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Building Capital

Author: Judith M. Wilson
September, 2014 Issue

Experts weigh in on the pros and cons of investing in real estate

 
One small house was the beginning of Marianne Strotz’s career in real estate investment. “We bought a little house on Belvedere Drive in Mill Valley,” she says, explaining that she and her architect husband, the late Gus Strotz, spruced it up, added a couple of rooms and then sold it at a profit, which they put into purchasing a condominium in Tiburon. It was 1966, and they were a young couple flipping property, a time-honored way for investors to make money on real estate over a relatively short period of time.
 

The ups and downs of flipping

Flipping became a big trend following the subprime mortgage crisis in 2008, which resulted in an abundance of short sales and foreclosed properties that professionals with ready cash snapped up for quick turnaround, reaping a tidy profit. It’s just one of many ways to invest in real estate, but it’s one of the easiest, particularly for an investor with expertise in construction.
 
Forrest Jinks of Altus Equity in Santa Rosa, a boutique alternate investment firm focused on real estate, got his start in the business by flipping houses 15 years ago, using his knowledge of building to do the work hands-on. Among other things, his company offers flipped properties as opportunities for investment, and he has the experience to make sure the profit margin is worthwhile, but he cautions that flipping properties isn’t always as lucrative as many people think. They usually require a fair amount of renovation, which, at the the low end, could cost upward of $20,000, while a remodel could easily take more than $100,000 in improvements, so the investment goes beyond the initial purchase of a property.
 
“We’ve done hundreds [of flipped properties],” he says, and observes that, even though the inventory of distressed properties has decreased significantly, flipping is still popular. “I think there are more people trying to do it now,” he says, but they’re doing it on a thinner margin.
 

Changing strategies

Although it continues to be popular in places like Santa Rosa, where property is more readily available, flipping is no longer widespread. “In general, we have limited residential foreclosures,” says Steve Heun, a real estate broker with Coldwell Banker Brokers of the Valley in Napa, who also holdS a CCIM designation as a commercial and investment member. He sees some, but believes they’re significantly down. He reports that flipping accounted for 50 to 60 percent of sales in 2010 to 2011 in Napa, but on turnaround, the sales were to new owners who wanted to live in the homes rather than rent them out, so they’re no longer investment properties.
 
Instead, the popular trend in long-term assets in Napa is second units or three or fourplex buildings. The potential for rental income is high because rentals are in short supply, with the vacancy rate currently only 1 to 2 percent. Part of the reason is THAT the development of the downtown area has created more jobs, resulting in a need for more housing. “Service sector jobs have brought about the need to supply,” says Heun, and he expects new multi-unit housing in the First Street area to be popular, because it’s close to downtown and residents will be able to walk to and from their jobs.
 
Also on the upswing in Napa are purchases of transitional properties. People who anticipate downsizing in the future are buying smaller properties that they’re renting out until they’re ready to move in themselves. Other investors are buying properties with a guesthouse and main house, then renting out the larger house and using the smaller unit for themselves occasionally or renting it out, too.
 
He adds that the rent-to-value ratio is good, and investors are seeing the leverage they can get by borrowing at 4.5 to 5 percent and finding properties that can make between 5 to 7 percent returns. He expects property to continue to appreciate in value. “Napa is one of the Bay Area’s most affordable communities. It’s still very well priced,” he says.
 
Michael Moffett, a realtor specializing in commercial investment properties at Coldwell Banker Commercial Brokers of the Valley, sees diminishing investment and rental inventory in Napa, especially downtown, but in the business parks as well. “Investments in Napa are generally tough to find, and most often require that they be held for the long-term to establish returns,” he says. “It’s slim pickings to find great deals.” He adds that rents are firming up, with downtown rents climbing above historic averages due to scarce inventory and newer buildings as much of the current available product. “Downtown Napa has seen a lot of activity with all the new infrastructure, the presence of downtown hotels and plentiful dining options,” he says. “It’s a desirable place to invest.” He adds, however, “Much of the growth and investment in business parks is dependent on how the wine industry is doing.”
 
