Stabilized Transactions Mastery Lesson 01

Lesson One: Start Here

1.1 Orientation
Before you get started with this course, please read the orientation blog to help you understand the key points of real estate investing. Use the following link to view the orientation: Click here to view the orientation.
1.2 Here’s What to Expect
This course is designed to help you learn about stabilized properties, the type of properties, how to analyze these deals, obtain financing, and provide you with industry knowledge and sample deals. At the end of each chapter, there will be a quiz to evaluate your knowledge of the information provided. By taking this course, you will receive an easy-to-use practical guide that will provide key formulas, guideposts, and metrics for real-world situations that you will be involved in.
Course Objectives:
  1. Life Insurance Companies: Generally the most conservative underwriters.
  2. Banks: Includes local banks (community banks), regional banks and money center banks. Note: most banks will no longer portfolio 10 year loans.
  3. Conduit Lenders: Also known as securitized lenders. These lenders aggregate loans, then repackage them as rated bonds or securities.
  4. Opportunistic Lenders: Typically lenders who hold whole loans on a balance sheet. Can include opportunity funds, finance companies, mezzanine lenders and mortgage REITs.
  5. Equity Investors: Has the “first loss piece” of the transaction, but also has an uncapped upside.
1.3 Asset Types
These are the first things you should concern yourself with — The “Four Food Groups.” Remember, we’re looking at income-producing commercial real estate.
Retail

There are 5 types of retail properties. First are the grocery anchored retailers. They are the most stable, as everyone has to eat. These are Safeway, Winn Dixie, Publix, Ralph’s, Whole Food, ShopKo’s, ShopRite and Pathmark in the northeast. We like these a lot and are currently raising funds to buy a chunk of them from a REIT selling these in a separate fund.

Second, are the unanchored retail. These are small centers, local tenants, least stable, trade at high cap rates. They are your “mom and pop” pizza chains, nail salons, and cafe’s.

Third, are the neighborhood centers. They are local centers and providing services to surrounding residential areas. Some may have a grocery store, such as a “mom and pop” business.

Fourth, we have the power centers. These are also called destination centers. They are a combination of “big box” and local inline space: Walmart, Home Depot, Lowes, Ross, Staples, Marshalls, etc.

Fifth, we have the regional malls. They are large restaurant centers, which have multiple anchors such as department stores.

Multifamily

Multi-family residential buildings vary by location (urban or suburban) and size of structure (high-rise or garden apartments). High rises are defined as four stories or greater. Generally, multi-family buildings are perceived as the most stable gue to the fact that people always need a place to live. However, they are also seen as the gateway from those residential investors making the leap into commercial. As a result, they are also the first to get bid up in heated markets

Multifamily contains 4 classes:

Class A: Multi-family residential buildings vary by location (urban or suburban) and size of structure (high-rise or garden apartments). High rises are defined as four stories or greater. Generally they are seen as being the most stable as people need a place to live; however, multifamily is seen as the gateway from those residential investors making the leap into commercial. As a result, they are also the first to get bid up in heated markets

From the outside, they look like other Class “A” products in the market with a high-end looking exterior that are usually built with high quality construction and the highest quality materials.

Class B: This is a product that has been built within the last 20 years, but the exterior and interior amenity package is dated and less than what is offered by properties in the high end of the market. Although dated, this product is usually of good quality construction with little deferred maintenance.

Class C: This describes an older product built within the last 30 years as evidenced by limited, dated exterior and interior amenity package. These are more of a 1970’s – 1980’s vintage product. Any improvements show some age with noticeable deferred maintenance. It’s not uncommon for any appliances or baths to be original from the time of construction.

Class D: Often forgot about, this is a product that is over 30 years old. These are worn properties, operationally not stable, that is situated in fringe or mediocre locations in a market. Tenants usually pay cash each month.

This product also has higher churn and burn; any system components have considerable wear and tear. There are no amenity packages offered (such as a concierge or front desk), most garden-style product will be “walk-ups,” having no elevator.

Office

Not all office properties are the same. Office properties generally come in 3 flavors or 3 classes: A, B, and C. Generally speaking, office buildings are viewed in three classes that relate to building quality, not location:

Class A: The newest, nicest, slickest and the best on the market

Class B: These are more of a 1970s vintage, without any ‘modern’ features.

