Where Is The Residential Market Today?

Recently, I attended a program on current market trends sponsored by a highly respected and well-known industry organization. It was an annually recurring program. The same speaker has presented this program since its inception more than fifteen years ago. He is an experienced and respected market researcher. His data and observations were accurate and, for the most part, incontrovertible.

There was one area, however, with which I have to take issue. On the subject of the inventory of residential product, the speaker observed that not only was it decreasing, but opined that the glut of foreclosures has run its course. All evidence points to the contrary. Industry and financial publications continue to report that there are mortgages in default that number in the millions. Purportedly, these loans have been kept off the radar screen for a variety of reasons including the lenders’:

·        Need to clean up their foreclosure procedures and practices;

·        Desire to keep REO off their balance sheets;

·        Reluctance to further depress the values of these properties by flooding the market with millions of additional homes.

Laurie S. Goodman, senior managing director of Amherst Securities Group, participated in a Senate subcommittee hearing in Washington on September 20^th, as reported in The Wall Street Journal’s online publication, Developments, on September 22nd:

“Ms. Goodman outlined the size of the foreclosure problem with extensive research behind her well-supported points. There are 4.5 million non-performing loans, of the total 54.9 million nationwide, Ms. Goodman notes, but she emphasized that there are an additional 10.4 million borrowers that are reasonably likely to default.”

If this is true, then the cautious and far-sighted developer isn’t going to be deceived by the appearance of a shrinking inventory of available homes. He will not commit to beefing up both the size of the development organization and the size of current and projected land acquisitions.

It seems safe to say, under these circumstances, that there will be no market for large raw land deals in the Greenfields perhaps for years to come. This means that, in most areas, the land development practice of creating large master-planned communities with the necessary long development time line and commitment of huge amounts of capital at the front end may be years away.

It seems safe to say, then, that the land acquisitions that will be made will be very specific with regard to certain factors:

·        They will be relatively small in size. If the market of available housing is flooded with low cost resale product, it’s wise to limit the size of your commitment to the more expensive new product that has to compete with it;

·        They will be in A locations. If your new construction product has to compete with lower priced properties that are reasonably new, well-constructed, close to schools, shopping, employment centers, and recreation facilities, and, in many cases, amenitized, your location has to be outstanding. You can’t compete on price, so you must find something else that gives you a competitive advantage.

·        They will be entitled. The costs of zoning and, in some areas, growth plan amendments adds too much to the cost of the new product and begs time delays that can eat through the bottom line and destroy the projected return on investment. All other factors being equal, a rezoning may be acceptable, particularly if it is a down zoning procedure.

·        They will be infrastructured, or partially so. The cost and delay of putting in the infrastructure can have the same effect on the project’s bottom line and projected return as discussed above regarding entitlements.

·        The prices will be discounted. These properties often will be owned by lenders who have acquired them through foreclosure, or deed in lieu of, and are motivated to get them off their balance sheets. I have seen some instances where the acquisition price consisted of an agreed minimum sum per homesite with a possibility of a kicker on the end if certain retail price levels are achieved.

When all these pieces are assembled, they spell out the obvious. For the foreseeable future, most residential developers will focus on infill properties that are in A locations, have entitlements and infrastructure in place, and can be acquired at a discount or through a well-structured acquisition price.

Sustainability: What's The Big Deal?

From time to time, questions are raised about the concept of sustainability. Is it just the current fad? Is there any real substance to the argument in favor of utilizing sustainable development practices? If sustainable development incurs additional costs, why do it?

The real key is to look at the project from the perspective of its life cycle, not merely the cost of developing it. Life cycle costs include operational expenses over the life of the project in addition to development costs.

Hard and soft costs can be 15% to 20% of the overall life cycle costs of the project. Consequently, moving forward from the development stage through the operating stage, lowering the project's operating expenses will enhance the return on investment. Properly done, sustainable development practices will lower the project's OPEX during the operating stage.

Update of Trends in Real Estate Development

A PwC survey reports that real estate investors are optimistic that the recovery is underway in commercial real estate, albeit in fits and starts. As investors strive to deploy capital in anticipation of rising interest rates, core assets are primary targets, although the report says that less attractive properties are beginning to appear on the radar screen. The effect of this interest has been to push cap rates down. The survey reports that cap rates decreased in 27 of the 31 markets surveyed. The expectation is that cap rates will either decline further or hold steady.

