So, in the more than three weeks of changing the way we do things we have changed everything, forever. The worldwide lockdown may prove one of the most interesting sociological experiments ever undertaken and in time will yield some very interesting revelations. For now we can stick to what we know about humans. We are creatures of habit. We like consistency, it allows us to plan, to remove the unknown and to feel like we have some agency in our lives. For the sake of brevity we won’t dive into these at any depth, it’s enough just to understand the ways we work and how those ways have been inexorably disrupted.
In mid-April I was talking with a good friend who is a broker in New York City and he expressed how much he just wanted to get “back to normal.” To “get business rolling again.” Here’s the thing: business didn’t stop. It changed dramatically but it didn’t stop. If you review the closed transactions from all over the country you will see many deals that closed (sales and leases) during the lockdown. Is it fewer than “normal” sure but just because you find yourself standing around with nothing to do doesn’t mean the industry has stopped. It means it changed and left you on the side. Will it come back and pick up again? Maybe, maybe not. Either way it’s not about the hand you’re dealt but how you play it that makes all the difference.
Every generation that offers wisdom to the next generation in this business will tell you that the ‘easy money’ was “all made twenty years ago.” This is a cute way of expressing the idea that things changed and the older generation did not change with it. It was ‘easy’ because it was well understood. The new generation has it ‘harder’ because the older generation does not fully grasp how it works.
This idea is critical because the shift we are going through right now is going to inexorably change the way commercial real estate looks and acts. Offices cannot operate as before with the old metrics of a certain number of people per square foot; retail has been shattered and will take decades to recover anything that even looks like the way it was in December; even industrial has had to modify its methods and requirements in the face of the virus.
All of these changes ripple through every part of the industry. Changing the financing; the way contractors are building out spaces; how properties are valued and of course changing how commercial real estate is transacted.
Consider that for a period of time during the lockdown there was no way to meet with a notary to validate a signature in order to close a deal. That’ll throw a little wrench in things. You couldn’t notarize a sales contract on Zoom. Inside of two weeks a solution was devised and now it is possible to remotely notarize documents. Changes like this, large and small, are rippling through the industry and the winners will be the ones who can adapt quickly. All of the changes are not temporary or reversible they’re the way business is now being done, the new normal.
We don’t like change. It forces us to adapt to modify things. To learn a new way. To look at our business differently. The new normal is change. The volatility we are seeing and will see in the coming months and years will have many people pulling their hair out and throwing in the towel. There are piles of loans on commercial properties that have already been put into workout programs. There will be many, many more. That same volatility provides the opportunity. It just doesn’t look the same as it did six months ago.
On the face of it brokers who focus on residential and those who focus on commercial properties do basically the same thing, right? So, why would a broker specialize in one or the other? Or as a buyer why pick one over the other?
While it is true that both types of brokers do basically the same thing, sell property, the similarities literally end there. The market, transaction process and consumer demands of commercial and residential real estate dictate significantly different education, experience and temperament.
For this discussion I will set aside smaller communities, generally well under 100,000 people, where there simply is not enough commercial property to justify specialization and the majority of brokers will do both categories.
Let’s begin by looking at the differences between residential and commercial properties which can help provide insight as to why specialization might be a good thing.
Residential real estate is generally limited to single family homes, duplexes, triplexes and fourplexes. These properties all share the primary function of being places where people live. The buyers are largely the primary occupant of whatever building is being purchased. While there are investors that specialize in residential properties they represent a small percentage of the overall transactions and in many cases are brokers themselves.
Commercial real estate includes larger apartment buildings (4 + units); retail properties; office properties; industrial and self storage properties. All of these, except apartment buildings, are built and maintained as the primary location for businesses of one type or another. Most will rarely see anyone living in them unless there is a repurposing (industrial to apartments, etc). Apartments being the exception, however, even here you will never see the owner of the apartment building actually living at the property.
This difference, Residential being where you live and Commercial being where you work, cannot be overstated. People think very differently about their homes than they do about their workspaces. This difference shapes the brokers that specialize in each discipline.
Residential brokers by and large are focused on the visual appeal of a property; the kitchen & bath layout; interior design and materials. generally looking to answer the question: ” would I like to live here.” Buyers typically spend less than fifteen minutes walking through a home before making a decision as to whether they want to buy it. In general residential buyers – and brokers – will not even turn on a sink to see if there is actually water running at the home.
