ARE WE FLYING TOO CLOSE TO THE SUN?

I have always liked Greek mythology. There was something about those larger-than-life figures like Zeus (the big boss), Mercury (they named a car after him), Poseidon (the underwater guy, and the name of a movie), Aphrodite (the Angelina Jolie of her day), and Achilles (the Brad Pitt of his day…I think that is why he was cast in the movie “Troy”).

One of the stories of Greek mythology that I liked the most, and I think serves, as a good analogy for many of life’s issues, is the one about Daedalus and his son, Icarus. It seems that Daedalus and Icarus were imprisoned by the King of Crete for doing something wrong. Daedalus, who was a respected and talented artisan of his time, and known for his skill as an architect, sculptor, and inventor, decided that the only way his son could escape was to build him a set of wings. The wings were made of feathers held in place by wax. On the big escape day, the father gave Icarus the following basic instructions: “Do not fly too low or the feathers will get wet and heavy, thus, you will fall into the ocean. On the other hand (sounds like the words of wisdom from an economist), do not fly too close to the sun or the wax will melt, causing the feathers to come loose, which will also cause you to fall into the ocean.” Icarus thought he understood, but got excited by the flying experience (sounds like me and my first car). I think you can guess what happened next. That’s right, Icarus flew too high, the feathers fell off, and the poor lad perished in the ocean.

Like Icarus, the Los Angeles County real estate investment market has been flying pretty close to the sun. What do I mean by that, you ask. Just look at the following chart of the “Average Capitalization Rate for Apartments in Los Angeles County from 2000-2005.” According to CoStar Group, the leading provider of market information regarding commercial real estate, Capitalization Rates for Apartments in LA County have dropped from an average of 8.76% to 4.99% in the past five years. Do you realize that if the Net Income of the “average” property did not change even one dollar during that time, the overall value would still have increased 76% (an average of 15% per year). If you bought the “average” property with a 75% loan, then your return on equity would be over 300% (an average of 60% per year). Again, these are averages, but I bet many of you experienced similar results. Just look at how many Mercedes there are on the streets.

So, where are we now, and what does the sad story of yet another teenager who did not listen to his father’s advice have to do with it? Well, I seriously think we are flying too close to the sun in the Los Angeles County world of investment real estate. It is time for you to make some decisions and take some action. The rest of this article will shift away from Greek mythology and focus on some recommendations. As the Bette Davis character, Margo Channing, said in the 1950 movie All About Eve, “Fasten your seatbelts, it’s going to be bumpy night.”

OVERVIEW

Let me begin by giving you an overview of today’s market conditions. The evidence is clear to those of us in the brokerage trenches that the market has shifted. What are we seeing, you ask?

Properties are not selling for the same Gross Rent Multiplier, Capitalization Rate, Price per Unit, and other price indicators as they did a year ago.

Properties are not experiencing multiple offers compared to a year ago.

Overall prices have come down compared to a year ago.
The availability of properties for sale has significantly increased. Take a few minutes and study the next chart that is based on information from LoopNet, the leading listing source in the commercial brokerage industry. Compare the number of Apartments on the market in L.A. County in January of 2004 (663) to August of this year (2,707).

That is an increase of 308%.

Remember what they taught you in Economics 101: As supply increases, prices will come down. I know that a lot of you are saying, “Hey, demand is still pretty good for apartments, so prices will not fall.” Before you think you got me on that point, here is another statistic you should ponder: In 2005, there were 24.1% fewer Apartment transactions in LA County as compared to 2004. That is pretty conclusive that demand is cooling off.

RECOMMENDATIONS

I do not know when the following line was first used in a movie, “Give it to me straight, doc, I can take it,” but I am going to give it to you straight right now regarding what I see as your alternatives based on today’s market conditions. My recommendations come from the perspective of two basic decisions– hold or sell. There is a scenario for each.

