The thinking that a grid provides multiple alternatives for traffic to negotiate and thus lessens the impact of traffic by comparison to the cul de sac or ‘dendritic’ style of mid century development. While this is geometrically accurate the human is still left second in this design. It is a design based on the mobility of cars and not people.
Accomodating the needs of drivers to traverse an area or otherwise be on their way. It does little for people and their movement or safety. While it can slow traffic, sometimes, it also increases the number of intersections and thus conflict points between people and cars.
In the US our urban evolution is still young and for nearly the last hundred years urban development has been undertaken with a car first vision. We are slowly starting to realize there might be a better way but the grid is a half step and one that can lock in cities and towns to a reliance on auto centric thinking.
Barcelona has recently begun converting groups of smaller blocks into what they’re calling ‘superblocks’.
These Superblocks provide access to local residents; emergency and service vehicle only and put the priority on pedestrian priorities. This reorientation is a way to retrofit the usual block system that we are still touting as a good idea. This is the evolution of the grid.
Designers and builders need to be looking forward and not backwards or half way. A company out of San Francisco called, somewhat ironically, Culdesac is doing just that with a new development in Tempe that will provide ZERO space for privately owned cars. It is a fundamental reorientation of the way we think it’s possible to live. Again in the US this is a unique effort while in Paris they’re looking at closing a major portion of the entire downtown to private automobiles. Imagine Manhattan or downtown San Francisco without private cars. The benefits are substantial.
As groundbreaking as this sounds it is really just a reversion to an urban fabric that existed before the automobile. When towns and cities were laid out and designed for the people in them and not for the people getting through them to somewhere else.
We are well past time for a shift in design thinking back to people. We have taken some baby steps and there are some taking a leap in this direction but we need to see this kind of change nationally. It is the kind of shift that can alleviate some of the substantial environmental pressures and produce a far higher quality of life for everyone.
Short advice on real estate and life
“To my real estate agent, Chernobyl is a fixer-upper.”―Yakov Smirnoff
“If you want to get rich in real estate sell things to Realtors.”―Anonymous
“If you love life, don’t waste time, for time is what life is made up of.”―Bruce Lee
“In real estate, you make 10% of your money because you’re a genius and 90% because you catch a great wave.”―Jeff Greene
“Perhaps the secret to making a billion dollars in real estate is that there is no secret.”―David Lichtenstein
A very brief look at the different levels of real estate investment
A friend asked me this past week about what is different between residential and commercial investment properties and I thought there are likely others who have the same question.
At the most basic level there is little difference between residential and commercial investment properties. In both cases the investor is purchasing a property and leasing it to someone who is paying for it. The devil is in the details as they say.
Starting with a single family home rental let’s get into the details.
Residential Income Properties (less than four units):
With residential income properties the investor is purchasing a single family home, duplex, triplex or quad / four unit property. This threshold is seemingly arbitrary and imposed by the lending regulations. More than four units is considered commercial and less is considered residential. Needless to say the largest relevant distinction for investors to understand is that lending terms can be far better in the residential world.
All of these are based on leasing out living space to tenants. Starting with a single family home an investor is buying an entire, stand alone, property that is, typically, leased to a single tenant. One lease, one roof, one foundation, one yard, etc.
Residential is typically provided with a variety of appliances including dishwashers, fridges, and even washers and dryers in some. All of these are for the use of a single tenant and maintenance is typically provided directly by the investor.
Small residential leases can be as rudimentary as a single page covering the basics; they can also be provided as a template from a city or county regulator or you can have a lawyer put something specific together for you. Given that most leases are for a year or less, exposure and risk are usually pretty small and the sums of money are limited.
Investors in residential run the gambit from individuals who may have only one property to major private equity funds that own thousands of homes. It is possible to make a very good living by amassing a handful of rental properties and self managing / maintaining them.
The downside to single unit rentals is that when they’re vacant there is no one providing an income. In a multi-unit property any vacancy load is spread evenly between the units. This is a critical difference and one that can sink a small investor if the market turns and they’re caught out.
From a financing perspective these can be quite a good deal as lenders typically offer similar terms to a primary residence. This can provide a very affordable way to get into property investing without substantial capital. Financing is one of the biggest things to change as we get into larger and more complex commercial properties.
Small Commercial Properties (single, under ~10,000sf properties):
These are all over. Once you start looking for them they’re everywhere. Smaller, strip retail centers, small office buildings and of course smaller industrial sites. The size cutoff is more arbitrary here, one I use more as a rule of thumb, and is not a size related lending change like the shift from single family to more than four units was. Instead I consider these properties where it is still quite reasonable to think that a single investor can purchase, manage and handle all the maintenance by themselves. Getting much over this level and it can quickly become clear that help is needed. This depends on the property type and tenant mind you. I know industrial guys that do 100,000sf single tenant properties all by themselves but that’s a unique case. In addition most of these will be owned by smaller local investors and even small groups.