Class C: These are older properties, and frequently the most unkempt.

Office also have 3 distinctive categories too. They are listed below:
  1. Urban – downtown locations, typically higher barriers to entry. Very expensive, trophy assets.
  2. Suburban – close employment bases and have fewer barriers to entry.
  3. Flex Space – typically suburban, typically one story; part office, part warehouse, part light manufacturing; usually have drive-in doors and some warehouse space.
Industrial

Industrial is categorized as a “safe” asset class as it is very homogeneous. Would you rather have Amazon.com paying you rent each month or a bunch of angry tenants having problems making ends meet? Unlike office space and multifamily where the quality of the asset and space drives the price, this is not so much the case with industrial and warehouses.

Now these asset classes come in different shapes and sizes — Not all office buildings are the same any more than any multifamily properties are the same.

1.4 The Total Real Estate Capital Strategy

Within the capital strategy, is structuring the deal. This is where the fun comes in. After you’ve gone through this, you’ll understand why vetting your deal is so important. At this point, you begin to add value and where the paydays come in. If you plan to become a consultant, you’re going to want to pay close attention here.

There are generally three ways to make money structuring your deals. And you’ll want to have these in the back of your mind when you’re pre-qualifying deals.

Capital Placement

Capital placement occurs when placing capital from one institution to a buyer looking to purchase or refinance a property. We call these folks “sponsors” or “owner/operators.” These institutions are usually real estate private equity funds, (discretionary lenders), family offices, pension funds, life and reinsurance companies, and endowments or hedge funds.

These same institutions generally provide capital across the entire capital structure; such as their debt, equity, or sometimes both. What you need to know is, the capital structure comprises of the total debt and equity at the asset level.

Sponsors are important because, a sponsor with equity is more valuable than someone with no money down.

How You Make Money

In any deal where you’re placing capital, you as the Intermediary are usually incentivized in the form of points or a percentage of the total loan amount.

For example: If you arrange and place $5,000,000 from a capital provider, such as a bridge lender, you’ll usually get paid between 1-1.5% of the total loan amount, or $50,000 to $75,000.

Depending on the deal – and the market – it’s not uncommon for you as the Intermediary to get a percentage of the deal after all improvements have been made.

So if that same $5,000,000 loan is placed on a property that will be worth $10,000,000 after all improvements are made (we call this the “terminal value” of the property) then if you are good at negotiations, and are able to score a 10% equity stake (otherwise known in the industry as “hope certificates”), then that is another $1,000,000 in equity.

Lastly, depending on how plentiful capital is, you may also be able to make a yield spread on this.

Let’s put this into context: When you deposit your money into a savings account at the bank, you expect to make somewhere between 1-2% in interest. What the bank does with that money is, they lend it out at 7% interest, then pay you the paltry 1% interest (with a straight face) and pocket the 6% interest rate spread.

You can do this too. Let’s see how.

If the capital provider is charging say 8% on a bridge loan, with your operator looking for 9-10%, tell him 9%, then tell the servicer to pay the net difference to you. To put this into perspective, on that $5,000,000 loan with a 1% simple interest spread, that could amount to $50,000 per year or $4,166.67 per month – to you.

When capital is plentiful and cheap, it becomes competitive, and every percentage point matters to your borrower. Someone will always undercut the other shop to get the deal done. However, when capital is scarce (think of 2008-2010), then it’s going to be much easier for you to get what you ask for. (Right now it should be understood that it’s far easier for you to think like a bank, rather than a landlord.)

Debt vs. Mezzanine vs. Equity: Not All Capital Is the Same

The parts within the capital structure comprise of what are called structured products that all have different levels of risk. This is something you must absolutely understand if you’re going to swim in the deep end with these institutional capital providers.

Want to solidify your credibility instantly? Always ask your sponsor or operator who is looking for capital these questions: “What kind of capital do you want? Where do you want your capital provider to be in the capital stack?” This will allow you to really effectively communicate to institutions.

Asset Arbitrage

In residential real estate, it’s called “wholesaling.” That’s what the little investors call it. In commercial real estate it is called “crossing a trade” or arbitrage. Now that we’re grown up and will be facing off with grown up men and women in the industry we’ll want to use these cocktail terms.

