Interest Rate hikes effects on Commercial Real Estate

Excerpts from a recent AP article and our comments surrounding it:

An important indicator in the U.S. commercial real-estate market is signaling that a decade long bull run is on shaky ground heading into the new year.

The gap between long-term borrowing rates and what some types of commercial properties on average yield is the narrowest it has been since 2008, according to data firm Trepp LLC.

In the past, this tightening spread has often presaged a drop in property prices, sometimes with dire results. “In 2007, looking back, that was a real red flag,” said David Steinbach, chief investment officer for Houston-based Hines.

Hines, one of the country’s biggest investors in office buildings, was a net-seller of that property type this year partly because it believes values are near their peaks, Mr. Steinbach said.

Other big investors and lenders are also reducing risk. Terra Capital Partners, a New York investment firm that specializes in commercial property debt, is offering fewer construction loans and making more first mortgages, which are safer.

Prudential Financial Inc. said it is cutting its exposure to property types that typically get hammered in a downturn—like office and fashion-oriented retail—and buying more recession-resistant property types, like housing that targets lower-income renters.

Commercial real-estate prices have increased steadily since 2009. In more recent years, as the economy has expanded, landlords also have enjoyed rising rents and falling vacancies.

But many are now thinking that prices have peaked. A Green Street Advisors value index of property owned by real-estate investment trusts increased only 2% in the 12 months ending Nov. 30, compared with the earlier years of the recovery which showed annual growth rates of as much as 20%.

At the end of the third quarter the average rate borrowers paid on loans packaged into commercial mortgage-backed securities was 5.03%.

One year earlier it was 4.52%, Trepp said. That increase “is a big deal on multimillion-dollar properties,” said Joe McBride, Trepp’s research director.

Rylee Park: As a general rule, a 1% increase in interest rates leads to a 10% decrease in purchasing power. Obviously this is a huge generalization as there are many cash purchasers, but the morale of the story is that the recent uptick in lending rates is a concern for short term asset appreciation. 

Not everyone thinks it is time to head for the exits. A still expanding U.S. economy and the amount of money sloshing around the market suggest the bull run can continue.

Investors purchased $152.7 billion of U.S. commercial property in the first three quarters {of 2018}, up 17% from the same period in 2017. 

Meanwhile, developers are building more, intensifying pressure on the supply side. JLL is projecting that this year more than 250 million square feet of industrial space will be delivered, compared with more 232.7 million in 2017.

Some major banks are also turning more bearish. Wells Fargo & Co., the country’s largest commercial property lender, has reduced its exposure to the sector to $110 billion this year, down over 5% in the past two years.

RPP: it is our contention that interest rate hikes will certainly play a role now and always in both the Real Estate and Equities markets. That said, the argument can be made that the Federal Reserve has been increasing rates recently simply as a measure to have 'bullets' in the recovery chest should the market slow down continue or increase. Given the amount of cash on the sidelines, commercial real estate and its creative 'triple net' structure will most certainly be a stable investment long term despite the short term hiccups it may encounter. This may not be true in the retail world as online stores continue to take market share, but will most certainly be the case in office/ industrial/ medical, etc on a market by market basis. 

For more information on Kirkland Commercial Real Estate, consider contacting us. You can reach me directly at Scott@ryleepark.com or via cell phone at 206.306.4034.

Scott Weitz - Designated Broker/ Attorney

Rylee Park Properties

www.ryleepark.com

Valuing a Seattle Small Business

Attaching a dollar value to an owners company is a touchy subject--especially if they have spent years building it from a fledgling start-up to a profitable enterprise. The process can quickly devolve into a pricing routine that is rooted in personal attachments and other subjective inputs rather than solid data based on marketplace realities.

Let's be clear: the value of your business is the amount someone is willing to pay for it in the business-for-sale marketplace. Period. Personal feelings about your company's worth are far less important than sound valuation methodology, accurate documentation, seller financing and other factors that could potentially influence value.

Common Valuation Methods

One of the reasons business valuation is such a complicated issue is because there are many acceptable valuation methods. Rather than using a "one-size-fits-all" valuation approach, sellers need to decide which method is right for their business based on industry, size and the circumstances of the sale. The reality is that the valuation can often be a negotiation based on one ore more of the below valuation options. 

An asset-based valuation is a straightforward method in which the value of the business is determined by the total value of the company's tangible and intangible assets. The challenge with this method is that asset-based valuations can neglect the value of the company's earnings potential. That is why asset-based valuation is a common method for the sale of defunct businesses and liquidations, but not for thriving companies.

The earnings multiplier method is often the best way to assign value to a healthy business that will be listed on the open marketplace. By basing price or value on some multiple of the business's earnings potential, prospective buyers gain the ability to translate the purchase into earnings and an informed return on investment (ROI) estimate.  This also provides a more tangible and simpler basis by which to compare different businesses in different industries or locations.

