OPM

Alec J. Pacella, CCIM

With lunchbreak now behind us, the school day moves on as we head to fifth period. We lingered a little too long at the lunchroom table and our next class is a double period so there is no time to waste!

It’s very popular for a real estate investment to include capital from sources in addition to the investor’s equity. The most common form is a mortgage, sometimes called a permanent loan, and many think that a loan is a loan is a loan. But that is not always the case. While a traditional mortgage is a very common tool used by investors, it’s not the only way to use other people’s money (OPM). To learn more about some alternatives, read on.

Construction loan

A construction loan is specifically used to finance a construction project. These are typically negotiated between a developer and a lender, with the loan being used to fund construction costs. But it is very different in its structure and characteristics. Construction loans have relatively short terms, usually one to three years, while permanent loans are much longer. A construction loan is disbursed from the lender to the borrower/developer gradually as the project progresses. These usually take the form of “draws,” with the borrower making a request to fund a specific amount. During the time, the only repayment obligation is the interest associated with the outstanding loan balance for a given time period and the interest is based on a short-term variable or floating rate. Once the project is completed, the entire outstanding balance is due in full. This is usually accomplished by using a permanent mortgage.

Bridge loan

A loan is sometimes used to cover the time period between the construction loan ending and the permanent loan commencing. A common scenario is the development of a speculative project, where the building is completed without sufficient tenant commitments in place that would be necessary to qualify for a permanent loan. The construction lender will want to have their loan retired when the project is physically completed but the permanent lender may not be willing to disburse funds until the building is substantially occupied. A short-term loan, sometimes called a “mini-perm,” is a common way to fill this gap.

Second Mortgage

Mortgages are ranked in terms of priority and any type of mortgage that is subordinated to the first mortgage is called a second mortgage. Second mortgages carry greater risk than first mortgages because of the potential to be eliminated should there be a foreclosure of the first mortgage. This is particularly true if the value of the property has decreased since the loan(s) were originated. Therefore, second mort- gages usually carry a higher interest rate and have a shorter outstanding term. The second mortgage holder typically gives notice of this encumbrance to the first mortgage holder and the first mortgage holder usually must consent to allow the creation of a second.

It’s very popular for a real estate investment to include capital from sources in addition to the investor’s equity. The most common form is a mortgage, sometimes called a permanent loan, and many think that a loan is a loan is a loan. But that is not always the case.

Mezzanine loan

An alternative to using a second mortgage to obtain additional financing is to use a mezzanine or “mezz” loan. It is different than a second mortgage because it is secured by the investor’s equity in the property instead of being collateralized against the real estate. As a result, if there is a default on repayment of the mezz loan, the lender would engage in legal proceedings that would give them an equity interest in the property. The mezz lender usually will enter into an agreement with the first mortgage holder to have a right to take over the mortgage should there be a default by the borrower. Mezz debt typically has an associated interest rate that is several percentage points higher as compared to the first mortgage and the repayment of the mezz loan ranks ahead of any cash distributions made to the equity investor but obviously behind any loans that have priority.

Convertible loan

This type of loan is similar to a mezz loan in that it is provided to the borrower and collateralized against the borrower’s equity interest. But in this instance, the loan holder has the right to convert the debt into a share of the equity rather than have the obligation repaid or retired. The timing, terms and result of a conversation will vary and be clearly spelled out in the loan document.

Participation loan

This is a mortgage secured against the real estate that typically has an associated interest rate lower than that of a traditional loan. In exchange for achieving a favorable rate, the borrower agrees to allow the lender to share in the upside of the investment. This sharing can come from various sources. The lender could receive a percentage of gross income, net operating income or cash flow after debt service and/or can share in the gain achieved because of the property being sold or refinanced. The agreement related to a participation loan is highly negotiable and there is no standard structure.

Joint venture

While not a loan in a traditional sense, a joint venture has several characteristics of an encumbrance in exchange for a stake in the real estate. In a joint venture, or JV, two or more parties share in the ownership of a real estate venture. This can be an effective way to pool equity from more than one source, as well as include parties with different expertise, capacity or access to capital. As with a participating loan, there are all sorts of arrangements and structures for a JV.As you can see, a loan is not always a loan, at least not in the way we traditionally think. Next month, we will roll into the second part of this class as we will dig a little deeper into some ways to analyze a few of these alternative approaches, as using OPM sometimes is a result of thinking outside of the box.

