CRE Thought Leadership

“Learn from the mistakes of others.  You can’t live long enough to make them all yourself.” 

Having spent my entire career in commercial real estate (CRE), I have made more than my share of mistakes and witnessed countless others.  There are literally thousands of decisions made in any commercial real estate transaction.  Many of them are so small they are virtually unrecognizable.  Early in my career, I was introduced to a very simple chart that I have grown to rely upon when making capital allocation decisions.  It very simply shows that as time elapses, your ability to influence the outcome diminishes, and the cost to influence that outcome grows.     

In simple terms, a dollar spent early in the process has a much greater influence on an outcome than a dollar spent later in the process.  I’ve seen this simple truth repeatedly played out in my career.  Not enough invested up front can be the difference between profit and loss.  This concept leads us to the first mistake CRE sponsors^[1] make: undercapitalizing the business plan.

Opportunity Zone investor incentives can sound compelling.  Where else can an investor receive increased returns (by paying little or no federal capital gain taxes) and at the same time help revitalize a local community?

Although Opportunity Zones provide substantial tax breaks for investors, they can be risky endeavors for bridge lenders and sponsors alike.  In this article, we will explain what Opportunity Zones are, why they were created, and how bridge lenders may approach their underwriting of projects within these zones.

What are Opportunity Zones?

Opportunity Zones (OZs) are designated areas throughout the United States that have been selected by state and federal agencies for economic revitalization.  In order to invest in OZs and receive federal tax breaks, investors must invest in a Qualified Opportunity Fund (“QOF”).  According to the legislation, a QOF is “any investment vehicle which is organized as a corporation or a partnership for the purpose of investing in qualified Opportunity Zone property…that holds at least 90 percent of its assets in qualified opportunity zone property.”  The legislation imposes a “substantial improvement” requirement on the QOF.  In order for an existing building to be designated as a qualified OZ project, the QOF is required to make improvements to the building in an amount equal to or in excess of the purchase cost of the building (less the land value).  Additionally, these improvements must be substantially completed within 30 months of the QOF’s purchase of the building.  As an example:

A Qualified Opportunity Fund buys a property for $1 million.  The land is worth $250,000 and the building is worth $750,000.

In this example, an additional $750,000 must be invested into the building within 30 months of the purchase date.

Obtaining commercial real estate debt financing is no easy task.  In certain scenarios, gathering and organizing the required information can be a monumental undertaking.  Many times, closing timeframes or difficult sellers can make it impossible.  However, when presenting an opportunity to a lender, the more information you can provide the better.  More importantly, you can expect more accurate feedback.  From a lender’s perspective, the overall focus or theme is “don’t lose.”  Because of this directive, lenders can be seen as “Debbie Downers” or “Negative Nellies”, seemingly unable to focus anywhere but on the downside scenario of the opportunity.  Because typical debt structures do not allow the lender to participate in the upside, the downside risks take the majority of the lender’s focus.  From this perspective, it is easy to see why lenders will tend to take a conservative approach.  As a broker (or sponsor), it is important to try and not let a lender replace missing information with overly negative assumptions (sometimes they just can’t help themselves).  A debt package that provides a complete picture of the opportunity will help manage any lender concerns upfront.  This allows the lender to focus on the business plan presented, rather than stalling out with questions about missing information. 

Below is an outline of important parts of any debt package that, when included, will help to keep the lender’s attention on the deal.

1. Background
2. Sources & Uses
3. Capex Budget
4. Historicals + Pro Forma
5. Sponsor Background
6. Market Data

Real estate crowdfunding has been quietly evolving on the sidelines during the latest commercial real estate bull market.  Critics dismissed this new form of capital raising as just another fad or buzzword du jour.  However, crowdfunding platform founders claim that it is destined to overtake traditional capitalization methods in the not too distant future.  Regardless, the major objections to crowdfunding are dissipating rapidly as advancements in supporting technology trends (to be discussed in a subsequent post) allow for greater investment transparency and growing user-adoption.  As this industry matures, real estate investors and sponsors will be able to connect more efficiently, creating greater competition for capital and deals.  This increased efficiency and competition will result in a broader demand for quality deals and cheap equity.  However, before market participants may hope to reap these benefits, they should first be aware of the basics of crowdfunding.

Over the course of a series of posts, I intend to cover some of the key differentiators of crowdfunding platforms that affect investors and sponsors.  These consist of two major areas: differentiation of platforms and differentiation of offerings.  While both platforms and offerings have significant effects on both investors and sponsors, investors should be more concerned with understanding the platform, and sponsors with understanding the offering.

In Part 1 and Part 2 of this series, we discussed the definitions as well as what factors decrease the useful and physical life of a commercial building.  In this article, we examine a specific property type of commercial real estate that has important deviations from a “typical” older commercial property: residential rental property.  We will explore why residential rental buildings (primarily apartments) have shorter economic useful life expectancies and what the main limiting factors in extending a property’s economic useful life is.

Economic Life of an Apartment is 27.5 Years

When considering the purchase of an older residential rental property (such as an apartment) it is important to understand that the useful economic life of an apartment building is significantly shorter than that of a commercial building.

As a reminder, the IRS allows 27.5 years over which you can depreciate residential rental buildings and 39 years for retail and other commercial structures.  This shorter depreciation schedule was established to encourage construction of new rental housing, however, it also reflects the fact that residential rental structures have a significantly shorter useful lifespan than commercial structures.  The tax code presumes that the useful life of a residential rental building is only 70% of the useful life expectancy of a commercial building.

What factors contribute to a shorter useful life for residential rental housing properties?

In Part 1 of this series, we discussed what the useful and physical life of a commercial building is, as well as the five stages of a building's life.  In this article, we will explore some of the factors that can decrease the physical and useful life of a commercial building. We will also touch on building obsolescence, which can be a major threat to older buildings.

*This is the first in a three-part series on considerations when purchasing older buildings.

Purchasing a building that is 25-years-old or older requires a significant historical investigation and analysis to determine the risks associated with the building.  These articles are intended to aid any investor attempting to answer the following questions:

• How do you identify the risks that come with the ownership of an older building?
• What factors can hurt the future net cash flow of an older building?
• How much more economic life is left in the building
• How many years are left that will produce reliable income from the ownership of the building?
• How do you determine the current value of an asset with a shorter economic life?

A building’s “useful life” depends on its previous ownership, intended use, and prior maintenance regime.