Anecdotes

I was talking to another realtor in my office a couple weeks ago. One of her clients is trading up her property for another in an upscale area of Marin county. According to this realtor, her client said the house in Marin was originally listed for $12 million, then the price dropped to $9 million. The house finally ended up in foreclosure at which point her client bought it for $4 million. My colleague and I both wished we had $4 million...

Word of advice. If you have any equity in your home, consider selling before foreclosure. Banks don't care about your equity, only recovering their loan.


Referral
I got a referral last week from a mortgage broker. It was a gentleman interested in buying foreclosures and flipping properties. Curious, I gave him a call. I learned he has $300K to start, has worked with around 20 realtors already, and has done real estate deals all over the world but has never owned real estate in the SF Bay Area. There are a lot of smart people who know what they are doing in the foreclosure market and besides, $300K isn't impressive. Good luck to him.

If you are interested in this area, I recommend www.realtytrac.com. The site lists notices of default (pre-foreclosure) and foreclosure for properties nationwide. The site will give you the owners name, the property address, bank information, and a link to contact the owner. There is also an auction area of foreclosed properties. The first 7 days are free, then it's $39/mo. Have a lot of cash on hand, do your due diligence on the property, and be sensitive to the people your contacting. Remember, you are dealing with people of a certain state of mind in unhappy circumstances.

Flip? Too many smart dollars looking for deals in San Francisco. Very few, if any, stones are left unturned here. There are more flipping opportunities in the East Bay.

Drivers

I recommend a book called Timing the Real Estate Market by Craig Hall. A contrarian investor, he is founder of Hall Financial Group, a real estate finance and investment firm. Hall has been in the business for a long time and bought his first property at the age of 17. He has made millions and lost millions over the years, especially during the 80's real estate craze. His book is any easy read and again I highly recommend it.

He discusses how the main profit of real estate is at the sale and therefore buying and selling at the right time for the right price is crucial to making money. Buy low sell high is, of course, the premise of any kind of investing and much easier said than done. If you can figure out the main forces driving a particular market, then you have some kind of indication of what point we are in the cycle. Hall indentifies the seven major drivers of real estate. I'll list them and throw in my take on it.

1) Inflation
It can be both good and bad. Inflation means increased rents for income properties but also increased costs. It all depends on whether your tenants are locked into a lease for a set price or whether you can raise rents to keep pace of rising costs. It also is a plus and minus for financing. The higher the inflation, the higher the mortgage rate. With a multi-family, higher inflation is a positive since this translates into more renters and less homebuyers. Unfortunately, this means your mortgage costs go up as well. Moderate inflation is ok, rampant inflation could be a sell signal. Deflation is bad and any indications of it suggest sell. Currently, inflation is moderate thanks to the global availability of cheap goods. Oil prices, which were not sustainable at over $3, have come down. There is a lot more money being printed, but this has translated to higher asset prices and only consumer good prices count. Inflation is neutral right now.

2) Interest rates
Interest rates are at their lowest in recent history. This has caused real estate values to go to levels never seen in some parts of the country. With record low fed rates, banks have been lax with credit standards and have devised some very creative loan products. This made it easier for unqualified individuals to get into the market. The extremity of these circumstances suggest overly inflated real estate values by speculators and lenient credit standards. With rates so low, there is only room for them to go up. Interest rate go up, prices come down. Although there are many forces trying to keep interest rates down so consumer consumption does not stop, there are forces in the form of the Federal Reserve that are intent on raising rates. An economist at the SFAR convention I attended last month suggested the fed has, in the past, interfered with the secondary mortgage market and we can't rule out that they won't now. He got this from an old friend, a former SF Fed Reserver. This is hearsay, but economist tend to run in the same circles. Greenspan kept talking about a housing bubble and we know what Greenspan does with bubbles (just think 2000). The interest rate situation will and is having a negative effect on real estate prices. This is a bearish signal.

3) Flow of Funds
There is the normal flow of funds into real estate driven by normal market conditions and then there is external circumstances that can whip the public into a real estate frenzy. In the early 80's Reagan accelerated the depreciation schedules and large amounts of capital flowed into real estate from investors seeking tax shelter. This created excess supply without the appropriate growth in demand. After the 2000 tech bubble burst, people began searching for a more safer investment. The combination of low interest rates creating large amounts of capital for mortgages coupled with investors moving from the stock market to real estate resulted in increased prices. If capital starts to move out of real estate, this is a sell signal. Fortunately (or unfortunately) getting that equity out of real estate is not easy. It could take weeks or months to sell, so large amounts of capital leaving real estate and resulting in an overnight drop is prices is a long shot. How fast prices drop depends on the will of the investors to hold and also the staying power of all those people who barely qualified for that mortgage. If wages can increase, then people can hold on and there won't be a large downward push in real estate prices. If defaults start to increase, it could get really ugly. Also if all the speculators start to bail (and they have been), this could spell trouble in some markets (a la Vegas). Remember prices in the end are driven by supply and demand.