Commercial brokers are focused on the functionality of a particular property, both physical and financial, above all else. Generally looking to answer the question: “will this work for my business or investment goals.” Buyers in commercial deals will generally do an initial evaluation of a property to determine viability before even setting foot in it. For business viability everything from local zoning to the size of the water tap can be reviewed to determine if the property could be a fit. When considering a property for investment most investors will add into their initial evaluation at least a rudimentary financial analysis if not a complete financial model to determine viability.
Even More Specialization
In larger cities, above ~200,000 people, you will find brokers that actually specialize in a specific type of commercial property. For instance, brokers who make their entire career mastering the details of only industrial properties in their markets. These specialists are invaluable to the market as their understanding of the unique details of a particular subtype of real estate can prove a requirement for success.
In most larger cities you can find brokers going even a step further in specialization, focusing completely on one particular niche of a type of property. Restaurants, for example, will generally have at least one brokerage firm that specializes in just doing leasing and sales of restaurant properties. Again the value of this kind of focused broker to sourcing the best spot for a restaurant can make an enormous difference to the businesses.
Conversely in residential you only occasionally come across firms that specialize in a particular product, condos for instance. However, it is far more typical for firms to specialize, if at all, along financial lines. Focusing on properties under $1,000,000 for example or above $2m. This specialization is generally driven more by the particular market demographics. If there is enough transactional volume to make a good living you will begin to see specialization.
Due diligence in residential is typically limited to less than 45 days in duration with the majority of this time eaten up by financing. Most buyers will have a physical inspection of a property completed by a professional inspector to ensure all systems are actually in working order. These inspections cover all aspects of the property and generally take two to four hours depending on the size and complexity of the property. Costing between $300 and $600 these reports are typically the first – and only – time most homebuyers will look ‘under the hood’ at their property. The due diligence period is also typically the only other time in the entire process where a buyer will revisit the property before closing. While in certain areas it may be recommended for buyers to perform specialized inspections, sewer scoping for instance, it is unusual to see much beyond the basic physical inspection. Most residential transactions will incur no more than $1,000 in total for any due diligence inspections.
The majority of this process is coordinated by the broker. Most will have a goto home inspection service and even know specialists for things like sewer should that be required. In some situations brokers and buyers will use inspections to come up with price reduction requests. Noting something found in an inspection a broker will request a price reduction or credit equal to the cost of repairing the noted item.
Commercial due diligence generally takes far longer than residential. The shortest is usually 60 days and it is not unheard of to see due diligence periods extend for more than six months. While there are complete commercial property inspectors, running in excess of $5,000 to evaluate a property, it is far more typical for a buyer to hire multiple specialists to evaluate specific items. Foundations for example would require a specialist to fully determine the current condition and give a buyer a detailed report on that one part of a property. It is not unusual to complete a dozen specific inspections during a due diligence period in commercial. From a survey to an environmental evaluation (Phase I) to determine any contamination. Each of these can cost thousands and take weeks to complete. Some, like a Phase II Environmental Inspection, even require drilling and taking core samples which adds an entire level of complexity to the negotiations. It is not unusual to see a commercial property buyer spend $25,000 in due diligence inspections and reviewing a potential purchase. Larger buyers and investors have entire on staff teams of people that just do pre purchase due diligence.
One very distinct difference in the Due Diligence period between Residential and Commercial is the extensive use of legal council in the commercial process. It is rare to see a buyer have a contract or additional docs reviewed by a lawyer, let alone have one at closing to ensure everything is accounted for. In Commercial, however, it would be a big red flag if a buyer did not have a lawyer involved from quite early all the way through the process.
Most Commercial buyers will have a goto lawyer they use for all legal issues related to their properties. Lease review, title review, contract review, contractor agreement review, survey review, etc. It is not unusual to see legal bills well into five figures just for buying a property.
While a broker may not be coordinating all of these inspectors and evaluations during the Due Diligence period they must track each one and fully understand the nuance of the results and how they will affect the deal.
In general in Residential transactions unless an inspection comes back with some big red flags there’s little further negotiation to be done and the deal will move to closing as soon as financing has completed.
Commercial can see the results of Due Diligence force a contract extension for either further inspection (Environmental Phase II) or remediation of various conditions (non functional sprinkler system) the seller would be obligated to repair regardless of the sale. These extensions can add months to a contract to complete everything.
The broker can in many cases be an invaluable shepherd in this process to guide the buyer and seller successfully through all the twists and turns to the closing.
