The “Bad and the Ugly”. Real Estate doom and gloom reports have been surrounding us for over a year now. The residential market continues to suffer, as the July, 2008 Ohio Association of Realtors study reported that Ohio’s residential sales activity mirrored the national sales decline of more than 13% during the past year. To make matters worse, the gloomy residential real estate picture has now been overshadowed by an even gloomier commercial real estate picture. In the August 25, 2008 issue of Crain’s Cleveland Business, Stan Bullard’s article, “Unhappy Anniversary” reports that on the one year anniversary of the “credit crunch” (August, 2008), commercial property sales in Northeast Ohio are down 57%. The Real Capital Analytics of New York study cited in Crain’s shows a similar downturn of commercial real estate sales, on a nationwide basis, of 59%.
Most trace the real estate industry’s problems to the vanishing act of the publicly traded mortgage securities market and big loan losses at banks across the Country. Real estate investors and developers from mom-and-pop shops to major REITs are all reporting that securing a commercial real estate loan today is: 1) more difficult (with increased loan documentation), 2) more expensive (with the cost of funds and fees magnified), and 3) less leveraged (equity requirements on commercial deals now range from 20% to 50%).
The “Good”. So, what to do? The easy answer for buyers is: buy. Now is the opportune time. Alex Pacella (Vice President at NAI Daus) reported in the August 25th Crain’s Article referenced above that: “A year and a half ago there were three or four buyers for every [commercial] property…now for every three or four properties there is one buyer”. Residentially, the Ohio and National Association of Realtors reported, in its July, 2008 study, that the median price for existing homes is down 7.1% from a year ago. Finally, we are told that the Federal Reserve Board is expected to increase the federal funds rate at its next meeting. In other words, it is time to be reminded that the nature of real estate is cyclical (always has been, and always will be); and when inventory is high and prices are low, we are at the bottom of a cycle. In fact, hopefully we are on the upswing, as existing home sales actually rose 3.1% from June to July of 2008.
So, get back in the “game” before we are again faced with a “limited schedule” and a “high price of admission”.
The “How to”. How to buy, when we seem to be in the worst credit crunch since the S&L crisis? The simple answer to this seemingly difficult question is: get creative again, with “Creative Financing”. “Creative Financing” is the term that has been widely used to refer to non-traditional means of real estate financing or financing techniques not commonly used. The following presents a summary of the more common, creative approaches you may want to consider for your next deal:
1. Seller Financing - What better way to double the interest you could otherwise earn today in a CD or money market account, than by taking back a mortgage on the property you are selling. Offering seller financing to your buyer may also help you justify a realistic (vs. a “fire sale”) sales price. A good team consisting of a real estate attorney, real estate broker and seller can seamlessly make a seller-financed deal a quicker, easier and less expensive process than associated with commercial lenders. A credit check and reasonable down-payment can help lower the risk.
2. Installment Sale (aka Land Installment Contract) - If a buyer cannot afford a sizable down-payment and/or the seller prefers additional security and flexibility, this type of deal can work extremely well. Under a typical installment contract, the buyer takes immediate possession, however, the seller retains legal title until the contract has been performed and the price has been paid in periodic installments. If the buyer defaults (for property improved by a dwelling) prior to paying 20% of the purchase price, or prior to making payments for 5 years, the seller is more akin to a landlord and will have, pursuant to Ohio law, an easier time retrieving possession of the property and evicting the “vendee” from the premises. (See Chapter 5313 of the Ohio Revised Code).
3. Contingency Sales - Contingency sales are nothing earth-shattering, nor new, but the expanded use of same in a purchase agreement can help a buyer afford to buy. Financing contingencies are the most widely utilized, however, they are often poorly drafted. Buyers should tailor-make the contingency to incorporate the financing it can afford in terms of the percentage of equity required, and interest rate and fees charged. Sellers can ensure that the deal will happen irrespective of the financing contingency by providing that if the commercial lender fails to meet the buyer’s terms, the seller will do so.
In residential transactions, buyers who will not be able to afford to buy a new house until their existing house is sold should insist upon a “sale of existing home contingency”. Traditionally, these contingencies have not been acceptable to sellers. However, this can be fairly remedied by giving the seller the right to continue to market the property and seek secondary deals. As a variation on this theme, an obligation to “put” to the buyer, the obligation to buy within thirty days of seller receiving a secondary offer (or relinquish the contingency) would then prevent the seller from losing a sale while the buyer is trying to sell its property.
In commercial transactions, multiple contingencies are customarily provided, unless the deal is a below market, “as-is” deal. Again, when representing the buyer, simply add what is needed to make the deal work financially (e.g., pre-sales, signed lease by anchor tenant, re-zoning). Unless the property can easily be sold without contingencies, most sellers will “go along for the ride”, provided they are compensated by buyer putting more “up front money” at risk.