4) Job growth
Second only to San Jose, San Francisco had the largest net loss in jobs from 2001-2005 yet experienced, over this same time period, one of the highest appreciations in real estate. San Francisco had the hottest real estate market until recently eclipsed by Manhattan. Usually there is a direct correlation between job losses and property values. True, San Francisco is a unique market and we started slowly gaining jobs according to the Employment Development Dept. I believe the recent net increase of 26,000 jobs in the Bay Area will have the most positive effect on rents. Tech jobs in San Jose will continue to be outsourced and this won't be good for the Bay Area as a whole, but we do have one saving grace: biotech. Our position on the Pacific rim is also a plus. Short term, large job losses plus large gains in property values, just doesn't add up for me. For labor statistics and data reports visit www.labormarketinfor.edd.ca.gov. It is run by EDD by the state.

5) In-or-out migration
The 1990's were exciting times in the Bay Area. It just hasn't been the same since all the dot-commers left. At least I can now get street parking. It doesn't take a rocket scientist to know that the Bay Area experienced out migration beginning in 2000. The good news is the massive migration into the city during the heyday of technology was an anomaly and the subsequent out migration was part of a return to normalcy. Some of you may remember the bidding wars for studio aparments. As long as the SF Bay Area can attract companies here, maintain an intellectual and creative environment that brings talented professionals, remain on the forefront of technology and ideas, and leverage our position on the Pacific rim, then out migration should not be a big long term problem.

6) Path of Progress
This refers to buying in an area that is not currently trendy or in favor, but is in the path of development. Think Castro or Hayes valley 15 years ago. Or the South Beach Area before SBC Park went up. Developement is starting to spread in areas like SOMA and property should go up as new development goes in. In the Bay Area as a whole it's hard to find any good path of progress areas with huge upside potential. You might consider Sacramento.

7) New Construction
Too much construction, too fast is a negative. On a positive note, there isn't much room to build around here. This limits supply and keeps prices higher than other parts of California. Developers did manage to find room to build a lot of new condos in South Beach, SOMA, Downtown, and some pockets throughout the city. Developers tend to have a very short sighted view of the market. They make money by building. It's the banks and investors that lose money if there is no demand. New supply should never outstrip demand. As you can discern from my other blog postings, I'm bearish on condos.


Two Myths

Hall tells readers in his book that there are two untrue beliefs held about real estate:
"It will only take $XX to cover needed real estate improvements on this property" and
"Real Estate is a cash flow business".

When investing, always have a reserve. A few days ago, I called up an apartment owner about changing his real estate portfolio around. He informed me that he bought an apartment building in a prime location two years ago for around $2 million. He has already sunk in an additional $200k since then. And that's with him managing the property himself. Needless to say, he had too much capital tied up in the property to sell now.

You make money at the sell, so you should always be thinking about your exit strategy. The exception is the property with the right location, well built and maintained, and producing a strong positive cash flow. That's a property you keep.

In the future, I plan to cut down on the lengthy blogs and focus on imparting my experiences around town and tibits of info I can gather.

Check out his book at Amazon.com http://www.amazon.com/gp/product/0071421955/104-5201187-3116760?v=glance&n=283155&n=507846&s=books&v=glance

Stay away from TICs

I've been browsing around some of the other real estate blogs out there and many are talking about tenants in common (TIC). Only natural, since almost everyone in the industry is talking about it. It's the latest "fad" and in a crazy market like SF I guess everyone is looking for a way to bypass City Counsel's strict property rules and try to make some money. They are also cheaper, so for some buyers it's a way to get into this market. The only advice I have for those considering buying into a TIC: stay away. For investors thinking of buying a building, emptying out the tenants, doing some remodeling, and marketing it as TIC's I would highly caution against it. I'm seeing empty buildings on the market that are being sold by contractors or LLCs. The listings are marketing them as possible TIC or condo conversions.

