commercial real estate

What Is The Difference Between A, B And C Properties? The commercial real estate industry uses a lot of lingo. This can seem daunting for first-time investors looking to make sense of different property types. One of the ways to distinguish amongst property types, for instance, is by a property’s “class” rating. Generally speaking, properties are classified as either Class A, Class B, or Class C properties. This is true across all real estate asset classes, regardless of whether you’re referring to office buildings, retail centers, apartment buildings, or industrial and warehouse facilities. With our expertise in transforming distressed commercial buildings into valuable assets, we are experts in determining the value of Class A, B, and C properties for your investment portfolio. Here is Appelmans’ guide to the ABCs to property types and when you should invest in each. What is a Class A property? Although there is no universally-accepted definition of a Class A (or Class B or Class C) properties, most in the industry consider Class A buildings to be newer with higher-quality finishes, amenities and accessibility. Class A properties tend to be located, and oftentimes have their own brand or lifestyle associated with them. Class A properties tend to be extremely desirable, investment-grade properties with the highest quality construction and workmanship, materials and systems. They often contain unique architectural features, utilize the highest quality finishes, and utilize first rate maintenance and management. Class A properties are also distinguishable by the tenants they attract. Most Class A properties will be occupied by prestigious, credit-worthy tenants that are willing to pay above average rental rates on longer term leases. Class A properties are frequently bought and sold by national and international investors, including institutional investors such as life insurance companies and pension funds, who are willing to pay a premium for quality assets. Example of a Class A property An example of a Class A property would be a newly-renovated office building located in downtown Tampa, Florida, such as the Wells Fargo Center. The property is located close to the waterfront with great views, in a premier location that makes it easy to attract best-in-class tenants. The property is considered highly sustainable (LEED Gold-certified) and has been designed with resiliency in mind. The property also contains robust technology to provide building-level cooling systems to provide the highest level of comfort for the office workers inside. The office building also offers robust amenities, such as a ground-floor café, restaurant, coworking space, bicycle storage, on-site showers and a full service fitness center, and valet service for the parking garage. Benefits of a Class A property There are several benefits to owning or investing in a Class A property. The most obvious benefit is the ability to attract high-quality, credit-worthy tenants that are willing to pay higher rents. The desirability of Class A buildings means that they provide more liquidity than Class B or Class C properties. In other words, there is enough consistent interest in purchasing Class A properties that an investor can expect to have an easier time selling the property than if they were trying to sell a Class B or Class C property in the same market. For all of these reasons, Class A properties are considered to be one of the “safest” additions to an investor’s portfolio (but conversely, offer somewhat lower returns in exchange for this lower risk profile). In fact, a recent study by the MIT Center for Real Estate finds that over the course of a market cycle, Class A properties located in secondary markets (e.g., Atlanta, Miami, Dallas, Houston, Phoenix, Denver, San Diego, Seattle, Minneapolis) outperform Class B properties in primary markets (New York, Los Angeles, Chicago, San Francisco, Boston, and Washington, D.C.). This, the study found, was true when evaluating both office buildings and multifamily properties. What is a Class B property? A Class B property tends to offer more utilitarian space with fewer amenities than one would find in a Class A building. It will typically have ordinary architecture design and structural features, with average interior finishes, systems, and floor plans. The systems will be in adequate condition and the property will be structurally sound, but not overwhelmingly impressive. Generally speaking, the older the property is, the more likely it will the designated as a Class B property. However, there are examples of older buildings that maintain a Class A designation. The maintenance, management, and tenants in a Class B property are considered good (but not necessarily great). Class B properties may also be less appealing to tenants, in general, as the buildings may be deficient in a number of respects, such as ceiling heights and building or facility condition. Tenants that leased space in a class B building tend to be be less established, have lower credit, or may be unable or unwilling to sign a long-term lease. Therefore, while Class B buildings tend to attract broad interest among a wide range of users, the rents these tenants are willing to pay tends to be less than a Class A property can command. Class B properties are often considered more of a speculative investment than their Class A counterparts. Class B properties will occasionally attract attention among national investors, but most investors tend to be local to the marketplace. Example of a Class B property An example of a Class B property would be a 20-year-old office building located in an urban location that has fair to good visual appeal. The office property may be located in an acceptable neighborhood but it is not likely to be the highest rent location. The building may provide ample on-site parking, have functional HVAC systems, and acceptable management. However, the building lacks the robust amenities found in today’s newly-build Class A office buildings. For example, the lobby may not have been renovated in many years and they look “dated”. Many of the suites in a Class B building have floorplans that need to be reconfigured to meet the needs of today’s workplace … Read more

