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I have just started investing in real estate and am looking at 4-families to start with. My agent has shown me probably 20 properties all over the city, and I can’t see how anyone makes money at the prices these things are selling for! My agent says that some of them are real bargains, because they’re listed for $10K-$20K below what other 4-families have sold for, but I just can’t make the numbers work. Am I being too conservative, or is everyone else overpaying?
S.M., Seattle. via email

The Truth About 4-Families

Many of them sell at a price where the purchasers will not see a dime in positive cash flow for 10 years or more. Why? In my humble opinion, there are several reasons. First, 4-families are very much in demand among newer investors who, in all honesty, don’t have the first idea how to properly evaluate cash flow. These buyers fall into the trap of determining the value by looking at what other people have paid for comparable 4-families to determine value, rather than doing a cash flow analysis to see how much money they’ll make at a particular purchase price. As a result, they pay what everyone else is paying—which, as you’ve already seen, is often more than one can pay and make any money!

Compounding the problem is the fact that many 4-families are sold by agents who also have no investing expertise. I’ve had many an agent “prove” to me that a 4-family is a good deal because it has a positive cash flow after mortgage payment, taxes, insurance, utilities, vacancy loss, and maintenance fees are taken out. What they don’t seem to understand is that, as the owner, I would also have to pay for extermination, evictions, mileage and wear-and-tear on my car, bank fees on my business account, accounting fees to keep my taxes straight, turnover and advertising costs associated with those vacancies, and the all-important replacement reserves for items that wear out slowly, such as boilers, roofs, and so on. When I show an agent that my real, true-to-God expenses on a particular building will outstrip income by 25% or more, they invariably tell me that I’m exaggerating—after all, the CURRENT owner makes money hand over fist! (Sure he does—he paid $20,000 for the building in 1954!)

Another reason for the gap between selling price and price at which a buyer could make money is that 4-families seem to be a favorite of super-conservative investors, many of whom pay all cash or a very hefty down payment, and, as a result, are able to get cash flow out of even the most overpriced properties. Think about it: if you didn’t have a mortgage payment on these properties you’re looking at, would they make money? Of course! Would they make a decent return on your investment? Heck no! But some investors aren’t looking for double-digit returns; they’re looking for an attractive, easy-to-manage property where they can sink their money and get a (more-or-less) guaranteed return.

My suggestion is this: leave the 4-families to the under-educated and over-conservative, and focus on the slightly larger properties that small investors like yourself can both afford and actually make money on. Five to 12 unit buildings give you the benefits of size plus eliminate the competition from over-paying amateurs and the better-funded corporate investors (who want much larger properties. And as an added bonus, it’s much easier to negotiate owner financing on these properties!
Good luck.

How do you know what an income property is worth? How do you know that if you pay X amount for a property that you can get the return you desire on your investment? Is there some way to calculate the maximum you can pay for an investment and still achieve your investment goals? Do you know how to get the answers to these questions? This article is written to give you a valuable tool to use in answering the critical questions regarding the value of an income property.

Among the many tools used by investors to gauge the worth of an income property, one of the most popular is a capitalization rate, aka cap rate. But as it is typically used, it is probably the one most misused concept in the real estate investment business. While brokers, sellers and lenders alike are fond of quoting deals based on the “cap rate”, the way it is typically used they are really shortcutting the true use of a valuable tool.

The typical way a broker prices a property is to take the Net Operating Income (NOI), divide it by the sales price, and voila!, there’s the cap rate. Example: Say the property has an NOI of $125,000, and the price is $1,125,000. Then

$125,000/ $1,125,000 = 11.1% cap rate.

But what does that number tell you? Does it tell you what your return will be if you use financing? No. Does it take into account the different finance terms available to different investors? No. Then just what does it show?

What the cap rate represents as used above is merely the projected return for one year as if the property were bought with all cash. Not many of us buy property for all cash, so we have to break the deal down, usually by trial and error, to find the cash on cash return on our actual investment using leverage (debt). Then we calculate the debt service, subtract it from the Net Operating Income, and then calculate our return. If the debt terms change, or loan to value, or our return requirement, then the whole calculation has to be performed again. That’s not exactly an efficient use of time or knowledge.

Brokers are also fond of quoting a “market cap rate.” This is an effort to legitimize an assumption, but it is flawed in its source.

As a comparison tool it is almost impossible by any means to find out what other properties have sold for on the basis of the cap rate. In order to correctly calculate a cap rate, and get an apples-to-apples comparison, we must know the correct income and expenses for the property, and that the calculations of each were done in the same way as will be explained below. This information is not part of any public record. The only way to access the information would be to contact a principal in the deal, and that just isn’t done because the information is generally held in the strictest confidence. A broker may have the details pertaining to several deals in the marketplace, and with enough information about enough deals the information may rise to the level of a market cap rate. But very few brokers are involved in enough deals in one market to have that much information. So the conventional wisdom becomes a range of cap rates for property types, which may or may not apply to the property you are looking at, and certainly does not take into account your own return requirements.

So what do you do when you’ve found a property that looks promising, and the broker tells you the cap rate is 11.1% and you better act fast? How do you know if it is worth pursuing? For years I would immediately jump in the car, go take a look, and then start crunching numbers making assumption after assumption to arrive at some estimate of value. The truth is I was guessing. I wasn’t looking at the right numbers, and I spent a lot of time guessing. There is a better way. It is not a magic bullet, but it does give an investor a powerful tool to use in gauging value.

What’s it Worth to YOU?
The real question in valuation is not how much I, or any other investor, or even an appraiser value a property at, nor the value from a cap rate estimated in the market, but rather the value at which YOU can attain YOUR investment goals, that is reflective of YOUR borrowing power, and gives you an intelligent starting point for the analysis. I can give you a tool that will give you that answer. I promise you if you learn how to do this it will give you a leg up on 90% of the brokers and investors out there.

First, we have to become conversant with the terminology.

Critical to this calculation is that the NOI (Net Operating Income) is figured consistently with industry norms. The generally accepted definition of NOI is:

Gross Income – Operating Expenses = NOI

Please note that the operating expenses do not include debt service, or the interest component of debt service.