Cap rates remember are integral to the pricing of a commercial real estate property. They represent the expected rate of return on capital invested based on the net operating income generated at rent stabilization. As rates decrease and NOI remains consistent, the price rises. IRRs also are lower. Best in class in some markets are showing IRRs in the 8% range.

The CEO of Allianz Real Estate America, the U.S. real estate arm of German insurer Allianz, announced that the company expects to invest between $1 billion and $3 billion in United States real estate over the next few years.

Both PwC and Allianz identified the multifamily sector as currently the most attractive for near-term prospects.

The news on the residential front was not good. The Department of Commerce reported that single-family home sales fell 16.9% from January to February. The seasonally adjusted annualized rate of 250,000 is the lowest on record. Sales fell by 28% year-over-year. Blame was liberally spread around to continuing high unemployment, the seemingly endless supply of foreclosed homes hitting the market, and the Federal Reserve’s stimulus efforts bottoming out.

Real Estate Development Oddity of the Week: Apparently there has been a significant increase in the purchase of survival bunkers. The earthquakes, tsunamis, volcanic action, violent storms, spreading unrest and violence in the Middle East, and various predictions (not the least of which being the Mayan target in December, 2012) are pushing some people into a survival mode.

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©2011 by The Falbey Institute for the Development of Real Estate

For Lenders & Investors With Troubled Assets: There Is A Solution!

GUEST BLOGGER: David Farmer

This week's blog is the first to be written by a guest blogger. David Farmer is a planner, developer, general contractor, licensed real estate broker and professional civil engineer as well as Founder and Managing Principal of Keystone Development Advisors, LLC. He also is a cofounder of Capital Four Advisors, LLC. 

"Investors and lenders have a lot in common when it comes to real estate.  Both investors and lenders want to minimize risk and optimize prospects for a return on their investment.  Investors want to buy low and sell high, and lenders want to fund transactions at low loan-to-value ratios and keep their margins of safety high.  The goals of investors and lenders have not changed since the real estate meltdown of 2006-2007.  What is different these days is that the roles of investors and lenders have to some extent been switched.  Investors are now "lending" their capital to fund purchases of distressed assets from lenders.  There is quite a bit that lenders and investors can learn from each other.  The present real estate market is making investors a bit more appreciative of underwriting standards and lenders a bit more appreciative of the complexities of owning and selling real estate.

There is always going to be risk for both investors and lenders.  Risk is bad because it means there is a real possibility you will not get your money back.  The best way to minimize risk is to increase knowledge.  If you were going to bet on horses you would be wise to learn everything you can about each horse in the race so you can make the very best choice possible in predicting the winner.  Investors need to understand not only the positive attributes of a distressed asset but also the underlying risks of zoning limitations, permit expiration dates, development bond repayment and environmental limitations.  Lenders also need to understand these issues if they want to sell their distressed assets for the highest price possible.  In a world where doubt equals discount, the more you know and understand the less doubt and hence discount will be applied to a given property.

Informed lenders retain experts in land development, many of whom are experienced, successful developers, to help them understand their assets and maximize their return of capital.  Most commercial special assets will benefit from a professional review of the underlying issues and the identification of steps to improve value.  Professional investors use teams to investigate potential acquisitions and minimize risk.  Some lenders are using the professional review as a basis to give to appraisers so that a more accurate value can be established prior to putting the asset up for sale.  

Too many times a lender will order an appraisal where seemingly similar properties are compared to estimate a value, when in fact the compared properties are not similar at all.  For example a lender orders an appraisal on a 10-acre industrial property and the appraiser looks up recent sales of industrial property to arrive at a value.  What the appraiser is probably not aware of is that any of the comparable properties, or the subject property, may have significant environmental limitations.  If the comparable properties have environmental issues then the appraised value of the subject property will be lower.  If the subject property has environmental issues, then its appraised value will be higher than what an informed buyer will pay given the environmental issues.  

A professional review team also will find items or qualities that add value to a given property.  Sometimes a property has impact fee credits or a historic type of zoning that can be vested by filing simple forms both of which can add significant value or capital recovery for the lender.

Uninformed investors and buyers have lost billions since the bursting of the real estate bubble, and one with money is nearly impossible to find these days.  Knowledge is power in today's real estate market.  Investors and lenders can gain valuable knowledge to help them buy or sell real estate by retaining a professional team, such as Capital Four Advisors, with years of specific knowledge and expertise in the development industry."

Wayne Falbey: Thanks, Dave! Your post is directly on point for the situation many lenders and investors find themselves in today. Projects have gone belly-up and the developer either is gone or no longer performing adequately. 