Heun, who has a degree in real estate, finance and development from Sacramento State and is also a certified commercial member, sees real estate investment in Napa as multifaceted and finds that investors are acquiring vineyards as well as residential and commercial properties. Heun gives François Pinault, who owns Chateau LaTour in Bordeaux as well as wineries in the Rhône Valley and Burgundy, as an example. Pinault added Araujo Vineyards in Calistoga to his portfolio in 2013, and he’s one of many investors from abroad who are looking at long-term assets in Napa Valley. Heun believes property in Napa is appealing because it’s less expensive than France and wine-growing areas in other countries. “Napa is on the map for the quality of wine,” he says. “It’s really a destination market globally.”
 
In Marin County, Melissa Prandi, president/CEO of Prandi Property Management, Inc. and author of The Unofficial Guide for Managing Rental Property, a how-to guide on professionally, legally and practically investing in and managing rental property, doesn’t see a lot of new opportunity for investors. She attributes that to two factors: First, “People aren’t moving as easily, because there’s no place to go.” Second, it’s a good market for sales, and that tightens the market for real estate investment. She does, however, see some apartments selling and adds the value is still there and money is cheap for those who can take advantage of the opportunity.
 
Prandi, who has 32 years’ experience renting and managing properties in Marin County, reports that rental inventory is low while the demand is high, especially for single-family homes, which often draw multiple qualified applications within only a few hours of listing the rental. “We’re seeing families from San Francisco with young children,” she says, and they’re looking for areas with good schools, where they can rent homes."
 
Meanwhile, older people who are moving into retirement communities or assisted living facilities are holding onto their homes rather than selling them, because their adult children don’t want to part with them or for tax reasons. “They have an attachment, so they rent the house,” says Prandi, thus helping to meet the demand for single-family home rentals.
 
Prandi, who represents investors locally, out of state and out of country, believes the market has stabilized. However, she doesn’t believe many people are purchasing single-family homes to use as rentals, as it’s difficult, given the cost of a single-family home today, to make cash flow sense. “The rent, even in this strong market, often doesn’t cover the fixed expenses,” she says.
 
Bob Bednarz, a loan agent at Mortgage Service Professionals in Larkspur, sees a market for income rental properties, but finds it limited in Marin County. “Since the meltdown, people are buying up duplexes and fourplexes,” he says. “There are still some good deals out there.” He qualifies that, however, by pointing out that for a positive cash flow, it’s better to go north to Novato or Santa Rosa, because the financial advantages are fewer closer to San Francisco.
 

Offering options

People who want the advantages of real estate investment without direct involvement can get in on the action in other ways. Altus Equity’s major focus is alternate investments, which aren’t tradable on markets such as stock exchanges and involve a negotiated agreement between a buyer and a seller. The company seeks opportunities, does due diligence, makes up contracts and then offers the deal to the investors in its database. Altus Equity might put together a fund before buying a building, or purchase a building and then find investors to be part of a syndicate; a large, single investor might take it on, or it could be a group.
 
Typically, the company puts together a syndicate, and investors have the option of cashing out in five years, although they could stay longer. “In nearly all cases, we do a preferred return,” says Jinks, and it’s usually 6 to 8 percent. Investors always get paid first. “We get paid on the success of investments,” he says. Two of the company’s current projects are a commercial building in Rohnert Park and a condominium building in Sacramento.
 
Jinks believes that, long term, the residential rental market is a growth area. “We’re very bullish on rentals. We believe there’s going to be a rental shortage for the foreseeable future,” he says, observing that the area’s population is growing, but the new housing market is not. He suspects, however, that the apartment market is becoming overheated, which he attributes to Silicon Valley money and buyers who purchase overpriced property without doing due diligence. “The reality isn’t close to being market-rate,” he says. “It’s like 2006, when prices didn’t reflect property value,” he observes, pointing out that the situation could lead to a downturn in prices as people begin to look at the value. He believes, though, that over time, the price and value will come back into line.
 

