Calculating the Cost of Delay

Stephon Martin

Happy Memorial Day to all and a heartfelt thank you to all those who serve and have served our country. Your sacrifices are truly appreciated by TRET.

Let us quickly discuss, on this last day of May, the value of Delay. Late payments, be they intentional or not, are costly, no matter how late they are. Time has a calculable value and delayed payments provide a monetary benefit to the payee and punish the lender or vendor. This value is easily observed in the world of retail, where giants like Wal-Mart, not only connect the speed with which they pay their vendors to the success of the products in their stores, but also fine retailers for late shipments. In retail, late shipments equate to lost sales. In real estate, late payments lead to increased opportunity costs and decreased value of money.

ARMs: A Quick Look

Stephon Martin

Adjustable-Rate Mortgages (ARMs) are a viable financing option for both single, multifamily and owner-occupied commercial property owners. Ever since their formal establishment by Title VII of the Garn–St Germain Depository Institutions Act of 1982, ARMs have offered the opportunity to link mortgage payments to marketplace activity. Coupled with the rate collars, ceilings and floors, these financial instruments have the potential to lock in the conditions of a favorable interest rate market, at interest rates that are typically lower than a fixed-rate mortgage. In the world of retail real estate, lower rates can translate into increased purchasing power. For the real estate investor, however, rate fluctuations and potential for sustained above market-rates usually tends to also lead to an early refinance. With the January 3, 2022 deadline for ARMs to decouple from the LIBOR index imposed by Fannie and Freddie, now is an opportune time to take a look at ARMs and their role in the mortgage market.

How to Navigate Legal Structures in Real Estate

Stephon Martin

As the real estate market attempts to move past the COVID-19 pandemic and progress toward a “New Normal,” federal moratoriums have become a way of life in real estate. Navigating the legal landscape of a local market has always been part of creating wealth in real estate. Every real estate marketplace is subject to its own local laws, as well as its state law and federal law. At the highest level, real estate investment and development is a game of understanding the rules—the applicable laws, ordinances, building codes, etc., and knowing when you can bend them in your favor through variances, court cases and lobbying. Although much of this may seem a little nefarious, it need not be, as our legal system was designed to establish a certain set of default rules for real estate, with a mechanism to allow for change in the event that either some rules are inapplicable generally or inadequate for a given situation. That stated, below are some ways to capitalize, navigate or at least survive the laws of any real estate market:

Let’s Not Forget the Expenses

When either forecasting, underwriting or simply checking the figures on a deal, it is important to account for expenses. The mere mention of the word expenses immediately brings certain images to the mind of most real estate professionals, such as taxes, labor and materials. Proper accounting for such expenses, however, can make or break a financial model and skew underwriting assumptions. That said, it is important to employ the following practices to ensure that your expense estimates are accurate and reflective of the market.

Property Maintenance Laws and Lending

The fight against property blight is a battle that has been waged for many decades. Some areas of the nation, have struggled with abandoned properties and even abandoned neighborhoods since the shrinking of the nation’s industrial sector beginning in the 1970’s. Other areas became intimately acquainted with blight as a result of the wave of foreclosures that took place at the end of the first decade of the century. However it may have arrived, the real estate finance market is certainly now affected by the palpable concern of property blight and has had to adjust to attempts to mitigate its damaging effects. 

Why Worry About Blight?

To be clear, blight is a real issue that can lead to a number of undesirable effects. Abandoned properties that are poorly maintained cause safety issues. Poorly maintained building systems and structure will eventually fail at some point, causing unsafe buildings. Overgrown landscaping leads to health concerns. These health and safety concerns become a problem for neighboring properties, as neighbors must then focus on how to curb the spread of these issues onto their properties. More generally, well-maintained properties inspire a pride of ownership that carries over to neighboring property owners. The opposite is also true—abandoned and poorly maintained properties drain the neighborhood of pride of ownership and lead to less diligent maintenance throughout the neighborhood.

