Gerald Tostowaryk Edmonton Commercial Real Estate

Life is so full of coincidences. A few days a month I instruct learners in the new Agent Licensing course and yesterday was one of those days. At the end of class one of the students, a gentleman my age (who (here's another coincidence) who happens to be the father of another agent whom I taught a few years back) comes up to me and relates the story of a transaction he thought he would complete without a REALTOR some years back to save some money. Of course you know where this is going.

Well, before I get to the story, a little preamble first. This morning as I decided to write a blog article about his experience, I logged into Linked In and there was an article posted by another top-notch commercial REALTOR I work with (Ahmed Assaf who is also a commercial mortgage broker www.excelcommercial.ca) about another nasty story involving a businessperson trying to complete a transaction without a REALTOR - and this was a commercial lease transaction.

You can read the article at http://tinyurl.com/7qjyvv5 and feel free to join our group "Edmonton Commercial Real Estate Network" on Linked In for updates on article of interest to commercial real estate buyers, sellers, landlords and tenants.

But back to our story.

Now this was only a residential transaction but the story is the same. An individual wanted to buy his home so he agreed to sell it to him and so they entered into an agreement. The agreement was unconditional so it was final, a done deal, a fait accompli so to speak. Or not.

The buyer was a wealthy individual and decided he wanted to get out of the transaction. To make this happen is pretty difficult in an unconditional contract situation. Or not. Contract law can be very complicated and the English language with over 600,000 word variations doesn't help. As it turns out there was a civic compliance issue with the property and the buyer used this as his ticket out.

Now my learner didn't ever tell me the final outcome but he did tell me that he spent ten years in court over it. Ten years! Think about that. No doubt it cost him a ton of money also, but anyone who has spent years in a legal scenario will tell you the time lost is far more painful than the money lost.

The moral of any story involving our legal system is that an ounce of prevention is worth a pound of cure. As professional REALTORS we use contracts drawn up by the best real estate lawyers in Canada to deal with just these types of scenarios. Any time another party wants to introduce a different contract into the mix (which is very very common in commercial real estate) we always review and between me and the lawyer, we suggest numerous changes.

So what is the moral? Use a professional. Time and time again the story is always the same.

I just wanted to save a buck.

Commercial real estate is, by its very nature, rather complicated. From determining a client's needs and wants, to sifting through the various property types available to fill those needs, to the often lengthy purchase negotiations followed by lengthy and intricate due diligence processes, through to final possession, there are many considerations that come into play. As if this wasn't enough, when valuing commercial properties, many more factors enter the equation. Possibly the most complex of these is the valuing of raw development land. Let's have a look at the myriad factors affecting land valuation.

Land Specific Factors

The first group of factors have to do with the land itself. the major ones include;

Lay of The Land - How level or gently rolling is the land? Is the natural drainage complementary to development or will it cause extra costs to be incurred?

Subsurface Conditions - Is the condition of the soil and underlying geology suitable to support the highest and best use of the land? A geotechnical study is generally required, at considerable expense, to determine this. Are their underground watercourses that will affect development?

Surface Water - Are there any watercourses or bodies of water on or near the land that will come under the jurisdiction of the Fisheries Act, Navigable Waters Act, or other Federal legislation affecting waterways?

Environmentally Sensitive Areas - Are there any environmentally sensitive areas on the land?  Are there any endangered species residing on the land? These factors can seriously impact developability.

Environmental Hazards - If the land has been previously used, are there any environmental concerns?

While not an exhaustive list of the land-specific factors, there are generally the major ones. There are also factors that relate to the actual development of the land, let's have a look at these now.

Development Specific Factors

Servicing the Land - Where are the nearest municipal services? What will be the path of the main lines? What is the municipality's policy on who pays (usually you), how, and when? Are any other developers going to be active in the area and when will they be active so that you can recoup your servicing costs? If the area is already serviced, will you be re-imbursing an earlier developer for your share?
If you are just servicing a particular lot, where are the tie-in points? Soil conditions will affect your cost per foot to service. Where is your building site? How far will you have to bring services in?

Highest and Best Use - This can be a difficult one. What development is already in the area? What will complement existing development? What kinds of developments could the area use? Which will bring the best return? If/once you have a specific use in mind, is the land zoned correctly for your usage?

