the interests of the investor and public aligned with their own but it is widely perceived that this is not so. Now under public pressure for accountability, congress is considering a bill that will force liability onto these agencies.

It is commonly known that credit rating agencies such as Moody’s, Standard and Poor’s, and Fitch make their money not from the public who uses their ratings but from the companies who pay to have their securities rated. This would seemingly create a conflict of interest, because the agencies would naturally be more eager to appease those who pay them than those who do not. Thus their official responsibilities (putting out accurate credit ratings) are in conflict with private interests (being paid by companies to rate them). Especially if that company is say, Lehman Brothers, whose financial viability rests upon the AAA ratings of their securities which they know to be worthless. A company in that position would undoubtedly be willing to fork over lots of cash to keep their self-sustaining illusion afloat. Likewise ratings agencies, faced with the proposition of losing business if they are not conciliatory, might be persuaded (through proper monetary investment) to help in that endeavor.

The ratings agencies response to their defaulted ratings is essentially “oops” because they are not liable for the ratings they put out. It is of course natural then that the public would want to strike back at these agencies and hold them accountable for their ratings, to ensure that no future “investment grade on Friday, bankrupt on Monday” ever occurs. But a regulation such as the one proposed is a tricky measure, in need of careful analysis before implementation.

For one, if those giving financial advice are suddenly made liable, to what extent and under what conditions can they be sued? It is possible something could evolve like what currently plagues the medical profession, a multitude of frivolous lawsuits which drive costs unnecessarily upward. Any investor could theoretically have a claim against these agencies, even if the market did take an unforeseen dip. Secondly, the regulation could come out looking like the widely criticized Sarbanes Oxley Act. An act which is generally hailed as being not only a hazardous maze of red tape but essentially a useless precaution. Finally, these agencies may not be liable but they cannot falsify their reports without reproach. Already there are pending law suits alleging major fraud, which could end up securing convictions, penalties or major settlements. These suits could bring about the accountability desired, making legislation unnecessary. Regulation is always more complex than it seems in principle; prudence requires us to be cautious, skeptical and thorough with regards to any proposal.

The net lease industry, like most others, depends upon the validity of credit ratings. One of its most appealing qualities is the promise of long-term viability. Discovering a portfolio of AAA properties is actually not even investment grade would simply be disastrous. Accurate ratings are without a doubt needed but legislation must be properly vetted to ensure it is not harmful, ineffective or unnecessary.