Alec Pacella, CCIM, president at NAIPleasant Valley, can be reached by phone at 216-455-925 or by email at apacella@naipvc.com.

Properties Magazine, February 2023

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Thought Leader Cybersecurity

Risky Business: Why Cybersecurity Should be Top of Mind for CRE Professionals

Over the past year, it’s sometimes felt like the number of factors that we, as commercial real estate (CRE) professionals, need to keep track of have grown exponentially. Especially in the face of challenging market conditions. 

At the same time, there’s an ever-increasing need to be conversant with new technology and tech tools that help boost productivity and add value for clients. The tools available  span the spectrum from social media to drone technology, climate-savvy building tech, and even augmented or virtual reality software.

For brokers, building managers, and developers incorporating these game-changing technologies, the possibilities are nearly endless.

There is, however, a flip side to this coin. And, like many things tech-related, it’s an area where CRE professionals have often been slow on the uptake: Implementing the right cybersecurity protocols.

A growing threat

Part of the problem is the idea that cybersecurity is something that’s handled exclusively by a dedicated team, or automatically built into the software being used. While that’s true to some extent, the fact remains that the tactics cyber criminals use, and the number of incidents each year, are continually growing.

Sophisticated “phishing” attacks, which aim to get staff to unwittingly compromise system security, and ransomware are the order of the day, and, as a recent incident in Australia shows, the real estate sector is far from exempt from these threats.

Given the amounts of sensitive data passing through or stored by the CRE industry, the question we need to ask is: Are we truly prepared in the event of a breach?

New risk vectors

The first thing all CRE businesses should consider is whether all possible systems, and avenues of access to those systems, have been identified and are properly protected. 

In an excellent recent interview on cyber threats in CRE, security consultant Coleman Wolf points out that many possible avenues of attack go unnoticed. These may be linked to building control systems (think temperature or lighting management) and other smart tech, or even to the specialized Internet-of-Things (IoT) systems being used in industrial operations.

If these systems are connected to the internet, but not adequately protected, they may act as a springboard for access to other systems or data. Hackers may then be able to tap into sensitive information, including financial and personal data stored elsewhere. Alternately, simply taking control of building systems can be used as a tactic in ransomware attacks.

As the CRE industry begins to adopt new smart building technologies, and we increasingly repurpose buildings for niche markets, like the booming medical office sector, the potential for sensitive information to form part of breaches also grows exponentially.

Other trends, like the Bring-Your-Own-Device (BYOD) movement where employees use personal devices in the office, create additional avenues of attack if those devices aren’t properly secured.

Best principles

While all the above may make it sound like it’s impossible to keep track of potential threats to a building or CRE enterprise, the good news is that there are certain essential principles that can be followed to mitigate the risk.

In a recent article on cybersecurity best practices in CRE, J.P. Morgan advises that:

• CRE companies should ensure all employees, beyond just the IT team, are aware of potential risks from phishing or ransomware and have been trained in how to minimize those risks.
• Companies ensure there’s appropriate access control. For example, implementing multifactor authorization (MFA) and other safeguards.
• Employees are aware of the risks of oversharing on social media (e.g., detailed information on job responsibilities and the type of data they have access to, which could make them phishing targets).

Of course, these recommendations are only starting points, and the exact requirements and level of detail needed will vary based on each firm’s unique context. There’s certainly no “one-size-fits-all” solution for CRE cybersecurity.

That said, an excellent resource to familiarize yourself with upcoming benchmarks and strategies for cyber-security can be found in PwC’s “C-suite united on cyber-ready futures” guide (you can register for free to download the report).

Securing the future

As we head into 2023 and beyond, some of the most exciting aspects of the CRE industry come in the form of new technology. There’s an ever-expanding array of Proptech tools on hand to help us close deals. Smarter building technologies ensure we meet environmental and climate imperatives while also offering something new and different for tenants and investors alike.

As CRE professionals, we’re right to be excited by the possibilities on offer. But we also need to make sure we keep security top of mind as we begin to integrate these tools.

As PwC summarizes: “Digitization makes security everyone’s business. The future promises more connected systems and exponentially more data — and more organized adversaries. With ever expanding cyber risks, business leaders have much more work to do.”