Obscure Regulations - This can be a real surprise. Sometimes not well-known zoning issues can surprise you in a nasty way. Corner sites in high traffic areas will often have setback requirements for visibility and traffic safety which can reduce the buildable area. Sunlight and shadow setbacks can also reduce buildable area dramatically.

Municipal Plan - What are the municipality's plans? If your desired usage doesn't fit the plan for the area, you are facing a large, uphill battle. Most municipal plans and planning documents are available on-line and should always be researched. A trip to the municipality may be in order. When does the municipal development plan foresee development in your area? If you purchase too soon, you may not have roads or services for years.

Other Factors

Time - Just how long is it going to take to complete your structure? Are you going to be selling it or leasing it? You need to account for a reasonable sale period or lease-up period.

Finances - How are you going to finance the development? Financial institutions don't finance development land to the same levels and in the same way as the purchase of existing structures. Be sure you can get financing and accurately predict your financing costs (including the numerous fees before you even see one dollar).

Commissions - My personal favourite, you will likely incur sales or leasing commissions if this is an investment you wish to sell or lease out.

While there are more factors to consider, this gives you an idea of most of the major considerations. There is a bit of good news though. While taking all the above factors into account can be overwhelming, a good commercial real estate agent can help you pre-determine relatively accurately the value of a parcel of land. Using recent comparable sales and accounting for as many of the above factors as possible, your professional REALTOR can give a fairly accurate pre-determination of the price. After negotiating a successful conditional offer to purchase, your due diligence process should allow you to account for many or all of the remaining unknowns.

Okay, there is no way to predict the end of a boom, well there is no accurate way. By accurate I mean accurate enough to tell you within a month when to get your money out. Booms are irrational creatures and trying to predict their behaviour is a fool's game.

But there are two pieces of advice that seem to stand the test of time that tell you the end is near. How near is hard to say but it is likely near.

The first one is one most of us have heard before, "When your cab driver is giving you investment tips, it's time to get out". I think that holds true because what it is really saying is when the average everyday blue collar working person on the street is an active investor, who is left to sell to? I remember during the last boom a couple years back receiving a call from a young man who sounded barely old enough to shave and his opening remarks were, "We are an international investment firm". I don't know but how did he get enough time and money to become an owner in an international investment firm?

The second one is one most of us have never heard. I  only heard it once after the boom of the late 70s -early 80s and while I don't recall the source, it seemed credible and so I never forgot that advice. This person said that the end of a boom is near when utility rates start to move up dramatically.

I think this is really a variation of the person on the street theme, but it has proved accurate two booms in a row. You see, utility companies are the "man on the street" of the corporate world. Up until corporate greed managed to hoodwink governments into privatizing utilities, they were tightly controlled. Tight control of utilities is a part of Canadian culture. Governments have controlled dairy products, bread and utilities for years. This is part of the societal belief that stability in the staples of life makes for a better quality of life for all. This is why the price of these products usually does not vary all that dramatically.

So, when the price of utilities begin to rise dramatically, it is a sign that the inflationary pressures of a boom have hit everywhere and the whole thing is likely to collapse soon. The logic seems to make sense, and it has proven very accurate over the last two booms. I guess the only wild card is the aforementioned fact that corporate interests have managed to work their way into private ownership of utilities and they will likely take price liberties whenever they can.

Interesting stuff, but don't ever bet the farm on these kinds of things.

Well, last post we discussed financial statement analysis as part of the due diligence process when purchasing income producing commercial real estate. Today let's delve into some of the common areas for the astute buyer to check for, and how to best use financial statements to help ensure a great purchase.

When buying income producing commercial real estate, it is highly likely the buyer will have to reconstruct the seller's income statements to arrive at a more realistic statement of net income.

Probably the most commonly manipulated area of financial statements is the maintenance expense section. Because of the substantial amount of dollars going into maintenance annually, this section offers a large amount of maneuvering room. As mentioned in the previous blog post, owners may under-maintain a building in the two or three years before selling in an attempt to increase income and therefore, apparent market value. This is relatively easy to work around. Work with a good commercial real estate agent who can provide you with a normal range of values for annual maintenance expenses.

This concept also holds true for other manipulated areas. If the owners are doing most of the ongoing maintenance and repairs, rent collection, etc., themselves, are they deducting a management expense? Somebody has to do that work and whoever does it, their time is worth money. If the owners do it themselves without pay, you still need to deduct a management expense, time is worth money.

There are numerous areas where expenses can be artificially "trimmed" with the intent of shoring up income in the year or two before a sale. Using a good real estate agent as your buyer's agent will help ensure you accurately re-construct the financial statements.