4. Lease - Option/Rent-to-Own - Lease-options have been traditionally used in commercial deals to give the tenant the option to buy, after the expiration of a long-term lease. For a seller that needs an income stream now, and a buyer having trouble securing financing, however, the lease-option can just as easily be used on a short-term basis. Again, rights to market the property during the duration of the option, and “put options” can be utilized to balance the needs and risks of the parties.
The “rent-to-own” form of lease-option used in the residential market has expanded over the years, and may be a good vehicle for a buyer who cannot qualify for traditional financing. These deals must be carefully scrutinized, however, because rent-to-own tenants are often obligated to pay an option fee, and a premium above market rents. However, because sales and option prices are still low, the bottom line numbers may balance favorably to the buyer who cannot qualify for conventional financing.
Sellers of large parcels of land should consider “rolling options”, or staged purchase deals, allowing the buyer-developer to buy the acreage in phases, rather than all at once. If a seller, for example, gives the buyer three (3) successive options to buy a thirty (30) acre property in three (3), ten (10) acre parcels, he/she might indeed, be left with 20 out of the 30 acres. However, the buyer in these types of deals will often have the right (or obligation) to make the overall, infrastructure improvements. Once these improvements are completed, the seller will have an easier time selling the remaining acreage to another buyer.
5. Bring in partners - True, a buyer would have to share the wealth and divide the “gold”, however, they would also be able to divide the cost of “prospecting”. We have put together many deals (typically, in limited liability company arrangements) consisting of real estate investors willing to work together, rather than bid against each other for a particular piece of income-producing property.
Private placement equity financing is also a very viable option. We recently handled a transaction whereby physician “tenants” in our client’s to be purchased office building also became equity holders in the property. The equity supplied by the investor-tenants financed the deal for our client, and gave the physicians “a piece of the rock” instead of just a rent obligation every month.
6. Hedge Funds - The Wall Street Journal recently reported (in an August 27, 2008 article by Ling Ling Wei) that investors seeking financing to acquire office towers, retail stores, hotels and other commercial property have been looking to the approximately 140 hedge funds that specialize not only in stressed assets and fixed income securities, but also provide commercial real estate lending. While the interest rate charged by these funds can be twice that charged by a conventional lender, these hedge fund loans have been reported to be worth the extra loan costs to avoid missing out on golden, income producing real estate opportunities. These loans are typically short-term (one to two years) and the properties securing the loans must have enough cash flow to cover debt payments and low loan to value ratios. Nevertheless, these hedge fund loans are being more and more looked at to “bridge the gap” during the credit crunch, much like construction loans bridge the gap until construction is complete and constructed buildings become income-producing assets. The Wall Street Journal article can be found at the following Site: http://online.wsj.com/article/SB121979484328774709.html.
The “real estate opportunity glass” is definitely half-full, and hopefully on its way to filling up fast. Conservative wisdom says “wait out the storm”. Conventional real estate wisdom, however, says “answer the door when opportunity knocks”. Now is the time to “answer the door” and buy, creatively.
Most trace the real estate industry’s problems to the vanishing act of the publicly traded mortgage securities market and big loan losses at banks across the Country. Real estate investors and developers from mom-and-pop shops to major REITs are all reporting that securing a commercial real estate loan today is: 1) more difficult (with increased loan documentation), 2) more expensive (with the cost of funds and fees magnified), and 3) less leveraged (equity requirements on commercial deals now range from 20% to 50%).
The “Good”. So, what to do? The easy answer for buyers is: buy. Now is the opportune time. Alex Pacella (Vice President at NAI Daus) reported in the August 25th Crain’s Article referenced above that: “A year and a half ago there were three or four buyers for every [commercial] property…now for every three or four properties there is one buyer”. Residentially, the Ohio and National Association of Realtors reported, in its July, 2008 study, that the median price for existing homes is down 7.1% from a year ago. Finally, we are told that the Federal Reserve Board is expected to increase the federal funds rate at its next meeting. In other words, it is time to be reminded that the nature of real estate is cyclical (always has been, and always will be); and when inventory is high and prices are low, we are at the bottom of a cycle. In fact, hopefully we are on the upswing, as existing home sales actually rose 3.1% from June to July of 2008.
So, get back in the “game” before we are again faced with a “limited schedule” and a “high price of admission”.
The “How to”. How to buy, when we seem to be in the worst credit crunch since the S&L crisis? The simple answer to this seemingly difficult question is: get creative again, with “Creative Financing”. “Creative Financing” is the term that has been widely used to refer to non-traditional means of real estate financing or financing techniques not commonly used. The following presents a summary of the more common, creative approaches you may want to consider for your next deal:
1. Seller Financing - What better way to double the interest you could otherwise earn today in a CD or money market account, than by taking back a mortgage on the property you are selling. Offering seller financing to your buyer may also help you justify a realistic (vs. a “fire sale”) sales price. A good team consisting of a real estate attorney, real estate broker and seller can seamlessly make a seller-financed deal a quicker, easier and less expensive process than associated with commercial lenders. A credit check and reasonable down-payment can help lower the risk.
