Finding a Good Investment in a Target Rich Environment

The current downturn will last for the next 18 - 24 months. Banks just finished the first round of writing down, or acknowledging the issues associated with sub prime loans. Banks still need to deal with the Alt-A ("no-doc" or "stated income") loans coming due, or resetting at higher rates. The issues are the same as the sub-prime market, lenders relaxed their rules, assets were over-valued, and money was lent to fund properties assuming continued appreciation. Now as the loans are coming due or resetting, the balance due on many assets is above the value of the asset. A recent article on bloomberg.com estimates "About 3 million U.S. borrowers have Alt-A mortgages totaling $1 trillion, compared with $855 billion of sub prime loans outstanding."

Assessing the environment, this is what we have - the CMBS market went away based on the sub-prime loan crisis, credit markets dried up as a result. Now the banks that survived the sub-prime wave must now deal with the Alt-A wave. In parallel, these factors have dried up lending on commercial projects. The lack of commercial lending will lead to a third wave of defaults.

What I'm experiencing as I find and examine discounted investments for my clients are several things. The biggest is that most banks don't yet have a handle on the size of problems in their commercial portfolios. Asset managers are overwhelmed and are managing real estate assets they have little experience managing. Also, the amount of developers that will walk away from their projects is still undefined.

The result for investors with capital is that there many discounted investments to choose from, and many more coming to market over the next 12 months. So how does one pick a good deal? First, have investment criteria and stick to the criteria. The second, stick to fundamentals.

Investment criteria - for example, I have a client that wants investment properties only, 8 CAP or higher (CAP rate or Capitalization rate, is the rate of return of an investment measured as percentage of the purchase price), for the following type of investments: hospitality, retail, single tenant industrial or office, national credit tenant with 10 years or more left on an absolute NNN lease. By sticking to these criteria, I'm able to quickly sort through investments that my client will consider. The evaluation process starts at that point.

Part two is sticking to fundamentals, recently I found an investment meeting all the above criteria. The national credit tenant was a publicly held outdoor equipment/camping equipment/hunting equipment retailer. When I started evaluating the tenant, I found that even though they were publicly held, they had not made a profit in the 5 years they were public. Considering the current weakness in the retail sector, and the expected length of said weakness, we passed on the investment. Although the deal looked good from many aspects, the fundamentals were not. The tenant isn't financially strong, they have a weak market cap, they have never shown a profit, and the prospects of increasing margins and/or revenue in the current retail environment are weak. Debt financing, will come at a steep price, if at all; and chances of raising equity financing in the next 24 months are also suspect. We concluded, they probably will not last through the life of their lease.

As another example, I found a client two good investments that matched all the investment criteria, and had good fundamentals. In this scenario we took the evaluation one step further. One investment had a higher CAP than the other (in other words, as a multiple of income, it was priced lower). On the surface, we would choose the higher CAP rate investment, but the equity requirements were different for both deals. The lower CAP investments required less equity, making the cash on cash return higher for the lower CAP investment. We chose the lower CAP investment.

Current credit and economic conditions are going to make the next 24 months a target rich environment for well funded investors. The key to picking good investments hasn't changed; define your criteria and stick to fundamentals. The failure of lending institutions to follow these investment fundamentals caused the current market correction. Many investors that followed sound principles through the boom, now have the capital to pick up good assets at steeply discounted prices. Which are you? Which do you want to be?

For more information contact Chris at christofer.pacheco@gmail.com .