• TIC's are one big headache to set up with legal documents that have to be drawn between the parties and clauses in case one party defaults. And you thought reading that condo CCR agreement was a pain. There are very few sources of funding for TIC mortgages. Last I heard, only Bank of Marin and Circle Bank provide loans for TIC. A mortgage broker told me that E-loan might allocate a couple million or so to the TIC market (that's enough for maybe six SF TICs). Bank of Marin may have already ran out of money for these types of mortgages and Circle Bank has few funds left (they are at least offering individual TIC loans). The interest costs are higher due to risks as they should be: in the event of foreclosure, the bank would technically become one of the tenants in common. I don't think the bank has any interest in moving into your TIC and the market for resale is not well established. Most banks require applicants to have six months worth of PITI reserves, FICO scores above 680, personal debt ratios not exceeding 45 % of income, and a 15% down payment. The interest rates are variable with 3 or 5 fixed or adjustable and are usually one to two points above the mortgage rate for a condo or single family home. There is also a prepayment penalty the first few years.
• Once a building has been Ellis Acted (the law under which rental buildings are converted to TIC), it cannot be placed back on the rental market for ten years without some consequences. Within the first two years, you can be liable for damages to the displaced tenant. Within the first five years, you must re-rent the unit to the displaced tenant at their original rent (hence, placing a price cap). Within the first ten years, you must offer it first to the displaced tenant but, you can charge the prevailing market rent. I don't know if the city can enforce this. Good luck finding that tenant years later.
• Real estate is already an illiquid asset. The TIC market is very small and undeveloped.
• I've seen some nasty divorces and property is almost always in the middle. Can you imagine 2-4 people, some of them strangers, sharing a title and a trust deed? If one person can't pay (e.g. lose their job) or have to move out of the city, the entire mortgage would either default or have to be refinanced (note: interest rates are rising). You can draw up legal documents that state the loan can be assumable by a new buyer, but the key is finding that new buyer willing to agree to the terms. I don't know what the future legal ramifications will be, but if you are a lawyer, I'd look into this market.

Why not just buy a condo? You can more easily get a mortgage for these and the legal docs in the form of CCRs are already drawn up. Yes, the HOA fees can be steep, but TIC's have costs as well. Just wait a bit before you look into buying a condo. There is a lot of new supply being developed, particularly in the downtown/south beach area. I was surprised to find that the office building across the street from my financial district office is being converted into condos. They overbuilt office buildings downtown and now there is about a 18% vacancy rate. I guess developers saw a hot housing market and decided to jump on the condo bandwagon. Can't make money with office leasings well, turn them into condos. I'm seeing a lot of supply in new condos and whether there will be demand is another story.

Loan

New property investors always assume that with a high FICO score and down payment that getting a loan for that new investment property will be as easy as getting the mortgage for their home. During the past few years any idiot with a pulse could get some type of mortgage loan, albeit a risky one (eg interest only, negative amortization, etc). The realm of commercial lending operates differently. First off, you can't walk into your favorite neighborhood branch and expect to get a loan on a 10 unit apartment building (unless you live near a commercial lender). Only certain banks lend on the commercial side and last I checked most big, known banks (except WAMU) only loan for residential. Commercial loans, like any business loan, is risky and for these types of loans you need to find the right lenders in your area. One of the keys to successful property investing is finding a very good commercial lender.

Commercial property is any building with more than 4 units, or a 1-4 unit building with roughly 25% of the space occupied by a commercial space (eg mixed use). You may be able to get a residential loan on a building less with than 4 units and a commerical space occupying 33% of total sq footage, but it will be a stretch. A 1-4 unit building with all residential is considered a residential property but, generally you will have to state whether its owner occupied or non-owner occupied. Please keep in mind I'm a real estate agent, not a mortgage broker, so please consult with a qualified mortgage agent before buying property.

Lenders underwriting investment properties will look at the property as well as the borrower. For investment properties, the lender will generally fund the lessor of the loan to value ratio (LTV) or debt coverage ratio (DCR) methods.

DCR
Debt Coverage Ratio = Net Operating Income / Annual Debt Service

Your lender will tell you their DCR requirements. Typically 1.2-1.5, but in SF at least 1.0 (1 to 1 ratio of NOI to Debt Service). In other words, the property should break even.

You can also work backwards to find out how much of a loan you can get. If the annual income is 57,000/year and the bank has a DCR requirement of 1.2 then,

1.2 = 57,000 / annual debt service => annual debt service = 47,500
47,500/12 months = 3,958 approx, which is your max monthly payment.


Loan to Value
LTV can be anything. Typically for commercial, lenders require 30% to 35% down payment, so loan to value will generally be between 65% to 70%. In San Francisco, investors should expect to place a higher downpayment and hence lower LTV.

Have a favorite lender. Please post in comments.