Obviously, the income and expenses must be verified, or all calculations that flow from them will be flawed. Verifying the income is usually easier than the expenses. Rent roll analysis and a contract contingency for tenant estoppel letters at closing can settle the income stream conclusively.

On the expense side, normal due diligence includes verifying with third party suppliers as many of the expenses as possible. Care must be taken in evaluating the operating expenses to uncover any anomalies that may exist under the present ownership. Owners often take a management fee that may or may not be market based; maintenance expenses may or may not include labor charges; items such as “office expense” or “professional fees” or “auto expense” may or may not be property specific. In short, before accepting the NOI presented, effort must be made to understand what is behind the numbers. This is known as “normalizing” the numbers. You can also tweak the numbers to reflect the way you will own and manage the property. No two investors will own and operate a property the same way. It is entirely possible for two investors to look at the same property and come up with two different NOIs, and two widely divergent values, and both are right.

That’s why appraisers use comparable sales, replacement value and the income approach as part of a three-pronged methodology in estimating value. They are charged with making the appraisal representative of the market conditions and the typical requirements of investors and lenders active in the market. The third method, the income approach, is usually given the most weight. That method is also known as the “band of investment” method of estimating the present value of future cash flows. That method addresses the return required on both equity and debt, and leads to what can be called a derived capitalization rate.

Deriving Your Cap Rate

After I am reasonably certain that the NOI is accurate the best way to get an initial value indication is to use a “derived” capitalization rate. That requires two more pieces of information. You have to know the terms of financing available to you and the return you want on your investment. We can then use these terms for both debt and equity to indicate the value at one precise point in time–the instance of when the operating numbers are calculated–to derive the cap rate that reflects those terms. (The value in future years is another discussion.)

Deriving a cap rate works like a weighted average, using the known required terms of debt and equity capital.

The Bank’s Return: the Loan Constant

Let’s start with the finance piece. We need to know the terms of the financing available, and from that we can develop what is known as the loan constant, also called a mortgage constant.

The loan’s constant, when multiplied by the loan amount, gives the payment needed to fully repay the debt over the specified amortization period. IT IS NOT AN INTEREST RATE, but a derivative of a specific interest rate AND amortization period. When deriving a cap rate, one must use the constant since it encompasses amortization and rate, rather than just the rate. Using just the interest rate would indicate an interest only payment and distort the overall capitalization process.

The formula for developing a constant is:

Annual Debt Service/Loan Principal Amount = Loan Constant

You can use ANY principal amount for the calculation, then calculate the debt service and complete the formula. The constant will be the same for any loan amount. For example, say your bank says they will generally make an acquisition loan at a two points over prime, with twenty-year amortization, with a maximum loan amount of 75% of the lower of cost or value.

Say prime is at its current 4.5%. That means the loan will have a 6.5% interest rate. Using a payment calculator or loan chart, find the payment for those terms. On a loan for $10,000, the annual debt service required is $894.72. Divide that by $10,000 to find the constant.

894.72/10,000= .08947

Using these terms, the loan constant for that loan would be .08947 (I usually round to four or five digits… depending on the level of exactitude desired, you can use as many as you like.) The answer will be the same if you use $100,000 or any other number as the principal amount. (One hint though: do not use a principal number with less than five digits, because the rounding will affect the outcome.)

You might note here that the mortgage constant is basically the lender’s cap rate on his piece of the investment. Both the mortgage constant and “cash-on-cash” rates for equity are “cap” rates in their basic forms. A cap rate is any rate that capitalizes a single year’s income into value (as opposed to a yield rate).

Your Return: Cash-on-Cash Return
The next step is to provide for the return on the equity.

Start with the return you want on your money: Say the cash-on-cash return you are seeking is 20%. The “cash-on-cash” rate is also known variously as the equity dividend rate, equity cap rate, and cash-throw-off rate. It represents the “cap” rate to the equity position, and to be consistent we will call it the equity constant. If an investor puts in $30,000 and requires a 20% pre-tax return, then his annual cash in the pocket after paying the mortgage (but before income taxes) would have to be $6,000.

In this case, the equity constant is .20.

Put It All Together: Weighted Average

Each of these cap rates is then weighted based on the loan-to-value ratio of each of the debt and equity positions to build the “overall cap rate”. The formula looks like this:

(LTV debt ratio x mortgage constant) + (LTV equity ratio x equity constant) = derived cap rate

To finish the example, using the mortgage terms given above, and the desired 20% cash on cash return, the following would be the “overall cap rate” with a 75% loan-to-value on the debt component:

(.75 x 0.08947) + (.25 x 0.20) = .1171
or
.0671 + .05 = .1171

To convert to a percentage, move the decimal two places, and therefore, under the stated conditions, the required cap rate for the property (income stream) is 11.71%. Using the normalized NOI figure, then the indicated value is calculated with this formula:

NOI/Cap Rate = Maximum Purchase Price

For the original deal above, the value would be calculated thusly to attain the desired return:

$125,000/11.71% = $1, 067,464

The asking price of $1,125,000 is very close (within 10%) to the indicated value of $1,067,464. This is a deal that would definitely be worth taking a look at. Had the deal been priced at a 10% cap rate, or $1,250,000, then I might still take a run at it since the indicated value is within ten to fifteen percent of the asking price. In a normal market, California aside, most sellers do not expect the property to sell for the asking price.

Not a Magic Bullet

Now please note that I said at the beginning that this is a starting point. It is not the end-all-and-be-all of valuation, nor should it be. That doesn’t exist.

Many factors can influence the value of an income property both up and down. Some of the most important include deferred maintenance; security of the income stream (strength of the tenants and length of the leases); comparable sales in the area; general economic and market conditions; and local market conditions. These factors speak to the relative risk and effort involved in the continuance of the income stream. As risk or effort increases, so does the investor’s required return on equity. Increase the required equity return and the cap rate changes, and so does the value. At this point you literally write your own paycheck.