Cooperatives

Welcome to another year at the Real Estate Think Tank. I enjoy writing about real estate and am thankful that I have this forum to share my thoughts on the subject. With that said, let’s get into Cooperatives.

A Cooperative, also known as a Real Estate Cooperative or Co-op, is a form of real estate ownership in which owners purchase shares in a corporate entity that owns a building. This entity is usually called an Apartment Corporation. Despite the name “Apartment Corporation,” a co-op can be both residential and commercial. Although residential co-ops, known as Housing Cooperatives, are more prevalent, commercial co-ops are not uncommon. 

In exchange for the purchase of shares in a co-op, each owner is given both an ownership interest in the Apartment Corporation, usually in the form of shares of stock, and a proprietary lease. The proprietary lease entitles each owner to occupy a certain portion of the building exclusively and confers most, if not all, of the rights of property ownership over the designated space, called an apartment.

Since the Apartment Corporation owns the building and not the owners, owners in a co-op are referred to as shareholders. Furthermore, shareholders do not technically own real estate or real property, but instead own shares, which are considered personal property. This distinction has certain legal ramifications that are noteworthy, but beyond the scope of this post. The ownership characteristics of a co-op, however, are also very interesting.

Condominiums

Condominium ownership is a form of real estate ownership that has unique characteristics. For those not well-versed in condominiums, here is a quick overview of their definition and purpose:

A condominium or condo allows a property, typically a multistory building, but not infrequently a large parcel of land, to be split into sections and owned by multiple owners. The unique aspect of condominium ownership is that it entitles an owner to ownership of a specific portion of a property and the space or “air” bounded by that portion. For example, through condominium ownership, one can convey the first floor of a three story building to one party, the second to another party and the third to yet another party. Interestingly, the units are frequently not required to be the same size, so one could create a two-unit condominium out of a three story building and convey the first floor to one party and the second and third floors to another party. A condominium is formed by recording a document, typically called a declaration in most jurisdictions, but also referred to by other names, such as a master deed, against the property. This document informs the public that the property is now a condominium, outlines the sizes of the units and common areas and provides other relevant information about the condominium.  Once a condominium is formed the property can no longer be sold as an undivided whole, unless the condominium regime is abandoned. The condominium regime will remain in effect until either the unit owners decide to abandon the condominium, the government dissolves the condominium, the property somehow loses the condominium status through the violation of local laws or the government condemns the property.

Easements

Easements are a common occurrence in real estate, but what are they really?

Essentially, an easement is the right to use a property granted by the owner of the property to a non-owner or class of non-owners. An easement is by no means the only way for a property owner to confer use to a non-owner, but unlike other forms used to grant usage rights, such as licenses and permits, easements are recorded against the title of the property over which they are granted and remain in effect despite the transfer of the land. The ability of an easement to survive the transfer of title is called “running with the land.”

Easements differ from leases, which also confer the usage rights of a property to non-owners and also run with the land, in that easements exist in perpetuity, whereas leases have a term with a termination date. As a result, in order to terminate or “extinguish” an easement, an affirmative action must be taken like merger or abandonment. A lease, however, automatically terminates upon the end of its term, without any further action by the parties to it.

There are different types of easements and easements are generally categorized in different ways. The first way that an easement can be categorized is based on to whom or what the rights of usage are granted. If the easement grants rights of usage to the owner or occupant of another property, it is called an easement appurtenant. In this instance, the property on which the easement is established is called the servient estate and the property that receives the right of usage is called the dominant estate.

Monte Carlo Mortgages

In his book Mortgage Wars, former CFO of Fannie Mae, Timothy Howard explains how Fannie's realization that mortgages behave like bonds with embedded call options revolutionized its ability to value its portfolio and manage risk. Prior to this change in thinking, Fannie Mae's methods for reserving capital were consistently shown to be inadequate. Today, the valuation of mortgages and mortgage-related securities as bonds with embedded calls is nothing new.