Commercial Real Estate Jargon Explained It’s tough enough being a commercial real estate investor without knowing all of the jargon and industry language you need to learn quickly. Don’t know the difference between asking rent and actual rent? Can’t figure out CapEx or DSCR? We’ve broken it down for you with our commercial real estate glossary. Here are some important terms and concepts to get you started. Absorption Absorption is a measure of the health of the market in which a building is located, measured in square footage. Net absorption is measured by subtracting the total commercial space that is occupied during a given timeframe (usually quarterly) as compared to the total occupied space in the prior timeframe. It takes into account new construction. Positive net absorption signals a healthy real estate market. In the recession of 2008, more commercial real estate square footage came to market than was being leased, leading to negative net absorption. This happened because in 2005, a lot of new buildings were planned. But because they take a couple of years to build, many of them came online in ’08, right when the economy collapsed. Tenants were purging space from the existing buildings while newly constructed buildings were being delivered. That was a double whammy and resulted in negative absorption. Asking Rent, Actual Rent Asking rent is fiction, actual rent is fact. Every landlord will list their asking prices. The most well-known listing service or database is called Costar. It has a virtual monopoly of databases in the United States for office space leasing. Every office building will list its asking prices in this database. But the actual rents are not disclosed, only rumored. As a rule of thumb, actual rents may run 5 percent to 10 percent below asking rents when you factor in concessions and the like, including free rent (see rent abatement, below). Sometimes the so-called “face rate” will equal the asking rent. But when you factor in free rent and extra tenant-improvement dollars and similar concessions, the actual rent is usually lower than the asking rent. That said, asking rents remain a valid barometer because they provide a relative index. CapEx, or Capital Expenditures, and Reserves CapEx refers to the capital improvements to a building. They are distinguished from tenant improvements (see below). A capital expenditure is part of the landlord’s basis for his entire investment in a project. When a landlord performs radical renovations of lobbies — we call them “lobby-ectomies“ — or improvements to offices (“office-ectomies”), they can cost millions. A lobby renovation can cost anywhere from $1 million to as much as $5 million. In most cases, CapEx cannot be passed through to the tenant under the operating expense clause in a lease, unless that particular capital improvement reduces the energy or the operations expense for running the building. In that case, it is legally allowed to be passed through to the tenants as an operating expense under the operating expense clause, with the expense attributable to normal operations as opposed to a one-time capital item. Operating expenses include normal and recurring maintenance. Every month or every year, you have certain minimum expenses. The utility expense for electricity is an operating expense because it’s a recurring expense for the normal operations of the building. The renovation of a lobby is something you don’t do every year; it’s a one-time capital investment. Operating expense can be a tax write off in the year incurred. CapEx, such as an investment in the lobby, is considered a capital improvement and is depreciated according to a depreciation schedule. Under the most recent tax laws, certain parts of a building may qualify for accelerated depreciation. There is a gray area about when a particular expense is a repair or when it is a capital improvement. Take an air conditioning system. If you replace the system’s chiller — this big, massive machine that runs a whole building — it’s a capital expenditure. But if you’re just replacing part of the system, that may be considered a repair, which can be a tax deduction for that year. Let’s discuss reserves for CapEx. Any prudent developer looking at buying a new building or projecting the future cash flow of an existing building they own should be allocating a recurring reserve annually for capital expenditures, almost like it is a recurring expense, though it’s technically not that. The reserve is usually expressed in cents per square foot. Here at Appelman Properties’, we have historically used 15 cents per square foot. Then we used 20 cents per square foot. Now we’re using 25 or 30 cents per square foot because over time these things get increasingly more expensive. Those amounts should be set aside in a fund to cover the eventuality that they may be needed. Developers don’t always do that. But some lenders — such as lenders that issue Commercial Mortgage Backed Securities, or CMBS ­— actually require developers each year to post