This is a powerful tool if understood and applied correctly. Play around with some alternative scenarios of returns, loan terms and rates, etc. and you will see the effect of changing different parts of deal structure. You should also now see why it is so critical to verify EXISTING income and expense BEFORE establishing value. This little exercise also shows why I harp all the time on no two investors coming up with the same value for the same property.

DO NOT however, use this as a “magic bullet”, and stop your analysis after the calculation. I cannot stress enough the importance of performing thorough due diligence in commercial income properties. That alone is what determines the difference between being a true “investor”, and the next “don’t wanter” seller.

My thanks to several people who posted valuable input on the commercial newsgroup at CRE Online. They include Paul Ness, MAI, Jim Rayner, and Jerry Menke.

The topic of pre-construction investing has rapidly gained popularity in our real estate investing community. The reason it has gained such popularity is because pre-construction investing offers some unique advantages that other types of real estate investing simply can not offer.

Pre-construction investing is exactly what is sounds like…locking up a property when it is pre-construction. In other words…the property has not been built yet. Currently the parcel of property is nothing more than a piece of vacant land. Then, over the next 12 to 24 months, the piece of real estate is constructed. During that period of time, there are things that happen. It is these unique occurrences that make pre-construction investing so desirable. The thing that makes pre-construction the greatest of all, is when it is done in the emerging market. I invest only in the emerging markets. More on that in a moment.

When a Property Is Pre-Construction, It Comes at a Lower Price

The very first thing that happens is that a pre-construction investor is able to lock-in the price on his property at a price that is lower than what the price will be after construction has been completed. As a development gets completed, the prices continue to increase from one phase to another.

During the Build Cycle, Appreciation Increases Value

In addition to our price increase on the front end, values also increase in another way. I only invest in two types of markets, (1) A market that is currently appreciating, (2) A market that will soon be appreciating. By only investing in the right markets, I have added an additional profit center to my investing…appreciation. While the property is being built, it is also appreciating in value.

No Payments Are Required During the Build Cycle

When a property is pre-construction, in many cases no mortgage is required. And if no mortgage is required, you got it…no payments are required. The construction is being completed with the developer’s financing. You would not need to obtain a mortgage until the property is completed, and if you want to hold the property long term. Many pre-construction investors sell their property before that point, and do not need to qualify for a mortgage at all.

When the Property Is Completed, We Have Locked-In Equity, and Also a Piece of Brand-New Construction

By obtaining a discounted price on the front end, and also appreciation during the build cycle, we have set ourselves up for success. By the time the project is completed we have obtained an equity position that allows us to profit as an investor. We also have the type of real estate that is easiest to sell…a piece of brand new construction. This further expedites our exit strategy.

As you can see, pre-construction investing offers some significant advantages that other types of real estate investing simply can’t offer. This is why so many real estate investors have one or two pre-construction properties churning away in the background while they also do their other types of real estate investing.

When pre-construction done in the emerging market, it is phenomenal way to invest in real estate. The emerging market is a market that is getting ready to appreciate, because of very specific factors that are getting ready to play out in the market. During our meeting with your group I will be discussing how I find these emerging markets and why they are such a powerful investment play. See you then!

The quickest way I know to make significant profits with commercial real estate is to do deals with substantial upside potential.
But first let’s define “upside”. I’m not talking about a paper increase in value due to scheduled rental increases, or replacing “below-market” leases, as many for-sale brochures define the term.

My definition of upside is to unlock hidden potential in a property that creates triple digit percentage gains on investment, provides positive cash flow along the way, and avoids major risks of loss. The upside may come from expansion, redevelopment, or by changing the market position of the property with major improvements.
How do you do that?

It boils down to three critical factors: the local market conditions; good structural bones; and a willing seller. When all three are present the deal is there for the taking, but only if the investor can design and implement the proper structure. The focus of this discussion will be in creating a structure to create and capture upside.

Market Is King

First and foremost is the local market. Regardless of property type, the first rule of real estate investing is we do not make markets—we serve them. A poor market will stop any plan dead in its tracks, so the first priority for any strategy is make sure the area demographics of population, income and employment are in a positive trend. Basic demographic research includes statistics for a three- to five-year period to show the trends. One year’s data is useless. To say a market had a 2% population growth in the previous year means nothing. But if the current 2% increase is up from 5% loss over the last five years indicates the market is turning and worthy of further investigation. With that knowledge we can be confident in seeking out the worst property we can find in a good location, because that’s where we’ll make the most money.

Good Bones

What we’re looking for is the things that can’t be changed being sound. We look beyond the cosmetics to the structural elements, such as foundations and basic construction of the buildings, the systems, and the grounds. If the structural elements are failing, then the property may not be suitable for turnaround without expending more funds than can be recovered. Aesthetics can be fixed.

Unless you are an expert in building systems, construction and environmental issues it is advisable to hire experts to inspect the relevant elements of the property. The cost is negligible when compared to the cost of fixing a mistake, or worse, not being able to fix it. Location is something else that can’t be changed. Don’t fall for the old sales line of “priced below replacement cost”. My first question is always “If given the chance to replace it, would I?” Understand the local market and how it works. A great deal in a bad location is not a deal… it’s a problem looking for an owner.

Seller Motivation and Deal Structure

The final question is to assess the seller’s willingness to help us solve his problem. There are a number of ways to accomplish that, and it takes some digging to get into the seller’s mind and discover his true motivations. Most commonly the property has existing debt. The seller may offer to finance part of the purchase price as a second mortgage. But the property can rarely support a new loan, and that requires the buyer to fund improvements from cash out-of-pocket. That’s hardly an attractive proposition, as the cash flow is usually not sufficient to carry the additional debt of the seller’s note and provide a return on the investor’s capital.

Typically the alternative is for the seller to greatly reduce the price, even below the amount of current debt, or accept a subordinated note with no payments. With those options many sellers will opt to keep the property rather than take the risk for no money. The deal falls apart for lack of an alternative structure. The ideal structure would allow the investor to obtain new financing that includes the funds needed for improvements, the seller to realize some of the upside in return for staying in the deal, and designed so the property produces a positive cash flow. Can that be done? Yes it can, as the following example from my files demonstrates.