Getting to Closing
With all the added complexity of Commercial transactions it is unusual to see any single broker working on more than three or four deals at once. Each one may look and feel completely different with differences in financing, contract terms and just about everything else. As I was told early in my career: “Everything in Commercial is Negotiable” and there are plenty of buyers and sellers that relish negotiating every little detail. You can literally be selling identical buildings and the contracts will look nothing like each other.
Conversely in Residential it is not unusual for a busy broker to close 40 houses in a year. Closing one a week or more. This is possible because so much has been streamlined and simplified already. From the ease of financing (thank you Fannie and Freddy) to the substantially shorter contract periods it becomes very possible to crank through a number of properties.
Interestingly in most states in the US both Commercial and Residential brokers are required to go through the same licensure training and testing. Seeing the dramatic difference in complexity this is a bit hard to understand but there it is. The day after I got my license my manager looked at me and said: “You can forget all that. Now we can teach you commercial.”
Short Advice on Real Estate and Life
“I will tell you how to become rich. Be fearful when others are greedy. Be greedy when others are fearful.”
“There is only one way to avoid criticism: Do nothing, say nothing, and be nothing.”
“Never forget the power of silence, that massively disconcerting pause which goes on and on and may last induce an opponent to babble and backtrack nervously.”
“Diplomacy is the art of letting someone else have your way.”
―Sir David Frost
“Allow other people to speak first; the important factor is not who talks… it’s who listens.”
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
We often talk about how to buy and sell, how to evaluate a particular property or find the best site for a business, but let’s pause for a moment and consider how the built environment affects us. There are both obvious cause and effect elements and more subtle situations that shape how we think and act without us even realizing it.
“Architecture is like a soundtrack that we’re not even fully aware is playing. It sends us subconscious messages about how to feel and what to expect.”
– Architect John Cary
From the micro environment of the way a particular office is laid out to the macro view of how a city’s streets are oriented, the effects on us are continuous and not always obvious.
There are the obvious conditions we can all observe and note the immediate effect, such as air quality, light, green space, water quality, safety and mobility, and there are the not so obvious conditions of things like blank walls, multiple lanes of traffic, high speeds and pedestrian crosswalks.
All of these (and many more) contribute to the ‘feel’ of a city. How does it feel to be in a city, to walk down its streets, to go about day to day errands and to enjoy an evening out.
The better it ‘feels’ the more time you will spend, the more time you spend, the more money you spend and the more you will identify and feel at home. The converse is also true. We have all driven through areas, and even entire cities, where we saw nothing that would entice us out of our cars. Nothing that made us want to stop but more often places that made us want to hurry up and get past.
There is an entire language around architecture and planning that is required learning for all nascent designers, however, thorough training in the application of this language seems to have been neglected. We all know good architecture when we see it. We know good spaces when we are in them. We may not even be conscious of it, but after leaving, realize that we relaxed in those spaces.
“We shape our buildings, and afterwards our buildings shape us.”
– Winston Churchill
Let’s start with where many people are headed when they get into their cars in the morning, the office:
The average American spends more than 90% of their life indoors or roughly 21 out of every 24 hours. The kicker is that many spend the remaining 3hrs a day in their cars but that’s another topic. For now we can look a little closer at these spaces where most of us spend the majority of our lives.
Just looking at the above photo will evoke a feeling for most people. Not that we can put our finger on all of the specific elements that we find distasteful but we all come away with a feeling of dread and anxiety when considering day after day in such a place.
It’s even difficult to list all of the obvious issues in this all too typical office environment: no natural light, no air circulation, ambient noise level, lack of personal space, beige everywhere, fluorescent lights, constant visual distraction and on and on.
All of these elements present workers with an environment rife with distraction; where getting up and going to the bathroom is the only way to find a quiet moment alone. Interestingly, this typical office layout was rebranded as the ‘open office’ in the late 90’s and early 2000’s and had some color added:
Spending more than 40 hours, almost 1/4 of our lives per week, in such an environment is going to have an effect. An effect we are still just beginning to understand.
Let’s move on to the next most popular place for people to gather in an average week: the road. A typical road is designed to move as many cars as quickly as possible from place to place.
“The line of traffic advancing towards the rising sun looked like a procession of the returning dead. Every one of them, solitaries in clean shirts, smoking, checking mirrors to see if their reflections were still there, wore dark glasses.”