This is simply identifying an asset that is undervalued, locking it up under a contract or an option, then either selling it or assigning it to an end buyer. You are “arbing” the asset. You are buying low and selling slightly higher. Not at retail or full market value because you want to leave enough meat on the bone to make your buyer truly interested and activate his or her greed glands. Got it? Good.

Remember, you need to be careful of Real Estate Commission rules of getting paid a commission on the sale of real estate without a real estate license. Get the property under contract, then sell or assign your contract for a fee since the contract is personal property as opposed to real estate.

Now that we have that out of the way, here’s what you need to do to make sure your deal is legitimate.

  • Lock Up The Property at a Low Basis.

This means there is strong market equity in the deal today. We call this imputed equity. It’s being sold for a number of reasons such as a partnership that has blown up and everyone wants out, the bank has taken it back through foreclosure or has filed foreclosure, and time is of the essence to get the property sold.

In other words, if I were to offer you a house for $60,000 that is worth $100,000 today, that’s a strong basis. Meaning you’re getting $40,000 worth of imputed equity today for that $60,000. But if I were to offer you that same $100,000 house for $95,000, that doesn’t sound as strong, does it?

  • You Need To Have Your End Buyers Identified and Pre-Qualified.

This is where everyone fails. They find an opportunity, then scramble to find a buyer. This rarely works out. As a result; the deal, your credibility, or both are lost because someone who tells you they were a buyer isn’t one, then they don’t perform and go radio silent. It’s extremely frustrating, especially if it’s your first deal, you will get easily discouraged.

The best use of time during the day is to spend about 30 minutes with yourself or someone else in your office, such as an intern or a domestic VA, finding and calling Qualified Institutional Buyers (“QIBs”). You’ll want to reference this blueprint below when speaking to them.

There are several types of QIBs out there and all of them have different motives. A publicly traded REIT for example will pay close to retail for most assets as it’s easier for them to raise more capital by issuing more shares of stock that is publicly traded.

Smaller private partnerships, comparatively speaking, have a higher cost of capital therefore they are more concerned about the basis at which they are buying an asset.

Of course, it’s far easier to cross a deal when you can get terms. If the buyer can assume the existing financing, then that makes the deal as a whole look way more compelling. Your retail investors, such as mom and pop investors; like doctors, dentists and accountants will almost always be more inclined to purchase these types of deals that are structured with existing financing.

Capital Formation

The third strategy is to raise capital yourself then, take the asset down to place into your portfolio. These deals are usually structured one of two ways: usually using a fund or a joint venture structure. Those who are proficient at raising capital have the appropriate tools do so, are able to effortlessly raise capital on demand. They’ve lined up prospective investors, retail or institutional, and know how to approach each.

They have an ever greened pitch book (a PowerPoint presentation) that they can use over and over again. They are prepared and have planned to be nimble whenever an opportunity comes. They simply “call the capital” when they need to. They leveraged other people’s proven systems to pull down the right tools from the shelf when they see opportunity.

Now, after reading this, you can probably come to the conclusion why most people who look to raise money around real estate deals fail immediately. It’s simply because, they fail to pre-qualify their opportunities. They can’t seem to look at these numbers dispassionately. Usually, because they are desperate to close a deal, or they are being strong-armed by a seller or investment professional who has a stronger personality than they do. Then, they merely can’t communicate the deal in a convincing, persuasive, and logical format.

If you’ve ever been pitched by someone who doesn’t know what they are doing, this scenario will likely be very familiar to you:

They send you a 20MB Investment Offering via email from a broker. It clogs your email.

They can’t explain the deal, so they tell you to read the whole 200 page Investment Offering.

The only thing they know about this deal that they are asking you to put your hard earned savings into is that it’s “great,” and “a sure bet.”

You have to do all your own research. There is a tremendous amount of pressure and sense of urgency to get you to invest. They have to close immediately – if not sooner.

No documents are drawn up, and you come to the conclusion that your operator or sponsor has no experience. You wasted all this time for nothing, or

You implicitly trust this operator to make the right decisions, and pray you don’t lose your hard earned money.

Incidentally, there is a blueprint you’ll want to review that we created for some larger news publications which discuss why you should run from any crowdfunded real estate deals – as a passive investor.

