From a small northwestern observatory…

Finance and economics generally focused on real estate

Seven Biggest Real Estate Mistakes — Part 2

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Two weeks ago, I introduced this series as a sneak peek at a new lecture series I’m developing for this year.  We hope to kick this off coincidental with the March release of my new book, Real Estate Valuation and Strategy.

Mistake #2 — Overpaying

Doesn’t this seem like common sense?  It really should be, but it’s amazing how many overpriced deals close every day.

Overpricing is often tied to falling in love with a property, an investment, an investment pool or team, or just being sloppy and having to put some money somewhere.  A real estate mentor of mine w-a-a-a-y back when taught me about the importance of walking away from a bad idea — that there will always be another “deal” coming along tomorrow.  There is no amount of inflation, great management, or market demand that will get you back to even on an over-priced investment.

For example, imagine a small investment which should throw off $1 million in Net Operating Income (NOI) during the first year.  Rents and net operating income are expected to grow by about 4% per year.  The market currently values investments of this type and quality at a capitalization rate of about 8%, and we expect this to remain fairly constant for the foreseeable future.  Thus, the indicated value, and purchase price, should be about ($1mm / 8% = ) $12,500,000.  However, for a variety of reasons, you are coaxed into overpaying for this — paying a “cap rate” of 7%, which translates into a purchase price of just over $14 million.  Obviously, this is a materially large difference, but more importantly, getting back to even will take some serious time.

Since the value at any point in time is the capitalized income, and income is increasing, then the “fairly” purchased investment should always be worth more than we paid for it (ignoring transaction costs and such).  However, the badly-purchased investment will be underwater until sometime in year 3, and that is only if everything else works out right.  Of course, we will be collecting rents, which increase year-to-year, so that will offset a bit of the mistake.  However, the overall return on investment (ROI) for the badly priced project will simply never catch up with the well-priced project.

1 20 20

If we had to sell the badly-priced property at the end of year 1, we’d actually have a negative ROI, even accounting for rents collected.  ROI (including both sales proceeds and collected rents) turns barely positive in year 2, but will never actually catch up.

What’s worse, investors stuck with overpriced properties eventually realized that they overpaid, and invariably these become the neglected mutts in the portfolio.  I’ve often seen overpaying to the extent that no amount of increasing rents will ever bail out the bad purchase price.  Invariably, such properties get neglected in favor of properties with better anticipated ROIs, and are often the last to be sold if a portfolio needs to be liquidated.  Remember, too, that in a liberal lending environment (such as we have right now), banks can be enablers of such mistakes, lending too much money on too little project.  In those scenarios, the actual loan-to-value, and the actual debt-service-coverage, will exceed the expectations, and the investors will find themselves owing too much money for too little collateral.

How to avoid these situations?  I would suggest five rules for taking on any real estate investment:

  1. Be sure to get the advice of an independent consultant or appraiser.  Pay someone who doesn’t have a horse in this race to evaluate the deal.
  2. Beware of projects that only seem to work with complex financing structures.  I recently looked at a project that was attractive because the general partner had extremely favorable financing.  Once we re-evaluated the project with market-normal financing, the pricing of the deal made no sense.
  3. Beware of the seller’s estimates of expenses, revenues, vacancy and collection problems, and miscellaneous rents.  Test these against market norms, and re-evaluate the operational structure against various scenarios.
  4.  Be very concerned when you hear the phrase, “if this works out the way we plan…”  (There is an old proverb:  If you want to hear God laugh, tell him your plans.)
  5. Never be afraid to walk away from a deal.

I’m a big fan of value-added or opportunistic investments, of which there are always plenty available.  In that context, chasing overpriced investments is a real waste of time, effort, and money.

Written by johnkilpatrick

January 19, 2020 at 10:58 am

Posted in Uncategorized

Seven Biggest Real Estate Mistakes

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I’m dusting off a new lecture series for 2020 with the above title.  I thought I’d go ahead and give everyone a peek here on the blog.  In the coming weeks, I’ll post a brief discussion on each of the seven.

Mistake #1 — Misuse of Leverage

Leverage is usually taught as a powerful advantage for real estate investors.  Residential buyers can commonly enjoy loan-to-value ratios above 80% and even approaching 100% with good credit.  Investors can typically enjoy 60% or 70% LTVs, and we recently advised one investment group that was offered 80% for an apartment development.