The Deal

The deal was a 54-Unit apartment complex, well-located in a great college-town market. The owner had let the property decline to the point that the performance had suffered tremendously. The expenses were high and the income unstable due to the poor condition of the property. The buildings needed new roofs, windows, kitchens, paving, heat pumps and new appliances. The existing NOI (net operating income) was about $145,000. The owner had existing debt of $950,000. The improvements were estimated to cost $350,000. The as-is appraised value (and the asking price) was $1,200,000, reflecting an as-is 12% cap rate. The projected value after the improvements was estimated to be $1,750,000, using the same NOI but a lower cap rate (8%) to reflect the completion of the capital improvements.

The Structure

We came up with the following deal structure: In lieu of down payment, the seller would get 20% equity-only (not profits) interest in a new LLC that would acquire the property. The LLC would obtain a bridge loan for $1,300,000 to pay off existing mortgage and fund the repairs.

The Plan

Our investment plan was to complete the improvements over a six-month time frame, and then raise the rents to market levels. In the first year we planned to complete the improvements and raise the rents for upcoming leasing season. No occupancy increases were projected, but the combination of higher rents and lower expenses were projected to significantly increase the NOI and cash flow. In the next two years it was expected that the occupancy would also rise to an average 97%, excluding collection and vacancy loss, further increasing NOI and cash flow. In the third year the LLC would refinance the property based on the increased income, and use the proceeds to pay off the seller’s LLC interest. At that point we would own 100% of the LLC interests and could either hold the property or sell at will.

The Result

The improvements were completed and the rents were raised $50-$75 per unit in the 1st year. Annual increases of $20 per unit were implemented in following two years. The occupancy increased from 90% to 98%, raising the NOI to almost $190,000, and the cash flow to $80,000. Now it was time to turn on the money pump. The property was refinanced with a $1,500,000 loan based on the higher value. We used $200,000 of the proceeds to pay off the seller’s interest and the LLC kept about $50,000. The loan was at a lower rate and longer amortization, so the cash flow actually increased to about $90,000. We held the property for two more years, and then sold it at a 7.6% cap rate on the next year’s projected net operating income of $186,200, yielding a price of $2,450,000.

Over the five year hold period the investment produced:
3 years cash flow @ avg. $80,000 = $240,000
2 years cash flow @ avg. $90,000 = $180,000
Refinance proceeds– $250,000
Equity at sale– $1,050,000
Total cash and equity $1,670,000
Less seller’s interest –$200,000
Total Gain–equity and cash $1,470,000

If you were paying close attention, you realize now that the deal was done with no money out-of-pocket from the buyer, but with none of the risks of over-leverage. This is a real deal. The sale was completed in April 2005 as a 1031 exchange. We bought a $3,000,000 office building with $1,000,000 equity, which also had upside potential, and from which we extracted $300,000 of tax-free cash equity after closing. We are now (2007) ready to exchange the office building for a $5,000,000 retail property from which we will extract over $1,000,000 of the equity in tax-free cash. This was an out-of-the-box solution that solved all the problems, produced significant upside, and created a money pump that keeps on going. This is how to build wealth in commercial real estate.

You may have heard all the buzz about the newest type of vacation home investment—condo hotels. These are condominiums located in four- and five-star hotels in cities like Miami and Las Vegas. Owners use their condos when they’d like. When not using their unit, they can place it in the hotel’s rental program and receive a percentage of the revenue it generates.

How do you choose a condo hotel unit that meets your desire for a vacation home and is also likely to produce a healthy revenue and appreciate down the road? Consider the following seven questions when evaluating a condo hotels:

1. Is a Condo Hotel Right For You?
Condo hotels are not your typical second homes. They are fabulously-furnished condominium suites in some of the most famous hotels and resorts around the country. The properties are usually large, high-rise, luxury hotels and come with premium amenities like valet, concierge and maid service. Prices can range from $250,000 to over $1 million for prime properties.

2. Is the Condo Hotel Well-Located?
Consider whether the property is located in a popular vacation destination, one that is likely to do a healthy tourist or business trade regardless of economic factors.

Also, you must be sure you yourself like the location. Does it offer you the ocean view or golf course access you always dreamed about for your vacation home? If you’ll be flying to this vacation home, how close is it to a major airport?

3.Does the Condo Hotel Have a Major Franchise?
The key to a successful condo hotel investment is the hotel operator. The better the operator and the franchise, the more likely the success of the property. A condo hotel with a name brand like Ritz-Carlton, Hilton, Starwood or Trump is likely to generate more revenue than a non-brand because it can charge higher room rates and benefit from international advertising and a centralized reservation system.

4. Will the Condo Hotel Receive Traffic From Any Nearby Attractions or Entertainment Venues?
A condo hotel that is near a convention center, a theme park or cruise port will benefit from proximity to these high-traffic venues.

5.Does the Condo Hotel Have Any On-Site Amenities That Will Draw Guests?
Such as a well-known health club, spa, fine dining restaurant or golf course? You’ll want to choose a condo hotel that has amenities you’ll enjoy using and also are a draw to attract hotel guests.

6. Does the Individual Unit That You’re Considering In a Condo Hotel Meet Your Needs?
Does it have enough bedrooms, enough square footage? Does it have a kitchen? (Some do, some don’t.) Does it offer an appealing view? Is it furnished to meet your tastes? Does it offer any owner storage?

7.Will the Condo Hotel Unit Appreciate?
While personal enjoyment should be your primary reason for considering a condo hotel purchase, it’s certainly worth thinking about whether the property you want has good appreciation potential.

Look at surrounding properties and area appreciation rates. Does the condo hotel have lots of competition? Is it different or better than area properties? How has the demand been since the property first came on the market? A realtor who is familiar with condo hotels and the area in which you’re looking can often help you determine if the condo hotel your considering has good appreciation potential.