For the majority of active investors this size property may be as far as you ever need go in your investing life. One or two of these properties, well managed, can prove a very nice set up. In residential these would be properties with between four and twenty units; in retail it’s typically four to six tenants; office can be up to ten or even more small users and industrial could be one tenant or broken up like an office into many tenants.
Keep in mind that this is the investment range where having multiple tenants under the same roof and on the same foundation really begins to benefit the ownership. Consider that if you owned six single family homes you’d have six of everything you’re responsible for (roofs; foundations; heating and cooling; laundry; etc.) but in a six unit apartment building you can have one roof; one foundation; a common laundry and possibly even a boiler system for heating the entire building. All of this reduces the number of different systems to be maintained and replaced.
This is the level where, as an investor, you will begin to see the advantages (and disadvantages) between the different product categories. For example: a good portion of retail, office and even industrial tenants will want to have longer lease terms than the standard residential one year term. Longer leases reduce management further and help lock in future value. Sign a lease one year and get paid on it for five years or sign a new lease every year with new tenants. Pretty easy math.
Leases in this category gain a level of complexity and when dealing with retail, office and industrial you will begin to see specific types of leases depending on what costs are paid by the tenants and which are paid by the landlord (NNN; NN; N vs MG). You need a good lawyer to assist in the drafting of these leases and may need them for any issues that arise as well. Commercial real estate brokers will become a part of your life in bringing tenants to your property; negotiating leases; and even canvasing your tenants to move them to another building.
This is also where you see investors begin to specialize in a particular product type. Specialization provides a better understanding and better management which is better for tenants and makes ownership much smoother. The details of owning a sixteen unit apartment building and six unit retail center are completely different and there are limited crossover benefits. Owning a sixteen unit apartment and a six unit apartment have multiple benefits including that you are able to provide an option for tenants moving between the two properties.
Lending at this level is also, generally, much more flexible and forgiving. Many local banks and credit unions love these properties because most owners are local and hands on. This makes owners directly accountable and lenders able to even drive by and see that a property is still there and in good condition. Terms can be more relaxed as well with less concern on deposit requirements and tenant improvement reserves. It’s still even entirely possible for a new investor to understand all of the terms and obligations of lending for these types of properties.
The Big Time (10,000sf and larger individual properties):
Above around 10,000sf things begin to change rather quickly and it becomes obvious that you need to have a pretty solid understanding of the systems and details in order to succeed. In essence it’s still the same fundamental concept: you own a building and tenants lease space in that building from you but the layers and details become very important. Understanding all the details and how little changes can have a big effect if you don’t get them right is imperative.
It also is less likely that a single investor or small group will be able to keep up with everything let alone be proactive. Juggling tenants, maintenance and financing on larger properties can keep a small team of people busy and that isn’t even taking into consideration accounting, legal and tax implications.
As investments get physically larger the layers of complexity grow and the interconnected, intertwined and interdependent issues multiply at a rather amazing rate. Everything from taxes to lease termination dates begin to play on other parts of the property. If a tenant moves out before the end of their lease that has a ripple effect and the cleanup can take weeks before you’re able to release the space and even when you do it will likely cost you money as, generally, no two tenants want their spaces laid out the same way. Nevermind the legal time and cost to pursue the tenant and on and on.
Around this sized property is where you see people begin to shift their view to it being an investment, not necessarily a project. This is the level where a large segment of those putting up money for projects and deals has no interest in managing or in many cases even seeing the property. This is an important underlying pressure that should be well understood. Answering to investors about why their returns were down this month is a whole other animal and one that can ruin an otherwise excellent deal.
As well lending changes, substantially, at this level. While banks still make up a fair portion of the leverage here there are multiple other sources that come into play. Including life insurance companies that have ample funding to place on a regular basis and prefer larger assets for their stability. The details of lending at this level also take on a rather amazing volume and understanding all of the lenders requirements can be critical as everyone wrestles for the best position in the investment. Most lenders don’t necessarily want to find ways to take the property over should you have trouble but they will have reams of requirements to insure that their investment in the property is protected. These can include monthly or quarterly reviews of the books to keep track of the solvency of the operations.
Again this is where you see entire companies dedicated to managing properties with individuals specializing in things like just managing the lenders needs and expectations. Specialization becomes required as it all becomes that much more complex.