― Iain Sinclair
These roads are not designed for you to spend any time in the surrounding area. Get along. Don’t linger. Piles of signs vying for your attention at 50 mph (no one is going the speed limit). The average American will spend more than three hours per week in this kind of an environment; doing battle to get errands done. The effect is substantial and not considered by those designing these wastelands.
These roads by their very nature create a sense of impatience in drivers that elevates anxiety and fosters everyone’s favorite disembodied state: road rage. The key is understanding that everything experienced on roads and areas is undesirable, if not repellent. So, our unconscious reaction is to hurry, to push to get through it and away from it. Someone pulling out of a drive that forces us to even dab the brakes can send most people into a state of rage.
Next let’s look at the typical American home, the suburban dream. While there’s been plenty of discussion and articles talking about everyone moving to the cities, do not be fooled by the vision of everyone living in high rise condos or brownstones on leafy, tree lined streets. Cities quickly expand their borders to include as much land as they want, generally called sprawl. The vast majority of this sprawl is made up of a startlingly repetitive model of endless three bedroom three bath boxes with names like “The Kitridge” or “Country Rambler”. Names trying hard to draw the perfect home picture and not let you look too closely at what six months ago was a cow field.
“Dollar for dollar, no other society approaches the United States in terms of the number of square feet per person, the number of baths per bedroom, the number of appliances in the kitchen, the quality of the climate control, and the convenience of the garage.”
– Andres Duany
The average American home has more than doubled in size in the last fifty years and is now closing in on 3,000 square feet. Larger than many barns. The reasons behind this are legion, but we will maintain our focus on the design effect this has on people. When your home is larger, nicer and everything can be delivered to you, why would you leave this cocoon? More and more people are choosing not to. Remote work, home based businesses, flex time, all of these save us the stress of venturing out into the world.
When you do have to leave the safety of the home, we are immediately confronted with a maze of streets and byways that would make a lab rat retreat. The unnecessary complexity of these neighborhoods can precipitate anxiety even before reaching the ‘feeder’ roads that take us to work or the mall.
If it’s such a chore to simply get out of your neighborhood, it becomes a brake to action, to human interaction and can have substantial detrimental effects. The social ramifications of this type of cul de sac environment are finally being understood and many are pushing back against it, but the vast majority still view this as their ultimate badge of success. The American Dream.
Lastly, let’s look at the design implications in downtowns and how good design can make a place ‘feel’ better. From a design perspective we’re looking to answer the simple question, “is there a ‘There’ there?” Is there a reason to be there? Not a business reason, but one that draws you in and makes you want to spend time, even live there.
“[Cities] are not like suburbs, only denser. They differ from towns and suburbs in basic ways, and one of these is that cities are, by definition, full of strangers.”
― Jane Jacobs
As we did above let’s start with some examples of when cities fail the people who live in them.
Houston is widely and roundly derided as one of the ugliest cities in the world. It suffers from a substantial and growing poor and homeless population, as well as a complete lack of formal zoning regulations. For all the difficulty developers struggle through in order to abide by zoning in most cities, Houston is a postcard from the other side of what can happen with a complete abdication of civic input into its built environment.
Zoning in many downtowns is necessarily more complex than outer regions of a city; following the idea that greater care and focus needs to be taken when more people are packed into smaller spaces. Does this make building more complex and expensive? Certainly. But this additional scrutiny will, hopefully, provide a better outcome for the city as a whole.
So how does a lack of civic direction affect the feel or attractiveness of a downtown? Much in the same way as was noted previously, but in a far more concentrated way. Fundamentally, zoning is the municipal way to say to the rest of the world, “we have a vision for how we want the city to grow and how we do not want it to grow.” They are directives about how big a building you can build and where on your property you can build it. Without this, or any substitute, a city is simply abdicating it’s vision of itself to the market. This is a prescription for a race to the bottom and Houston sits a proof of this failure in management.
“Listening to mayor after mayor and how they explained their idea of a successful city, it became very clear that both the best measure of a thriving place and perhaps the best contributor to a thriving place was street life: walkability.”
– Jeff Speck
The elements of what makes a city like Houston ‘feel’ awful generally boil down to a fairly straightforward idea: has the city been built with people in mind or as a factory? When cities are built for people, they attract and retain people. Conversely, when they are built as factories, they repel people. Much like the picture of the office space above, people may put up with it in trade for money, but they will not spend a moment of additional time there. Successful cities provide so much that you neither need, nor want to leave them.