The other side of the coin is when owners accidentally include too many expenses as part of their operating statement, and this is where the buying opportunities lie.

A common area to check is where seller's mistakenly include capital expenses as part of their operating expenses. Capital expenses are expenses that are not considered to be required to "operate" the building. These are generally things like upgrading the boiler from standard efficiency to high efficiency, replacing windows, constructing an addition, etc. These are expenses that are to be added to the value of the building and amortized over its remaining economic life. This is a great area of opportunity for the astute buyer. By adding capital expenses to operating income, the Seller accidentally states net income of the property lower than it actually is. If their real estate agent is not familiar with this common error, they may be asking less than the property is actually worth.

In an effort to keep operating expenses low for tax purposes, many sellers add in non-essential expenses. For example, going out for lunch while working on the building, they may add in the lunch expenses as well as vehicle expenses.

Another common error is the adding in of mortgage interest as an expense. Oh it is an expense but not a strict operating expense. Since every owner carries different levels of debt on their buildings, mortgage interest needs to be deducted after first determining EBITDA which is simply nothing more than accounting lingo for earnings before mortgage interest and amortization.

Speaking of amortization, many building owners deduct depreciation off their building's income. While this is allowed, it is not a real expense. Experience has shown that buildings actually appreciate over time, so deducting depreciation is really only a tax deferral - sooner or later, you will have to pay taxes on that depreciation you claimed.

These are probably the most common areas of income statement analysis. The things to remember are, where an owner understates expenses, the buyer will likely overpay for the building. Where the owner overstates expenses, the buyer may underpay. I wish the opportunities to "underpay" were actually that common. They are not, they are very uncommon. Human nature being what it is, we all tend to think our buildings are worth more than they are and even owners who understate their net income seem to be acutely aware of asking prices for other buildings. BUT that is okay. Your greatest enemy as a buyer is trying to find that "great deal" Invariably, the alleged great deal is a sucker play and you are the bait. The real return on investment with real estate is not the great deal you get when you buy, but the slow, steady accumulation of income and capital value over time. In a few short years, this will far outstrip the few dollars you "could have" saved getting that "great deal". Forget the great deal, find a good building at a fair price.

Next blog post - Balance Sheet analysis.

GAAP, CCA, Capital Expenses vs Operating expenses...say what? What language is that and what does it have to do with commercial real estate investing? Well, some of you probably recognize this as accounting lingo; and it has everything to do with commercial real estate investing....well, at least with successful commercial real estate investing.

In my last discussion on successful commercial real estate investing, I did a general overview of points of importance to commercial real estate investors. Let's delve a little more into detail today. What better place to start than with financial considerations? And what better financial place to start than GAAP?

GAAP stands for Generally Accepted Accounting Principles. GAAP is (are?) a set of standard procedures for accounting for income, expenses, assets and liabilities. Without a standard, it would be impossible to know a company's true income. Without standard procedures, it would be impossible to compare that company's income to another company's. It would be impossible to value a company and to compare it's value. The same applies in commercial real estate. One must be able to know a property's true income and true value, and to be able to compare these to other properties in the hopes of making a wise investment decision.

While we don't exactly follow GAAP in commercial real estate investment analysis, we do follow certain standards and they are fairly closely linked to GAAP. One problem - most owners of commercial real estate don't quite follow standard procedures when doing their accounting. There are two problems this creates. First problem, some owners add in as many expenses as possible to keep their taxable income low, which keeps their taxes low. While this certainly does keep their taxes low (at least until a Canada Customs and Revenue audit), the value of investment properties is tightly linked to their ability to produce income. It's difficult to justify a higher price for a property than the income suggests.

The second problem is, you guessed it, owners adding in too few expenses in the last few years before they know they are going to sell a property in an attempt to increase the income and support a higher price. this is usually in the form of minimal maintenance. The problem with this is that the buyer who believed the income statements and paid the higher price finds that they actually achieve lower income for years because they have high expenses as they have to pay for extra maintenance the previous owner neglected.

Okay, this is probably enough boring information for one blog entry. In the next installment, we will discuss how we re-create a more standard set of financial statements, and more importantly, the latent opportunities for the savvy real estate investor to take advantage of financial statement analysis.

Well, between a busy schedule and a couple of very short vacations, it's been quite a while since I had the opportunity to make a blog post. One idea did cross my mind while dealing with a prospective customer who had made some bad investments.