Investors in this upper size range will likely have decided to specialize in one particular product type. Given all the detail work required and the nuance of each property type at this level it is unusual for an investor to cross products in their portfolio. Unless, they have a large enough operation to have built the support to manage each type. Typically seen only towards the upper end of this range.
Towards the upper end of this range you will begin to bump into the institutional investors. This highly efficient and well funded group plays by metrics that the average commercial property investor cannot compete with. Many times formed under the acronym REIT, or Real Estate Investment Trust, these are typically large portfolio buyers and owners with hundreds of employees spread around the country. In general these companies do not require leverage to acquire properties, as they’re placing investor capital, and their financial modeling is some of the most sophisticated and intense you will ever see. They generally know where every penny goes and have it’s path mapped since they are beholden to regulators who like to ensure there’s no funny business going on. Unless you have a unique angle or very deep pockets and a penchant for very low cap rates competing for deals with institutional buyers is not something I recommend. They’re generally amortizing returns over an enormous portfolio of properties and thus can stomach some rather absurd cap rate deals that do not look to be worth it.
The Portfolio – Go Big and then Go Bigger:
Reserved for the institutional and the manically driven the level of owning large numbers of larger properties is a beast unto itself. Investors at this level typically have large companies in support and most will never set foot in the majority of their properties. Typically single product type focused these companies, like REITs, are focused and diligent on the details. Shopping center owners and office park owners live here and when the go looking for a lender they look to the likes of sovereign wealth funds and large state retirement funds. This adds yet another level of complexity to ownership with full teams assigned to lender management.
If you ever get the opportunity to visit and tour an operation like this take it. Even if it’s self storage or industrial and you care little for the product. At this level it’s just a huge company whose product happens to be space. The operations will look familiar but astronomically more complex.
At the root though it’s still just owning a property and leasing out the space.
Short Advice on Real Estate and Life
“Don’t wait to buy real estate. Buy real estate and wait.”— Will Rogers
“If you think hiring a professional is expensive, wait until you hire an amateur.” – Red Adair
“Entrepreneurship is living a few years of your life like most people won’t, so that you can spend the rest of your life like most people can’t.”―Anonymous
“Landlords grow rich in their sleep.”―John Stuart Mill
“Buildings don’t move, but neighborhoods change all the time.”―Anonymous
There are developments that fit into a specific area, think Market City Center in downtown Chattanooga (https://marketcitycenter.com/) and then there are developments that literally remake cities. The Red Wolves soccer stadium and development in East Ridge is just such a project. This immense effort to bring professional soccer to the city is transforming the quiet strip of East Ridge from a suburban city in Chattanooga’s shadow to a destination all its own.
With the goal of building what amounts to an entire downtown core centered around a brand new, state of the art, soccer stadium this $125m project is an immense undertaking and unchallenged as being the largest development ever to happen in East Ridge. You could call it audacious but this is not the first time the developer, Bob Martino, has done this. His first version of this idea is already rocking in Salt Lake City. A great omen for the success of this project.
East Ridge is also digging in and leveraging this project combined with the fast unfolding Camp Jordan, just across Hwy 75, to market the city as the premier location for sporting and active people.
Taking a closer look at the Red Wolves project there are a number of points worthy of note. First, just from a site selection position the placement of the entire development looks to be absolutely ideal. At the intersection of Hwys 24 and 75 with interchanges to both very proximate which will provide unparalleled access.
Second, looking closer at the initial site plan provided by ASA Engineering, the overall layout and orientation of the site appears to integrate well with the existing neighborhoods. This is always a concern as lack of integration can cause areas around major attractions to actually go down in value following development. The integration as well as the addition of a pseudo downtown to the development should prove a boon to the adjacent residential areas.
Lastly, as just noted, the integration of a downtown like area including apartments should prove the lynch pin that is missing in many stadium projects. Developing just a stadium, without any supporting urban fabric, is a guarantee of a dead spot in a city. Stadiums themselves are much like churches and graveyards, they’re used one day a week for maybe a couple hours and the rest of the time lie dormant. Creating the area around a stadium to be a full time lifestyle project means the stadium activities will be a bonus on top of the pedestrian centric area.
Naturally there are many steps to go through in the next three to five years as the project is built out and missteps are to be expected. However, looking at the project from here I’d say it’s going to be a pretty solid win for the developer, the team and the city. We could use more projects like this.
“If you find yourself in a fair fight, you didn’t plan your mission properly.”
– Colonel David Hackworth
Let’s begin this post by laying out that there is no such thing as a level playing field. Someone always has an advantage. Whether it’s information, capital, experience, motivation or even patience everyone has a different base and set of criteria they’re working with.