The question all-to-often is not “can you do it” but “should you do it”.  Inarguably, the recent housing debacle was triggered in no small measure by the mis-use of leverage.  Intriguingly, though, many shrewd investors who understood the proper use (and potential mis-use) of leverage came thru the real estate crisis quite well.

Consider a $1 million commercial investment which can be financed with either a 70% LTV loan or an 80% loan.  The initial “cap rate” is 7%, and both net rents and value are expected to increase by 5% per year:

1 7 20 a

1 7 20 b






Cash-on-cash return favors 70% leverage, due to the lower debt service burden.  However, in a positive-growth scenario, the 80% leverage situation catches up after year 5.  As far as equity return is concerned, it is hands-down an 80% leverage race, with much steeper increases from the start.

However, consider a model with some negative returns.  Let’s say, just for an example, that rents actually decline by 10% after year 1, but then return to a positive trend after that.  The scenario is quite different:

1 7 20 c

1 7 20 d






With just a little negativity, the 70% LTV model dominates cash-on-cash return, in fact dominates the equity return until after year 4.  Naturally, these sensitivity analyses can be run quite easily for any one of a number of potential scenarios.

So, what do the smartest folks in the room do?  One clue comes from successful REITs, many of which enjoyed positive returns thru the last recession.  Admittedly, REITs in problematic sectors (mortgage REITs, for example) were in trouble.  However, every sector faced struggles with vacancy, collections, and rent growth during the recession.  REITs that are successful in the very long turn use leverage sparingly.  For example, Hudson Pacific Properties, which owns about 50 or so office buildings on the west coast, has about $7.5 Billion in assets.  They are only leveraged about 47% as of the last SEC filing.  Essex Property Trust is one of the largest apartment REITs, with about 60,000 apartments across the U.S.  Their $13 Billion in assets are funded by only about 50% debt, even though apartments are generally recognized as fairly low on the risk scale.

In general, well-managed real estate portfolios maintain leverage somewhere south of 60% or even 50% in more risky sectors.  While real estate is generally considered to be a great hedge against troubled economic times, that hedge won’t work if it is over-leveraged.  Leverage can be your friend, but can at times also be your enemy.

As always, I or colleagues at Greenfield may or may not have investments in firms mentioned in this blog.  Mentioning a firm in this blog is not to be construed as a recommendation to buy, sell, or hold a particular investment.  Always consult with your advisors on these matters.

Written by johnkilpatrick

January 7, 2020 at 10:30 am

Posted in Uncategorized

Tax burdens and real estate

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I’m not paid to be an apologist for California.  I’ve enjoyed visiting there many times, have had a few profitable projects there, and I can speak very highly for their wine (although Washington will give them a run for their money).  That said, I’ve heard California slammed recently for its supposedly onerous tax burden, and the impact that supposedly has on property values.  Somehow, this doesn’t resonate — yes, California has a somewhat higher tax burden than other states, but by how much?  And how does that impact their overall economy and property values?

I’ve gathered a bit of data, and I’ll be honing this into a more formal study in the coming weeks, but I thought I’d give you a bit of a peek into what I’m finding.  First, California does not have the worst tax burden in America.  According to information I’ve gathered from the Tax Foundation, the overall average tax burden in California from 1977-2012 was 10.95%.  It actually declined significantly over that period.  To put this in comparison, the highest average tax burden among the states during that period was New York (12.53%) and the lowest was Alaska (6.61%).

The question of course is, do these local taxes have an impact on property values and the economy in general?  I’m still crunching the numbers, but it appears that there is little if any linkage.  For example, as noted, California’s tax burden has actually dropped over the 35-year period in this study, but incomes have increased by 43.5%, and property values increased by 192.67% from 1991 to 3rd quarter 2019 (yes, this takes into account the up and down of the recession).  In New York, where the highest local taxes were recorded, incomes increased 78.31% over the 35-year study period and property values have increased 154.19% since 1991.

In the lowest tax state (Alaska), incomes increased 1.56% over a 35-year period (yes, you read that right) but indeed property values increased 167.7% from 1991 to the present.  Among the 50 states plus DC, the average property value increase from 1991 to the present was 262.59%, while the average tax burden was 9.75%.  Ironically, this means that California, at 10.95%, was only 1.2 percentage points higher than the national average for local tax burden.  The average per-capita income, averaged by states, grew by 31.19% over the 35-year study period.  Thus, both New York and California had measurably above average increases in per-capital incomes, despite having somewhat higher local tax burdens.  However, property values in those states, while they increased, increased at a somewhat slower rate than over states.

