By Karen Hanover
The author has permitted the reprinting and redistribution of this article.
The residential foreclosure mess while terrible for those losing their homes, is wonderful for apartment investors. As many former homeowners migrate back into apartment living, occupancy levels and rents are being driven up.
On the other side of the supplydemand equation…because of constrained capital available for construction, very little new supply is coming online. So, in a nutshell, demand is up and supply is down… a perfect storm for apartment returns to soar!
However, many apartment buildings will head into foreclosure. Let me explain…
Two factors contribute to commercial property value.
1. Market forces (Cap rate)
2. Cash Flows (NOI)
Value = NOICap Rate
The value of commercial property is derived by dividing the NOI by the market cap rate. While we can’t control cap rates anymore than we can control residential values and “comps”, we can control the NOI to a certain degree.
Rents – Expenses = NOI
By increasing income andor decreasing expenses we can increase NOI. By increasing NOI, we drive the value of the property up having nothing to do with market forces. Therefore, we can control this component of the value equation regardless of what the market is doing.
NOI = $120,000
Cap Rate = 10
Value = $1,200,000
NOI = $190,000
Cap Rate = 10
Value = $1,900,000
Notice the market force (cap rate) stayed the same but only the cash flow changed. By increasing the cash flow, we can increase the value of the property regardless of market conditions.
Many apartments are performing wonderfully and their operating fundamentals are sound, yet experts are predicting a tidal wave of apartment foreclosures. Let me try to explain using a residential example.
Let’s say you bought a house for $1,200,000, put $200,000 down and took a $1,000,000 loan (83% LTV) on a short term loan so that $1,000,000 would be due in 5 years. Now let’s say that house was cash flowing $100,000 per year.
For 5 years, the same tenant lives there and pays rent like clockwork. You are thrilled and making money hand over fist. However, as the national economy goes into a tailspin and your neighbors lose their homes to foreclosures the value of your house is dragged down with them. Hey, but you don’t care because that house is cash flowing like crazy and you have no plans to sell. So who cares what it’s worth, right You’ll just collect your rents and hang on until the market comes back even if it takes a few years.
But then you get a letter from your lender reminding you that your 5 year loan is coming due in a few months. So you decide to refinance only to find that the value of your house is now only $800,000 (a 33% decrease in value which is exactly the kinds of losses we’ve seen) and you still owe $950,000 on the note. Additionally, banks will only lend 70% LTV now so based on an $800,000 value and 70% LTV the bank will only refinance $560,000 of the remaining $950,000 on the note.
If you don’t come up with the $390,000 difference, you will lose that house to foreclosure even though it has tremendous cash flow. If you had taken long term debt you wouldn’t be in this situation but because the note is due, you’re in trouble!
That’s exactly what is happening to many apartment owners. The properties are performing well yet they are headed to foreclosure because they took out short term debt which is coming due.
Experts track the numbers and can forecast how many of those notes are coming due and how many of them are “under water” wherein there is more owed than the value of the property. These experts predict a tidal wave of foreclosures.
There is a small window of opportunity to cash in on the opportunity to buy apartment foreclosures as these property types are rarely distressed. Additionally, interest rates are historically low making this opportunity even better.
Lawrence Yun, Chief Economist of the National Association of Realtors predicts a turnaround in the second half of 2009. This means there is a very small window to learn about apartments and apartment foreclosures. The tidal wave is coming! Will you ride the wave
Karen Hanover is a Certified Commercial Real Estate Advisor and commercial real estate broker. She founded the Commercial Investment Education Institute to educate both new and seasoned investors. Take a FREE Online Course at httpwww.cieinst.com
If you would like to take advantage of the market and learn how to invest in real estate and you are local to the Dallas Fort Worth area, I know a really great teacher and mentor here in Arlington Texas. Please take a look at his web site: DennisJHenson.com, Dennis has a great Mentoring and training program, I know because I am one of his former students. I learned a lot from his one on one teaching technique. – Michael Harman 817-457-7572 email@example.com