WHY GO DOWN ON A SINKING SHIP?
Cash-flow Alternatives for Investors

Consider the following scenario.

You own a significant number of shares in IBM. Whether the stock goes up or the stock goes down is of great concern to you. Then you have me. I am your best friend. I am also a psychic. But my powers are limited. I know one week in advance which way, up or down, IBM and Apple stocks will go.

On Monday, I have a premonition. IBM’s stock will plummet 20% by Friday. Conversely, Apple’s stock will gain 10%. Since we are best friends, and since I know you have a lot of money in IBM, I call you right away to give you the news.

What would you do? Last time you checked, the SEC imposed no rules against fortune telling. Plus, you know my previous visions have been 100% correct. The answer is simple: sell IBM and buy Apple. You would be nuts not to.

So, what is the lesson here? Find an agent that is a psychic? Hardly. Instead, you get the next best thing— a professional. What is a professional? First and foremost, a professional is a market expert. My team and I are market experts. In order to negotiate the best possible deal for our clients, we draw on research from every possible source. Whether it is from economists, government studies, academic reports, lenders, appraisers, or the good old-fashioned method of being in the market day in and day out, we leave no stone unturned. We sift through all of this information in order to formulate our opinion of the market for the next 6-12 months, and in some cases, beyond that.

Why am I telling you all this? Because each of us has to make a decision in order to set the future course of our investments. We are in the midst of the worst economic condition since The Great Depression. The good news is that we still have options. It is not too late. A review of the market for the past six months of 2008 to the present, affords us a critical insight into where values are headed in 2009. Not only that, but we will possess the needed framework in order to develop a strategy for not only surviving the economic crisis, but profiting during it.

2008, the Second Half
During the second half of 2008 we witnessed what felt like one economic tidal wave after another. The sub-prime mortgage fallout has precipitated a series of financial catastrophes across the broader economic landscape to a staggering degree.

Let’s quickly recap:

• In March, the Federal Reserve made the unprecedented and highly controversial move to assume $30 billion in liabilities from Bear Stearns. To boot, the Fed acted as go-between for the sale of Bear Stearns to J.P. Morgan Chase. The price was for peanuts.
  
  
• On September 7th, in a desperate move to stabilize the plummeting stock prices of Freddie Mac and Fannie Mae, the Treasury Department takes over both mortgage giants.
  
  
• Lehman Brothers attempts to ride on the coattails of the Fed’s charity toward Bear Stearns. But Federal Reserve Chairman, Ben Bernanke, dishes them out tough-love instead. Lehman declares bankruptcy on September 12th. Fearing a similar fate, powerhouse brokerage firm, Merrill Lynch, sells to Bank of America. Now we read that it was not such a good deal after all.
  
  
• The dark side of the credit default swap market finally rears its ugly head and on September 16th when the Fed bails out American International Group (AIG) with $85 billion. Unlike Lehman Brothers, this time the Fed argues that AIG is too big to fail.
  
  
• On September 18th, Treasury Secretary Henry Paulson perhaps senses a trend, so he submits to Congress a 3-page, $700 billion proposal to buy toxic assets from the nation’s biggest banks. Incredulous laughter from the House ensues.
  
  
• Still laughing on September 19th, the House rejects Paulson’s bailout plan. The S&P 500 dropped 500 points (9% of its value), which was the biggest percentage drop since 1987.
  
  
• Washington Mutual, the country’s largest savings and loan, gets bought by J.P. Morgan Chase on September 25th. This was following a 10-day run on the bank, totaling $16.4 billion in withdrawals.
  
  
• Having switched from laughter to tears, the House follows the Senate lead and passes the bailout plan on the October 3rd.
  
  
• On October 8th, the world’s biggest central banks call a meeting in order to coordinate an international interest rate cut.
  
  
• Following Ben Bernanke’s glooming predications, the Dow plunges 733 points on October 13th.
  
  
• On October 29th, the Federal Reserve cuts the key lending rate to 1%. The Big Three American automakers go to Washington seeking bailout money on November 19th. After Congress says no way, President Bush finally steps-in and issues $17.4 billion in emergency loans to be shared between GM and Chrysler.

The above captures only the major movements of the last six months of 2008, with many incidents not listed. Frankly, there are simply too many to name. All contain an array of complexities and implications for the larger economy. But what is certain is this: the credit markets are frozen, making lending criteria so strict that even a car loan requires a near perfect credit score.

Furthermore, companies continue to shed workers by the thousands, with new announcements every week of 10+% lay-offs. For some organizations, it’s the second and third round of cuts. Added to this, consumers are spending significantly less, which has forced some retailers into store closings and even bankruptcy. This has not been limited to new companies, but major names like Circuit City, Meryvn’s, and Linen ‘n Things.
States are in trouble too. California, for example, was long stalled in its gargantuan budget crisis. The predicament lowered the Golden State’s bond rating to the second lowest in the country, right above Louisiana. What’s more, for this year’s state tax return, individuals almost got IOU’s instead of money. Understaffed schools and colleges might experience a further downsize in teachers. The gauge on the unemployment benefits account is creeping toward empty.

