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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   February 2008

Find Opportunities in Today’s Market

The future may be uncertain, but your business plan doesn’t have to be

We are facing a world of unknowns. Many industry veterans and observers agree that our business has never seen a time like this before.

Nevertheless, this can also be a moment of opportunity for those who know how to capitalize. Many savvy players are beginning to raise capital in hopes of acquiring good assets at a discounted price. Opportunities will be available for you to help them find funding. First, you should take time to assess which loans will be good candidates in a constantly shifting economic environment.

Before you can begin doing that, it’s helpful to examine some key economic factors.

The nonprime mortgage meltdown triggered the screeching halt of the real estate capital markets and called into question the value of all mortgage-backed securities. The failing housing market plays into the mix. As their ARM rates adjust upward, many homeowners will soon face unmanageable payments. This will lead to additional foreclosures and more vacant homes on the market, thus putting further downward pressure on prices. The drying up of available mortgage capital only exacerbates the decline in home values. This has resulted in a crisis of confidence.

Many experts now say that the sheer size and complexity of the current situation could take years to stabilize, and that until then, banks and other lenders will be nervous and tight with credit.

Banks are seeking liquidity and are even pulling back on business loans. This means that investors and developers without sufficient capital to ride out the current market may end up in foreclosure or fire-sale situations. These defaults will lead to more problems for banks and the capital markets, which will further heighten the credit crunch and negatively impact values. No one is sure where this cycle ends.

The big question at present is whether we are headed for a recession. This much is certain: Storm clouds lie on the horizon.

Retail sales are sluggish and consumer confidence is down. And historically, when banks tighten across the board, as they are now, recession isn’t far off.

Considering value

Given all these unknowns, one key to capitalizing on today’s challenging times is to be prepared -- and to help your clients be prepared. It’s imperative that your investor clients have a plan to identify and acquire target assets, as well as one to manage those assets adequately. They should have capital sources already in place so that they can move quickly.

Property value is one of the most-important factors lenders will consider.

What is the value now? This question isn’t easy to answer. Appraisals tend to look backward at comparables and often don’t reflect what a potential buyer would pay in today’s environment. Whatever you do, don’t just accept the value shown in an appraisal. This approach will almost certainly lead your borrowers to overpay for the asset.

If you do use the appraisal as a starting point, you must carefully evaluate all of the assumptions to make sure they accurately reflect the current state of the market.

With income properties in particular, understand what market rents will be for the duration of the property’s investment horizon. Remember that the economy may not be as strong in the future and that rents may flatten or fall. In addition, evaluate the strength of the rent roll and understand the impact of tenant rollover.

With residential developments, work backward from the end-selling-price of the homes to be constructed. Then deduct construction and selling costs to get the finished lot value. From the finished value of the lots, if you deduct the costs to improve the lots, you will be left with the value of paper lots. As a general rule, the cost of a finished lot should be about 20 percent of the selling price of the home being constructed. Keep in mind that certain prime locations may command a lot premium.

The main thing to remember is that lot values are derived from home values. So if no new homes are being built in the particular market at that time, the value of the lots will be further diminished until building activity begins or resumes.

Also, try to project future economic and market conditions to determine what the value will be at the end of the holding period. With all of the flux in the capital markets and a cloudy economic future, this can be somewhat challenging to figure out.

Knowing the exit strategy

Another important step for investors entering into any transaction is to know how they plan to get out. Typically, the exit strategy is either a sale or refinance of the asset.

If it is a sale, you and your borrowers should examine whether the market is strong for that type of asset. For example, if few developers are building new homes in the market right now, factor this inactivity into your analysis of the sales option.

Building activity may pick up, but until then, it will probably be land speculators buying the lots and not builders or developers. Determining who the potential buyers currently are and when the borrowers plan to exit is important.

If the investors plan to exit through a refinance, you should know the current status of the refinance market as well as what the market may look like when the borrowers plan to exit. With the current credit crunch and associated tougher underwriting, this knowledge is especially important.

With a refinance, you have to work backward accordingly, as well, making sure that the asset will be performing at a level that would meet the future refinancing lender’s guidelines. The debt-service-coverage ratio, occupancy and net operating income should all be considered.

Be prepared

Do your research and rigorously underwrite any potential deal. Again, a conservative approach based on sound real estate fundamentals will serve you best. A little effort could save you from having problems after the borrowers have closed on the transaction -- when it is too late to fix a problem or pass on the deal.

Seek out borrowers who seek funding for properties with high intrinsic value or upside potential. For example, coastal land generally retains its value well and is some of the first property to recover in a downturn. Individual properties that are well located in urban in-fill areas or walkable urban areas have high intrinsic value. Areas with strong job growth also offer upside opportunity. Income properties that simply require repositioning and stabilization also offer good potential upside.

Be cautious of big developments. The carry on these projects often means they may not  be viable.

Begin aligning yourself with capital-providers now. Your clients will inevitably need debt and equity funds, so start forming those relationships in advance. Once the opportunities present themselves to your clients, you will be in position to help them move forward and capitalize quickly.

Your clients may also want to consider purchasing bank’s real-estate-owned portfolios, as well as distressed loan portfolios. The special-assets groups at banks are barraged these days with opportunistic buyers, so it’s important that borrowers impress them with the fact that they are credible, knowledgeable and well-capitalized.

•  •  •

Even in these times of change and uncertainty, smart investors will find quality assets that have been overtaken by the macro events of the credit crunch, falling housing market and weakening economy. If you’re wise, you’ll seek out these investors and help fund their loans.

To capitalize on today’s market, take a disciplined and patient approach. Everything will take longer than you would like. If you’re working with borrowers who select the right assets, you could be well-rewarded for your efforts. 


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