The suppliers of capital for the project usually are not developers. They don't have an experienced understand of the day-to-day challenges that threaten to further devalue the investment they have capitalized. This is the time for them to become very proactive in bringing in a consultant team, such as Capital Four Advisors, to guide them in stemming their losses, restoring value to the investment, and disposing of the asset on optimal price and terms.

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©2011 by The Falbey Institute for the Development

Receiverships: The New Sheriff In Town

Wikipedia, the online encyclopedia, currently defines receiverships as follows:

“In law, receivership is the situation in which an institution or enterprise is being held by a receiver, a person "placed in the custodial responsibility for the property of others, including tangible and intangible assets and rights. Various types of receiver appointments exist:

1.    a receiver appointed by a (government) regulator pursuant to a statute;

2.    a privately-appointed receiver; and

3.    a court-appointed receiver.”

Because of the recent financial meltdown, many loan portfolios, investment portfolios, and development entities and projects contain or are, troubled assets. The classic method for dealing with these has been, and remains, the appointment of a receiver.

Formally speaking, the receiver’s principal duties include:

·        Recover and take possession of the books, records and assets


·        Complete a physical and accounting review of the assets


·        Establish/adhere to a budget


·        Stabilize the assets


·        Establish the fair market value of the assets


·        Preserve, conserve and protect assets


·        Operate and maintain property


·        Pay bills


·        Avoid/settle liens and claims


·        Complete the development process, if so    directed


·        Otherwise control, oversee, supervise and direct all administrative, personnel, financial, accounting, contractual, legal, and other operational functions involving the assets

In simpler terms, the receiver’s duty is to mitigate as quickly and as completely as possible the lender’s, investor’s, or business owner’s (individuals and shareholders) financial bleeding. This is a two-step process.

First, the receiver must analyze the situation, mitigate costs and determine the intrinsic issues. The receiver also has to value the asset. Real estate valuations generally are thought to be the province of appraisers. But, at the risk of seeming a wag, didn’t the appraisal community contribute substantially to the over-valuing of real estate that led to the meltdown? Also, don’t appraisers generally use recent comparable sales as a method for determining a property’s value? If so, the danger is that recent sales in many cases have been of a distressed nature – short sales, foreclosures, bankruptcies, etc.

The second step is to recommend the optimal course of action designed to cut the bleeding and stop the burn.

In a nutshell, the receiver is operating the business, which, for our purposes, is a real estate development company or project. So why is it that receivers so often are drawn from the disciplines of accounting or lending? It is eminently more reasonable to engage as a receiver someone from the development community. Who knows more about the issues – large and small – involved in the day-to-day operation of a development project or company than an experienced developer? Who is better qualified to:

·        Determine actual value,

·        Restructure the operation for optimal cash flow,

·        Restructure capitalization,

·        Reposition the asset for added value, and

·        Dispose of the asset on optimal terms?

I’m not suggesting it be the same developer who was involved in creating this troubled asset, although that does sometimes happen. No, I’m talking about the new sheriff in town; the experienced developer who has a track record of successful completion of projects stretching back over past recessionary cycles in the economy. These individuals exist and have experience in successfully cleaning up troubled projects for lenders, investors, and development entities, adding value, and recouping capital.

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©2011 by The Falbey Institute for the Development of Real Estate

Discounted Cash Flow Analysis: Part 3

Part 1 of this discussion of discounted cash flow analysis, or DCF, was a general description of what it is and why it has significance for real estate investment and development. Part 2 discussed Net Present Value. Among other things, NPV provides a means of comparing alternative investment opportunities to determine which one is likely to produce the greatest value or return on dollars invested today given the investor’s desired rate of return.

Part 3 concludes the exploration of DCF with a discussion of the Internal Rate of Return, or IRR. The IRR is the discount rate at which the present worth of future cash flows is exactly equal to the capital invested. It calculates the return earned on the invested capital over the life of the investment, not just during the initial year. The IRR calculations produce a percentage, not a number. The percentage represents the return on each dollar invested from the time it was invested.

In other words, the calculation determines what percentage is necessary to discount cash flows to be produced by the investment in the future years of operation back to the time the investment is made so that the sum of those cash flows, positive and negative, equal zero. 

As is true of the NPV calculations, the components of the IRR calculation are:

1.   In-place (existing rents)

2.   Forecasted (predicted future rent increases)*

3.   Terminal or reversion (net sale proceeds)*

*These latter two are highly speculative and shouldn’t be given much weight in today’s calculations.