The unemployment rate for the state of California and Los Angeles County are currently over 10%, with the city of Los Angeles at 12%. The city of Santa Monica is still under 9% unemployed. Do not forget about the Screen Actor’s Guild as well. If the actors do hit the picket lines and it resembles anything like the writers’ strike, we can expect a tremendous contraction in the local economy.

Local Real Estate Conditions
The real estate market has deteriorated across all sub-markets and all property types. Rents have dropped and will continue on this trend well into 2010. Vacancy rates, currently at around 12% for commercial space, will continue to climb as companies cut employees and retailers close their stores. On the Westside, the largest commercial market in Greater Los Angeles, about a third of available space is on sublease. With this increase in vacancies, rents could be pushed down as much as 30% in the next year, according to some reports. Furthermore, a recent Urban Land Institute survey recently put the bottom anywhere from 6 -12 months away.

Not surprising, housing prices continue to drop as foreclosures and newly built homes have created a glut in inventory. New homes sales were down 63% against the 20-year average for December, while median home prices fell 35% for that same month at the 2007 level.

In the multi-family sector, we will continue to see a trajectory of negative appreciation. With the rise in unemployment and decreased incomes, market rents have dipped as much as 25%, while vacant units are taking a month or more to rent. This includes even the much more resilient Santa Monica/Westside areas. One only has to walk down the street in order to see the many “For Rent” signs.

The three forces determinate value– Income, Cap Rate, and Demand– will continue to head in the wrong direction. Moreover, we see GRM’s dropping into 11-12 X Gross range. Tighter lending terms have forced buyers into making taxingly large down payments. Quite simply, there are fewer buyers, less 1031 exchanges, and less activity on all fronts. We could be headed into a scenario much like in the early 1990s where values in Brentwood/ North of Wilshire market were at a meager 10 GRM.

Yikes! What Do I Do?
No one anticipated the magnitude of the current recession. What we can expect, though, is that 2009 will be the year when the full effects of the market downturn are to be felt. What am I recommending to my clients? It is time to get you into a positive cash-flow position. Luckily, it is not too late.

If you follow the Business section of the paper, you will often read the phrase, “Flight to quality.” In essence, when the market is in trouble, savvy investors take a hard look at what works and what doesn’t. Then they seek out opportunities with strong fundamentals. While the ship that carried the peak price for your apartment property has already sailed, I can still get my clients a respectable sales price of 2% or higher and then shift the money into an opportunity that yields a higher return and that is not burdened by rent control.

In many situations, I have calculated a 1%-2% return on current equity of an owner’s property when the owner thought it was closer to 7%-10%. This means that the equity is not working hard for you. By selling the property and trading into another property (and taking advantage of a tax deferred exchange rules), you can increase your cash flow and return on equity.

Rather than waiting-out the market downturn, hoping against hope that the up-cycle is just around the corner, you can improve your situation right now. Right now, and going forward for the next 6 to 12 months, it is my professional belief that it’s time for many folks to move their investments into single-tenant, Triple Net, commercial properties. I am referring to fast-food chains, major banks, industrial properties, government agencies, or any number of well-known entities with strong consumer identification and market presence. These are properties that are leased on a long term basis to one tenant.

Do you think McDonalds or Carl’s Jr. is going anywhere? With people cutting their expenses right now, who do you think has seen their sales drop, fast- food restaurants or expensive fashion boutiques?

Now, let me review the advantages for the investor of Triple Net investment properties. There are several. First, all expenses (real estate taxes, fire insurance, and maintenance) are paid by the tenant (hence the term “Triple Net”).

Second, since you have divested yourself of management responsibility, you will save yourself the headache of dealing with tenant issues. You simply collect the check every month, often arranging for the money to be wired directly into your bank account.

Last and most importantly, I am seeing opportunities where owners are making double, triple, and even quadruple their previous cash-flow. Couldn’t you use the extra money? The price of college tuitions are only going up. What about that vacation that you have been putting off? You have worked hard, why not let your property work hard for you? You are not alone. There are many investors who are in the same perilous boat who are in need of a more lucrative option. I can improve your situation.

Conclusion
With the economy’s rapid rate of decline, we are more often seeing apartment owners experiencing negative appreciation on their investments. Unfortunately, rents will continue to be in jeopardy. In response, astute buyers will turn their equities into cash-flow properties. Why own a property experiencing negative appreciation when you can get a cash-on-cash return of 7% to 8.5%?