A call option is a type of derivative, which conveys the right (but not the obligation) to purchase another financial instrument (the underlying asset) for a specified price (the strike price) at a specified time (the expiration date). Purchasing a call option offers the right to purchase the underlying asset and selling a call options impose the obligation of delivering the underlying asset at the strike price on the execution date.

Mortgages are freely refinanceable at any point. In this way, they function as bonds in which the payments from the homeowner serve as the coupon payment and the ability to refinance serves as a call option sold to the homeowner by the mortgage holder. Typically the refinance rates increase as interest rates decrease. Although mortgage prepayment penalties are included in mortgages to discourage refinancing, a large enough drop in interest rates can make refinancing worthwhile to a property owner in spite of the prepayment penalty. For mortgage and MBS investors, prepayments are undesirable. Given that most mortgage investors look to invest anywhere between 5 and 30 years, an early decline in interest rates can leave many investors with cash from prepayments that must be invested in a market offering lower interests rates. This undesirable situation is the double-edged sword of prepayment risk for mortgages.

Why Historical Beta Does Not Always Work For Real Estate

Real estate investment is typically viewed as an essential part of any balanced portfolio. Its immutable characteristics, such as its relatively long pricing cycles and its above average returns, cause real estate to be seen as a stable asset. On the other hand, due to its sensitivity to interest rates, its lack of liquidity at the property level and its longer periods appreciation, exposure to the real estate can also serve as an inflationary hedge. Although real estate exposure may be purchased for any number of reasons, the risk profile of real estate assets is of interest to most, if not all, real estate investors.

The ways in which the risk profile of real estate has been expressed vary from the informal to the highly computational. On the most informal end of the spectrum, owner-operators of property frequently concern themselves with the tax consequences and appreciation of the property, content to face changes in the market or externalities, as they come. On the opposite end of the spectrum are portfolio managers and fixed-income investors, who seek quantifiable means to express the volatility of real estate securities. One such attempt at quantifying the volatility of real estate and its related securities is through the use of real estate's historical beta.

Taxes, Taxes, Taxes

This may be stating the obvious, but the tax consequences of a real estate transaction are one of the most important aspects of the deal. Although most generic measures of property value, such as cap rate and NOI seek to exclude taxation in order to generate values that can be comparable across investors, an individualized tax assessment of any real estate acquisition is essential to determining its true rate of return of and its opportunity costs.

Although I am not a tax professional, tax expert or tax adviser, I would like to briefly discuss various real estate investment tax considerations. I will attempt to address a few of the more popular tax considerations at the property, entity and security level:

Second Mortgages: Why They Are Less Prevalent In Commercial Real Estate Than In Residential Real Estate

Early in my whole loan trading career, an investor once offered to fund a partnership that would purchase second position liens, also known as second mortgages, secured by commercial real estate. The investor promised to pledge a substantial amount of capital, if I was able to assemble a portfolio of target assets. Understanding the risk/reward profile of such an investment and desiring to deliver for what seemed to be a potential source of new business, I quickly began to work on finding commercial seconds to underwrite and select. After a few days on the phone with a number of commercial lenders, real estate debt funds and large financial institutions, I began to realize that commercial real estate second mortgages were not easy to find. Finally, after a few weeks of searching, I informed the investor that I was unable to find any asset worth purchasing that met his mandate.

Nearly ten years later, I now understand why the second mortgage, an established method of financing in the world of residential finance, is so infrequently used in commercial real estate. To state it plainly, the property-income focus of commercial real estate, makes commercial seconds more of a liability than an asset. It is this income focus that leads most commercial lenders to emphasize property performance over the qualifications of the borrower. As a result, most commercial financing is offered with no recourse to the buyer upon default, giving the lender as much control over a distressed asset as possible and incentivizing the owner of a distressed property to “walk away” when there are no more options. In order to maintain as much control over the property as possible, most commercial real estate lenders will insist that they be on the only creditor of the property and that the property be structured in such a way that it is remote from the bankruptcy of the borrower. These goals are typically accomplished by establishing a holding entity for the property to be financed, placing the borrower in the equity position of the entity and making the lender a creditor of the entity, secured by its largest asset.