The Winner’s Circle

Alec J. Pacella, CCIM

Last month, we continued our “back to school” theme and started a discussion regarding capital accumulation. And equally important, we took a walk down memory lane, discussing slot car racing sets that were a part of my childhood in the 1960s and ’70s.

If you read last month’s column, you may recall that although Internal Rate of Return (IRR) is a well-established measure of an investment, it has some deficiencies. This is particularly true related to what I called the investor’s total pile of cash. IRR only cares about money in the deal and gives no consideration to money that comes out of the deal – even though an investor can reinvest these cash flows. Interwoven in that discussion was the story of AFX, a leader in the slot car racing scene of the ‘60s and ‘70s, and upstart Tyco, which proved to be a worthy alternative. This month, we are going to continue this discussion as AFX vs. Tyco isn’t the only battleline being drawn. This is the last period before our lunch break so let’s go! Modified Internal Rate of Return (MIRR) was initially developed in the 1960s and primarily used by businesses to make a more accurate comparison between investment alternatives. It addressed one of IRR’s main limitations of ignoring cash flows produced from a primary investment by introducing a couple concepts. If you recall, last month I used the analogy of putting money produced by an investment in a mason jar and burying it in the back yard. This would equate to a reinvest- ment rate of zero, as the money in that jar would be earning nothing. But we can do something more productive with those cash flows – like redeploy them at a realistic reinvestment rate, usually a rate comparable to the firm’s cost of capital. Also, any additional outlays that would be needed to cover anticipated shortfalls (i.e., negative cash flows) over the holding period are assumed to be funded upfront at the firm’s cost of debt. Figure 1 illustrates the MIRR process, using an 8% cost of capital and 4% financing cost. As you can see, the $10,000 negative cash flow anticipated to occur in year three is acknowledged at the beginning of the investment by dis- counting the shortfall back to time period 0 at 4% and adding this to the initial investment. Meanwhile, all of the positive cash flows are reinvested at 8% to end of the fifth year. As a result, the $108,890 initially invested is anticipated to produce $201,501, which equates to a MIRR of 13.10%.

Figure 1

Capital accumulation is newer, developed in the 1980s. While the basic premise is the same as MIRR, the concept is more specific to a real estate investor and introduces a few twists. A primary difference is the treatment of negative cash flows. MIRR eliminates future anticipated deficits by setting aside the additional capital necessary upfront, at time period 0. Capital accumulation discounts negative cash flows back one year at a time, offsetting it against any positive cash flows produced in the preceding year(s) until the deficit is eliminated. This is done at a “safe rate,” which represents the rate of a secondary investment that can confidently be achieved. After eliminating any negative cash flows, the remaining positive cash flows produced by the primary investment are assumed to be reinvested at rate representative of an investment alter- native readily available to the investor. But rather than compounding the positive cash flows produced each year to a corresponding future value at the end of the time horizon, capital accumulation only compounds each annual cash flow forward to the following year. This is added to any cash flow expected to be released in that following year and then the entire sum is again compounded forward one year. A second, related nuance is that capital accumulation can have multiple, or tiered, reinvestment rates. A higher reinvestment rate may be available as specific dollar thresholds are met. This acknowledges a premium in return as a result of the aggregate amount being reinvested. This kicker is a concept similar to “jumbo CDs” of years past. By compounding cash flows one year at a time, the opportunity to exceed any established thresholds can be realized. This acknowledges a premium in return as a result of the aggregate amount being reinvested. This kicker is a concept similar to “jumbo CDs” of years past. By compounding cash flows one year at a time, the opportunity to exceed any established thresholds can be realized.

Figure 2 illustrates an investment with the same series of cash flows but utilizing the capital accumulation approach, with a tiered reinvestment assumption of 8% for positive cash flows up to $50,000 and 9% thereafter as well as 4% safe rate for negative cash flows. Note the differences in handling of both positive and negative cash flows as compared to Figure 1. Capital accumulation uses periodic positive cash flow in year two to offset the discounted shortfall from year three. It then compounds the remaining positive cash flows one year at a time, which allows it to take advantage of the higher 9% return as a result of exceeding the $50,000 threshold in year four.

These subtle nuances have a significant cumulative impact on the results; the $100,000 initially invested is anticipated to produce $190,077 by the end of year five, resulting in a capital growth rate (CGR) of 13.71%.