Thinking big

For investors looking for bigger returns without personal involvement, a real estate investment group might be the best option. Seagate Properties in San Rafael works with high-net-worth individuals as well as pension funds, endowments, insurance companies and institutions, and counts businesses like J.P. Morgan and Guggenheim Investments among its investors. “We look for value-added investment opportunities to provide superior returns to our investment partners,” says Willis K. Polite, president of the five-man partnership that’s involved in commercial real estate investment, third-party asset management, property management and land development.
 
He explains that what creates the value-added aspect of the transactions is a property’s need for major physical renovation, recapitalization, dysfunctional ownership or new tenants. The usual investment horizon is five to seven years, although they’ll hold a unique property longer. After execution of the initial investment strategy, he and his partners will analyze a property and decide whether it’s best to keep it or “harvest the gain now,” he says, and cites Montecito Shopping Center in San Rafael as an example of a property that Seagate has owned since the 1980s and finds feasible to keep, because the location presents enormous barriers to entry and it doesn’t have any competition. In contrast, the company recently sold the San Rafael Corporate Center to BioMarin, which needed a specialty building to house its labs, in a reflection of the growing biotechnology industry’s need for space in the North Bay.
 
“We offer the opportunity for a private individual to invest in a much larger commercial investment arena,” says Polite, who’s seeing a continued increase in value and expects to see a solid upside for at least the next two to three years. He also observes an influx of foreign capital committing to the Bay Area from overseas investors in both China and Europe, due to the strong economy and because it’s a safe location to invest the real estate portion of their portfolios.
 
Polite calls predicting the future beyond the next few years “a fuzzy crystal ball” and points out that real estate is cyclical, and unexpected changes occur on a regular basis. “If you’re going to directly invest in commercial real estate, plan to hold onto it longer than you expect,” he says. And his advice to novice investors is: “Have substantial capital going in.”
 
On commercial rental properties, “The suburban markets haven’t seen the explosive upside of rents that San Francisco and the peninsula have experienced,” he says, but adds, “I think you’re going to see an upward pressure on rent in suburban areas,” which he attributes to skyrocketing urban rents coupled with the general recovery from the recession. “There’s more liquidity in the capital markets than there’s been for a long time,” he observes.
 
Polite believes private investment, in association with a professional real property investment and management company, is a good strategy, because it provides the benefits of immediate yield from real estate without the investor having to be directly involved in the daily operations of the business. “If they don’t have the expertise, we bring it,” says Polite.
 

Getting hooked

Real estate investment doesn’t appeal to everyone, because it’s not liquid. It’s attractive for people who want income over the long term but doesn’t work for anyone who wants to be able to cash out quickly. “If you need quick access to cash, it’s not a good strategy,” says Jinks, who also points out that some people love to track stocks and see the changes daily, so real estate isn’t for them. For those who do invest in real estate, it’s a long-term vision, he points out, and some people are happy waiting five or 10 years. “I have stuff we bought 12 years ago,” he says.
 
For many, the lure is irresistible. Marianne Strotz and her husband put the profit from the sale of their Tiburon condominium into a fourplex in Healdsburg and then sold it and purchased property in Santa Rosa. Today, her company, Strotz Properties in Tiburon, owns a duplex and a fourplex in Santa Rosa, and she’s settled into the role of property manager as well as investor. She even went to real estate school so she’d know how to do it properly and could deal with the multitude of forms and disclosures. Recently, she sold a lot in Santa Rosa, and now she’s looking for a condominium in Point Tiburon. When she finds one, she’ll rent it until she’s ready to downsize, and then she’ll live there herself and rent her house. She anticipates the rental income making a nice college fund for her grandchildren.
 
She loves real estate and says, “I’m a very good landlady, and I listen to people if they have a problem. I like the idea of handling tenants and being good at it.” Among the advantages of real estate investment, “You have a real thing,” she says. “You don’t have control over investment in stocks.” She manages a portfolio for herself and her grandchildren, but finds owning property more satisfying. “Real estate is a good investment. It’s always been a good investment,” she says. “It’s California. People are coming here, and they have to live somewhere.”
 
Unique landscape, a great climate and proximity to a world-class city are attributes contributing to the North Bay’s appeal. People want to live and work here, and that makes real estate a winning proposition.
 