As you look around at a city, take note of what you see and ask, “was this built for people or machines (cars, etc)?” You will quickly see the specific elements of great cities: wide sidewalks, tree lined streets, traffic calming, benches you’d actually sit on, clusters of small interesting shops, but most importantly, you will see other people.
As humans we enjoy places that make us feel good. Places that feel safe and welcoming. While there is an entire language for the creation of these spaces, most of us simply say we like a place without understanding the elements that make it up. Most people, frankly, do not need to learn this language, but for designers, builders and developers it should be mandatory. These are the people creating our cities, towns and homes and allowing all of it to be built to the most ‘cost effective’ option. Developing in this way creates places no one wants to be.
There are some excellent sources to further your understanding of how the built environment shapes us. Here are just a few (Disclosure: I am an Amazon Affiliate and if you buy from the links below I will make millions and retire to Boca):
I noted that there is an entire language around building that should be compulsory for all who build and the dictionary for that language is Christopher Alexander et al’s tome ‘A Pattern Language’. This is a reference book not an armchair read (except for the seriously nerdy among us) but it is an invaluable addition to understanding why some places work and others fail.
From the unapologetic urbanist Andres Duany comes the seminal work on what has gone wrong in American cities in the past fifty years and more importantly how to fix it: ‘Suburban Nation’.
Also, from Duany is ‘The Smart Growth Manual’ which is a handy reference for understanding the principles for smart growth and lays them out in a simple reference format. Each principle is given a page with an example image and detailed text outlining the goal of the principle.
From one of Duany’s co-authors on Suburban Nation and the Smart Growth Manual, Jeff Speck brings us the ‘Walkable City’, which is a great read on how cities in the US can work to improve their citizens experience by focusing on the principles of walkability.
Moving away from the urban planning vein, the cognitive neuroscientist Colin Ellard’s excellent book ‘Places of the Heart’ takes an indepth look at how the places we occupy affect us and shape our thinking. A fascinating and dense read, I highly recommend this book if you are looking to get deep into the relationship of humans to their built environment.
I’m not even sure where to start. It’s an office building. It’s literally the cheapest thing you an build. It is utterly devoid of any aesthetic value. It looks like a prison. Really? You think people will want to live here? Are you high? Who let this crap get through.
For ‘The Edge’ apartment building they added some paint and variable skin to this but it’s still about as interesting as a block of concrete. This is an utter waste and creates an awful experience for the entire area. Walking by these huge blank faces is cold and repulsive. Not even awnings. Absolutely no street value.
Yes there are constraints and restrictions and requirements. Just like every other city on the planet. So, why exactly is this worthless garbage being built? I would venture that it’s what happens when apartments are built to a ‘bottom line’ on a proforma rather than being built to perform for the residents and the city. With the market for apartment buildings being so overblown nationally these will endure for quite a while with little to no further investment. Meaning we will be looking at these blank, featureless prison faces for the next twenty or more years.
Here are a couple examples of apartments that could have been built instead of this cheap crap:
None of these are difficult from a building standpoint and they bring the entire area around them up in aesthetic value. They’re additive.
Enough with the ‘bottom line building’. With 6000 + units being built in the last five years it’s time for Chattanooga to lead the charge and push projects of actual civic value. We have beds now we need vision.
Unique buildings have always commanded a premium. So the money excuse is a weak one. So, who is going to step up and actually give us something to be proud of. Something the rest of the country will see and say ‘WOW!’ Look at what they’re doing in Chattanooga. Something that will add value to the city rather than just using our infrastructure to enrich the owners.
If you’ve walked down Frazier in the last couple years you’ve likely seen the shell of the building just of Market next to Locals Only and wondered what they’re going to do with it. Well, the rumors were right and it’s going to be retail and condos.
The Times is reporting that the units will be priced from under $500,000 to $1,200,000 and that parking has yet to be sorted out but will not be garaged. Provided they can sell all the units the developer should do alright as they bought the property in 2014 for ~$1,030,000. Add in five years of carrying costs and that’ll take a bite out of profits.
The North Shore is certainly doing a nice job of producing smaller projects. Projects of a scale that seem to fit more in the area. At least at the moment. I am aware of at least three projects in the rumor or planning phase that are looking to have more than 150 units each but they’re all at least a year or two away.
The smaller, boutique, projects can provide an excellent counterpoint to the larger ones and in my experience tend to draw higher prices and a sense of exclusivity, provided they’re done well.