reserves to a lockbox account or a cash collateral account from which they cannot withdraw funds unless they are for a capital expenditure. Each month and each year, money is deposited from cash flow into that account. CMBS lenders also require tenant-improvement reserves, because in the course of managing an office building, there are always going to be tenant improvements. A lender will negotiate reserves for tenant improvements, separate and apart from CapEx reserves. Debt Service Coverage Ratio (DSCR) DSCR is the net operating income (NOI) divided by the debt service. It’s the most important metric in the commercial real estate business, a measure of a project’s financial productivity. It’s the key metric that a lender wants to see. Net operating income refers to all the revenue derived from a property — whether it be an office building, a retail shopping center or an industrial building — minus operating expenses. Revenues include all of the office rents from all of the spaces in a building, plus all of the revenue for ancillary services. … Read more

The 5-3-2 Model for Fix-and-Flip Investors The 5-3-2 Model Explained The 5-3-2 Model is very simple: 5 – Buy and rehab 5 homes 3 – Sell 3 homes through traditional means 2 – Carry back the note on the other 2 homes That is, for every 5 properties that you purchase, sell 3 and “be the bank” for 2. When you sell the 3 homes, it provides you with the ongoing cash flow for your business. For the other 2 homes, ideally, you want to pick out the best properties to carry back the loans on. If you do it correctly, you should have nothing invested in those two properties because you would’ve received all the money back through down payments and the profits from the other 3 properties you’ve sold. Benefits of the 5-3-2 Model The benefits of following the 5-3-2 Model are two-fold: First, you receive ongoing, passive capital to continue building your business. You will continue to receive the profits from selling the 3 properties, as well as the ongoing interest payments from the other 2 properties. Also, since you are carrying the note, rather than being the landlord of the property, you are able to transfer the taxes, insurance, and repair responsibilities to that buyer. Therefore, the investment is completely passive, and also, technically, an infinite return. Secondly, you’ve created residual value that operates like an annuity or retirement plan. Self-employed people, which include real estate investors, tend to forget the value of long-term retirement strategies. Instead, they tend to live deal to deal, rolling the dice, or money, into the next deal. Following this strategy allows you to get the best of both worlds: the instant gratification of realizing the fix-and-flip profits, as well as the long-term, residual income that can be a “safety net” for when the unexpected occurs, like unforeseen personal issues (health, family, etc.) or the market taking it’s next turn for the worse. Please make sure to subscribe and follow our channels for resources in up-to-date strategies for your real estate investing journey.

WHAT IS CAP RATE COMPRESSION? Cap rates can be an incredibly valuable tool for investors looking to establish a property’s value. The cap rate, expressed as a percentage, is calculated by dividing the property’s net operating income by its purchase price. The resulting percentage generally ranges anywhere from 3 percent to 15 percent or more. Cap rates have an inverse relationship to property value. The lower the cap rate, the more valuable the property—and vice versa. Therefore, it is often said that a cap rate is the yield an investor is getting on the purchase price. The lower the cap rate, the higher the yield. Another way to think about cap rates is that they are the inverse of an equity multiple. For example, a five-cap is said to be a 20 multiple on income. What is cap rate compression? Cap rate compression is when the cap rates for any specific property or property type come down. At the building level, cap rate compression can occur after a property has been markedly improved, physically or operationally, or has a significant improvement in the tenancy. For example, if Apple, Google or the federal government signs a long-term lease for a Class A office building, it will likely trade at a lower cap rate than if it were leased to multiple office tenants with less impressive credit. Investors are willing to pay more for these properties given the perceived stability of the tenant. Cap rate compression can also occur among all buildings of a certain property type within a specific geography. For example, when Amazon announced its “HQ2” in Crystal City, Virginia, investor interest in the area skyrocketed. Investors, buoyed by Amazon’s long-term investment in the region, started purchasing other office and multifamily buildings with rapid speed. The significant uptick in investor interest caused cap rate compression within the marketplace. There’s been similar cap rate compression in the Tampa Bay, Florida office market. Investors who once focused on properties in Los Angeles, San Francisco and New York City have watched a growing number of workers relocated to Florida in the aftermath of COVID. Now, those investors are reallocating large swaths of their portfolios to Florida-based office buildings given the uptick in demand. As competition for Florida office buildings has increased, cap rates have correspondingly compressed. Office cap rate compression While cap rate compression impacts all real estate asset classes, it has specific impacts on the office sector. The biggest distinction between office cap