Property Investing 101

Numbers

Investment properties are generally valued using the Income Approach. Residential properties on the other hand are valued using the comparative market approach or the cost method (for newer properties).

There are two variants to the income valuation approach: 1) the direct capitilization method and 2) the gross income mulitiplier method.


1) Direct Cap Method

Cap rate equation:

Price = Net Operating Income/ Cap Rate
with cap rate = required rate of return - growth rate of NOI

Net operating income is...

+Gross income
-PPTY Taxes
- Insurance
-Maintenance
-Op Expenses (ppty mgmt fees, water, garbage)
-Vacancy Costs
=NOI

NOI excludes the cost of debt.

There is an inverse relationship between cap rate and price. The higher the cap rate, the lower the price.

Cap rates can be calculated three ways: market extraction technique, band of investment technique and the built-up technique.

Market Extraction Technique
Cap rates can be extracted from the price. For example, if a building's asking price is 1,050,000 and the NOI is 40,000 then,

1,050,000 = 40,000/ cap rate =>
cap rate = 3.8%

Band of Investment Technique
BOI utilizes the investor's weighted cost of capital (for you corporate finance people, this is familiar).

Cap rate (BOI) = (mortgage weight x mortgage cost) + (equity weight x equity cost)

Example:
Price $1,050,000
Mortgage = 525,000
Equity (cash) = 525,000
Interest rate = 6.7%
Required return on equity = 10%
Weight of each is 50% (half debt, half cash)
Cap rate = (.5 x 6.7%) + (.5 x 10%) = 8.35%

Given the cost of debt and the expected return of 10% for your cash investment, your expected return on total capital invested in the property would be 8.35% .

Return on equity can be extracted from the market cap rate. From the previous example
3.8% = (.5 x 6.7 %) + (.5 x ROE) => ROE = 0.9%

This doesn't look too good considering you can take your $525,000, put it into a savings account and earn at least 1.5% with less risk. But keep in mind the 3.8% market cap is based on NOI and does not consider property appreciation.


Built-up Technique

Cap (BU) = +Pure interest rate (US Govt bond adj for RE tax savings)
+Liquidity premium (compensation for illiquid nature of RE)
+ Recapture premium (depreciation minus appreciation)
+ Risk premium (premium required for exposure to invest risks)

These factors can be estimated using models. Sophisticated investors investing in large commerical properties may use this method.

So what conclusions can we gather from cap rates. Let us look at the 3.8% market cap rate calculated above. This is mostly based on a real property that my client was bidding on recently. A 4% cap rate would be considered good for this area. The ppty is yielding 3.8% with 100% cash (remember NOI is before debt financing). The interest rate on a commercial loan varies, but I can almost assure you that it will be higher than 3.8%. Debt financing for this 3 unit mixed use will cost anywhere between 5.49% to 8.00% fixed initially, then variable (banks rarely will lend 30 yr fixed on commercial ppty). I'll use 6.7% as the interest rate of debt on this ppty. The 3.8% cash yield versus 6.7% debt service does not sound so good. For this property to break even at a 6.7% mortgage with 30 yr amortization, the investor would have to put down a little over 55% in downpayment . Investors in SF can expect to put at least 40% down on a property due to prices being so high relative to rental income. You could pay cash but you would lose one of the benefits of property ownership- positive leveraging. I have excluded the package of benefits that induces investors to buy real estate in the first place (the big WHY?). I'll be talking more about this in the next blog posting.


2) Gross Rent (Income) Multiplier

GRM = Price/potential gross rent
gross rent can be annualized or per month
GRM excludes operating expenses

For our 3 unit mixed use the annual GRM will be
1,050,000/ 57,600= 18.23

GRM can be used to compare properties within a location or of similiar type. For example, if you looked at 3 unit mixed use buildings that have sold in that district within the last six months, with the annual income reported in the MLS, you'll find two buildings that sold for around 16.5 GRM and another that sold for a whopping 32 GRM. A buyer can see if a building's price is out of line with similiar properties in the area by taking it's annual income and multiplying it by an average GRM based on other properties. For example at 20x,

57,600 (annual rent) x 20 = 1,152,000 market price.

What conclusions can we draw from GRM? If you can find the data, it can useful to compare properties. The more data you have to find an average, the better. But in a city like SF I like to look at cash flow and appreciation potential. Prices can get outrageous and just because your paying the average GRM, doesn't mean you getting a good deal or making money.

If all these numbers are confusing you, drop me an email and I'll go over them. For you seasoned property investors, feel free to post a comment to this blog. There are a lot of people new to this game and would love to hear your two cents.