If you understand how residential developers and builders make their buying decisions, you will be likelier to achieve success in buying or selling land. Some builders search for property strictly by geographic area. Others search for parcels that would enable them to reach particular buyer submarkets, such as housing type, price range, lifestyle and age group. Either way, they begin by casting the net into their areas or markets of choice and sifting through potential acquisition candidates. They often have to pick through dozens of properties before they find one they think they can develop profitably and frequently spend varying amounts of time, effort and money collecting information before they even know if the parcel will work. Their due diligence focuses on obtaining answers to five fundamental but critical questions:

What can I build?
How many can I build?
What can I sell them for?
How long will it take to sell them?
What are the costs?

These questions collectively define economic feasibility and influence every decision developers and builders make – from their initial contact with the property, during negotiation of the contract with the seller, through subdivision approval, to the day of closing and beyond.

How do you estimate the value of land for residential development? For starters, you should never price it by the acre or even think of it in terms of X$/acre. Raw land value is not derived from the number of acres but rather from what the property could yield, how it can be used, and the projected sale value of the total package end product (the new home on its lot). Its value is also related to the hard costs (i.e., costs for installing “horizontal improvements” to the site, such as streets, curbing, sidewalks, utility lines, and house construction costs or “vertical improvements”) and soft costs (expenses that will be incurred during the approval process). Accordingly, residential builders and developers do their income and expense projections for properties on a per-lot and not a per-acre basis. For all practical purposes, the parcel’s overall size is a meaningless number in the developer’s determination of property value.

Here’s an illustration:

Suppose there are two vacant 50 acre parcels you’re thinking about buying in the same municipality. Zoning for Parcel A requires a minimum lot size of 40,000 SF and width of 200 feet; Parcel B zoning requires 30,000 SF lots and 150 ft. widths. On average, the new homes would sell for $300,000 on Parcel A and $350,000 on Parcel B. Each parcel is fairly level with no remarkable physical constraints. Suppose per-lot improvement costs are ball parked at $56,000 for A and $43,500 for B.

In this scenario, Parcel A would probably be worth around $760,000 (or $19,000 per lot raw) to a builder who was buying fully-contingent. Parcel B, however, would command a price of over $2.3 mil ($44,000/lot). The reason that there’s a big difference in the bottom-line value of these parcels is that there are differences in the lot yield, end product value and horizontal improvement costs. In this example, if Parcel A were for sale at $19,000/acre, it would be for sale for a long time because it was significantly overpriced. On the other hand, if Parcel B were for sale at $44,000/acre, it would sell in a heartbeat because it was greatly underpriced.

For the Select Few

Fractional ownership of vacation homes, also called private residence clubs, is a relatively new concept that allows you to enjoy four to 12 weeks of home ownership privileges per year at an upscale, luxury resort but at a fraction of the cost of whole ownership.

If you want to own an impressive second home complete with personalized services and located in an expensive resort area but can’t quite justify the expense because you’ll only be using it a few weeks or months of the year, this type of real estate arrangement may appeal to you.

Amenities Galore

Most private residence clubs offer extensive amenities. These may include an extravagant clubhouse and spa, plus five-star hotel services, the kind you couldn’t expect to have in a wholly-owned vacation home, high-end condo or timeshare.

Imagine this: You are going on vacation and you call ahead to the staff at your private residence club home. At your request, the staff shops for your groceries, dry-cleans your clothing, makes your restaurant reservations, heats your private splash pool, and places knick-knacks and favorite pictures of family members around your residence. You are met at the airport by a staff person who shuttles you to your home where a just-detailed Jaguar is sitting in your parking space for use at your disposal.

Get the picture? Private residence clubs are NOT your ordinary second home.

Outstanding Locations

Fractionals or residence clubs have sprung up in exclusive, world-class resort destinations worldwide. St. Thomas, Virgin Islands, Puerta Vallarta and Mexico are popular locations.

In the U.S., the first fractionals were in major ski areas out west, particularly Colorado where real estate was so costly that wholly-owned second homes were out of the question for most people. Eventually they spread to northeastern ski areas. Since then fractionals have begun appearing in golf-oriented communities like Hilton Head Island, South Carolina and popular beach states like Florida.

Some of the most popular fractionals can be found in Jupiter, FL; Aspen Highlands, Bachelor Gulch, and Aspen Snowmass, CO; Lake Tahoe, CA; and Whistler, British Columbia. Fractionals located in the U.S. usually offer good access to major airports that allows for easy transportation arrangements.

Management by Five-Star Companies

The key to the success of fractionals is their professional management. Most are operated by well-respected hospitality companies known worldwide for their world-class resorts. Among them are Ritz Carlton, Four Seasons, Starwood, Intrawest and Millennium, brands known for their five-star services and amenities.

Hassle-free Ownership

Part of the appeal of fractionals is that they are completely hassle free. In addition to having a staff for personalized service at your disposal, at a private residence club you never have to worry about repairs, maintenance or housekeeping. Everything is included in the price and annual fees and taken care of by the professional management company.

Appreciation Potential

To date there have been very few fractional resort developments. The demand is high. As a result, it is likely there will be substantial appreciation, rather than the depreciation that usually occurs with timeshares.

Real estate experts say that the outlook for investment appreciation appears excellent. You can expect at the very least an appreciation parity against other real estate in the resort area in which the fractional is located.

Prices

To buy a fractional, you pay a one-time purchase price and then a yearly upkeep fee that covers all of the expenses associated with property ownership and its use and services.

What do fractionals cost? Prices vary based on the size, amenities and location of the individual property. But most are in the $100,000-$500,000 range. Keep in mind that these are truly top-of-the-line homes that would cost you two to five times as much if purchased outright as wholly-owned vacation homes.

Comparison of Fractionals to Timeshares

How do fractionals compare with timeshares? They really don’t. Fractionals are far more exclusive and include many more luxury amenities and services than timeshares. They tend to be larger homes, usually three to five bedrooms. Timeshares usually allow you use for just one to two weeks per year. Fractionals offer from two to 13 weeks, and those don’t necessarily have to be consecutive weeks. Pick the weeks you want.

With regard to financing, obtaining a bank or mortgage company loan on a timeshare is difficult. Rates are high, regardless of how good your credit. That’s because it’s a well-known fact that most timeshares depreciate over time. Conversely, banks and mortgage firms consider fractionals to be appreciating assets and will often treat them like any other second-home purchase.

