“I’m Looking for a Really Great Deal” – That Guy

Don’t be “that guy.” Telling a real estate professional that you’re looking for a “really great deal” says a lot about you and none of it good.

First of all, duh. Who’s looking for a really bad deal? “What I’m really looking to do is buy something above market with negative cash flows and then sell it for a loss,” said no one ever. The purpose of investing in real estate is to make money. You wouldn’t be doing it otherwise. Wanting a positive return on your investment goes without saying.

Second, it shows a fundamental lack of respect for a broker’s expertise and time. “Really great deals” are rare. Their scarcity is what makes them valuable. You’re not going to find an investment with such characteristics on the open market. Competing offers would drive up the price until it became a “market deal.” Truly “great deals” trade off-market and, as such, require extensive research which consumes time and energy. Real estate professionals are typically paid commissions when a deal closes. Anyone that thinks that a broker looking for a needle in a haystack is a productive use of their time reveals how little they respect it.

Third, if I find a “really great deal” why would I tell you about it? I’d buy it myself (or find the means to). If I put in the time and effort to find an off-market investment opportunity, put the deal together, etc. I’m going to be the one that benefits as a result. If one expresses their willingness to work with a broker only on the condition that they bring them a “really great deal” they’re revealing an underlying narcissism that makes them exactly the type of client you don’t want to work with.

*** The previous 2 examples do not apply if a buyer is willing to pay a broker a retainer for their services with clearly stated deliverables ***

Finally, “really great” is a subjective term and unless someone can clearly articulate their investment parameters they’re not a real investor and will most likely waste your time. A “really great deal” for some may not be for others. A good deal is a market deal. Therefore, by definition, a great deal would be one that produces above-market returns. If someone says that they’re looking for a “really great deal” without saying where, what return that amounts to, etc. they’re not really looking for anything. How can they confirm a deal is “really great” if they don’t have parameters against which to measure it?

True real estate investors know that “really great deals” are the result of hard work, both in finding the opportunity and effective management during the holding period. The investigative efforts to identify an off-market opportunity can be time intensive and resource draining. In real estate (particularly brokerage), time is money and to expect a real estate professional to perform these services on a contingency basis is unreasonable and denotes a lack of mutual respect.

To expect a “really great deal” to fall in your lap is like expecting to win the lottery. The most successful real estate investors haven’t gotten lucky over and over again; they’ve used sound investment principles to guide their decisions on when to buy and when to sell. They understand that adding value is the true way to turn a good deal into a great deal. This can take the form of investing in capital improvements, increasing rents, lowering operating expenses, etc. Real investors run cost benefit analyses to determine the most effective and efficient actions that can be taken to increase a property’s returns and maximize value.

In conclusion, don’t be “that guy.” Determine your investment return parameters and goals and be able to clearly articulate them. Experienced real estate professionals, particularly CCIMs, have the expertise and resources to show you how to turn a market deal into a great deal through creative deal structuring, effective property/asset management, capital improvements, etc.

Fairfax Center (Fair Oaks/Fair Lakes) Submarket Overview Q1 2019

 

Office tenants continue to prefer Northern Virginia submarkets with direct access to Metro stations, and relocations to areas like Tysons Corner are having a significant impact on Fairfax Center’s fundamentals. Vacancies, which have increased since 2013, are now near an all-time high. Draws for this submarket include retail amenities, connectivity to other areas of the region, and a diverse array of employers. Major tenants in Fairfax Center include defense contractors (ManTech International, General Dynamics, and Northrop Grumman), healthcare (Kaiser Permanente), the local Fairfax County government, and IT firms (Argon ST, CGI Group). Net absorption struggled from 2015–17, but was at its highest level since 2011 after the first three quarters of this year. The most recent delivery was in January 2018, when Apple Federal Credit Union (AFCU) completed its 150,000 SF building at Fairfax Corner. As of October, the property was more than 90% leased, with AFCU taking 93,000 SF and Atlantic Coast Mortgage taking 26,000 SF. The last delivery of note before this year was Inova Health Systems’ 112,500-SF medical office in the Fair Oaks Hospital center. The property delivered in 2014 and remains more than 40% vacant but is facing further risks—Inova Health Systems plans to consolidate to its new campus in Merrifield near the Dunn-Loring Metro station.

Merrifield Submarket Overview Q1 2019

Merrifield’s office market, with its concentration of healthcare, professional and business, and defense sectors, has struggled this cycle, like most suburban submarkets in the metro. Exxon Mobil’s relocation of its Fairfax operations to Houston in 2015 caused vacancies to spike, and while the submarket has since recovered, vacancies are still slightly above the metro average. Merrifield is far from thriving; many office tenants have been leaving for areas like Reston or Tysons, slowing the submarket’s rent growth and construction; however, the submarket recently received welcome news in the form of new leases and company expansions. As of mid- October, volume in Merrifield for 2018 was less than $10 million. At about $159 million, sales were strong in 2017 but failed to match the levels reached earlier this cycle.

