Market Drivers

One of the hardest things to really get comfortable with as a commercial real estate (CRE) investor are the drivers of the particular market you are in. What I mean by drivers are the things that directly affect the particular genre of CRE you either own or are interested in.

For instance if you own a 20,000sf warehouse the Market Drivers you are looking to understand are those things that will impact your ability to lease your space for the highest possible price. Including: whether the city you’re in is attracting and growing businesses that need warehouse space; whether others are building additional properties on speculation and thus affecting the supply of similar spaces; whether there has been a legislative change that will somehow constrain or limit potential users of your building. These are your Market Drivers.

Market Drivers are what should keep you reading the news everyday and doing your best to keep up with the shifting of the local business climate.

Chattanooga has been a transit hub for a long time. It’s well positioned roughly a two hour drive from so many population centers it has a distinct geographical advantage. This was not lost on people in the business of transportation and there have been many companies founded and moved here for exactly that reason.

The news today that Arrive Logistics has raised another $25m for future expansion is a prime example of local Market Driver. Their expansion will naturally require an expanded footprint in proximity to their existing headquarters.

https://www.timesfreepress.com/news/breakingnews/story/2019/jun/18/arrive-logistics-raises-another-25-million-equity-it-prepares-major-expansion-chattanooga/496896/

With the volume of office space available in downtown and the growth of downtown residential this is a very important step in filling out the core of Chattanooga and making it a 24hr city.

Congratulations to Arrive Logistics and especially to downtown Chattanooga this is a great step in the right direction.

Top Ten Seller Mistakes

To be fair to buyers there are plenty of mistakes sellers make. Some are similar and some are unique and well worth paying attention to. Again this is my list of ten from my experience in no particular order. Each of these should be understood and avoided.

  1. Are you selling or fishing
  2. Where are you going to put the money
  3. FSBO
  4. Knowing where the market is
  5. Failing to assemble a full package on the property
  6. Not having a lawyer
  7. Understanding the timing
  8. Not Cleaning Up Title Issues
  9. Fixating on price
  10. Underestimating the costs of selling

Are You Selling or Fishing:

Why. Why are you selling. What is your goal. What is your motivation. If it’s not clear to you you’re going to be pulled all different directions in the process and have a very hard time getting the deal to close.

‘Fishing’ is saying “I’d sell if the price is right”. That’s not selling. Everyone who owns a building will “sell if the price is right”, listed for sale or not. Fishing is saying “I will only sell if I get my price”. This is hubris. You’re saying to the market that you know best.

There is a stigma that happens to properties that have been listed for sale for a long time. First and foremost people think there is something wrong with the property and second seasoned investors and brokers can smell that the seller isn’t ready to sell. They’re fishing.

The best indicator of this type of hubris (that I had never seen until moving to Tennessee) was a seller INCREASING a listed price with no explanation of added value. If you take a vacant building and get it leased up there is value there to a buyer. If you just wake up one day and say I think the market has gone up and I’m going to raise my price you’re not a seller.

Get clear on your motivations and goals before you come to market. Fishing wastes everyone’s time.

Where Are You Going to Put The Money:

Sometimes individual sellers don’t consider their next steps prior to putting their properties on the market. More often than not though it is a partnership that decides to list a property for sale but fails to let everyone know or deliberately doesn’t. Regardless of the cause if you are caught at closing and you have not set up an exchange you will be liable for the taxes. A brutal lesson in considering the future.

Keep in mind I am not saying run out and spend the money on a boat or some other bit of nonsense. I’m saying you need to plan your exit as well as you planned your entrance, if not better. To pay the tax can reduce your gains to the point that your investment return is as bad as having left the money in a savings account. You don’t want this.

So, understand the exchange process. The requirements and the steps. Learn it well before you need it. Selling is very stressful and exchanges can be doubly so. You are doing two transactions.

It goes without saying that you should have a good CPA and they should be up to speed on your plans. If they understand your desire to sell they can help you structure everything. They may even know someone looking for a property like yours.

FSBO:

This is pretty simple: do not sell your own property. Don’t do it. In the residential world it’s not a big deal to sell your own house or that short term rental that didn’t work out quite so well but commercial is a whole different animal. Unless your job is selling the type of property you are listing don’t do it.