Who Should Value the Property: BPO's Versus Appraisals

Appraisers and brokers are frequently considered integral components of a real estate transaction. Their roles are clearly defined in residential real estate, however, in commercial real estate, both professions frequently cross into a number disciplines. It isn’t uncommon for a commercial real estate broker to manage a property, arrange financing, market mortgage notes and even raise funds. Commercial appraisers are often asked to inspect buildings, estimate repair costs, estimate the value of construction materials and determine replacement costs. Brokers not only procure parties and assist in the negotiations of transactions, they are also frequently called on to value properties from a number of perspectives.

In light of the various demands on both the real estate broker and appraiser, there may be some questions as to the differences in the valuation reports that each professional issues. It has been my experience that a broker price opinion (BPO) and a property appraisal each serve different, but useful purposes. A broker price opinion typically reflects the value for which a property will generate either a successful lease or sale. The opinion can also suggest a value at which the property will generate substantial interest on the market. An appraisal, however, is typically useful as a justification of a given price, as may arise under a purchase contract, after an assessment or upon any other instance of valuation. Better stated, a broker price opinion can be seen as a forward looking valuation and the appraisal can be seen as a justification or backward looking valuation.

Return on Equity

Let’s keep this post short and sweet, by discussing Return on Equity (ROE). ROE is a measure of the rate at which a property’s after tax cash flow has performed in relation to either the equity in a property or initial investment. As a result, ROE has two definitions that yield different values:

1)   ROE = Cash Flow After Taxes/Initial Investment

2)   ROE = Cash Flow After Taxes/(Market Value – Mortgage Balance)

The first definition tends to be more useful to understand the first year of property ownership, where there is a negligible amount of mortgage reduction and market value has not changed much. The second definition is more useful to track the growth of ROE over time.

It is interesting to note, however, that as both cash flow and mortgage principal reduction increases over time, ROE decreases. There is a school of thought that advocates monetizing equity for reinvestment as ROE decreases. I tend to disagree, since I view debt reduction and equity build-up as benefits that must be considered. Additionally, ROE should not influence the decisions that one makes about other benefits of owning investment property--depreciation, tax shelter, appreciation, and improved utility.

What do you think?

IRR: Its Meaning, Its Uses, Its Benefits, Its Limitations and Capital Accumulation

It is time for this blog to take another step toward legitimacy in the ever growing world of real estate blogs. I am now going to address the frequently used and highly touted real estate metric of Internal Rate of Return. I remember being mesmerized by IRR when I was first learning about commercial real estate metrics. It was introduced to me as the magic number that could explain the true return of a property. I have since learned to respect it as one of the many tools that can be used to understand the return value of an investment property or ABS, while understanding its limitations.

In the interest of brevity, I am going to explain IRR as it pertains to investment property. I will not get into its uses in RMBS and CMBS bonds, as I will save that for a later post. I also will not go into detail on the iterative, successive-approximations technique by which the IRR value is derived. I am on the fence as to whether or not such a discussion would be helpful to this blog. Now that I have told you what I will not do, please allow me to begin my discussion of IRR.

Net Present Value, Discouted Cash Flow, and Profitability Index: Their Uses, Benefits and Drawbacks

It’s good to finally post again. I have recently finished reading What Every Real Estate Investor Needs to Know About Cash Flow…and 36 Other Key Financial Measures, by Frank Gallinelli. Gallinelli’s book is a well-known, highly respected “must read” for those who are looking to understand the basics of commercial real estate property valuation. Having read a number of books on real estate, I have come to two realizations—1) Books on investment property metrics and valuations, by and large, are very similar, 2) I secretly enjoy reading books about real estate. At first, I thought I was reading for informational purposes, but having read about NOI for at least the 20^th time, I have finally admitted to myself that I enjoy doing so. Now let’s get to the meat and potatoes.