What makes a successful real estate investor? I mean investors come and go, get rich in real estate programs come and go, but only a small percentage stay the course in the real estate investment world. Now I can only speak from my experience, and there are several qualities of good investors, so I will tackle one or two at a time in various blog posts.

In my opinion, the most important quality for a successful real estate investor to have is plain old common sense.  And no, common sense isn't so common. If common sense is so "common" why are there so many television infomercials? And why are they so successful? Because they employ what is known in the sales world as the "irresistible offer"; an offer so good you can't resist. If you register on my web site NOW as a client, I will provide you with FREE market updates. BUT WAIT THAT'S NOT ALL! I will throw in a FREE market analysis on your current investment properties. WHAT'S THAT? THERE'S MORE? Yes, register within the next 10 minutes and you will receive a free, limited edition picture of Black Beauty! Only 500 have been printed and no more will ever be printed! ....Do you get the picture?

Why do they require you to act within 10 minutes? No not because, as Mr. Slap Chop says, we can't do this all day. It's because if you stop and think, your common sense might, just maybe, kick in and you will say, this is stupid (and also fear of loss, the greatest sales technique in the world).

Now stop and think for a minute. Have you noticed in the last 5 years there have been real estate investment groups everywhere? Have you noticed there are real estate investment magazines with ads from all these young and upwardly mobile success stories who are selling you their secrets? Have you noticed there are real estate investment seminars everywhere? Where were they 15 years ago? Real estate has been around since mankind first moved out of caves. Why is it only now a "get rich quick" investment? Well, think  back 15 years ago to when the stock market was the "get rich quick" place to be. The market had been on quite a tear for a couple years and what did we see everywhere? Stock market investment groups, stock market investment magazines with ads from all these young and upwardly mobile success stories who were selling you their secrets, and stock market investment seminars.

Where are those stock market investment groups and magazines now...the same place all the real estate investment group are heading. How many people are buying new homes now to flip for a tidy profit when they are complete? How many condominium conversions are happening right now? How many homes have seven buyers lined up waiting to see them now?

For sure some people pocketed some fast cash during this period, but just as many were left in huge debt when the inevitable correction happened. And no, those that profited were not investment gurus, they were nothing more than in the right place at the right time. They took some gambles and guessed right (or were on vacation) when the inevitable correction happened. Corrections ALWAYS happen swiftly and unexpectedly and not getting caught with your pants down is 2/3 luck for the speculative investor (read Gambler). Where were all the large real estate investment firms during all this? They sat it out, or they were selling. Who do you think is buying now? That's right, all the large real estate investment firms, who happen to have enough experience to employ managers with, you guessed it, common sense.

I've mentioned these books before but check out "Extraordinary Popular Delusions and the Madness of Crowds" (written in the 1800s) and "Devil Take The Hindmost" a more recent book, and you will see just how uncommon common sense is. Next I will talk about how to employ common sense in real estate investing.

Well, after my last couple of blogs, I can not neglect to mention leverage and my thoughts on how to use it today in the the Edmonton real estate market.

Most of you no doubt know that leverage refers to how much debt one uses to purchase something. A general rule of thumb is that the more leverage one uses, the greater ones return on investment. Sounds great, doesn't it? Well, there is another rule of thumb; the greater the leverage one uses, the greater the risk also. Someone once told me there is an old Chinese saying (why is there an old Chinese saying for everything? One of these days I'm going to check out the veracity of these claims) that you have to go into the tiger's den if you want to get the kittens. Well, leverage is certainly going after the kittens in every respect - risk and reward.

Before one decides on purchasing an investment (I'm going to stick to real estate investments because that is where I have some knowledge), one must complete significant due diligence. This includes risk, return, liquidity, management, and tax analysis. I use a great software program called Investit (www.investit.ca) which allows me to do in-depth financial analysis based on numerous "what-if" scenarios. Using software programs such as Investit allows me to compare the return and the risk associated with various levels of leveraging. This is critical in analyzing leverage risk because one can see firsthand what risk/returns trade-offs one is making in taking on various levels of leverage, and hopefully arriving at the best risk/return ratio for oneself. Just as an example, let's say I want to see what my return on investment (yes there are various measures of ROI) will be at 75% leverage with a vacancy rate rising to 15% in years two and three, lowering to 5% in years four and five, with rents rising at 3% in year 3 and 4% in year five. I can do that. I can do any scenario I want. AND if you are planning on investing your money in commercial real estate, you should too.