AFX slot car racing has several similarities to MIRR. Both are more established and set a standard in their respective worlds. Both have a wide following. And both take a more conservative approach. Tyco and capital accumulation also have several similarities. Both are upstarts and offer some twists to their more established counterparts. Both have a niche following. And both take a more unconventional approach. By understanding these nuances and choosing the path that best fits your needs, you will be in a better position to end up in the winner’s circle.

What I C @ PVC                

STILL HOT Investment sales, particularly industrial warehouse product, continues to achieve record pricing. Last month, a 125,000-square- foot facility in Middleburg Heights sold for $13.7 million or $109 per square foot. This is the 12th industrial investment sale to break the $100 per square foot mark this year. –AP

From December 2022, Properties Magazine

Thought Leadership Women in CRE

Investing in Gender Equity is an Investment in CRE’s Future

When it comes to parity, commercial real estate (CRE) still has some ways to go in leveling the playing field for women in our industry. That’s the central message of the latest report from the Commercial Real Estate Women Network (CREW), a national organization with a focus on diversity, equity and inclusion in CRE.

Hidden figures

One of the biggest pain points for women in the industry according to the report is the culture of secrecy around salaries. Of the 1228 CRE professionals interviewed, 68% indicated they’d change jobs to work at a company with greater salary transparency (even with a similar salary offer on the table as what they currently earn). Around 82% said they wanted job listings to include wage and benefits information, with many adding this would give them more confidence in salary negotiations.

In an industry with a proven record of pay disparity, those numbers are especially telling and highlight an important point. Part of creating equity is building transparency into the recruiting and salary negotiation process.

Another concern raised was the disparity faced by women of color specifically, who, according to PayScale’s 2022 Gender Pay Gap data, typically earn far less (across a variety of industries) than white men or even their white women counterparts. CREW also noted in a previous report, that women of color were less likely to have a sponsor or mentor in CRE, blocking their opportunities for advancement in the industry.

Building better businesses

Besides the obvious social imperative to address these issues, investing in gender and racial equity is an increasingly important part of building business resilience.

As, Lily Trager, Head of Investing with Impact for Morgan Stanley Wealth Management, recently pointed out: “When our quantitative team analyzed global companies based on their percentage of female employees and other metrics of gender diversity, companies that have taken a holistic approach toward equal representation have outperformed their less diverse peers by 3.1% per year.”

Trager added that a growing requirement from Morgan Stanley’s “high-net-worth investors” is that Diversity, Equity, and Inclusion (DEI) be a priority for the companies they invest in.

Promoting equity

For us in CRE, the challenge is to address the historically low numbers of women both in our industry, and especially in C-suite positions. And while that process should be driven by everyone, it’s especially important that the policy decisions and changes we make to promote equity are guided by the experience and expertise of women in the space.

The CREW Network’s recommendations in this regard include:

• Committing to pay transparent practices – In other words ensuring that both salaries and the processes for earning pay increases are clear and accessible.
• Supporting professional development – Encouraging women in your organization to pursue professional development opportunities (and join women’s forums) and financing those opportunities.
• Formal mentorship and sponsorship programs for women – We all know that in the real estate industry, mentorships are invaluable in shaping the trajectory of an individual’s career. For women, and especially women of color, we should incorporate and encourage mentorship as a central part of our business.

A commitment to gender equity

The legacy of gender, and other, inequities won’t be undone overnight. What’s vital to accelerate the process is that, as business leaders, we commit to creating workplaces that make Diversity, Equity, and Inclusion a reality. In doing so, we can build a CRE future that enables the best in our people and our business.

For more information about NAI’s own commitment to Diversity, Equity, and Inclusion,  please visit our page here, or find more information about the NAI Global Women’s Alliance here.   Or join us in becoming signatories to the CREW Network’s Pledge for Action![SR2] 

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DEAD IN THE WATER

Joseph Hauman

Do you know where the saying dead in the water comes from? It was originally used to refer to a boat that was stuck out at sea with no wind. No wind means no movement and as you could imagine, no movement is not good for a boat in a large body of water. Over the last 2 years, people have been telling me that the office market in Cleveland is “dead in the water” as everyone from your nephew’s Lemonade stand to Google decide if they need more space or if they even want any space. To be honest with you I believed it for a little bit too. I thought there is no wind in the sails of the office market in Cleveland, but then I allowed myself to take a real look at the industry.

