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Bruce Norris is joined once again this week by Erik Hernandez. Erik is the senior vice president with Lee and Associates. He specializes in commercial real estate, his exact specialty being industrial real estate. He specializes in land sales and development representation, landlord representation, and investment sales and analysis.
In the last segment they talked about mezzanine financing. If someone wanted an equity position that is 35-30% of spread in a first trust deed. However, when you are talking about mezzanine financing it is usually in a second trust deed position. The willingness could change from when they are in a timid market to non-existent to aggressive could be up to 95% loan-to-value. This money is usually private money and high net worth individuals. Erik said he would not include pension funds since this could be a little too risky for them and outside of the scope of what they would even be allowed to do. It could also be family offices, private money pulled together to seek returns, or a variety of other things.
Some of these people have money they need to play, so they are chasing yield and return. This means it cannot sit in the bank right now and earn 0. It may even be giving them a slight negative return depending on what your opinion of inflation is. They have to put this money out the door, but they don’t always have the capacity to do it. They will partner with an established real estate investor, for example in Southern California, and bring him in to help them deploy that money. This will turn into an arrangement whereas before in the last cycle they may have been purely mezzanine. Today, they may dictate more of the terms of what is happening and may even be the one that goes into a first position in some type of joint venture arrangement. They control where the debt will be and have much heavier influence over the project and call the shots.
There is new word that has come up in the real estate world called crowd-funding. Bruce asked if this has affected how commercial real estate is being funded. Erik said he has not seen this but they have two versions of this on the commercial side. One was really popular in the 90s called syndication. Also, in the last cycle we had what were called tics, or tenant in common properties. This is where you would buy stock or put money in a deal. An institution would then go buy a property, but the underlying ownership of that property might actually be 50-60 individuals who all pool their money to go buy a $10 million property where normally none of the individuals would have had that opportunity. However, if you put them together they were able to buy it. On the surface it seemed like a good idea.
However, there were a lot of underlying issues that rise out of this, the primary one being liquidity. These are not so easy to get out of once you are in them. Real estate in itself is not as liquid as other asset classes, including stocks and bonds. If you decide one day you need to sell something, it creates a lot of underlying issues with that structure that can complicate things. This means you forgot to read the page that says there is no market for what you just bought.
If you were to look at the office building first and then industrial, Bruce wondered what percentage of the market right now would be lender-owned properties. Erik said on the office side, it is probably very small and you can count on one hand. For certain it is under 10%. On the industrial side, there are a handful but they are typically small buildings where a business may have owned the property. This could be a husband and wife, individual, or limited partnerships. If they occupied the building and it failed, then they were no longer able to service the debt on the building. It is a one-at-a-time problem rather than the whole segment being in trouble. Today if that happens, unless you pay the absolute peak value for the property, even if your business is struggling you probably have some built in equity into the building. This way if you called someone like Erik they could dispose of the assets, put money in your pocket, and exit the building without going through a foreclosure or REO process.
Bruce said one thing he has noticed in the office building complex he bought two and a half years ago was that 70% of the entire complex set up in the 4500 square foot condos under an 1800 square foot roof were mostly vacant but some were owned free and clear. They have legs and do not have to do anything and just sit there. The one he bought was a lender-owned property that originally sold for $950 and he bought it for $319. There is another comp that is similar, and these are the only two comps. Oddly enough, it does not seem to affect the asking price of anything else that is available.
An interesting thing happened out here in the market. When the market changed, a lot of funds were put together to take advantage of what they thought was going to be a coming foreclosure crisis. This never really happened, and a lot of existing owners when asked if they would sell their property said they not only did not want to sell it but wanted help in finding something to buy that was like it. Bruce said when he had locked up the property, he called the listing guy who had all the other properties no longer for sale. Bruce called him up and asked him what the number was. His answer made Bruce feel like he did not get a deal until the guy realized he was talking about purchase and had bought it for $75 a foot. His first comment was if he wanted to sell it. His customer who was stuck with all this vacant property would have bought the building from Bruce because the price was so much better.