Discounted Cash Flow (DCF), Net Present Value (NPV) and Profitability Index are all measures of the value of investment property cash flow. The DCF is derived from the sum of a property’s cash flows, present or projected, discounted to the present. Discounting the value of a cash flow is necessary, due to the time value of money, which accounts for the fact that money today is more valuable than money in the future. An in depth discussion of the time value of money is beyond the scope of this post, but I am more than happy to write a post on it, if I receive a few request for one in the comments below.

Lender’s Fees: How Should One Account For Them?

Lender’s fees are a fact of life in real estate acquisitions. I was recently reading a chapter in a real estate handbook that outlined the justifications of a number fees commonly associated with mortgage origination and it offered a number of options for reducing their amounts. The relative negotiability of each lender fee, however, depends greatly on the lender, the credit worthiness of the borrower, the size of the asset, the size of the down-payment and market conditions. Generally, the stronger the buyer, the larger the asset and the larger the down-payment, the more negotiable lender’s fees are. Below is a discussion of some of the most common lender fees and how to account for them.

Capitalization Rates: Prespective on Their True Meaning

Cap rates are one of the most referenced metrics in all of commercial real estate. Unfortunately, they are also one of the most misunderstood metrics in our industry. I genuinely believe that this misunderstanding comes from the diversity of significant players in commercial real estate. Unlike the equities and debt markets, commercial real estate does not require the presence of a financial institution to mitigate the flow of information and to establish standard practices. Moreover, the equities markets are heavily regulated to insure honesty, transparency and equality of information. The debt markets, though not transparent, however, are generally restricted to institutional investors and high net worth individuals. Commercial real estate sales and acquisitions have no such regulations or restrictions and therefore do not require knowledge of the real estate metrics and their related mathematics to effectively transact. Many commercial property owners purchase properties based on simplified formulas, local knowledge of the property, purchasing rituals or merely "gut feelings." The presence of such transaction activity lends to frequent misuse of real estate metrics.

Despite the misunderstanding of real estate mathematics amongst a certain sector of the real estate market, savvy real estate purchasers, appraisers, institutional buyers and real estate analyst are typically comfortable with the metrics used to describe property performance. The Capitalization Rate or cap rate of a property is one such metric that can offer a wealth of information about the performance of a property and the market assumptions of the seller.

The cap rate expresses the annual rate of return of a property's net operating income given its market value or purchase price. Since debt service, income and expense escalations, and tax considerations, it is not the most reliable method of determining annual return. If properly calculated, however, the cap rate can be compared with a metric of opportunity costs, such as the Weighted Average Cost of Capital from the world of equities to determine the desirability of the property given alternative investments.

I recently found a paper written for the Journal of Real Estate Research that explains the components of cap rate. It explains that cap rates are significantly influenced by the debt and equities markets, but contain significant time lags, given the illiquidity of real estate. The paper asserts that there are 4 components to a cap rate: the risk free rate (here measured by 3 month treasuries, usually measured by the rate of 30 yr. treasuries); a component composed of the market cost of debt divided by the property value (let's call it the property's market LTV) and the spread of a BAA rated bond (lowest possible investment grade); a component comprised of the 1 minus the property's market LTV, the equity spread (as measured by the performance of the S&P 500) and a volatility coefficient beta for stocks (measured by the covariance between real estate equity returns and market returns, divided by the variance of market returns); finally, the negative of the growth rate.

Cap rates are also typically expressed as the discount rate less the property growth rate. Following this logic, one can collapse all of the above components of the cap rate, except for the growth rate negative, into the cap rate's given discount rate. Therefore, given a cap rate, one can look up the risk free rate, the market cost of debt, the BAA bond spread, the equity spread and the equity volatility beta and find the growth rate of the property assumed. All of the aforementioned components are regularly published.