Why do fractionals tend to appreciate while timeshares usually depreciate? There are a couple of reasons. With fractionals, more of the buyer’s dollar goes to high quality finishes and “bricks and mortar” vs. sales commissions which can be as high as 40%-50% with timeshares.

Furthermore, timeshare values have historically been poor because of the large number of resales on the market, not to mention a continuous stream of new developments. The fact is the secondary market for timeshares has never really developed.

Conversely, there are a limited number of fractionals on the market. Most likely, that number will stay small because fractionals are built in only the very best, most highly desirable locations. Therefore, demand outpaces supply and results in property appreciation.

Comparison of Fractionals to Condo Hotels

Fractionals (private residence clubs) differ from condo hotels in that you have a set amount of time when you can use your vacation home. Condo hotels are in fact, condos located within hotels. You can use your unit whenever you want, and place it in the rental program when not using it. Fractionals do not offer rental program participation.

Fractionals tend to be larger than most condo hotel units. Most fractionals offer three to five bedrooms, while most condo hotel units are studios, one bedrooms or two bedrooms. Currently, most condo hotels are located in Miami and other surrounding cities in South Florida. Fractionals are most prevalent on the West Coast, particularly in ski areas. However, both types of real estate are rapidly gaining popularity and soon there will likely be more of a supply across the country to meet the growing demand.

Having rehabbed over 470 properties in the last seven years and collected over 600 apartment units I’m often asked, how can I become wealthier faster investing in real estate?

While most investors concentrate on some aspect of single family houses, I was always interested in multi-units (apartments) first, and then single family homes as a means of getting more multi-units .

From the very beginning of my investing in real estate, I liked the idea that a group of people (the tenants in a building) would get together and pool their money to pay down the mortgage on a property, and I liked the idea that they would also pool their money together to pay for all of the maintenance work for a building.

I especially liked the idea that they would give an owner so much money that the owner would have a bunch of money left over at the end of every month that could be used to either re-invest, save or to go out and have a good time with.

Essentially, I like the idea that other people were willing to help make me wealthy. I liked it even more when I started using management companies to manage my properties and no longer had to have contact with my tenants.

I soon came to realize that I could also wholesale, retail, pre-foreclosure, rehab, subject to and lease option apartment houses as well.

I also realized that there were certain advantages that investing in multi-units buildings had over single families.

* The first was cash flow. Cash flow on a multi-family is always greater than that of a single family. Simply because you have more rents coming in.

The more units you have under one roof, the less risk you have. If you have a single family house and you lose your tenant, you’ve lost 100% of your income. In some instances, this could be your entire profit for the year. If you had a three family and lost a tenant, you still have two rent coming in to pay your expenses.

* Economies of scale are in mulit-unit buildings. If you have six single family houses opposed to one six family, you have six roofs to be replaced or repaired, six lawns to be maintain, six tenants spread out through out your city or town.

In your six family you have one roof, one lawn and your tenants are centrally located. Economies of scale are in your favor.

* There’s a lot less competition than there are in single family houses. Why? Because no one is out there teaching how to do it and all the single family guru’s make flipping single family houses sound as easy as chewing gum in the dark. The smart investors put multi-units in their portfolios along with single family houses.

* Because of the bigger cash flows, you can afford to hire management companies to manage your tenants, thus eliminating that hassle while you go out and do what you do best (or should do best), find and finance them.

* Your pay days are a lot bigger when you finally sell your property. This is because an apartment complex cost more than single family homes, because of this they obtain a greater dollar amount of appreciation. For example, a $100,000 single family house will in a market that appreciates 10% will be worth $110,000 while a three family house worth $300,000 in the same market (10% appreciation) will increase to $330,000. That’s $20,000 more money in your pocket!

You’ve know a few people who have made a lot of money flipping single family houses, but if you think of the all the people you know who have become extremely wealthy through real estate, you’ll realize that they did it through owning multi-units (apartments).

These are the five biggest advantages to investing in multi-units, there are many, many more. If you are interested in creating more wealth at a faster rate, adding multi-unit to your portfolio is the way to do it!

Redevelopment and change-of-use is one of my favorite deal strategies. Many properties are functionally obsolescent, or the market has passed them by for that property type. These properties are often producing income, but not at the level of the highest and best use of the land.

A reader sent me a good example recently. The property is a six unit apartment building, about thirty years old in rough condition, with a low-end rent roll and loads of deferred maintenance. It’s located on a main thoroughfare that had developed as a commercial strip with a traffic count of 30,000 vehicles per day, and this property sit on the corner of a signaled intersection. With a deal like this it’s possible to get “paid to play”. The existing income stream carries the property while you’re solidifying the plans for redevelopment. The steps to investigate the feasibility of a change-of-use redevelopment are not at all complicated.

Step One: The Planning Department
The first stop should be the local planning department, either in person or online. We need the street address, tax parcel number, or other identifying information for the property to proceed. (Many jurisdictions now have GIS systems that are accessible online with all the relevant tax data. Some also put the zoning and subdivision ordinances online as well. For those that don’t a trip to get a hard copy will be necessary.)

Verify the existing zoning district for the property. If it is already zoned for commercial use you’re in luck. Look in that chapter of the zoning ordinance for a list of permitted uses, maximum density, maximum height, and development standards (e.g. setbacks, green space, # of parking spaces, etc.). That’s the information we need to determine the maximum amount of developed space, and type of space, that can be built on the property. If it is not zoned appropriately for the use desired, then you’ll need information regarding the rezoning process. At this point a general overview is sufficient, required forms, any required engineering, exhibits (e.g. site plan, survey, etc.), and a rough idea of the time required to go through the process.

Step Two: Estimate Total Cost of Improvements
Now we’re ready to crunch some numbers. But don’t worry, this is not rocket science. We know how much space can be built (per the zoning ordinance), and the required site improvements (e.g. parking, storm water, utilities, landscaping, etc.). Using local building costs, or a rough estimate of per square foot costs from a local contractor, we can do a preliminary estimate of the development costs. To that add the demolition costs for the existing structures. Again, a local contractor can usually give you a ballpark estimate of what it will cost to remove the existing structure(s). Together, the sum of cost of development and the demolition costs is the total cost of improvements.