Now let’s get into the world of incentives and their effect on development.
Collins English Dictionary defines tax incentives as : “A tax incentive is a government measure that is intended to encourage individuals and businesses to spend money or to save money by reducing the amount of tax that they have to pay.”
Not all incentives are tax based but the definition helps to set the stage for how incentives work. They’re used to encourage specific activities desired by those providing the incentive.
Cities use them to overcome real or perceived obstacles to entice developers to build specific buildings in a desired area. Chattanooga used tax incentives to draw developers to start building residential units in the downtown core. With 6000 units built in five years and at least 2000 more in process I’d say those were successful. Would residential have been developed without those tax breaks? Very likely yes but at a different timeline and without the focus provided by what is a pseudo public / private partnership.
So are they fair? In a word, no but that’s not the goal, nor is it a cities obligation to be fair. Cities, ideally, are interested in the best possible outcome for everyone. Obviously there are plenty of stories of incentives being taken advantage of by less than scrupulous individuals but our point here is not to address criminals. So, cities are able to bend the rules in order to get something they want.
Incentives are used extensively in affordable housing development. Affordable housing projects are notoriously difficult to make a return on investment – without incentives. The forced cap on income limits the viability and interest from developers. There is a small subset of developers, however, who have been able to build up a very good business focusing on affordable housing by mastering the incentives, both federal and local, that can be leveraged to finance a project.
So, as you look around a city and see all the distinct elements that have come together realize that some things have been given a little nudge in order to be built the way they are. It all goes into making up the cities we live in and shape the world around us.
Short advice on real estate and life
are those frightful things you see when you take your eyes off the
goal. – Henry Ford
because you’re being taught a lesson doesn’t mean your learning.
– M.D. McKee
and invention are inseparable twins. – Anonymous
“Real estate cannot be lost or stolen, nor can it be carried away. Purchased with common sense, paid for in full, and managed with reasonable care, it is about the safest investment in the world.” – Franklin D. Roosevelt
“In any market, in any country, there are developers who make money. So I say all of this doom and gloom, but there will always be people who make money, because people always want homes.” – Sarah Beeny
Or why a winning market can be a losing proposition.
Bloomberg Businessweek’s latest issue (Oct 28th) has a very interesting national map of average home price, by county, compared to median income around the country. Noting in the opening “Home prices in the US are up 25% in five years, according to the S&P CoreLogic Case-Shiller index”. It also details which states have the ability to implement rent control and details on a few cities that have already implemented rent control. This brought up for me all the issues that arise as a market heats up. Those things that make it harder to buy and sell and less attractive to be in the countries hottest markets.
Keeping it ‘Affordable’
From a tenants perspective rent control seems rather like a nice idea. Limiting the increases in rents can help keep the cost of living more in line with incomes in expensive communities. From the investment perspective rent control can have a chilling effect on investment and development.
Consider that the value of investment multifamily is directly linked to the income generated from the property and in rent controlled cities the municipality is saying “you cannot raise the rent”. The byproduct of which, in theory, is to keep a lid on the valuations of those same properties. Another stark result of rent control is the chilling effect on investment and development of new multifamily properties. This type of economic subsidy has the perverse effect of keeping housing stock low and thus rents high. It also reduces the number of investors willing to consider acquiring an asset in a rent controlled city thus reducing the market demand for these assets.
“Sure I’ll Sell my Property…”
Another, more hidden, issue that arises in hot markets is that there just isn’t much that is available to buy. When markets heat up, prices go up and as owners we all enjoy that, but the availability of properties goes down. Towards the peak of hot markets it can be hard to find anything even listed for sale. This has a chilling effect on the volume of transactions.
Keep in mind that the system of commercial real estate ownership is structured in such a way that once you have equity in a property and decide to sell you are going to want to exchange your equity from that initial property into another, via the 1031 exchange process, to avoid taxes. This, by its very nature, requires you to exchange into a more expensive property, which when the market has ample options can look like a good idea. You can trade up to a larger, better cash flowing property.
The difficulty arises when the market has few options that merit consideration. This then puts the brakes on an owners willingness to sell as they are aware that finding replacement properties is unlikely. This can, in time, cause a slowdown in the market as exchange buyers are sidelined, leaving only those cash rich buyers able to participate.
This kind of market necessarily benefits the likes of private equity investors who are not tied to disposition in order to purchase. This change in the makeup of the buyers can also push pricing well out of reach of local investors. A well capitalized private equity fund that is looking to buy up nice assets will, undoubtedly, have a wider price target and deeper pockets than just about any local buyer. This pushes prices up even further and keeps local buyers waiting for a correction. A natural part of the cycle but not a fun one if you are looking to sell your 5,000sf strip mall and buy into a 10,000sf one.