2. Installment Sale (aka Land Installment Contract) - If a buyer cannot afford a sizable down-payment and/or the seller prefers additional security and flexibility, this type of deal can work extremely well. Under a typical installment contract, the buyer takes immediate possession, however, the seller retains legal title until the contract has been performed and the price has been paid in periodic installments. If the buyer defaults (for property improved by a dwelling) prior to paying 20% of the purchase price, or prior to making payments for 5 years, the seller is more akin to a landlord and will have, pursuant to Ohio law, an easier time retrieving possession of the property and evicting the “vendee” from the premises. (See Chapter 5313 of the Ohio Revised Code).
3. Contingency Sales - Contingency sales are nothing earth-shattering, nor new, but the expanded use of same in a purchase agreement can help a buyer afford to buy. Financing contingencies are the most widely utilized, however, they are often poorly drafted. Buyers should tailor-make the contingency to incorporate the financing it can afford in terms of the percentage of equity required, and interest rate and fees charged. Sellers can ensure that the deal will happen irrespective of the financing contingency by providing that if the commercial lender fails to meet the buyer’s terms, the seller will do so.
In residential transactions, buyers who will not be able to afford to buy a new house until their existing house is sold should insist upon a “sale of existing home contingency”. Traditionally, these contingencies have not been acceptable to sellers. However, this can be fairly remedied by giving the seller the right to continue to market the property and seek secondary deals. As a variation on this theme, an obligation to “put” to the buyer, the obligation to buy within thirty days of seller receiving a secondary offer (or relinquish the contingency) would then prevent the seller from losing a sale while the buyer is trying to sell its property.
In commercial transactions, multiple contingencies are customarily provided, unless the deal is a below market, “as-is” deal. Again, when representing the buyer, simply add what is needed to make the deal work financially (e.g., pre-sales, signed lease by anchor tenant, re-zoning). Unless the property can easily be sold without contingencies, most sellers will “go along for the ride”, provided they are compensated by buyer putting more “up front money” at risk.
4. Lease - Option/Rent-to-Own - Lease-options have been traditionally used in commercial deals to give the tenant the option to buy, after the expiration of a long-term lease. For a seller that needs an income stream now, and a buyer having trouble securing financing, however, the lease-option can just as easily be used on a short-term basis. Again, rights to market the property during the duration of the option, and “put options” can be utilized to balance the needs and risks of the parties.
The “rent-to-own” form of lease-option used in the residential market has expanded over the years, and may be a good vehicle for a buyer who cannot qualify for traditional financing. These deals must be carefully scrutinized, however, because rent-to-own tenants are often obligated to pay an option fee, and a premium above market rents. However, because sales and option prices are still low, the bottom line numbers may balance favorably to the buyer who cannot qualify for conventional financing.
Sellers of large parcels of land should consider “rolling options”, or staged purchase deals, allowing the buyer-developer to buy the acreage in phases, rather than all at once. If a seller, for example, gives the buyer three (3) successive options to buy a thirty (30) acre property in three (3), ten (10) acre parcels, he/she might indeed, be left with 20 out of the 30 acres. However, the buyer in these types of deals will often have the right (or obligation) to make the overall, infrastructure improvements. Once these improvements are completed, the seller will have an easier time selling the remaining acreage to another buyer.
5. Bring in partners - True, a buyer would have to share the wealth and divide the “gold”, however, they would also be able to divide the cost of “prospecting”. We have put together many deals (typically, in limited liability company arrangements) consisting of real estate investors willing to work together, rather than bid against each other for a particular piece of income-producing property.
Private placement equity financing is also a very viable option. We recently handled a transaction whereby physician “tenants” in our client’s to be purchased office building also became equity holders in the property. The equity supplied by the investor-tenants financed the deal for our client, and gave the physicians “a piece of the rock” instead of just a rent obligation every month.
6. Hedge Funds - The Wall Street Journal recently reported (in an August 27, 2008 article by Ling Ling Wei) that investors seeking financing to acquire office towers, retail stores, hotels and other commercial property have been looking to the approximately 140 hedge funds that specialize not only in stressed assets and fixed income securities, but also provide commercial real estate lending. While the interest rate charged by these funds can be twice that charged by a conventional lender, these hedge fund loans have been reported to be worth the extra loan costs to avoid missing out on golden, income producing real estate opportunities. These loans are typically short-term (one to two years) and the properties securing the loans must have enough cash flow to cover debt payments and low loan to value ratios. Nevertheless, these hedge fund loans are being more and more looked at to “bridge the gap” during the credit crunch, much like construction loans bridge the gap until construction is complete and constructed buildings become income-producing assets. The Wall Street Journal article can be found at the following Site: http://online.wsj.com/article/SB121979484328774709.html.
The “real estate opportunity glass” is definitely half-full, and hopefully on its way to filling up fast. Conservative wisdom says “wait out the storm”. Conventional real estate wisdom, however, says “answer the door when opportunity knocks”. Now is the time to “answer the door” and buy, creatively.
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