Over the many years I’ve been in the commercial real estate business I’ve come across all sorts of investors. Occasionally, I encounter someone who has fallen in love with their commercial property. You know the type. Their approach to their property is based more on feelings than sound investment decisions.
Want to find out if you’ve fallen in love with your property? Answer these four questions. Do I do these things?
The 4 Question Test
- Do I consider my commercial real estate a “trophy property?” Is it a real beauty? Do I drive by and just smile? Do I like to show it off to my friends?
- Do I make cosmetic improvements to the property for no other reason than I want to?
- Would it be difficult for me to sell my property, even at a premium price, because it holds special significance for me? Would it be like selling an old friend? Or has the property been owned by my family for decades and selling it would be tantamount to betraying good ol’ dad?
- Do I ignore or am I oblivious to my property’s abysmal return on equity because I’m unwilling to refinance the property even though it’s highly likely it’s in my best interests to do so?
If you answered yes to two or more of these questions, it’s time for an intervention! Yes my friend, you have fallen in love with your property but it’s not too late. Call your team of commercial real estate advisors – your real estate broker, your mortgage broker, your real estate attorney, your property manager, your CPA. Call anyone that will help you see the error of your way. Have them set up an intervention so you can start making real estate investment decisions again based on good and wise counsel.
I apologize for my lame attempt at humor. Let’s be clear. There is no sin in falling in love with your property. There are far worse things that you could do like neglecting your property altogether, or consciously deciding to be a slumlord. But if you decide it’s time to manage your property like an investment here are three suggestions to turn things around:
3 Steps to Recovery
- Let’s start with the obvious: Consider your property an investment, not a love object. As we all know, love can make us do stupid things. Let’s limit love to our personal relationships and not to our investments.
- Always have a well maintained property. Always have pride of ownership but make improvements that can be justified by either higher rents or an upside in long term appreciation.
- Once a year go through the exercise of determining your property’s Return on Equity (ROE). If it’s yielding a return you find acceptable then leave it alone. If not, take action. What action? Either sell the property or refinance it and pull cash out. The cash back to you from a refinance can be used to purchase another property or enjoyed as you see fit.
To determine whether it’s time to sell a property I’ll leave to another article. I couldn’t do the topic justice in a few short paragraphs. So let’s focus for a moment on when it’s appropriate for an investor to refinance his property. Again, I believe it starts with determining if the property is generating an acceptable return on your money.
What’s an acceptable return you ask? For other investment vehicles – stocks, bonds, precious metals, etc. we have in the back of our minds an acceptable yield that we want to achieve. It’s not uncommon for my friends to tell me that their IRA or stock portfolio made X percent last year. That’s their way of saying that their investments did well (notice they never tell you when they’ve had a bad year how much money they lost, only when things are going well).
Return on Equity Defined
It’s surprising to me that most real estate investors don’t apply the same standard to their commercial real estate investments. So let me show you a simple method that I use to calculate a property’s ROE. To do this I look at two things:
- The annual owner distributions. In the example below, to simplify things, we are going to equate owner distributions with Cash Flow after Debt Service.
- The amount of equity in the property, which simply defined is the market value of the property less the mortgage balance.
Let’s say years ago you purchased an apartment for $4 million. At the time of purchase you financed it with a 75% LTV loan or a loan of $3 million. The strong rental market over the past several years has significantly increased the property’s value to $6 million today. In the meantime, you have paid down the mortgage balance to $2.0 million. So let’s do the math:
Status Quo ROE vs Refinance ROE
|Equity in the Property||4,000,000|
|Cash Flow Before Debt Service||360,000|
|Annual Debt Service @ $3M, 6%, 30 Yr Am||-215,838|
|Cash Flow After Debt Service||144,162|
|Return on Equity ($144,162 ÷ $4,000,000)||3.6%|
In the Status Quo example shown above the property is currently generating a paltry 3.6% Return on Equity. Would you consider a 3.6% annual return on your stock portfolio acceptable? Heck no! No way! So why are many CRE investors satisfied with that type of return on their commercial real estate? They shouldn’t be.
So let’s look at what happens to the property’s ROE if the property were to be refinanced at 75% LTV. Notice it has the same market value and the same cash flow before debt service as in the previous example. The only two factors that have changed are the amount of equity in the property and the annual debt service.
|Equity in the Property||1,500,000|
|Cash Flow Before Debt Service||360,000|
|Annual Debt Service @ $4.5M, 4%, 30 Yr Am||-257,808|
|Cash Flow After Debt Service||102,192|
|Return on Equity ($102,192 ÷ $1,500,000)||6.8%|
If the owner was to refinance with a 75% LTV loan, not only would he increase the property’s ROE to 6.8% but he also gets $2.5 million ($4.5 million – $2.0 million) in cash back! It’s a win-win for the investor. He gets a higher ROE on his property and he gets $2.5 million in his pocket to do as he pleases.
Under this scenario, why wouldn’t he want to refinance his property? Yet, there are many investors that don’t take advantage of refinancing their properties. Are you one of them? Do you have a substantial amount of equity in your properties generating an abysmal return on your equity? If so, let’s talk. Let me see what I can do for you.
Doug Marshall, CCIM
Marshall Commercial Funding