rate compression and other product types pertains to credit. For example, when someone is contemplating the purchase of a 300-unit apartment building, few buyers are going to dig into the credit of all 300 tenants renting units in that building. It will be assumed that the tenants met some preliminary screening criteria as part of the broader application process and therefore, have at least some minimum credit score. In contrast, those looking to purchase an office building will generally look to see at least three years’ worth of an office tenant’s trailing financials, balance sheets and cash flow statements. They will also ask to see any projections that the office tenants have relative to their future income and expenses. Prospective buyers might even look for news stories or undertake other investigative measures to understand the stability of an office tenant. Investors spend significantly more time evaluating the credit of office tenants than they do the tenants of residential buildings. The stringent due diligence on office tenants’ creditworthiness is because office tenants tend to be on long-term leases. Depending on the size of the property, the building may be leased to one or just a few office tenants. If one of those tenants stops making their rent payments, or worse, goes bankrupt, then the landlord could experience a significant disruption in their cash flow. An investor who has purchased a property at the height of the market, in a tight cap rate environment, will likely need that income to remain solvent. Conversely, the creditworthiness of office tenants can impact a building’s cap rate. Tenants that are S&P or otherwise formally rated are considered the “safest” tenants and therefore, landlords can usually command prices for these properties. A building with highly-rated tenants, especially if those tenants are on long-term leases, will generally trade for lower cap rates than a building leased to tenants with more questionable credit. Each prospective buyer evaluates tenants’ creditworthiness differently, and therefore, will make their own judgments about the tenants’ stability. This due diligence process is part art, part science. As such, two different buyers could come to different valuations (and therefore, different cap rates) based upon their assessment of the tenants’ creditworthiness – something that is decidedly unique in the office sector compared to multifamily investments. Is cap rate compression good or bad? Whether cap rate compression is good or bad depends on a person’s perspective and role in a commercial real estate deal. Sponsors with existing real estate will generally find cap rate compression to be a good thing as it makes their buildings and assets more valuable. Cap rate compression can also lead to higher rents over time. For example, someone who purchases a property at the top of the market for a low cap rate may feel more pressure to fully stabilize a property and increase rents than if they had purchased the same building at a lower price and higher cap rate. Those who pay top dollar for a property naturally want to grow their yield as much as possible. Conversely, from a tenant’s perspective, cap rate compression might be viewed as a bad thing if it results in higher rents. Unless tenants have other options, they may be forced to pay more for their leases than they would in a higher cap rate environment. Ultimately, the extent to which cap rate compression has an impact on the local rents will depend on total supply and demand. If there is excess supply in a marketplace, cap rate compression will not have … Read more

What is IRR in Real Estate? When investing in an income-producing asset, it’s important to know how much money you will make as well as when you will receive it. Checking the performance of stocks and bonds can be easily done by logging into a brokerage account for updates. However, identifying current and future real estate returns is much more difficult because the same property does not change hands every day. Of the various financial analysis metrics available to real estate investors, IRR is one of the most often used calculations. IRR in real estate incorporates key investment criteria to help identify property that meets the specific goals of each individual investor. What is IRR? Internal rate of return (IRR) is a financial metric used to measure the profitability of an investment over a specific period of time and is expressed as a percentage. For example, if you have an annual IRR of 12%, that means you have 12% more of something than you did 12 months earlier. The IRR calculation combines profit and time into one formula: Profit is how much cash the investment generates over the holding period compared to the amount of capital invested Time value of money (TVM) estimates what the current value is of money received in the future Opportunity cost by comparing the IRR of one investment to other alternatives A good way to think about IRR is that it is the discount rate – or interest rate – that makes the net present value (NPV) of the cash flows you receive equal to zero. By weighting the periodic cash flows, IRR helps you to make a fair comparison to alternative investments with cash flows that occur at different points in time. That’s because a dollar actually received today is worth more than the promise of a dollar received several years from now, due to factors such as inflation, unknown future events, and general investment risk. As a real estate investor, you have a required rate of return on the capital being deployed in order for the investment to make sense. Everything else being equal, the