Most savvy investors have a hurdle rate or minimum rate of return they desire from any given investment. It generally is equal to or greater than the cost of capital. Therefore, in the IRR calculation:

·        If the IRR is greater than desired rate of return, the investment is financially attractive;

·        If the IRR is equal to the desired rate of return, the investor is indifferent toward the investment;

·        If the IRR is less than the desired rate of return, the investment is not financially attractive;

In days long gone by, discounted cash flow analyses were performed by hand using the Ellwood Tables. It was a laborious task and one fraught with opportunities for errors. Today the calculations are easily made with the use of programmable financial calculators such as the “gold standard” hp12C, or through the use of electronic spreadsheets such as Excel.

For example, suppose an investor has an opportunity to purchase a property that requires an investment today of $750,000 and is expected to produce $100,000 per year in cash flow before taxes. Suppose also that the investor intends to sell the property after five years and expects the sale to net $1,000,000. If these numbers prove accurate, what is the rate of return that the investment will produce?

Visually, the cash flows can be expressed like this:

Cash Flow:

Today: Invested Capital = ($750,000)

Year 1: $100,000

Year 2: $100,000

Year 3: $100,000

Year 4: $100,000

Year 5: $100,000 + Proceeds of Sale: $1,000,000 = $1,100,000

Using the hp12C, the number produced is 17.99% return on the life of the investment. If this exceeds the cost of capital, the investment is attractive. 

This is superior to the cash-on-cash or cap rate methods of calculating return, because they focus on a single year only. But is this method perfect? No, for one thing, it relies on assumptions. One of these is that as the cash flows are received, they are reinvested at the discount rate. If this is not the case, the IRR overstates the actual rate of return. In addition, the IRR does not consider the cost of capital involved in the investment. There is a method, the Modified Internal Rate of Return (MIRR), that does this.

Also, a potential investment indicating a higher IRR than an alternative investment actually may not be as attractive. This is because the NPV of the second potential investment may more greatly enhance the investor’s wealth that the first one.

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©2011 by The Falbey Institute for the Development of Real Estate

Discounted Cash Flow Analysis: Part 2 Revised

Part 1 of this discussion of discounted cash flow analysis, or DCF, was a general description of what it is and why it has significance for real estate investment and development. It is a means to measure or assess the present value of cash flows to be generated by the property (investment) in future periods (c.f., years of ownership). Here’s another way of looking at it:

·        The initial investment to acquire or develop an income generating property is made today, in today’s dollars

·        This property will generate income (primarily from rent) over a multiyear period of development and operation

·        The dollars to be generated in these future year cash flows do not have the same value as today’s dollars

·        The further out each succeeding year is, the less value the dollars generated in that year have in comparison to today’s dollars

·        Therefore, these future cash flows have to be discounted (by some means) in order to determine their real value in today’s dollars

This process is called net present value or NPV. Because any type of investment – real estate or otherwise – is expected to produce cash flow, even if it’s simply a sale in a future year, NPV can be applied. As a consequence, NPV provides a means of comparing alternative investment opportunities to determine which one is likely to produce the greatest value or return on dollars invested today. Therefore, you can compare a real estate investment to an investment in pork belly futures, fine art, precious metals, equities, literally anything.

The components of NPV calculations for real estate are the following cash flows, positive and negative:

·        The initial capital invested (negative)

·        Subsequent capital investments (negative

·        In-place (existing rents - positive)

·        Forecasted (predicted future rent increases - positive)*

·        Terminal or reversion (net sale proceeds - positive)*

*These latter two are highly speculative and not given much weight in today’s market.

First, let’s clear up any confusion about present value versus net present value. Present Value is a short-form methodology used to evaluate a property using its current-year NOI: Present Value (PV) = NOI ÷ cap rate. This is the essence of the cap rate that was discussed in an earlier posting to this blog.

Net Present Value, as noted above, is the value today of all future cash flows, positive and negative, to be generated by the project as discounted by the required rate of return (i.e., hurdle rate) minus the cost of acquiring the property. The discount or hurdle rate is a rate that reflects opportunity costs, inflation, and risks accompanying the passage of time. It is personal to every investor because each person assesses and weights risks differently.