Space Acquisition Process: When to Start

When should a tenant or buyer begin their search for commercial space? The answer to this question depends on a number of factors, but in general the more time a user gives themselves the better. A compressed timeframe puts pressure on the user to acquire space quickly to either begin business operations or ensure the continuity thereof. Tenants or buyers that provide themselves with adequate time can methodically and intelligently locate the best possible space and negotiate the most advantageous terms.

Perhaps the most driving factor impacting the timeline allotted to the space acquisition process is existing lease expiration dates. Tenants may have the option of renewing their existing lease either by way of a renewal option or through simple negotiations with the landlord.  In the case of renewal options, tenants will be required to provide notice of their election to exercise their renewal right which may range from a few months to a year. If the landlord has other plans for the space tenants may be required to vacate at the end of the lease term or incur holdover penalties in addition to other damages incurred by the landlord. It is important for tenants to know if staying in place is an option when deciding when they need to begin the search process.

The nature of the tenant’s business and asset class will also impact runway time needed. Office users can generally give themselves less time due to the uniformity of most office build outs and relative abundance of options. Retail users, on the other hand, must place special emphasis on location within a submarket/trade area as well as within the retail project itself. Many retail landlords provide exclusivity provisions to existing tenants which prevents another similar user from leasing space in the same center. The more specific and unique the requirement the less options and thus more time required to find a space that works.

Another factor influencing the space acquisition timeline is whether or not the space will require modification. Depending on the locality the build out process may be lengthy, in some cases taking 6 months or longer. Drawings will need to be prepared by an architect, approved by both the landlord and tenant, and then submitted to the applicable municipality for review and approval after which permits are granted so that construction can begin. The construction timeline can then vary based on the experience of the contractor, availability of materials, complexity of the build out, etc. If a user is looking to take a space as-is they can allow for less time.

The length of lease term is a related matter. If a tenant is only interested in a short-term lease (less than 5 years) they can allow themselves less time to acquire space. Without adequate time over which to amortize their costs, neither tenants nor landlords will be willing to invest capital into a costly build out. Tenants that are looking for short-term leases will most likely be required to take the space as-is or with minimal improvements. Usually limited to paint and carpet/flooring and/or minor demo, such work does not require permits and can be completed quickly.

Market conditions and inventory should also be considered before beginning the space acquisition process. In a landlord’s market, categorized by low vacancies (low supply/high demand), tenants will need to give themselves more time to find space. If key elements of a user’s requirements such as square footage, budget, location, etc. are relatively inflexible then tenants may be forced to wait for new inventory to become available.

Determining the right amount of time to give to the space acquisition process is more of an art than a science. Users must weigh a number of internal and external factors that will impact the time in which they can identify, acquire, and occupy suitable space. In a perfect world, users would be able to take space that works as-is and begin beneficial occupancy on 1) the day they would like to open for business or 2) the first day of the month after their current lease expiration date.  In an imperfect world, businesses must balance between giving themselves too much time, potentially reducing the amount of rental abatement they can negotiate, and too little time in which case they may be unable to find space that works or forced into taking space under less than ideal conditions. In general, it’s better to give yourself more time than less so that you’re not putting short-term needs ahead of long-term goals.

Perhaps the best practice is to reverse engineer the process; working back through the construction process, lease negotiations, letter of intent negotiations, identification period, and requirements gathering and then assigning timelines to each step based on the internal and external factors previously discussed. After adding it all up, businesses may be surprised by how long it may take for them to comfortably acquire space. It’s always advisable to work with an experienced commercial real estate broker who can help you assign accurate timelines for each step based on your specific needs and market conditions within the applicable submarket.

Thank you, IRS!

The IRS just issued final rules on the 20% business income deduction (Section 199A of the Tax Code) that was part of the 2017 Tax Cuts and Jobs Act. Yes, you read that correctly. The new tax law provides you with a 20% deduction on your business income… 20% right off the top!

The rules confirm that this deduction applies if you operate as a sole proprietor, owner of a partnership, S corporation, or limited liability company (LLC). It applies even if your income exceeds the threshold set in the law of $157,500 for single filers and $315,000 for joint filers.

How it Applies to Rental Income from Real Estate Investments

Income from rental/investment properties is eligible for the deduction as long as the rental operation is part of a trade or business. Meaning you can claim the deduction if your rental activities, which include maintaining and repairing property, collecting rent, paying expenses, and conducting other typical landlord activities, total at least 250 hours per year.

