COVER STORY, DECEMBER 2004

WESTERN FINANCE: VALUE & VARIETY
Southern California’s a great place to be selling these days.
David Sonnenblick and Elliot Eichner

Sonnenblick

Go west, young man” was the famous adage attributed to Horace Greeley. If he were alive today — and if he were privy to some of the same information that we are — Mr. Greeley might well have amended his remarks to, “Go west and buy institutional real estate.” West, that is, nearly everywhere but Southern California, where values are peaking, and the voracious appetite of investor capital is pushing down cap rates to all-time lows. Unlike the Bay area, where real estate values have imploded after the failure of the dot-coms and other technology ventures, Southern California properties have sustained their values because of the diverse economy that includes entertainment, financial services, aerospace and bio-tech industries.

Eichner

Where in the west, then, should investors look for value? By exercising proper selectivity, comparative bargains are to be had in cities like:

• Sacramento. One of the fastest-growing areas in California, Sacramento is attracting a growing number of young professionals and government workers who seek to live close to state office buildings rather than distant suburbs.

• Portland. Rapidly escalating housing prices in this popular city suggest that the multifamily market will remain strong in the city and its suburbs.

• Seattle. Still feeling the effects of the dot-com bust and a slight cooling down of the computer market, Seattle is a contrarian market that offers investors a good chance at appreciation on recovery.

• Las Vegas. Perhaps the fastest growing city in the United States, Las Vegas is also a magnet for new business formation and job creation. While there is abundant single-family housing, the apartment market remains robust.

• San Francisco and the Bay area. The fallout of the tech wreck on Bay area real estate has been well documented. Office rents have fallen by 60 percent in some places, and some local markets remain awash in sublease space. With regard to the multifamily market, occupancy rates have fallen since the recent boom in housing, however, San Francisco and its environs will always be popular with renters. Consequently, many investors are looking at the Bay area as a potential investment opportunity.

• San Jose. Located in the heart of Silicon Valley, if not the nerve center, San Jose was growing rapidly before 2002. With the tech downturn, the city is long on multifamily units. This may present an investment opportunity for shrewd investors in this high-barrier-to-entry market.

As it relates to selling in Southern California and buying elsewhere, Southern California is one of the strongest markets in the country, with a tremendous amount of institutional capital chasing too few quality projects. Many of the buyers are pension funds and real estate investment trusts (REITs) looking for stabilized and performing assets as a hedge against inflation. These are properties that will appreciate faster than the rate of inflation and maintain their residual value. To put it simply, there is more money than product. Unless you are a “coupon-clipper” kind of investor — someone who is content to collect a modest amount of income in return for safety and reliability — you need to go outside of Southern California to achieve your yield thresholds. Internal Rates of Return (IRRs) in Southern California are in the single digits. IRRs for institutional properties in other western markets can achieve low teens or higher.

There is value in all property types, but the caution is that in-depth market knowledge is required to make investments in such specialized areas as retail, office or industrial properties. It is necessary to research the market you’re most interested in and hire a local investment advisor, broker or management company with first-hand knowledge. For example, retail is extremely location and tenant-mix sensitive. A given market area can contain properties that offer tremendous upside as well as properties that are functionally obsolescent. Similarly, investments in small office buildings can do well if those buildings are located in strong, established markets. As in retail, office investment goes on a case-by-case basis and should involve people who understand the intricacies of the market and asset class.

Multifamily continues to be the strongest and perhaps safest product type in the western region. Although interest rates have begun to creep up and the housing market has shown signs of cooling, home prices still remain out of reach for many people. With the continued population growth in Southern California, a demonstrable need still exists for multifamily complexes, which should continue to make this product type a secure capital investment.

Investors do have the ability to increase their return on investment (yield) by taking greater risks. Increased yields can be achieved by investing in value-added deals – deals that typically require additional capital investment. This can include the renovation of existing, stabilized apartment buildings or older office buildings and hotel properties. Some investors will convert properties into alternative uses such as taking an older office building and creating apartments or loft units, or taking an older multifamily building and creating a hotel property. In these cases, investors usually seek out interim financing for renovation (essentially a construction loan plus a time period for stabilization). These loans typically float over the London Interbank Offering Rate (LIBOR) and are interest-only with no amortization. On the other hand, more conservative or less experienced investors may opt for a stabilized property in good condition, and obtain permanent financing — that is, a mortgage — with maturities ranging anywhere from 10 to 30 years. Amortization periods vary from 20 to 30 years depending on product type. By amortizing the payments over a longer period of time, lenders are able to offer investors a lower debt service payment each month and consequently more cash flow from their property. The downside for the investor is that most of the monthly mortgage payments will go to pay interest, rather than build up equity for the buyer. At the end of loan period, the loan becomes due or “balloons,” requiring a refinancing or sale.

Many real estate entrepreneurs are looking to development to achieve their target yields. With buying existing properties offering record-low yields, many owners find that developing new product is the only way to meet their return hurdles. Developing real estate obviously requires a much larger skill set than owning or managing an existing asset. Many investors may find it hard to reinvest in Southern California, where their windfall proceeds from the sale of buildings in this market can not be easily replaced with a like-kind property in the same area.

David Sonnenblick & Elliot Eichner are the principals of Los Angeles-based Sonnenblick-Eichner Company.

©2004 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.