NPV calculations produce a number, not a percentage. The key to interpreting the results of these calculations is in the nature and amount of the number produced:

·        If NPV > 0, the financial value of the invested assets would be increased, (i.e., the return on invested capital is greater than the investor’s hurdle rate)

·        If NPV = 0, the financial value of the invested assets would neither increase nor decrease, (i.e., the return on invested capital is equal to the investor’s hurdle rate)

·        If NPV < 0, the financial value of the invested assets would be decreased, (i.e., the return on invested capital is less than the investor’s hurdle rate)

For example, suppose an investor is seeking a minimum return on capital invested (hurdle rate) of 15%. He or she has an opportunity to purchase a property that requires an investment $500,000 and will produce $125,000 per year in cash flow before taxes. Suppose also that the investor intends to sell the property after five years and expects the sale to net $1,000,000.

Will the investment produce a return at least equal to 15% under these circumstances? While the calculation requires use of a programmable financial calculator or spreadsheet software, the answer is “yes”.  The calculation produces the number 416,196. Because we’re dealing with cash, this number actually is expressed as $416,196 and it’s a positive number. It means that the investment will produce the 15% return AND an additional $416,196. In fact, the actual rate of return (Internal Rate of Return or IRR) is 35.04%.

So, what actually happened here? Each year’s cash flow was discounted from the time it was (will be) generated back to the present using a discount rate of 15% (the investor's hurdle rate). Those respective annual cash flows, as discounted at 15%, have a value today of: $108,696, $94,518, $82,189, $71,469, and $559,324. That’s a total of $916,196. After deducting the initial capital outlay of $500,000, the result (NPV) is $416,196.

The next posting to this blog will discuss the Internal Rate of Return - IRR.

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©2011 by The Falbey Institute for the Development of Real Estate

Return on Investment in Real Estate: Discounted Cash Flow Analysis

In recent posts to this blog, we’ve looked at relatively simple methods for measuring the return on invested funds.

·        The cash-on-cash method measures the rate of return, expressed as a percentage, on invested equity only.

·        The capitalization rate, or cap rate, measures the rate of return on all capital invested, debt and equity. It also is expressed as a percentage.

While these methods are commonly used in the industry, they leave much to be desired. Primarily, they measure return for a single annual period, whereas most real estate investments or projects experience a multiyear cycle of development and operation. If your capital is at risk for a period of several years, shouldn’t your measure of return reflect this? Can you really understand and measure return on your investment by looking at a single year’s activity, such as the first year at stabilization?

Another issue is the time value of money. Is a dollar received in Year Ten’s cash flow worth as much as a dollar received in Year One’s cash flow? If you invested $100,000 today and received $200,000 within the first year, did you double your money? What if it took five years to get the $200,000? If you fail to see the difference, ask yourself this question: suppose you won $10,000,000 in your state’s lottery, but the state asked you if it could keep the funds for a couple of years then pay you – no interest accrues. Would you say, “Sure!”?  Of course you wouldn’t. It’s the “bird in hand theory”. A dollar received today is worth more than a dollar received somewhere down the road, because, among other things, dollars lose purchasing power over time, inflation eats away at it’s value, there is the cost of lost opportunities, and there is the risk of default or nonperformance. This is the essence of the time value of money.    

So, the question is: Given the effects of the time value of money, is there a way to measure return on investment over a multiyear period? The answer is yes, using discounted cash flow analysis. It is a means to measure or assess the present value of cash flows to be generated by the property (investment) in future periods (c.f., years of ownership).

There are three principal discounted cash flow methods utilized in real estate:

·        Mortgage Amortization: In real estate, this essentially is a sinking fund in which regularly scheduled payments containing principal and interest are made over a specified period of years so that the final payment completely satisfies the mortgage debt.

·        Net Present Value (NPV) :  Measures and compares the attractiveness of alternative investment opportunities. This actual defies conventional wisdom by proving that you really can compare apples to oranges.

·        Internal Rate of Return (IRR): Calculates the return earned on the invested capital over the life of the investment, not just the initial year.

In this discussion, we’ll concentrate on NPV and IRR.

The components of NPV and IRR calculations are the following cash flows, positive and negative:

·        The initial capital invested (negative)

·        Subsequent capital investments (negative)

·        In-place (existing rents - positive)

·        Forecasted (predicted future rent increases - positive)*

·        Terminal or reversion (net sale proceeds - positive)*

*These latter two are highly speculative. Since the recent financial meltdown, investors and lenders are more conservative in underwriting the forecasted and terminal cash flows.  Thus, in-place cash flows are a larger portion of the calculation – meaning cap rates have to rise, which pushes purchase prices (values) down if the investments are going to pencil out.

The next posting to this blog will discuss Net Present Value specifically.

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©2011 by The Falbey Institute for the Development of Real Estate