How it Applies to 1031 Exchanges

Originally if income was above the threshold levels previously mentioned ($157,500 single filing or $315,000 joint filing) the amount of the deduction was subject to reduction; however, due to successful lobbying efforts by the National Association of Realtors, CCIM Institute, and other trade groups the rules were changed. Now one can use the unadjusted basis of the depreciable portion of the property to claim at least a partial deduction.

Source – National Association of Realtors, January 24, 2019

For more information it’s recommended to seek the advice of a licensed tax professional or tax/business planning attorney.

Legal Ownership Structures Series: Sole Proprietorship

 

“One is the loneliest number.”

A sole proprietorship is the simplest ownership form under which can operate a business and consists of a single person. It is not a legal entity but rather a business form in which there is no separation between business and owner. Many sole proprietorships operate under the owner’s name, i.e. Ryan Rauner; however, they can also operate under a fictious or trade name, i.e. Ryan’s Nail Salon, which does not create a separate legal entity.

Here are the pros and cons of operating as a sole proprietorship:

Pros

  • Ease of creation – Sole proprietorships are created the moment an individual does business for oneself. There is no formal filing or event, only buying and selling goods or services is required.
    *** Sole proprietors must still register their name and secure any licenses required for their particular business activity, i.e. real estate license.
  • No cost – there are no formal costs to set up a sole proprietorship.
  • Little to no formalities – Sole proprietors do not need to file articles of incorporation with the state, hold formal meetings, etc. Owners typically sign contracts and receive payments under their own name even if the business uses a trade name. They can also comingle business and personal funds/assets.
  • No unemployment tax (on owner) – Owners are not required to pay unemployment taxes on themselves (but must for any employees).
  • Tax advantage (losses) – Because income, expenses, gains, and losses are reported on the owner’s individual tax return any losses from operations can be used to offset income earned from other sources.
  • Simplicity of taxation – Owners must only fill out and file a Schedule C along with the standard Form 1040 to report income, losses, and expenses. Sole proprietors must also file a Schedule SE to calculate the amount of self-employment tax owed.

Cons

  • Unlimited personal liability – Perhaps the largest disadvantage to a sole proprietorship is that the owner is subject to unlimited personal liability for the business’ debts. If an owner borrows money to operate the business and is unable to repay the loan or is sued by another party for negligence the owner’s personal assets, such as their house, retirement accounts, etc. are at risk.
  • Difficulty raising capital – Because they consist of a single person and thus cannot sell interests in the business, sole proprietorships may have difficulty raising capital.
  • Mortality – Sole proprietorships end with the death of the owner and thus do not retain any value.
  • Self-employment tax – Owners of sole proprietorships must pay self-employment taxes up to legally mandated limits, which amounts to double taxation as the owner must pay both the employer and employee portion of the tax for a total of 15.3%.

Taken as a whole the advantages of sole proprietorships are outweighed by their disadvantages and, as a result, are not the ideal form of ownership for real estate investments. The unlimited personal liability, alone, puts the owner at risk of losing more than just their equity in a particular investment as courts can proceed against the individual’s personal assets to satisfy judgments.

As always, it’s recommended to speak with an attorney before deciding on which business entity works for your personal situation.  

Northern Virginia Town and City Submarkets Q1 2019

fairfax county city-town submarkets

Fairfax City Submarket Q1 2019

Fairfax City is the main hub for the Fairfax County government and George Mason University (GMU). In fact, aside from these two, there is only one other tenant in the submarket that occupies more than 50,000 SF. The Fairfax County government and GMU’s presence have helped stabilize Fairfax City’s office vacancies, which remain below the metro average despite negative absorption that drove significant mid-cycle increases.

What the submarket lacks in Metro access it makes up for in affordability and connectivity to other areas of the DMV. Office rents here are lower than in both Tysons Corner and Reston, but like in many suburban submarkets, growth has been inconsistent. Still, Fairfax City has seen a steady increase in inventory turnover since 2013, with an average of 20 deals closing each year. 

Falls Church Submarket Q1 2019

Much of Falls Church’s office space is in older buildings, with 3 Star or lower inventory making up over 80% of stock. Nonetheless, demand was solid from 2014–16, although it lost momentum in 2017 and through the first three quarters of 2018. Absorption went sharply negative in 18Q2 due to move-outs at the Falls Church Corporate Center. Vacancies expanded dramatically as a result, although they remain below the metro average. The submarket’s biggest challenge is competition from Tysons Corner, where 4 & 5 Star product comprises about 60% of inventory, making it much more likely to attract the large users that were the primary drivers of metro-wide absorption in 2017. Rents in Tysons Corner are 40% higher (or more) than they are here, but that submarket appeals to many tenants and benefits from the flight-to-quality trend. However, Falls Church provides an alternative to tenants who can’t afford office space in Tysons but want Metro accessibility. Given the inventory mix, it’s no surprise that most transaction close for less than $1 million. The primary market movers are local investors, and annual volume typically stays below $10 million. 