Owning Rental Property

Bob Bednarz, a loan agent at Mortgage Service Professionals in Larkspur, advises people to look beyond the appreciated value of a property. He explains that, if you put $10,000 into a house, it will likely keep up with inflation because property values have historically increased over time. The gain, however, isn’t just in the value of the property itself. An owner receives rent from an investment property, which might go to pay off a mortgage over a number of years. “Depending on how you structure it, your tenants contribute to paying down your mortgage,” he says.
 
If, for example, your monthly housing expenses are $2,600, and the monthly rent you’re collecting is $3,000, you’re realizing a positive net cash flow of $400 per month  as well as making your mortgage payment. Then, once the debt is retired, the rent the owner collects (net of taxes, insurance and maintenance) becomes direct income. Bednarz also suggests taking the down payment into consideration. You’re not paying that off, so it’s basically compounding interest, he explains.
 
Other advantages are tax deductions. “You can get financing up to $1 million and get an interest deduction for primary and secondary homes,” he says. “Plus, interest expense is generally deductible—though you should consult with a tax professional to be sure.” In addition, real estate investors can take Schedule E deductions on maintenance, repairs, property taxes and insurance. “The net income is what they’re taxed on,” he says. Owners can also get a write-off on depreciation, which can be significant.
 
The advantage: With the right investment property, you can get a positive cash flow, plus your tenant assists in making your monthly mortgage payments.
 

1031 Exchanges

Section 1031 of the United States Internal Revenue Code lets taxpayers with investment properties exchange them for like-kind properties and defer capital gains taxes. Basically, it’s a swap of one property for another, so a taxpayer sells a property and pays little or no tax at the time of the sale. An intermediary holds the funds, and the investor must designate a replacement property within 45 days and apply the funds to the like-kind property. Bednarz gives the example of a couple who owned two small properties in Oregon and exchanged them for a duplex in Novato in a 1031 Exchange, letting them roll over the gain from one piece of real estate to another.
 

Ways to Invest

Basic Rental
An individual buys a property and rents it out to a tenant. The rental income covers the cost of the mortgage, if one is necessary, and provides monthly income when the property is paid for in full. Meanwhile, the property appreciates in value, adding further value. Basic rentals are long-term investments and require either time and effort on the part of the landlord or hiring a property manager.
 
Trading and Flipping
An investor purchases a property and then sells it at a higher price, usually after making improvements to add value. In short-term trading, an investor buys a property at a reasonable price and makes minor improvements before reselling. In longer-term investment, the owner/investor does substantial renovation before selling the property. It can be a time-consuming process if the owner acts as the contractor or does renovations hands-on. An element of risk is involved, because the owner might not be able to sell the property.
 
Real Estate Investment Groups
A company buys and sells property, such as apartment blocks, office buildings or shopping centers, on behalf of a group of investors. The company manages the property and receives a percentage of the monthly rent in return. Investors earn income from rent.
 
Real Estate Investment Trusts
Trust companies, also known as REITs, invest in rental property or mortgages on behalf of their clients and pay dividends from the rental income or interest.
 
The REIT Dilemma
REITs have been around for a long time and began with the best of intentions. President Dwight D. Eisenhower signed the REIT Act, which was part of the Cigar Tax Extension, in 1960, and a key feature was the exemption from corporate taxes. The country was thriving, and the bill was notable because it opened real estate investment to a wide range of people.
 
To qualify as a REIT, a company must meet the Internal Revenue Service’s specific criteria. Among them, a REIT must pay shareholders a common dividend equal to at least 90 percent of income that would otherwise be taxable. Because the dividends REIT investors receive out of the company’s earnings aren’t subject to taxes at the corporate level, REITs can be an attractive way to earn real estate income.
 
Some REITs, however, got caught during the economic downturn. Holding property that suddenly lost value, many were unable to break even when they sold property and couldn’t meet the requirements to pay their investors. Although they were popular before 2008, many were unable to survive the economic downturn, and few are still operating in the North Bay.

 

 

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