If you are a holder, then this is what I recommend:
Now is an excellent time to put fixed-rate financing on a property or re-finance an existing variable rate loan. As long as inflation continues to increase (just look at the recent numbers and you can see that it is going in that direction), the Federal Reserve is going to continue to increase their benchmark rate. This will trickle down to an increase in real estate loans. Five years from now, the current rates will look very good. It is never too late to re-finance in an increasing rate environment.
Put a fixed rate mortgage on your property. Current fixed rates for Apartments are approximately 6.2%, 10-year fixed, 30-year amortization. At the end of the ten years, the loan converts to an adjustable rate.

If you do not have a lender that you know, please call me and I will give you the name of several that we work with who are excellent.

If you are a seller, then this is what I recommend:
The market is softer now than a year ago, but it is still a good market. Your property, if priced correctly, will sell. The key is pricing it right. The days of over-pricing a property in hopes of catching a “speeder” (defined as someone in a heated rush to buy something) is over. You should strongly consider taking your net proceeds from a sale and purchasing a replacement property by using a 1031 tax deferred exchange.

There are several advantages to buying replacement property:
You can buy a larger property if you have a lot of equity in your existing property and are willing to place a conservative level of financing on the new property.
With a new depreciable basis (that is tax talk), you can again start to shelter the property’s income, thus, more money in your pocket.
You can buy a property in a better location or a newer one with more modern amenities.
You can buy a different type of property.

There are several alternatives for a replacement property:
Another single-asset income property (either the same type or another type). This alternative is self-explanatory. You sell your investment real estate and buy some other investment property. *

Tenant-In-Common investments. These relatively new investments were approved by the IRS in 2004. They allow group ownership of a single asset to qualify for a 1031 exchange if the situation meets certain guidelines and structuring. There are about 70 major “TIC” sponsors and many more minor ones. This vehicle gives you the opportunity to own a piece of a major institutional asset such as a high-rise office building or regional shopping center. *
Royalty Trusts. This is probably the most overlooked trade vehicle. In the early 1940s, court rulings affirmed that oil and gas royalties qualify as a “like kind” investment in a 1031 exchange. Therefore, you can exchange brick-and-mortar real estate into royalty interests, which have a very attractive current yield (10%+). These products are sold through securities dealers. *

Carry the financing. When you sell your property, it is not necessary to “cash out.” You can always make the decision to be the lender on your property by “carrying the paper.” If the buyer is qualified, and you get a good down payment, you can negotiate an interest rate and terms on the First or Second Note that might yield you more cash flow than the property had when you owned it. The “installment sale” qualifies for favorable tax treatment because you are not receiving the entire principal at one time, thus, your tax liability in the year of the sale would be a fraction of what it would be if the sale were structured as “all cash” at the close of escrow. Another point to consider is that with an installment sale, you earn interest on the taxes that have not been paid in the year of the sale. That sounds good to me! This is a good deal structuring alternative if you do not want to exchange, but rather, prefer to take your money and run. *

* NOTE: Please verify all comments that I have made about taxes and qualifying properties with your CPA or tax advisor.

Well, there you have it. I think the market is now at a state where you should make a decision on several issues. Doing nothing is not a good alternative. This has been a very good market that has rewarded us all; however, you should not take the market for granted. Market cycles are a natural part of the real estate business, and, if fact, all businesses.

I was watching the movie King Kong the other day. In both the old and new version, the last line is the same. The people are hovering around Kong, who has just fallen off the Empire State Building. In the original version (my favorite), a police officer says, “Gee, what a sight. Well, the aviators got him.” Carl Denham replies, “Oh no, ‘twasn’t the aviators. It was beauty killed the beast.” Sorry for the bad grammar on the quotes, but that is the way they talked in 1933.

So with that, let me close by saying that this has been a beautiful real estate market for the past ten years. Do not let the historic beauty of this market keep you from doing what is in your best interest, and ultimately, affecting your investment.