However, even the earnings multiplier valuation method presents challenges. Although earnings data is based on the business's historical financial performance, the calculation requires earnings to be precisely defined and agreed upon by both parties. Likewise, you will need to select the right multiplier to apply to defined earnings. There can be a large variance in multipliers (e.g. 1, 3, 5, 10 or more) since the valuation reflects business risk and industry standards. With that being said, a simple way to get to a proper multiple is to work with a business broker who can share recently sold business comparables (commonly known as "comps"), so that you can see what multiples businesses in your industry and location have historically or recently sold for. Prior to working with a broker, you can visit business for sale websites like BizBuySell.com or BizQuest.com to see what prices and multiples of cash flow or revenue current businesses are listed for and have sold for.

How to Improve Business Value

There are options you can take to increase it prior to a sale. It is important to start immediately however, as you need to start planning months or years in advance to implement the kinds of changes that substantially improve the value of your company.

From a buyer's perspective, proven profitability and future earnings potential are the most attractive qualities in a potential business acquisition. By documenting a multi-year track record of profits and positive cash flow, you can drive up the value of your company--substantially, if you choose to use the earnings multiplier valuation method.

But it's also important to strategically position your business for future earnings, identifying advantages your business either has or will have in the general marketplace. In some instances, the future prospects of the sector itself can be a factor in driving up business value.

Another strategy for improving business value is basic organization. Carefully maintained financial records, documented employee policies, a neat and clean facility--it all counts when it comes to the amount buyers are willing to pay for your business. Simplicity has value, and the easier it is for buyers to understand your business and envision themselves at the helm, the more likely it is that your business will sell for its full value.

Seller financing also plays a role in improving the value of your business. Although financing part of the sale is not an option for every seller, buyers are sometimes willing to pay more for businesses that include some level of seller financing, particularly in tight credit markets. Business owners who use their network and business-for-sale website listings to advertise their willingness to finance part of the deal should expect a significant uptick in the number of offers.

For more information on valuing your business, consider contacting a Seattle Business Broker. Feel free to contact me directly. 

Scott Weitz

Attorney/ Designated Broker - Rylee Park Properties

150 Lake Street S; Ste 216

Kirkland, WA 98033

Direct: (206) 306-4034

Seattle 1031 Rules

While many know of the general 1031 rules and application, few know the details of the 1031 process and exact what is allowed to be identified prior to the 45 day identification period. Below is a brief overview of some the limitations of what can be identified. For more formation, consider contacting a Seattle 1031 Broker. 

Identification Rules and Exceptions (1031 Exchange ID Rules)

For a successful 1031 that is IRS compliant, you must comply with at least one of the following identification rules or exceptions when completing the identification of your like-kind replacement properties:

Three (3) Property Identification Rule

The three (3) property identification rule limits the total (aggregate) number of like-kind replacement properties that you can identify to three (3) potential like-kind replacement properties.  The vast majority of Investors today use this three (3) property identification rule.

You could acquire all three of the identified like-kind replacement properties as part of your 1031 Exchange, but most Investors generally only acquire one of the three identified properties.  The second and third identified properties are merely identified as back-up like-kind replacement properties in case you can not acquire the first property.

You can skip the three (3) property identification rule and use the 200% of Fair Market Value Rule if you are trying to diversify your investment portfolio and wish to identify more than three (3) like-kind replacement properties.

200% of Fair Market Value Identification Rule

The IRS allows you to identify more than three (3) like-kind replacement properties as long as the total (aggregate) fair market value of all the identified like-kind replacement properties does not exceed 200% of the total (aggregate) net sales value of your relinquished property(ies) sold in your 1031 Exchange.  The limitation is only on the total (aggregate) identified value.  There is no limitation on the total number of like-kind replacement properties. 

For example, if you sold relinquished property(ies) in the amount of $2,000,000 you would be able to identify as many like-kind replacement properties as you want as long as the total (aggregate) value of the identified like-kind replacement properties does not exceed $4,000,000 (200% of $2,000,000).

95% Identification Exception

Its good to have choices, but be careful with this exception.  It is an exceptionally useful tool under the right circumstances, but can present some tricky problems. 

You may need to identify significantly more like-kind replacement properties than the first two identification rules permit.   There is no limit as to the total (aggregate) number or value of identified like-kind replacement properties permitted under the 95% exception as long as you actually acquire and close on 95% of the value identified.

However, if you do not acquire and close on at least 95% of the value of the identified like-kind replacement properties the entire 1031 Exchange transaction will be disallowed.

Hopefully, you find this helpful! For more information consider reaching out to a Kirkland 1031 Real Estate Broker.

You can reach me direction at the following: 

Scott Weitz

Kirkland Real Estate Attorney/ Designated Broker

University of Washington LLM in Taxation

T: (206) 306-4034

Scott@ryleepark.com