Harsh? Yup. FSBO in the commercial world kills more deals than just about anything else. The fee you pay to a good listing broker to handle all the details of the sale is well worth it. Most importantly you want their expertise in determining pricing, targeting potential buyers and keeping track of interested parties. You will get a higher price with a broker than without. Don’t think for a moment you’re saving any money. There are plenty of buyers that will not even look at a property listed FSBO because they’re so difficult to deal with.

Keep it simple and say NO to FSBO.

Knowing where the market is:

I realize that I just told you to hire a broker to help with selling and now I’m telling you to know where the market is but they’re not in opposition. Wherever you get your information you need to understand where the current market for your property is. Without understanding this you will have no idea how to plan for the timing, contingencies or other issues that may be specific to the current market.

An extreme example was the downturn in 2008. Actually late 2007 when very suddenly, around September, the CMBS market dried up. If you had gone to list your 20,000sf mixed use property in November and not been aware of where the lending market was you’d have been in for a rude shock. Not that the downturn wasn’t rude enough on it’s own.

Knowing the market, even in a cursory way, will also help you understand where your property fits in the market. Are you the nicest house on the worst block, so to speak. What are the strengths of your property and the weaknesses. Where can you expect a savvy buyer to zero in on their due diligence and use to try and get some concessions.

So as you begin to consider selling have conversations with your CPA, your lawyer, your banker and maybe especially your broker. To understand the current market and what issues may arise that will impact your potential sale.

Failing to Assemble a Full Package on The Property:

Well if you hire a broker they’ve put together a full package, right? Well, yes they should do that but it is reliant upon you as the seller getting them all the relevant information to build the package. Just saying ‘list my property for $1m’ is going to make life a pretty big pain for everyone.

Collect and deliver to your broker income and expense reports; rent roll; capital improvement details for the prior two years; tax records; legal / dispute records; insurance claims; etc. The more detail you can provide the better package can be built and the better picture a buyer can get even before they walk your property. Every property has issues. Don’t hid yours put them out there right next to the good stuff so buyers can determine whether they can make it work.

When you don’t provide a complete package up front you are setting up for seemingly endless requests by potential buyers for everything. Clean it up and make it faster for people to evaluate and get to yes.

Not Having a Lawyer:

I said it before in the buyers mistakes post and I will say it again louder here: GET A REAL ESTATE LAWYER.

If they don’t know what ‘estoppel’ is they’re not a real estate lawyer. Get someone who knows the local market and understands the type of building you are selling.

In many states the seller has very little to do and in fact has very few options to exit a contract once it has been executed. Having a lawyer on your side can help mitigate this and a myriad of other potential pitfalls.

Understanding The Timing:

As a seller you need to have a good understanding of how long things are going to take. You need to be able to set not only your (and any partners) expectations but you will need to be able to anticipate when certain things might occur.

A great example is knowing that the 1500 acre ranch you just listed for sale could take between two and five years – or more – to sell. If you understand this you will plan accordingly for next steps and determine your required due diligence period as well.

How long do you need to wrap up any projects with the building? How long do you need to secure an exchange property? How long do your partners require? How long do you need to move all that stuff you’ve been storing out behind the building?

Get a clear understanding of how long you expect the listing period to take; the due diligence period and any contingencies as they come up. If the buyer is going to require a Phase II Environmental Report to be completed how long is that going to take.

Not Cleaning Up Title Issues:

Many, many properties have title issues that need attention. From legacy easements to rights of way. As a seller you should pull title to your own property and review everything in it. if there are issues you need to work to get them resolved before listing.

Title issues can sink deals and fast. If the property has an abandoned utility easement and you do not get it formally vacated your buyer will likely require it prior to closing. This can delay or derail closing.

Have a title attorney assist you if the issues are at all complex. Again, your brother’s friend who is a lawyer is not the guy you need. You need someone who specializes in title work.

Fixating on Price:

Look we all want the highest price possible when selling but price is typically not the sole consideration. There are timing concerns; accomodation of an exchange; deferred maintenance to be finished; titlework to be cleaned; etc.

As a general rule you can have price OR terms. If you get your price it’ll be the buyers terms and vice versa. It’s never that clean though and there are always things where negotiation and compromise is required.

I have seen sellers kill deals over $50,000 on a $2,000,000 deal. Is there another buyer out there, possibly, but why would you kill the deal you have.