Great Falls Submarket Q1 2019

McLean Submarket Q1 2019

Oakton Submarket Q1 2019

Vienna Submarket Q1 2019

Northern Virginia Town & City Multi-Family Overview Q1 2019

 

Fairfax/Oakton Multi-Family Submarket Q1 2019

Vacancies continued their decline this year after a new delivery and a demolition caused significant vacancy expansion a few years ago. The Modera Fairfax Ridge apartments delivered in 2015 and struggled to lease up. This is important, considering another 800 units are under construction in two developments from Combined Properties. The next few quarters should enjoy stability, something of a norm in this submarket, before new supply delivers in 2019 and 2020, potentially disrupting the multifamily market. Developers also face competition from a large home ownership population and affordability concerns. Rent growth was down last quarter, but did enjoy two quarters of strong leasing earlier this year. Investors are still finding opportunities for value-add plays, despite the submarkets small multifamily inventory.

Falls Church/Vienna Multi-Family Submarket Q1 2019

Falls Church/Vienna was a developer favorite early in the cycle. More than 2,000 units delivered in 2012 and 2013 alone. Recent deliveries are near emerging live/work/play centers. Dunn Loring Metro station serves as the focal point of the Mosaic District and Halstead Square. Volatile vacancies fell back below the historical average this year, thanks to no supply and strong absorption. Projects in the pipeline have since subsided, as there were no units under construction at the start of 18Q4.

McLean/Great Falls Multi-Family Submarket Q1 2019

Home to some of the wealthiest and most educated residents in the D.C. metro, the McLean/Great Falls Submarket is a homeowner’s paradise. Incomes top $200,000, and the average house is selling for upwards of $1 million. Apartment vacancies and rents are volatile, as the multifamily inventory is small. Investors and developers target neighboring Tysons Corner and Reston for their density, town centers and job nodes.

You Know What Really Grinds My Gears? (Cap Rate Edition)

 

You Know What Really Grinds My Gears? When people tell me they want to invest in real estate… and are looking for a property with a(n) “X%” cap rate.

“Why?” you ask.

Without even going into cases where the cap rate they’re looking for amounts to a needle in a haystack in the market(s) they’re interested in (DC multi-family properties have been trading as low as 4.5% cap rates), the statement shows a fundamental lack of understanding of basic real estate investment principles.

Cap rates are a way to measure the market value of a property as opposed to the investment value (see my article, Market Value vs. Investment Value: What’s the Difference?).  The difference is subtle and can best be understood by which side of a real estate transaction you’re on: Buyer side (Investment Value) vs. Seller side (Market Value).

Sellers want to sell their properties at the lowest cap rate possible because if NOI remains constant a decrease in the cap rate will increase the market value of the property (the price that a property can yield in an arm’s length transaction). As demand increases for a particular asset type and supply remains relatively constant, buyers are willing to pay more for an asset or, better stated, a greater amount for the income that asset generates. As a result, decreasing cap rates function as a type of inflation on the net operating income that a property produces; decreasing the value of each dollar by requiring a lower return. Therefore, the seller’s focus is on the market cap rate, as determined by comparable sales, which sets the market value for the property based on its net operating income.

Investment value is a matter of perspective and subjective to each investor. It refers to the value that a particular investor is willing to pay for a property and is based on their required return NOT cap rate. I discuss the differences between cap rates and internal rate of return in depth in my article, Cap Rate vs. IRR: What’s the Difference?, but in short because cap rates only consider 1-year of NOI and thus do not account for changes in net operating income over the holding period, the effects of financing, or the tax benefits associated with real estate ownership they are an insufficient method of assessing value for the investor.

Real estate investors should be able to clearly articulate their required return (or range) in order to purchase an asset. They speak in terms like internal rate of return (IRR), yield, cash-on-cash, etc. Sophisticated investors understand that the use of financing can increase a property’s return through positive leverage (where there exists a gap between the cost of funds and the properties unleveraged return/cap rate). They are also aware of the tax benefits of real estate ownership that can also increase returns by lowering taxable income.

If a buyer can’t differentiate between a return and a cap rate they’re not a real estate investor. True real estate investors understand that cap rates tell only part of the story and that investments must be analyzed over the entire holding period with considerations made for potential changes in NOI through annual escalations, increased market rents, vacancies, etc. The purpose of investing in real estate is to make money. If a buyer is talking about cap rates they’re focused on the seller’s return, not their own.