Crowdfunding is seen as being the next “big thing” in real estate. History has yet to be written on the effectiveness of this approach however, here’s a blueprint you will want to download to quiz your brother-in-law who is bragging about the $10,000 he dropped in a “very significant real estate deal.” The point here is that if you truly desire to be successful, you need to wear the right clothes to this party.

Quite frankly, it’s not that difficult. Those who aspire to become Real Estate Private Equity Fund Managers need to focus on using a proven system to do only two things. Find deals and fund them.

1.5 Stabilized Properties: The What and Why

This course begins with the simplest form of transaction; stabilized properties. We begin the series of courses with stabilized properties because such property is generally purchased for its predictable cash-flow stream, much like a bond or dividend payment. The investor might believe that there is upside potential in rent growth, but the primary goal is a stable income stream. For a property to be considered stabilized, it must have the following characteristics:

  • The property is fully leased or leased to market occupancy.
  • Property rents are at market rates.
  • Tenant turnover is minimal in the short term and is staggered over the long-term.
  • The property requires no minimal or major capital improvements.

Stabilized real estate properties are an accepted asset class for institutional investment diversification. The safest assets have the following characteristics:

  • Macro location: A large, dynamic market (e.g., New York, Washington, D.C., San Francisco, Chicago.
  • Micro location: Well located within the submarket.
  • Newer construction: Constructed in the past 5 to 10 years.
  • Tenants: Excellent tenant credit quality, with long-term leases.

This course will focus on stabilized properties; however, the graphic below is provide you with a brief overview of the other types of properties: Unstabilized or Value Added Properties and Opportunistic Properties. We will cover these properties in an upcoming course.

1.6 Rules of Investing

Stabilized Properties: Investors buy these properties under the assumption that the risk is substantially removed from the transaction and nothing negative will happen to reduce future cash flow.

Value-Added Properties: Investors are betting that something positive will happen to increase the Net Operating Income (NOI) then in turn transform the value-added property into a more valuable stabilized property.

Stabilized investors do not want surprises or uncertainty, they want stable cash flow. When underwritten correctly, these investments can outperform stocks and bonds. Yet, the intelligent investor must understand the key components in stabilized investing:

  • Operating history
  • Rent roll
  • Cash-on-cash return (the capitalization [cap] rate)
  • Leveraged cash-on return
  • Operating expense structure (pass-throughs and stops)
  • Leverage structure (underwritten net operating income [NOI])
  • Market and demand drivers
  • Leasing and exit strategy
1.7 Sample Transaction: Stabilized Property Example #1
Debt vs. Mezzanine vs. Equity: Not All Capital Is the Same

Purchase price

(Including closing costs):

Stabilized NOI:

$10,000,000

$950,000

Sources and Uses of Funds

Sources of cash:

Borrower cash equity:

Loan request:

Total:

$2,000,000

$8,000,000

$10,000,000

Uses of cash:

Property acquisition:

Total:

$10,000,000

$10,000,000

Debt Assumptions

Permanent loan:

6.75% rate

30-year amortization

(Constant 7.78%)

1.8 Sample Transaction: Stabilized Property Example #2

The following example will also be used during this course. In this example, the investor is buying a 70,000 square foot stabilized retail center.

Acquisition Assumptions

Loan Request:

Sponsor Equity:

Total Capital Structure:

Stabilized NOI:

$8,000,000

$2,000,000

$10,000,000

$950,000

Sources and Uses of Funds

Sources of cash:

Borrower cash equity:

Loan request:

Total:

$2,000,000

$8,000,000

$10,000,000

Uses of cash:

First Trust Loan:

Remaining Equity:

Total:

$8,000,000

$2,000,000

$10,000,000

Debt Assumptions

Permanent loan:

6.75% rate

30-year amortization

(Constant 7.78%)

Assignment:

In Lesson 1, you learned about the four property asset types: Retail, Multifamily, Office, and Industrial. For this assignment, find a property that is for sale in each of these four categories. After finding the listing, you will begin to perform due diligence on each of the four listings. Your due diligence should include the following:

  • List Price versus Assessed Price
  • Location description
  • Current use of the property
  • Recent sales in the area of similar properties

Provide a detailed report of each of the four listings.

This assignment is your study guide to ensure you have learned these materials before you take the required quiz.