Knowing the assumed growth rate of a property allows for a deeper understanding of how that property is priced and how it is expected to perform. It also explains the inverse relationship between cap rate and price, as a larger cap rate assumes more negative growth or appreciation, as it is called in real estate.

One caveat to both this discussion and the paper referenced is that I am not convinced that cap rates are significantly influenced by the changes in the equities market, although equities are an appropriate asset by which opportunity costs can be measured. The influence of both property REIT's and mortgage REIT's as well as the proximity of the stock market's historical returns (hovering around 8.5%) to historical cap rates (around 7.6%) all make the case that the equities market has some influence on cap rates. Given real estate's local nature and the idiosyncrasies of each property type, however, it is difficult to believe that the link between cap rates and equities can remain significant in the face of more influential determinants of the property's value. I prefer to think of the equities portion of the equation as open to be replaced by whatever alternative investment is feasible to the purchaser at the time the cap rate is figured, accompanied by its related volatility beta.

Commercial Notes and Properties

Commercial mortgage note valuations are distinguished from residential note valuations in that commercial notes, and by extension their related CMBS bonds and derivatives are based on the performance of the underwritten property, whereas residential notes and their related securities rely heavily on the financial behavior of the borrower. Many commercial mortgages are non-recourse to the borrower and often the borrower of a commercial mortgage is an entity, which can be dissolved and disappear upon insolvency or bankruptcy. It is also not unheard of to find commercial lenders and servicers managing properties obtained through foreclosure for a number of years to collect the cash flow from the property until it is sold. Bank-owned residential properties, however, are generally seen as liabilities to be sold at the highest price, as quickly as possible.

Given the non-recourse nature of most commercial financing and the strong consideration of the performance of the property, many commercial note valuation financial models are very similar to commercial asset acquisition models, with a number of lending considerations, such as debt yield, added. The closely related nature of commercial note and commercial property valuations has led me to title this post "Commercial Mortgage Notes and Properties." There are a number of elements that are essential components of both types of models. First, an asset description worksheet detailing the asset and its financing is key. This worksheet should be flexible enough to run a number of quick scenarios or "stress tests" and should have some basic information that it is being fed from other worksheets in the model.

The next essential component of a good commercial mortgage and property model is a rent role worksheet. This worksheet can be separate from combined with a lease expiration table. A clear presentation of such information will allow one to quickly evaluate the condition of the property's rent role in order to understand the flexibility of the asset and how it will perform over the life of the acquisition or note. The next component is a valuation table that should compare a number of different methods of valuing the worth of the property. Area cap rate, replacement costs, and appraised value are some of the many ways to find the value of an asset.  Another important component is an expense and profit escalation table. This table will allow one to project the possible value of the asset over the life of the deal. These projections will be essential to obtaining the asset's net present value (NPV) and for obtaining a rate for the internal rate of return (IRR). I also like to add a worksheet that attempts to predict how this asset as a note will behave if it were securitized with similar assets, worse assets or better assets. Access to the rating agencies' projected returns for each asset class can be very helpful in building and using such a worksheet.

Having discussed the relative de-emphasis of the credit worthiness of the borrower of a commercial mortgage, I must clarify that the borrower credit history is still important to commercial mortgage underwriting and note valuation. Unworthy borrowers lower the value of commercial note, as any foreclosure process, even a "springing-lock box" mortgage, deed of trust or bank foreclosure mortgage (the three least expensive mortgages to foreclose) can be costly in terms of lost cash flow and lost time. Management costs will also accrue after the foreclosure process is complete. No lender wishes to underwrite a deal that will lead to foreclosure, as it would be cheaper for the lender to simply purchase the property, therefore borrower risk must be evaluated and priced through an appropriate interest rate. Borrower credit-worthiness, therefore, should not be absent from your commercial mortgage note model.

Having posted this cursory overview of Commercial Mortgage Note and Asset modeling, I welcome your comments on this or any other post on this blog.