Sailboats are great but they need something to push them. A tide, current, or wind is needed to make a boat with no motor move. I believe that office rents in the Cleveland Market have stayed stagnant because they have been the tide, current, or wind in the sails of our largely vacant office market.  What do I mean by that? Owners in Cleveland often think that they are in competition with each other. They attract tenants to their buildings by offering a low price, free rent, and higher tenant improvement allowances than what they view are their competitor’s. That, in turn, makes other owners lower their prices and it becomes a price war at its most basic level. For years, that has been the reason why the office market continued to truck along with very few new buildings and stagnated rent growth. Lower prices and increasing free rent packages were the slow wind that was pushing the sails of a fundamentally broken office market.

Why are low prices so bad in an office market? The answer is they aren’t when they can be controlled and used to attract quality businesses that will help the area grow. That, however, is not the situation that the Cleveland office market is in. We are in a vicious cycle of rent reduction to attract businesses that don’t choose Cleveland because of the lack of amenities, in both buildings and the city, and because they don’t choose Cleveland both the owner and city miss out on valuable tax and rental income that could be used to pay for new amenities to attract new businesses. This is the reason why the Cleveland office market is “Dead in the water”.

Nobody cared about this issue until the past two years when work from home skyrocketed and tenants didn’t care how much you reduced their rent; they just wanted out. It was no longer a price war because price mattered very little anymore. It became an agent’s job to keep tenants from bull rushing out of a building. Any wind that was ever present, was lost. No hope, right? Wrong.    

Going back to what I had said earlier when technology advanced we learned that we could put an engine on a boat and we had no more need for the wind to propel us. The wind and the sail didn’t matter anymore because the fundamental idea of a boat changed. It was no longer difficult to maneuver, slow, or relied on something totally out of one’s control. Instead, a boat became fun, attractive, and a sign of success for most. Office buildings need a motor. The entire idea of an office building needs to be changed. Low rent and new paint aren’t enough anymore. You need a space that makes people want to come to work. If your building doesn’t do that, then you need to take a hard look at the future success and viability of that building. If you are a landlord you must know your effective vacancy on any building you own. I don’t mean how many people you are getting checks from every month or the number of available square feet you tell your broker to put on the flyer. I mean how many people are coming in and using your space on a DAILY basis? If you have amazing tenants that don’t want that stuff then, congratulations, you have won the jackpot. If you have large amounts of vacant space and are wondering how to change it, then hold on because I’m going to tell you.

ASK AND YOU SHALL RECEIVE

I know most office buildings or parks are purchased as a semi-passive investment which is great and I fully support it, but if you have a high vacancy you need to get a broker, or property manager or go yourself to each tenant and ask what they are looking for. Ask what your building lacks and where it could be improved. If you have current amenities in the building ask if they use them and how often. If you have someone that works in an amenity like a dry cleaner, food service, or gym, ask them how often people come through and what sort of mood they are in when they come in. If you have services in the building you need to find out if people are using them because the service is good or if it’s convenient. If tenants are using it out of convenience then that’s great, but it’s not enough to keep them there at your building. The true testament to the amenities that you provide should be if a tenant leaves and still comes back to your building to use your amenities. Obviously, not all amenities are offered to people that are not tenants, but ones that are, such as an open cafeteria or dry-cleaning service should be good tests. If you ask tenants for their opinion make sure they are valued and listened to. Asking them questions only to do nothing in hopes that they will stay is going to do you no good. If you want to have a low vacancy you need to get things in the building that people want. Let the ideas flow. Everything from a VR gaming setup, driving simulator, or golf simulator might be options that are relatively inexpensive in comparison to renovating a cafeteria or building out a new gym. Take the answers to the questions that you get from your tenants and mix them with your ideas and see if it’s possible. Maybe call me and let me come take a look and allow me to give you my opinion.

If your building represents a sailboat that is quickly or slowly losing wind then pull it out of the water and put an engine on that sucker because if you don’t make a change soon your boat will be dead in the office market water. 

Have something to say? Great, I would love to hear it. Shoot me an email at Joe.Hauman@NAIPVC.com or give me a call 440-591-3723.