Step Three: Total Project Cost
Now we add an estimate of soft costs such as engineering, architectural, loan fees, appraisal and third-party reports, developer’s fee, etc. You’ll have to make some calls to local engineering and architectural firms to get these estimates. Some may want to know more details than you are prepared to give at this point, in which case you can ask for the average cost per square foot, per parcel size (i.e. per acre), or per project. Don’t worry if the estimates are a range. That is the usual case, and will allow you to later establish the margin of error for your estimated costs. Add the soft costs to the cost of improvements. Then add the purchase price of the property and the answer is the total project cost.

Step Four: Calculate the Projected Income
Use existing market rental rates and expenses to construct a rough pro forma projected income statement. For rental rates in the market you can use the “For Lease” side of Loopnet.com. Estimated expenses can come from other property listings, your own experience, or from an appraiser. Calculate the first year NOI (Net Operating Income, gross rent – operating expenses = NOI). Divide the NOI by 1.25 (the typical minimum debt coverage ratio for lenders). The answer is the maximum allowable annual debt service (DS).

Now estimate the loan terms (rate and amortization period) available for this type of deal using typical bank financing. (This is where having a relationship with a banker that knows commercial real estate is invaluable.) Once you have the loan terms, divide the DS by the loan constant. (for direction in how to calculate the loan constant, see the article “What’s it Worth”). That’s the maximum loan amount. Add any equity you’re putting in the deal to the maximum loan amount. If that sum is more than the total projected costs, you’ve got a viable project.

I also use one more calculation at the end to establish feasibility. Figure the cash flow by subtracting the DS from NOI. The result is the cash flow, and if you divide that by your minimum required return, the answer will be the amount of equity that can be put into the deal and meet your requirements. Add that amount to the maximum loan, and if the answer is at or above the total cost, the deal is worth pursuing.

With interest rates headed upward yet again with the latest round of belt tightening by the Federal Reserve, and the stock market falling with no bottom in sight, many people are crying doom and gloom. I hear talk of watching for a rise in foreclosures due to stock market losses. Builder friends are convinced they are about to be ruined. In my opinion, this is no time to rush for the exits. The fundamentals of real estate investments are sound. A short history lesson may prove worthwhile.

My experience goes back to 1980-82, when I was a single-family homebuilder. Now that was tight money. With prime in the high teens, very few deals made any financial sense for lender or borrower. Then came the 5 years of favorable tax treatment that made dumb and dumber deals look good… until Congress pulled the plug on passive losses. Then we had to re-learn an old lesson, if it doesn’t cash flow, it’s not a deal. The recession of 1990-91 was a cakewalk for those who weren’t over-leveraged… I wasn’t one of them, and paid dearly for the mistake.

Fast forward to 1998, we were riding what has now become the longest economic expansion in history. Asia went ape, the Russian ruble turns to rubble, and the markets gave a physics lesson… what goes up, does come down. The Fed cut rates, everything settled down, and for the most part it was business as usual on Main Street. But for the first time we got an up close and personal look at how interconnected this global economy has become.

Now it’s the year 2000. Y2K turned out to be a non-event, though it took the blame for a general slowdown in activity in fourth quarter 1999. Gas prices are at record levels, yet spending remains strong. Why? Are we heading for recession? Does it matter? How do we plan for the next five or ten years?

One fact remains constant for the real estate industry. Our health and well-being has always been tied to the availability and the cost of debt capital. That is to say that as long as we as investors have access to reasonably priced financing for our properties, we can survive in any market. I learned in 1991 that it wasn’t enough to have equity, property has to cash flow as well. I also learned that when I can present my company as a stable enterprise, insulated from the uncertainty of highly speculative investments, lenders will roll out the red carpet for my deals.

Always Follow the Money

If then we are dependent on debt capital to fuel our operations, it is important that we as investors understand what influences and moves the markets in way that affect the cost of our funds.

The first thing to know when listening to the gloom and doom reports in the media, is that they have little knowledge about any business other than reporting what people tell them is important. When they report the Dow Jones Industrial Average (DJIA), they are using the implied credibility of a well known financial measuring stick for a good news/bad news sound bite under the assumption that you know what it means. Most of us don’t. The DJIA is made up of thirty companies, picked to represent a cross section of the economy. To put that number in perspective, there are 3090 companies listed on the NYSE, 771 on AMEX, and over 6500 on NASDAQ. The DJIA companies represent approximately one fifth of the value of all US stocks, and about one fourth of the value of the stocks listed on the NYSE. This “average” isn’t designed to predict anything, but rather to track the general trend of where the market has BEEN. Trying to gauge where the economy is headed by watching the stock market is much like dressing for Alaska with only the knowledge that it has an average temperature of 55 degrees.

The result, as Nobel-laureate economist Paul A. Samuelson put it: “The market has predicted nine of the last five recessions.”

But the market is an indicator of the collective perceptions of the investment world. When political turmoil hits, as we saw in Asia and Russia in 1998, money will flee quickly to safety and liquidity. Money doesn’t care who owns it, but it despises instability and uncertainty. “Tight credit” is another way of saying “minimize risk”. Stocks carry risk, and therefore when things get dicey, money moves into low-risk investments, causing the price of stocks to fall. The present tech-stock fallout is another indication that the market perceives the risks to outweigh the potential rewards.

Conversely, as the low risk investments, namely government bonds also known as T-bills, come into higher demand because they are both safe and liquid, the price of those bonds will rise. As the price of a bond rises, the yield drops. Many commercial and residential mortgage loans use the yield of government bonds (or T-bills) as the index for the interest rate charged on the loan. The interest amount over the index rate is known as the spread, generally quoted in basis points (100 basis points = 1 percentage point) over the index rate.

This is the element of commercial lending that falls into chaos in a scenario like we witnessed in 1998.

