You hear a lot of talk these days about the commercial real estate bubble, and how it'll be the next to burst. While there is some truth to this, it's not an absolute in all segments of the commercial real estate spectrum. Small-business owners can do very well in America with commercial real estate investments if they avoid certain pitfalls and learn from history.
Before the economic and credit boom of the 2000s, traditional lenders for commercial real estate capped their loan amounts at 65 percent of the value of the property. If you owned a $100 million building (God bless you), you could get a loan for a max of $65 million. Hedge funds and private equity funds saw the potential to corner this market and began offering much higher loan to value ratios, meaning they would lend as much as 80 percent of the value of the property. You could refinance your $100 million building for $80 million and put $15 million in your pocket tax-free! It sounded like a great deal, but there was a catch. These loans needed to be refinanced after five years. Commercial building owners began pulling hundreds of billions out of their properties, lighting the fuse on a ticking time bomb.
Fast forward five years and the entire economic picture has changed. After the credit crisis of 2008, many sources of financing for commercial real estate have dried up. Those commercial loans are due to be refinanced, but those hedge funds and private equity firms are out of business now. The traditional sources of commercial financing--with max LTV ratios of 65 percent--are all that remain. Additionally, the properties have lost value. These owners are in a difficult position. Here's the ugly math:
Adjusted property value: $80 million (down from $100 million)
Loan amount to be refinanced: $80 million
Maximum LTV ratio: 65 percent
Maximum new loan amount: $52 million (65 percent of $80 million)
Shortfall: $28 million
Result: impending bankruptcy
Note all of the fundamentals of a good commercial real estate investment may still be intact (good tenants, positive cash flow, a great building). The problem here is not fundamental. It is circumstantial, and it's deadly. These owners can't ride out the recession because their loans are due and they're short, or worse, upside-down.
There are a few lessons that can be learned from this, and they apply to commercial property investors and homeowners alike.
- Leave your equity in your property. Successful real estate owners don't tap their equity at the peak of an up cycle; they leave it safe in their properties so they can ride out the down cycles. The "commercial bust" doesn't apply to owners who left their equity alone. Yes, values have come down, but from a very high peak. Properties are far more valuable today than they were 10 and 15 years ago.
- Stick with trusted lenders. By taking a short term loan from an untested source (hedge funds) owners placed themselves at the mercy of the down market. A traditional lender wouldn't have financed more than 65 percent of the property value, leaving owners with some cushion against flucuating property values.
Here's a profile of the successful individual real estate investor that entrepreneurs should emulate:
- Don't approach real estate investing as a buy and flip proposition. Set out to accumulate a portfolio, one good property at a time, over the long haul.
- Don't buy until you can afford to make a healthy down payment (30 - 40 percent is my sweet spot). This reduces your carrying costs by lowering your mortgage payment; plus, it gives you a cushion against a declining market.
- Keep a healthy relationship with your tenants. It's always strange when a building owner complains about tenants. Sure, tenants can be a pain, but they are the clients. It's like a restaurant owner being annoyed at hungry diners.
When done right, real estate investing is a stabilizing force in your business finances. It may not be the most exciting ride, but at times like these, boring and stable is just fine.