Underestimating The Costs of Selling:

Selling is expensive. Broker fees; transfer fees; title fees; closing fees; etc. A good rule of thumb is to figure ten percent of your deal will be fees (obviously this varies substantially, especially on big money deals). Still you need to be prepared for the expenses. Plus if you’ve not made plans to exchange your biggest fee will be the taxes on the gain.

It is wise to go over all of these early in the process with your broker and title company to ensure you are planning for them. For certain things there may be ways to save a few dollars but you cannot eliminate all of them. Plan ahead and avoid the surprise at closing when the proceeds you thought you were getting have a haircut.

Here We Go Again….Maybe

Anyone remember subprime? Or maybe how many deals you did in 2008? Well strap in cause we haven’t learned a damn thing. When the feds clamped down on banks lending to less than able home buyers the market just came up with alternative lenders that are willing to shoulder the risk.

This should serve as a good reminder to always underwrite prospective deals conservatively. If they work in bad times they’ll work really well in good times and not leave you high and dry in bad times.

https://www.timesfreepress.com/news/business/aroundregion/story/2019/jun/11/risky-borrowing-banks-sideline/496452/

Building Trades Worker Shortage

This has been a growing issue nationally. It is the achilles heel for the booming real estate market. Deals have been falling apart because builders cannot be found or the prices they’re bidding throw projects out of whack before they’ve even begun. On the residential side the prefabrication of homes can help to alleviate some of this issue but that takes substantial research and many of the good companies are running six month backlogs. Either way this is a complex issue to be aware of as you consider projects:

https://www.timesfreepress.com/news/business/aroundregion/story/2019/jun/12/home-projects-suffer-worker-shortage/496453/

This article from the BBC provides a good insight into the potential future of building:

http://www.bbc.com/future/bespoke/the-disruptors/the-house-the-robots-built/

Top Ten Buyer Mistakes

Starting this week I will be posting a regular weekly column dealing with a particular topic. Nothing too in depth but hopefully instructive with a bit of humor.

There are so many potential mistakes when buying a commercial property it’s hard to pick just ten. Hopefully posting these will help some of you avoid some of the classic issues that can sink a purchase. The following are in no particular order. All are important to get right and each one may play an outsized role in a particular deal.

  1. Punching above your weight class
  2. Failing to line up all the pieces
  3. Failing to fully underwrite and evaluate financials
  4. Not fully vetting partners
  5. Not having a lawyer – a commercial real estate lawyer
  6. Not understanding the market
  7. Rushing to Purchase and Sale Agreement (PSA)
  8. Rushing the DD period
  9. Failing to complete and understand inspections and DD items
  10. Being in a hurry

Punching Above Your Weight Class:

If you weigh 165 pounds you wouldn’t sign up to fight someone who weighed 230 pounds. So, why would you do the same when buying commercial real estate. Simple, your ego. Your ego says you’re as smart as that investor you met the other week and he’s buying $10m dollar office buildings so you can too.

Well slow down there ego my boy. If you let yourself be led into deals well above your experience level you are exposing yourself to substantial increased risk. You may be able to pull it off but more than likely somewhere along the line you will get into trouble and you won’t have the experience to get yourself out.

Best advice is to move methodically and grow your portfolio and experience organically. This will allow you time to understand the systems and issues that come up at each level of investing. Plus you may find that you like $1m retail properties and just make a portfolio out of those. If you do decide to jump into a deal well above your experience level make sure you have a trusted partner and advisor who can shepherd you. Not in the good times but when things get sideways. Everyone looks like a genius in an up market.

Failing to Line Up All The Pieces:

What does that even mean? Line up all what pieces? Well in the buying process there are numerous moving parts and they all need to be dealt with in time. You can’t get loan approval until you have a Purchase and Sale Agreement (PSA) executed (an obvious but useful example). And you can’t get loan approval until you have to put together a ‘book’ or promote package that will include all of the principals financial details along with a full write up of the property and submitted it to the lender. So, there’s a lot to do and generally never enough time to do it.

Before you even tour a potential purchase you should understand the financial and/or value add proposition thoroughly and be confident that it could work based on your requirements. If you have partners you should have their buy in before pursuing a property beyond a cursory review. You should also talk to your banker before touring. Bankers typically have lots of experience and may have worked on the building you are considering before. If they have, or if anyone they know has, their insight can prove invaluable. Ditto if you’re working with a broker. They can potentially tell you the recent history of a property and obvious issues.