Again, a lesson from our recent past can best illustrate the point. As the benchmark 30 year and 10 year T-bills soared to record prices, the yields dropped to record lows. Lenders, especially the conduit programs for Commercial Mortgage Backed Securities (CMBS) on Wall Street, were caught in a classic squeeze. They had untold millions of dollars committed at spreads agreed upon months earlier with no warning of any trouble on the horizon, and were faced with funding these commitments at interest rates below their cost of funds. The market took six months to readjust to the new paradigm, and spreads have returned to manageable levels.

But the most interesting development to the Wall Street debacle was the way commercial banks and credit companies moved quickly to fill the void. Since the waves in the market were not from any instability in the collateral, i.e. real estate, the money became available from other sources. In short, the markets corrected the inefficiencies, and money flow resumed when certainty and stability were again in place.

What does this mean to the average real estate investor? It means that money continues to be available for deals that make sense. That rates are a tick or two higher will not in general make a strong deal weak, or a weak deal undoable. It must make sense.

So how do we determine which investments actually do make sense?

Main Street vs. Wall Street

The fundamentals of the real estate industry have not changed. The Wall Street players, and the relatively recent use of the CMBS to capitalize real estate, have not captured so much of the market as to control access to debt capital. Commercial banks, insurance companies, and to a certain extent pension funds, are still the mainstay of real estate funding. However, some sectors of real estate are going to be harder to finance due to the effects of other market factors, and may be best left to those players big enough to weather the storm.

Hotels, for instance, have been on the brink of overbuilding for the past two years, and the alarm was sounded for a slowdown in room growth completely independent of the global financial problems or the cost of oil. This is not to say that there will be no hotels built for the next year. But the ones that are built will most likely have a strong franchise, a killer location, and a verifiable market. In short, the deal will make sense from a hospitality business standpoint, not as a speculative real estate project.

One side note on oil: We must be aware that this one commodity has the power to move our markets in ways we don’t even fully fathom. Being in the hotel business, I watch the price of gasoline for the obvious effect it has on travel. I started getting nervous last December when prices topped $1.40 and no one was saying anything. In mid-January OPEC intimated it would vote to increase production at its spring meeting in Geneva, but that the increase would be too late to affect prices during the summer travel season. I was still concerned, but relieved that OPEC was not going to take a hard line ala 1973. Then the media, in their usual clumsy manner, finally noticed the price of gas in late March and sounded the alarm. Mind you, the problem was already solved, and now the media and the government wanted to get in front of the crowd and take credit for fixing a problem they hadn’t even noticed until it was over. Some say the clumsy handling and belated pressure from Washington actually made it harder for OPEC to do what they had already planned to do, lest it look like they were caving into pressure from the US. I get nervous when government actually acts. I’d much rather see gridlock.

Watch the Right Numbers

For the market as a whole, the base demographics that real estate relies on remain solid. Looking at the industry through the lens of a few select property types can offer insights into where we are headed in general, as well as highlight specific islands of opportunity.

Mobile Home Parks remain strong, and are in fact category killers when it comes to valuations. The REIT’s have scarped up most of the investment grade parks, and are now homing in on the larger parks of B and C grade to soak up the cash being made available for the product. This serves to drive up the valuations of formerly unattractive parks, and ever-restrictive zoning standards across the country combine to give this property type one of the highest potential returns available in real estate. The demand for affordable housing continues to grow, and mobile home sales are predicted by the Manufactured Housing Institute to continue to comprise about 30% of single family housing sales.

Commercial growth and development remains strong. Reacting to a perceived threat from Internet sales, traditional retailers have found they can compete in a hi-tech, hi-touch environment, and that online activity in fact boosts in store sales. Online spending has in fact created a mini-boom in warehouse and distribution facilities. Commercial occupancies reported to the International Council of Shopping Centers are averaging in the nineties. Retail spending remains strong. Consumer credit, while higher in dollar amounts, is in fact the least we have seen in recent years as a percentage of income. The income and employment levels of the population as a whole are the strongest in history, which in turn drives spending, and are the key indicators for the near term economy.

The National Association of Homebuilders predicts single family housing starts to fall somewhat in 2000, but still average over 1.3 million starts, more than double the starts in 1982, and 50% higher than the 840,000 starts in 1991. This is good news for rental property owners without being bad news for builders. Apartments have both permanent and bridge financing products available to fit almost any scenario. Rates can range from the mid 7% range to a point higher in most parts of the country. Debt coverage ratios on even marginal properties are in the 1.15-1.25 range, certainly not an indication of overly tight money. Rents are rising faster now, due in part to rising residential mortgage rates, which are cooling home sales. Occupancies remain strong as a reflection of the record low unemployment rates we have enjoyed in the past several years.

These are the fundamental demographics that control our industry. In short, if a deal is really a deal, it will make sense on these factors, and it can be funded and profited from, global financial hiccups and market swings aside.

The Roaring 2000’s

I recently read a book titled The Roaring 2000’s, by Harry S. Dent. In it he predicts that the greatest economic expansion in history will occur in the first decade of this new century. He bases his predictions on the population curve and spending patterns of the baby boom generation, and a multitude of other long-term trends that are operative in our economy. I tend to agree with his analysis, (and highly recommend the book) and believe that some of the highest appreciation gains in real estate ever seen will occur in the next eight to ten years.

Now is the time to position our income real estate for maximum valuations. That means making capital improvements with the cheapest money we can find, and raising rents on the strength of the completed improvements. Take this opportunity to examine service contracts, evaluate expense trends, and check utility consumption. If you’re looking at an acquisition, make sure it makes good business sense. The formula for growth now, as in the past, is “Create stability to attract funds.” Remember that lenders are in the business of loaning money for the purpose of gaining a return… and they’re counting on us to bring them deals that make sense for all parties.

Unless the world can solve Asia’s debt problems, bring political stability to Russia, hold up the weather in Mexico, and turn the Eurodollar into the United States of Europe, all in the next year, there is no where else but the US for world money to hide. And once it gets here, it won’t be happy with a 4.5% T-bill yield for long. Will we be ready? Will we have the product available to invest in when the time comes? As the market weeds out the uncertainty, good deals will get better, and the quick will reap the profits.

I intend to be in front of the line.