This is a very insidious side effect that is currently taking shape in many western markets (CO; UT; etc) and has already affected nearly $20m in transactions for me personally. I can only imagine the ripple effect. Factoring that my deals would have yielded four direct transactions and likely at least that many again for those buyers and sellers on the other side of these deals. I know that at least one of the buyers was an exchange out of another sale where their buyer was an exchange buyer. It’s easy to get lost in a weird mirror world with a long chain of contingent exchange deals.
Keep in mind that on a macro level this is just money moving around and none of it is new money coming into the market. An economist likely would say this is an indicator of some type. I would simply speculate that it is another indicator of markets that have peaked.
The silver lining to this, at least initially, is that smaller buyers are forced into considering less than desirable assets and how they can be upgraded to increase their value. Included in this effort is the repositioning of dated office buildings and old industrial sites into residential, which from a city’s perspective is a boon.
Hot markets also have an effect on the buildings being developed. As prices rise they’re not usually uniform, meaning ground prices can rise faster than finished buildings. This discord (along with labor and materials costs) can have a rather ‘ugly’ effect on development.
Look closely at any hot market and you will see the phenomenon of newer buildings using every last square foot allowed by code as leasable / saleable space. This happens in response to high ground prices in relation to the finished market price for a given space. We can call it ‘squeezing’, since the developer is trying to ‘squeeze’ every last dime out of a building site. This type of building has the serious side effect of creating large and architecturally repulsive boxes. Places that have maximal saleable space and minimal aesthetic value.
The precedent set by these projects can have long lasting effects on a city as well since these buildings contribute to the overall feel and sense of place created in a city. Canyons of crappy boxes do not make a place anyone wants to spend much time.
And Then What…
What is being seen in many of the markets that have experienced incredible price growth in the past decade (San Francisco; SLC; NYC; Boulder; Denver; etc) is a strange decoupling of the financial preconceptions underpinning commercial real estate as an investment.
There is a point, financially, where an investment doesn’t make sense. Typically each individual investor determines their desired return and focuses on securing assets that deliver that return. In hot markets the prices are shoved upwards and it is not unusual to see capitalization rates of 3% and lower. I have worked on a number of deals where the actual cap rate was negative. Meaning it was going to cost the buyer money every month to acquire the property. So why would an investor buy such an asset?
In short, these investors want into a market so badly that they decide that other factors are of greater importance than the property acting as a cash flowing asset. There can be outsized appreciation in a particular market that, when considered over the holding period of a property, can offset a lack of cash flow. For instance if a market is blasting along and producing 10%+ appreciation year over year and the property is only producing 1% cash flow, an investor can justify it saying they’ll get they’re value at sale. If rents are rising at a similar clip a buyer can bet on the future cash flow. It is a bet and is very reliant upon an investors time horizon.
There are also those individuals and companies who are no longer looking at commercial property as an investment but are looking for a trophy. Every city has these buyers / owners and they typically retain the most visible properties in a given market. They do not care much what the cash flow is or will be. They want to be able to say to people: “That is my building”. These buyers can make a mess of markets when the proportion of them becomes dominant. Because they are not tied to economic drivers in pricing their buildings they will typically trade at prices where there is zero investment value for a buyer. From one ego to another.
Who is Actually Making Money Then:
Value-add investors are the ones making money in these markets. Those with creativity, backing and a taste for risk who are able to consider what a particular property could be and then make it happen. The most successful of these are developers with a strong financial grounding. The margins are very thin and these types are able to carve out profits in places the typical investor doesn’t even look. Can there be another two stories of residential added to a particular building; can you take an old transfer building and make it into a food hall. These are the types of value add that are yielding returns.
Not a path for the faint of heart as investors of this ilk are able to buy properties at market prices and add enough value that when they sell they make a healthy return. If they bet wrong they’re likely filing for bankruptcy as the numbers are substantial and the pressure intense.
Hot or Not
Hot markets can be great for making money, if you’re in the right place with the right tools at the right time. They can also be infuriating when things do not work. Understanding that, just because a part of a market is rocketing along doesn’t mean you’ll be able to grab a piece of it is critical. You will miss more waves than you ever catch.
Short Advice on Real Estate and Life
Cash is King
If you want to know your worth in this world make a list of the people who will starve when you die – Anonymous
All human knowledge is uncertain, inexact and partial. – Bertrand Russell
No one ever washed a rental car…(Ownership is critical) – Anonymous
Always take the high road. It’s far less crowded. – Warren Buffett