It was almost like he was leveraging his cost. In essence, he was wanting to put in one really good deal to where his cost basis was different. Bruce thought it was an interesting comment that he had a guy who looked like he was already in trouble willing to buy another one for cash. This was a very common thing out here. What happened was the last part of 2008, going into 2009 was the deal volumes dropped dramatically because the people who did have to sell found a market that was a little stronger than they had realized would exist because there was money that had already been put together to start acquiring assets. At that point in time if you were a life company, investor, or pension fund.
The idea of putting a lot of money into the stock market was not really appealing. You could wake up the next day and realize it was a lot less. On the real estate side, you had return because you had income streams, and this was a hard asset. A lot of these firms will sit around and do their asset allegation and say instead of having 10% real estate one year they want to have 14%. This is a dramatic increase, so there was money that was ready to buy along with private money that was put together and ready to jump on deals. Since there weren’t many deals, those properties found ready and willing buyers.
Bruce asked how Auction.com has affected the commercial world. Erik said the auction websites right now are perceived as a loss where you sell properties that are not bread and butter properties. There may be a problem with it, it’s a one-off property, or it is a triple net investment that is not located on the main path. That local market may not be deep enough to find someone looking for a Jiffy Lube coupon clipper in a particular area. There are people who specialize in finding Jiffy Lubes all over the country to buy. The interesting thing is Google made a pretty large investment in Auction.com. Bruce was aware of this because he interviewed Rick Sharga, who is the vice president of Auction.com. From the people Erik talked to, he has gathered that the online marketplace is transitioning and their position is revolving more into an electronic marketplace for real estate that is more mainstream than when it first started. Bruce thinks the owner is always ahead of the curve. His first auction was in Riverside, and he was pretty young and a building contractor. He went to land sales and would buy tax-foreclosed land and auction it. He does have a history of figuring out what is next.
Erik thinks Google invested around $50 million, which is not a lot of money for them, to figure out how to make that work and what the future market is for it. He has looked at the technology for them and their competitors, and the technology is really evolving and a lot more sophisticated than most may realize. To become better, you have to sell out some forms. You are talking real dollars here. It is not unlike Ebay since here you are obligated and your account will be dinged if you are the winning bid. For certain properties it will be very helpful. There are certain institutions that have a fiduciary requirement to meet, and this a very transparent way to do this. This is something they need to watch.
Bruce asked about short sales in the commercial real estate world. REOs dropped off, and short sales took over. This same transition happened in commercial, so Bruce wondered if this is still occurring. Erik said the short sales were definitely around for a while. What typically happened on the commercial side was on big portfolios the values bounced back pretty quickly, so not many people had to take cuts. If they were publically traded companies, they usually didn’t sell. They just marked down the assets on the balance sheet and moved on. On properties under $5 million, what you often have is a first trust deed with a brand name bank. You would then have a second trust deed for another 30-40% left on a property with what we would call an SBA lender. These loans were guaranteed by the SBA, who being in a second position were the ones who usually had to take a haircut to allow the property to be sold. Sometimes the first was also participating depending on who the bank was. Unless they bought at the absolute peak, that window is pretty much gone. We really don’t see many short sales happen anymore.
Bruce asked what has happened to the price of land. When the commercial real estate world tanked after 2008, Bruce wondered if the land just crashed. Erik said land in in 2008 and 2009, the only thing land did was grow weeds and taxes on it. But then something interesting happened. On the technology side, the e-commerce world really took off and these large 500,000 square foot distribution centers, in terms of the technology and automation equipment, really went through the roof. A big demand for this was really in Southern California. If you are going to be out here, you typically have to look at the Inland Empire. The land market for land that was a rectangular-configured piece that was 20 acres and above really started to come back quickly. It became a very hot commodity, so there is almost two worlds for land. There is land you would build a big large industrial building, then there was land where you might build a business park for small units for lease or larger buildings for sale under 100,000 square feet. That land market did not start coming back until last year because it did not pencil still to buy land build buildings, then sell them. You could not sell them for what it would cost to produce them.