You'll notice I said we need to find the best risk/return ratio for ourself. We are all different and we can all tolerate different levels of risk. I can not tell you what ratio of leverage is best for you, only you can do that. There is no "right" amount of leverage, we each must find our own level of comfort. Have you ever lost money before? How did you handle it? There is a clue to your level.

Okay, and so finally, what do I recommend in today's market for leverage? I certainly recommend leverage at any point in time. Buying straight cash is a waste of time and money. In today's market I recommend keeping your leverage well below your tolerance point. Depending on the type of investment you have, I recommend you keep a significant cash resource available to you for negative cash flows. The world economy (see my previous blogs and any recent economic news item for that matter) is very much in turmoil, and I would place more emphasis than usual on being able to keep my investments for the foreseeable future. All we have to do is look at the American experience; many property owners are struggling severely just to be able to hang on to their properties and their personal credit rating. Yes, we are certainly in the tiger's den at the moment. Be careful, but go get some kittens.

There sure seems to be a lot of talk about the danger of runaway inflation and subsequent rising interest rates. Will it happen? What effect will this have on commercial real estate?

Well, first things first. Will we see runaway inflation and rising interest rates? Now I am not an economist and I certainly do not pretend to be one. Fortunately that doesn't bother me because there is an old saying that goes, "If you placed all the economists in the world end to end, they wouldn't reach a conclusion". In other words, economics is so complicated, making projections is risky at best. So, what the hey, I may as well jump into the fray, couldn't hurt.

Up until recently, I have been quite concerned about runaway inflation and interest rates but my concerns have recently abated....somewhat. Okay, first, a primer on inflation and interest rates. Theoretically there is no such thing as inflation. The theory goes that prices don't rise; rather, printing more money makes the dollar worth less (and eventually worthless). To illustrate, imagine that there was $100 billion in the whole world and suddenly our governments printed another $100 billion overnight. Would we all get rich? No, prices would just double because there is twice as much money chasing the same amount of goods and services.

Governments raise and lower the amount of money available (money supply) to increase or decrease economic activity. They also use interest rates for a similar purpose. If you want consumers to spend more, lower interest rates so that debt is cheaper. If you want consumers to spend less, raise interest rates so that debt is too expensive and less people borrow money.

Sometimes governments get a little out of whack and need to print money for their own purposes, like for example, to finance foreign wars in, oh I don't know, Afghanistan and Iraq for example (in actuality, throughout history Kings have used debt, printed money, taxed citizens, etc., etc., to pay for their wars). Word on the street is that the US has printed wheelbarrow loads of money to finance their foreign wars. This money found it's way into the hands of investors who decided real estate was the place to be. They (US Gov't) also lowered interest rates at the same time, spurring a double whammy - loads of money and cheap interest rates - spurring untold investment in real estate and subsequent home price inflation.

Oh, one more important point. When we say governments "print" money, I'm not so sure they actually print most of it. You see, banks are allowed to create money. For every dollar people put into their bank accounts, the banks are allowed to loan out much larger sums, say $100. Where does the $100 come from? Thin air, it is simply, well, created. It probably doesn't exist other than as a number in a deposit record.

Finally, the bubble burst and now debt is hard to get, and billions and billions of dollars simply disappeared when home prices dropped. AND THAT is why I am becoming a little skeptical about the runaway inflation and interest rates. You see, inflation is a by-product of the "printed" money getting into circulation. Well, it's been in circulation for a few years now, why no inflation? Well, I believe we saw the inflation already, but it was mostly focused on real estate (and wages). BUT before it could spread throughout the economy in a more lasting manner, the bubble burst. Home prices fell dramatically, and a huge chunk of the inflation-causing money simply vanished, taking much of the inflationary pressure with it.

And subsequently, I don't expect huge interest rate increases, but we will probably experience some movement off the historical lows. Now, after that great big long story on money, what to do with our real estate? My best guess is that you keep your properties at a safe level of leverage (not too much debt). Things are still very unsettled and you don't want to lose it all; don't play it risky right now.

Remember money is more of a concept than an actual "thing". I mean, really, money is just paper with numbers on it. It is nothing more than a way to count the real value that rests in assets, goods and services. So, I am beginning to wonder if the whole inflation thing is well...overinflated.

Aaah but then there's Greece. Stay tuned.