Oh and you’ll usually have to get all this done in an atmosphere of desperation as there always seems to be another buyer that shows up and starts talking about making an offer the moment you do. Get used to rushing. So, the more you can prepare and line up all the pieces before hand the smoother things will go, hopefully.

Failing to Fully Underwrite and Evaluate Financials:

As noted above you should have a solid understanding of how the property is going to make money before you look at it. You should understand the rents and expenses so you can observe obvious issues, like the added expense of patching the roof every spring if that is what is being done.

This starts with evaluating the financial information provided to you by the seller. Not the proforma nonsense the sellers broker shows you that makes the property look great – next year – but the current income and expenses. Once you have looked at these and what you see looks viable then it’s worth going to the next step. Learn what and APOD and Cash Flow are and get very comfortable building them for every property you look at.

Once you have looked at the building specific financials you should get at least a sense of the neighborhood fundamentals as well to see how this property compares. Look at recent sales of similar buildings. Look at asking lease rates for similar space. You will not come up with a specific mark you are looking to hit but you will develop a feel for the area and be able to understand when something looks out of place. When a property’s rent numbers are 30% higher than similar buildings around it that should be a big red flag.

Don’t fall in love with how a building looks fall in love with the financials.

Not Fully Vetting Partners:

Just because they have money doesn’t make them good partners. In fact many times it can make them bad partners. Partners are what can be called a necessary evil in the commercial real estate world. Whether you’re considering private equity, personal friends and family or a traditional bank they all think of themselves as partners. You need to consider any relationship in depth and realize that any partnership can go South no matter how good things look when you start.

A couple things to fully understand with any partner are their motivations for joining you in the deal and their terms and expectations. Banks and private equity partners will typically have these criteria in writing and be able to clearly articulate their terms and expectations. Friends and family not so much. So, it’s imperative that you sort these things out before getting financially tied to someone.

The number one reason commercial properties are put up for sale is because of partnership issues. One partner wants to sell. A partner has died and his family wants to sell. One partner has remarried and his new wife is a broker and is pushing him to sell so she can make a commission. There are millions of stories that will show you that just because someone is smiling when you are buying a property doesn’t mean they’re going to be even talking to you in a year. Protect yourself and vet potential partners thoroughly.

Not Having a Lawyer – a Commercial Real Estate Lawyer:

Not surprisingly the next mistake is not having a solid lawyer in your corner before you get into a deal. There are so many pitfalls in the world of commercial transactions going into a deal without competent council is like walking into a lion cage with a raw steak on your head. You will be killed, quickly.

Let’s be very clear here: your family member who practices divorce law is not what you need and is more likely to get you into trouble than keep you out of it. Mostly by way of ignorance. Commercial real estate law is focused on actually finding a way to do the deal while mitigating as many risks as possible. Lawyers from other disciplines typically end up wanting to mitigate all the risk in a deal which is not ever possible. So, they end up killing the deal.

Find a lawyer who works with developers and large investors and put them on retainer. Someone who is knowledgeable of the current market can also provide great insight regarding who and what they know. They may even be able to help you find a property as lawyers are sometimes the first to know, outside of family, that an owner is considering selling. They’re expensive but worth every penny if they keep you out of trouble.

Not Understanding The Market:

Real estate and especially commercial real estate is local. Very local. There are REITs and larger national owners who view the entire country as their market but each of them will have a specialist on the ground in each market they own or are interested in. Someone who is out everyday talking to people and watching all of the pieces of the market.

On average it will take you at least six months of concerted study to begin to get your head around a particular market. I don’t mean look at the asking prices of buildings on Loopnet and saying “wow! That’s a great price!” I mean understanding that the major employer in the city has just cut half it’s workers and that is rippling through the market.

Having analyzed hundreds of properties in many different markets I will tell you that most real estate is listed at just about the right price for the market that it’s in. If it looks like a deal to you it’s likely because you do not fully understand all the factors affecting the pricing. Do not be fooled by slick marketing. Learn the market. Learn why people are there. Learn the taxes and transfer fees. Learn the drivers in a local economy and the points where it is falling behind. Every city has pluses and minuses. Learn them before you jump into a purchase.

The stories of the out of town guy who flys in looks around and drops $2m on a building or project never end well. It’s a great way to make a million dollars.