investment that generates an IRR greater than or equal to your required rate of return will be worthwhile taking a closer look at. Examples of calculating IRR Let’s assume you invest $100,000 in a property with a holding period of five years. If you choose the wrong investment and have no cash flows and no profit or loss at the time of sale, your IRR is 0%. However, the three more likely potential outcomes are: #1: Annual cash flow and no profit from sale Initial investment $100,000 Annual cash flow $12,000 Initial investment of $100,000 recovered at the end of the five-year holding period IRR is 12%, which is another way of saying that the investment generated an annualized profit of 12% #2: No annual cash flows but a profit from sale Initial investment $100,000 No cash flows over the holding period Initial investment of $100,000 recovered plus a $25,000 profit from sale for a total of $125,000 IRR is 4.56% because a profit was generated when the property was sold at the end of five years – note that the IRR is lower than Outcomes #1 and #3, due to the NPV and TVM concepts #3: Annual cash flow and profit from sale Initial investment $100,000 Annual cash flow $12,000 Initial investment of $100,000 recovered plus a $25,000 profit from sale for a total of $125,000 IRR is 15.66% because cash flows were received and a profit was made when the property was sold at the end of five years Assuming your required rate of return is 6%, the only outcome that is worth considering is the last one with an IRR of 15.66%. Key assumptions that affect IRR Note that in order to calculate the potential IRR of a real estate investment you’ll need to make four assumptions: Amount of periodic cash flows Timing of periodic cash flows Date property will be sold Sales price of property Minor changes in these four assumptions can have a significant impact on your IRR, such as receiving cash flows monthly or annually. For example, if you invest $100,000 and receive $1,000 the first month, you now have $101,000. That’s 1% more than your original investment, and a monthly IRR of 1%. Assuming your investment grows by 1% each month, in the second month you would have made $102,010 ($101,000 x 1.01), and by the end of 12 months you would have made a total of $12,682.50 from your original investment. The annual IRR of 12.68% ($112,682.50 / $100,000) – 1 = 0.1268 or 12.68%. On the other hand, if you received a single annual distribution of $12,000 from your $100,000 investment, your annual IRR would be just 12%. What is a Good IRR? IRR is a comprehensive way of thinking about the potential profitability of a real estate investment. When you think about what a good IRR is, it’s important to take a detailed look at the prospective investment and understand that an IRR isn’t always what it appears to be. For example, a project may boast a big top-level IRR, but the net IRR to you as an investor is lower because of asset management fees taken by the developer or sponsor before distributions are made. On the other hand, an IRR may be understated due to the industry standard of calculating investment returns on an annual basis, when distributions are actually made monthly or quarterly. Core Plus, Core, and Value Add investments will also yield different IRRs due to the anticipated income stability and the level of risk: Core Plus investments will generate a lower but very predictable IRR similar to the regular payment schedule of a bond or stock dividend, with little upside or downside Core properties will return slightly higher IRRs due to gradually increasing cash flows and an upside gain when the property is sold Value Add projects may provide higher IRRs, although … Read more

What Is 70 Rule In House Flipping What Is The 70% Rule In House Flipping And How Can It Help Me Decide How Much To Pay For A Distressed Property? What’s the key to flipping houses successfully? Buying homes at a low enough price so that when you sell them you make a large profit. Overspending on the front end of a home purchase will make it much more difficult to earn those big dollars. But how do you determine when a home’s sales price is right? The 70% rule can help. It’s important to remember, though, that this rule is just a general guideline and won’t replace the long hours of research you’ll still need to do to make sure you’re not overpaying for a home you want to flip. What Is The 70% Rule In House Flipping? Home flippers have a simple plan for earning money: They buy a home cheap, fix it up, and then sell it at a higher price. The goal for flippers is to buy low and then sell high to boost their profits. The 70% rule can help flippers when they’re scouring real estate listings. Basically, it says that investors should pay no more than 70% of the after-repair value of a property minus the cost of the repairs necessary to renovate the home. What does this mean? The after-repair value, or ARV, of a property is the amount that a home could sell for after flippers renovate it. When buying a home to flip, investors need to estimate how much they think the property could sell for after it’s been renovated. They can then multiply that amount by 70% and subtract it from the estimated cost of renovating the property. The resulting figure is the highest price that flippers should consider paying for that property. The key here, though, is to realize that the 70% rule is just a general rule of thumb. Before buying any home, you need to study market conditions, work with real estate professionals to get a more accurate resale estimate and meet with contractors to determine how much repairs will cost and which renovations are needed.