A Note to Buyers and Sellers

Michael L. McCune Comments
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"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to heaven, we were all going direct the other way..."

Charles Dickens' famous opening line from A Tale of Two Cities can be used to describe a typical sale between two parties in a real estate transaction. In other words, one party's gain is typically the other's loss. There is, however, an unusual situation that exists when buyer and seller can both win.

Today, we have the happy circumstance in which buyer and seller can achieve their goals in a sales transaction without hurting the other's position. Clearly, positive economics do not resolve all of the differences that may occur in a real estate deal. However, given reasonable expectations and a measure of goodwill, the current economic climate will allow buyers and sellers to more quickly find common ground. Let's take a look at why this unusual circumstance exists today.

Financing

I'm sure most would guess low interest rates have something to do with our pleasant plight. While this does not come as a surprise, understanding the rarity of the low rates and the magnitude of their impact is worth more than a cursory nod.

Interest rates have been at historic lows and have continued to fall under pressure from the Federal Reserve to encourage the recovery of the economy. The Fed has cut rates 11 times without stopping to even take a breath. Fortunately, these actions appear to have worked their magic and reversed (or at least slowed) the recession before it had its usual run of malaise. This effort by the Fed has driven interest rates to their lowest levels in many years.

But now we hear the Fed may be having different thoughts about the direction of interest rates and may well begin to raise them in the not too distant future. To see what this change in rates means to potential buyers, we will construct a typical sale to show how lower interest rates will make the buyer more enthusiastic about a property:

Details About Our Sale Cash-On-Cash Return
Revenue $315,000 Loan @ 6.25% 18.40%
Expenses $105,000 Loan @ 7.50% 15.40%
NOI $210,000 Loan @ 8.50% 13.00%
Cap Rate 10.5 Loan @ 9.50% 10.50%
VALUE $2,000,000
LOAN $1,500,000

As these results illustrate, the return to a buyer is about 41 percent higher on the same deal when interest rates are just 1.75 percent lower. The best part is this increase in return costs the seller nothing, i.e., the buyer and the seller both benefit.

There is also a valid argument that there are more buyers for properties providing a 15 percent return than for properties with a 10 percent return. This increase in the number of potential buyers results in a much faster sale. While not all owners are busy doing this math, many buyers I spoke with at the Inside Self-Storage Las Vegas Expo had this formula in mind. I'm sure this happy convergence of positive economics had a lot to do with the exceptionally large attendance at the show.

In addition to low interest rates, there is also an availability of financing for quality self-storage facilities. Although underwriting of loans has become much more difficult and thorough, funds are still available. Because of troubles in other types of real estate, lenders are becoming more cautious and concerned about real estate in general. This disappointing performance by other real estate types may ultimately affect the availability of lending for self-storage.

Confidence

So far, the recession has appeared to minimally impact the self-storage industry, giving potential buyers confidence in the ability of self-storage properties to produce consistent returns. This trend is reflected in the foreclosure percentages for various types of real estate, with self-storage being the lowest by a very wide margin. Reducing general uncertainty in the market helps buyers and sellers achieve their respective goals in a transaction. An increase in realistic confidence benefits both, without a cost to either party.

Recession Recovery

If there is no war and the recession is really over, potential buyers can look forward to possible increases in rental rates and occupancies. Given the expected turnaround in the economy, this allows buyers to be optimistic about the future. Clearly, the seller is not penalized in the transaction because of this fortuitous turn of events, and the buyer will benefit by "buying at the bottom."

Let us revisit our hypothetical transaction and see what just a little optimism would do to the buyer's pro forma for next year. Even if the recovery is not vigorous, a reasonable assumption might be a 3 percent increase in occupancy and rental rates. With such assumptions, the revenue would increase by $18,900, the NOI would increase to $228,900, and the cash-on-cash return increases even more. These returns will cause most serious investors to pay attention.

Competing Investments

With the stock market having given investors a harsh lesson over the last couple of years, they remain anxious about the future security of their stock investments. Likewise, other types of real estate are out of favor because of the effects of 9/11 and the real estate recession. Thus, investors are very intrigued with the real cash flow and the security of self-storage investments.

One of the great advantages of a self-storage investment is an investor can "see" and "feel" it and easily understand the underlying business. A self-storage investment is a lot more intuitive than a hedge fund or a manufacturer of Internet routers. In other words, most investors don't need Arthur Andersen to explain the numbers.

All Good Things Come to an End

Alas, my friends, it is my sad duty to report this unique time will come to an end. Interest rates will go up, lenders will be difficult, buyers and sellers will be back to fighting over the same dollars, doubt will surface again, and the promise of future gains will be less certain. I wish I could predict exactly when this would happen, but I can't. However, my guess is it is somewhat sooner than later. Buyers and sellers will be asking, "Why didn't I do something in 2003?"

I also have to tell you that despite the best of times, the positive economic situation will not make a jewel out of a bad property. Although buyers have incentives to purchase, buyers have not suspended common sense or forgotten how to run the numbers (or contact someone who does). The chances of a seller finding "the greater fool" are about the same as Linus finding the Great Pumpkin. It is a great time for a fair deal, but these good times won't make just any deal work or a deal work at any price.

Michael L. McCune has been actively involved in commercial real estate throughout the United States for more than 20 years. Since 1984, he has been owner and president of Argus Real Estate Inc., a real estate consulting, brokerage and development company based in Denver. In January 1994, he created the Argus Self Storage Real Estate Network, now the nation's largest network of independent commercial real estate brokers dedicated to the buying and selling of self-storage facilities. For more information, call 800.55.STORE or visit www.selfstorage.com.

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