We are at the point where we can see the price appreciation where it makes sense again to build some of smaller buildings and be able to sell them into an environment where you can make money. Bruce asked if gigantic pockets usually own land as well. This means it is usually owned free and clear and owned by people who can wait. Out here you would be surprised at the variety of land sales that you have. Sometimes in places like Ontario and Chino you may run into dairy families that are third generation who have owned the land for decades that are now in a path of progress that would be sellers. There are several deals like this that have happened down there recently. Out in Ontario in some of the secondary markets, you will find people who maybe bought land 10-15 years ago and land banked it.
The other thing that has happened out here is because of the large demand for these large parcels, it became harder to find one landowner who owned everything. You have seen over the last 2-3 years the return of assemblages. This is where you put together 15 to 20, sometimes 30 different owners of smaller properties of land so you can configure the type of larger side you need to build what you want to build. It is like the opposite of sub-dividing. You are putting them all back together, and a lot of this is happening in Fontana on the south 10 freeway and in Rialto on the south side of the municipal airport off Boulder.
Bruce said they have one investor who has done very well doing exactly this. Some of the money that was very successful in some deals Erik worked on were assemblers who would put together the land, get it tied up under contract, get it entitled for development, then flip it to an end developer who would take the construction risk on it and build the buildings. This process can be complicated and take a year or two or three to put those deals together. However, if you put it together and time it right, everybody wins. The individual owners of the smaller parcels did not really have a market to sell into. You are not really doing anybody harm since they did not own what happens to be popular right now. A market was created that did not exist, so they were able to sell their property for a lot more than they would have otherwise been able to get. Value has been added, and everybody wins.
Bruce also asked about foreign investors in the commercial space. In California there are pockets where foreign money is definitely driving prices in a way where if they choose a city it can have some dramatic affects. Bruce wondered if they have landed in the commercial world and if there is a segment they prefer. The further west you go in the Inland Empire, it can be heavily influenced by the Chinese buyers and market. They could be U.S. citizens here with visas or foreign residents. They could be here on an EB-5 visa, but they like to buy real estate. A lot of times this money is coming from China. They could already be an established business here, but that particular market disappeared when the market reset itself. That segment of the market is definitely back out there looking for property.
Bruce does not know much about commercial values in China, but he does know that in Beijing the multiple times income California reached in 2006 and 2007 for residential is over twice as high in Beijing for residential. This is 25 times gross income is their price level for the median price. In California, if you had a $60 grand median income your price would be $1 million and a half. He is not saying real estate value is going to double, but he is saying this is why Chinese investors are taking money out of there and putting it here. This can create a speculation or a driver for price that is unrealistic. Bruce said he made a mistake in 1989 when there was a lot of demand for custom homes in Palm Springs since the Japanese market had exploded in value and you had a lot of people with a lot of money. One of the things they liked to do was golf. In some places in Japan you had to pay $1 million for a golf membership. You could own a home in California on the golf course for less than that. Bruce built seven of them, and by the time he got done the Japanese market had crashed and all those dollars went home.
This is an interesting market because pieces of it are driven by demand that could go away. Erik said it is hard to generalize when he talks about the Chinese market. Today, a big component of this you see in places like the San Gabriel Valley and in the business sectors of industry, including Diamond Bar, Walnut, and along the 60 corridor. That market is mostly built out, and there is a heavy concentration of Chinese related companies there. When they like to buy real estate, it is difficult to find things for sale in that market. They will come east into Chino and West Ontario. These two markets in particular are prone to much higher influence of that segment of the market. This is partially because they are west end and because those markets tend to do the best as far as pricing goes. This is just like in the Inland Empire when they get a lot of people to own properties there since they get priced out in Orange County or LA.
Bruce also asked about the mortgage-backed security world for real estate. This used to be a gigantic player, so Bruce wondered if this was a factor now and if it is coming back. Erik said it is, but slowly. At one point in the market they were a big percentage of what was being financed. It would interesting to see what the percentages are now since he has not looked at this in a couple years. It was almost a non-existent chart. It could be up 1,000% and not be significant.
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California Real Estate Investing News is a post from: The Norris Group