Equity Based Services, Inc

Commercial Real Estate can be grossly categorized into the following types- Cash Flow, Value Add/Opportunity, and Appreciative Speculation.

I would argue that the last year or two have been a bad time to invest in Appreciative Speculation. In other words, making real estate investments in hopes that the value will appreciate for no other reason than an expanding market.

It’s arguable whether this type of speculation makes sense today, as we have seen a pull back in prices in most real estate classes, especially in the housing market. The question of the day… How do you know when you’ve hit bottom?

I would argue that the best indication of a bottom in the real estate market is when end users start buying again. In other words, non-speculators. The glut we saw in inventories was partly related to what I call the “me too!”s. Investors that saw a lot of money being made in flipping, or speculating in real estate markets. People that built or bought at an ever increasing fervor with the belief that everything would continue going up… Speculators sold to speculators. There was a mass hysteria of thinking that the only thing that you needed to add value in real estate was time.

Clearly, this was not always true. There was a lot more inventory than end users. We are still seeing the pains of slow absorption in overbuilt markets as well as an obvious absence of buyers.

What I am saying is this- once the inventory starts to predominantly trade to end users, and not speculators, this will be a sign of recovery. Once the recovery stabilizes, it will once again be a good time for speculators.

Clearly, this is a simplification on what’s going on in the real estate markets and doesn’t take into account all of the other variables such as consumer confidence, joblessness, debt markets, etc. But, if you lasso all of the issues together, I still believe, the bottom will be best indicated when end users/home owners/owner-operators start moving back into the market. Then, of course, the time will be ripe for speculation.

Cash Flow Investments

At EBS, we have always liked Cash Flow real estate. It is not dependant on fluctuations in real estate values. If there is a cash flow business running on top of your real estate, and the fundamentals are strong with that business, the only time that you would care about the value of the underlying dirt is if you needed to liquidate or cash out.

Self Storage is a strong cash producer. The business on top of the real estate makes sense in both up and down economies. So, even if there is a recession in real estate prices, cash flow will usually not see much change.

In times of irrational exuberance, there isn’t as much interest in cash flow investments. In the fury of the tech bubble, investors were speculating hugely, and for the most part, making lots of money buying and selling stocks in companies that would NEVER PAY A DIVIDEND! This is an interesting point to me… Raw speculation at its best. A giant ponzi scheme where the only intrinsic value was the ability to sell something to someone else for more than you bought it for.

In those days, it wasn’t as easy to sell someone on the idea of a cash flow real estate deal that payed a tax sheltered 8%/year cash on cash return.

Today, with interest rates at or near all-time lows, with mass uncertainty in the stock markets, with banks going bankrupt, with retirement portfolios worth half of what they were last year… an 8% cash on cash return looks pretty nice.

In Self Storage, most stabilized facilities trade at a CAP rate between 7-8.5%. You will see some deviation depending on local markets, but, that’s a pretty good range for sake of discussion. What this means is that you can buy a facility, leverage 70-75% of it. After paying its debt service, expenses, payroll, taxes, insurance, etc… This investment will pay, usually in monthly payments, somewhere in the neighborhood of 8% returns on the entire capital outlay… So, a $100,000 investment will pay a tax sheltered $8,000 per year. That’s nearly an order of magnitude more than you would expect in your passbook savings account today. Not even taking into account that the 2% interest that you may be making in a savings account is taxed as ordinary income…

As the economy improves, the cash flow will improve, and, the value of the underlying real estate will appreciate. But, even if this is a slow process… it’s nice to have cash flow checks coming in every month…

Obviously, these are strong cash flow investments for investors looking for fixed income deals. So, what about those of us who are more interested in opportunities and Value Add plays?

The Value Add Investment

Typically, a Value Add real estate investment will involve a deep discount on the stabilized value of a property to mitigate the risk in stabilizing it. The cash flow will be minimal, if any, but, the potential return will be much higher.

Typical Value Add opportunities are lease-ups. In other words, the buyer takes on the burden of leasing up and stabilizing the facility. This could be due to the facility being new, such as an acquisition at, or shortly after, receiving its Certificate of Occupancy, or, it could be due to mismanagement, Capital Improvement requirements, or simply market repositioning.

In Self Storage, you can generally expect a 12-36 month period to stabilize a facility. The facility will normally be purchased with a lower leverage bridge loan as opposed to permanent financing. The cash flow will be on the low side (or absent) to start, but, will grow with stabilization.

Once the property is stabilized, it will normally be refinanced with a higher leveraged loan with more attractive terms since the banks will see less risk in a stabilized facility than they will in a lease up deal.

With a refinancing, a substantial portion of the initial investment can be returned to the investor/owner/operator, and then, the facility will behave like a normal cash flow deal.

The appreciation, and return on investment is realized partially at the time of the return of capital facilitated by the refinancing, or, through the sale of the asset, which will now trade at it’s fair market value as a stabilized asset.

Obviously, the Value Add deal is higher risk, as, the owner/operator may or may not be able to affect positive change during the repositioning and stabilization of the asset. For that risk, there is a higher potential reward that will vary depending on the particular property and the market that it’s in.

Today, there is a lot of interest in the stabilized, cash flow deals, but, still a lot of opportunity in the Value Add deals. What I normally suggest to potential investors that are trying to determine which is right for their particular situation, is to determine how much cash flow they need, or would like in the next 5-7 years. Some don’t need any and choose to invest in the higher potential returns of the Opportunistic deals. Others that are more fixed-income oriented will go for the cash flow deals. And the vast majority of us will talk over our individual situations with a professional and find some blend between these two asset types.

In any case, there is a lot of potential in Commercial Real Estate today, and an 8%/year, tax sheltered cash on cash return is looking pretty attractive amidst the general turmoil that we are seeing in other traditional investments.