Rushing to Purchase and Sale Agreement (PSA):

Speed is the enemy of understanding. Deals take time. They take time just to get to the PSA. If it’s just you as the buyer you have a checklist of criteria that should be met or at least addressed before you move ahead on making an offer. If you have partners, new partners especially, you have their checklists to clear and their concerns to address as well prior to writing paper.

Those who move fast successfully are typically very experienced in the marketplace, have all their ducks in a row as a matter of course and are not in any doubt about their financing.

You will hear the same story everywhere you go: “The really good deals are already gone.” I’ve even said it. What it really means is that you’re not looking at the market or deal in the right way. Regardless, you need to ignore the chatter and slow down. Do all the pre work that needs to be done to give you the confidence that this property might work for your goals. The faster you move the more you are likely to miss. If you’re lucky it’s little stuff you can recover from, if your not it can be catastrophic.

Don’t let anyone rush you and if anything raises a red flag for you stop and address it until you are fully comfortable with the issue before you move on.

There is always another deal.

Rushing the Due Diligence period:

In the same vein as rushing to the PSA is not giving yourself enough time to complete all the Due Diligence (DD) you and your partners require. A typical residential sale can be closed in 30 days without much difficulty these days. Closing just about any sized commercial deal in less than 60 days is very risky. There are a myriad of factors and details that need to be reviewed, verified, bid, inspected and gotten comfortable with. Again, those that move quickly in DD successfully typically have years, if not decades, of experience in evaluating properties. Until you have that you will increase your chances of success by giving yourself ample time.

A simple 10,000sf commercial property purchase could require the following: a new survey (3-5wks); a new appraisal (4-6wks); lender approval (after appraisal 6+wks); complete physical inspection (1-3wks); bids from individual service providers (2-4wks); post inspection negotiation (3-6wks); city approval for use or modification (6-50+wks).

Add to all of those that likely there will be things that come up during DD that will require you to rethink your plans for the property. In that same breath you will need to determine if it is a make or break issue or something you can live with. If you live with it you need to factor it into your plan for the property. For example if you find out in inspection that the roof leaks, you will need a bid on repair or replacement. You will need to know whether the seller will compensate for this deficiency and if not you will need to decide if you still want the building. Even then you will need to financially factor in the repair to your valuation and also your capital plan for the building.

Rushing through DD is a great way to end up owning a serious headache. Slow down.

Failing to Complete and Understand Inspections and DD Items:

As noted above there are many different items that need to be completed in the DD period. Not completing basic or required inspections or simply not grasping how the results of a particular inspection could potentially affect a property can cause no end of headaches in the future.

Using the same 10,000sf building as discussed before consider that a Phase I environmental report is recommended based on the neighborhood the building is in. When you get the report back you quickly scan it to see if anything jumps out at you. It’s late on a Tuesday and you’re tired so you don’t pay close attention to the findings where it notes that neighboring properties have had significant issues and while this property does not appear to have direct contamination it cannot be ruled out and a Phase II survey is recommended.

This kind of thing gets missed a lot. A physical inspection report for a typical house might run ten pages a commercial inspection can easily run ten times that. There is much to be reviewed and fully understood.

Being in a hurry:

You have probably sensed this one coming from it being included in many of the points above. The single best piece of advice it to slow down. Slow down in your initial evaluation; slow down in your underwriting; slow down in your due diligence and slow down in closing.

Commercial deals have many many potential issues and each has it’ sown effect on a deal. The only way to begin to understand these is to consider each of them and that takes time. So, take the time. If someone else comes in and buys the building before you can pull the trigger that’s fine. When you have a decade of experience and are working in a market you understand you too can ‘jump’ on deals because you will understand how to manage the risks. When you’re just getting going you barely understand what all the risks are.

Slow down. Commercial real estate is a long game.

Nautilus Building Sold

A good indication of the appeal of Chattanooga that a group out of California bought the Nautilus Building:

  • Listed Sale Price: $2,699,000 ($157.99psf)
  • Sale Price: $2,550,000
  • PSF: $149.27
  • Total Building Size: 17,083sf
  • 4 Retail spaces totalling 6,000sf
  • 8 Apartments

A marque property and a great comp for future sales in the North Shore.

https://www.timesfreepress.com/news/business/aroundregion/story/2019/may/31/nautilus-building-north-shore-sold-255-millio/495803/