By the way, my adopted home state, Washington, had above-average property value increases over time (286.24%), above average income increases (59.84%) and a slightly below average local tax burden (9.41%).

There is w-a-a-y more to be done on this.  I’ll keep you posted as I know more.

Local tax burdens are a function of state income tax rates, local property taxes, sales taxes, and other state revenues paid by individuals.  Property values are based on the Federal Housing Finance Authority All-Property Index.  Per capita income comes from the Census Bureau.  Tax and income data is lagged to 2012 in order to forecast later year home values.  Averages are based on 5-year increments over a 35-year period from 1997 to 2012.

Written by johnkilpatrick

December 7, 2019 at 5:14 pm

Posted in Uncategorized

Real Estate as a Tax Hedge

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There is a fair amount of speculation about the future of the U.S. tax code.  I don’t want to get into politics here, but if and as the tax rates change going forward, many serious investors will look backwards and say, “Gosh, I wish I’d done _____ when I had a chance.”

Well selected and well managed real estate has, for generations, been recognized as a hedge against taxes, inflation, recessions, market instability, and all manner of economic fluctuations.  Looking at the economic history of the past 100 years or so, we can only point to one real estate-related bubble, and in reality that was, at the core, a finance problem and not a real estate problem.  Even before, during, and after the most recent recession, well-selected and properly priced real estate performed well.

A few tips and notes, and as usual please bear in mind this is neither tax, legal, accounting, nor investment advice —

  • Current income from real estate can be sheltered by depreciation.  Indeed, for most income-producing properties, the current income will be nearly tax free, both for state and Federal taxation.
  • Unlike municipal bonds, the income is usually tax sheltered regardless of which state the property is located.  For example, in New York, a muni bond is state-tax exempt only if it is a New York bond.  However, the real estate can be located anywhere and benefit from depreciation sheltering.
  • For family-run businesses, real estate can be an excellent way to bifurcate the returns on the business between participating family members and non-participating ones.  The property can be separately held in a trust, with rents paid from the business and enjoyed — with tax sheltering — by all family members.  This also helps insulate the family wealth from any potential business problems that may arise.
  • Intergenerational transfers of real estate can be accomplished in a simplified, and often tax-advantaged manner.
  • Personal residences are usually sheltered in part from bankruptcy, and in some states (Florida, for example) the entire residence may be used as a bankruptcy shelter.

There is more, of course.  As a reminder, I have a book coming out in January from McGraw Hill — Real Estate Valuation and Strategy.  I’ll expand on these and many other real estate investment topics between now and then.

3D Kilpatrick (002)

Written by johnkilpatrick

November 14, 2019 at 8:24 am

Posted in Uncategorized

A brief primer on interest rates

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Someone asked me, “Should I wait to buy a house since interest rates are headed to zero?”.  Huh… well, dude, I got bad news for you – – interest rates whipped past zero a while ago.  Denmark just this week issued some bonds with negative yields.  I’m not saying this is as low as it gets, but it might be helpful to understand a bit more about how interest rate changes affect the consumer.

First, note what I’ll call “wholesale” rates and “retail” rates.  I bought a dozen eggs this week at the grocery.  Locally sourced, cage free, no anti-biotic eggs, from chickens that ate a nice diet of bugs and stuff — the sort of stuff chickens like to eat.  I paid $3.99 (plus tax).  I’m sure we can both agree that the farmer didn’t get all of that $3.99.  Some of it went to the grocer.  Some of it went to the truck driver.  Some of it went to the wholesaler.  The farmer was probably lucky to get $2 (but that’s another story).

Mortgage loans are like that.  Most mortgages get bundled into mortgage backed securities and sold through a somewhat complex pipeline to investors (Fannie Mae, Freddie Mac, certain trusts and pension plans, etc.).  These trusts cannot purposely buy paper at negative yields.  The managers have a fiduciary duty to their clients not to do that.  Hence, there is a floor below which wholesale mortgage rates cannot fall, and that floor is not a negative number.

Now, above that floor, everyone has to get a piece of the action, just like the people in the pipeline who sold me eggs.  Let’s face it, they have bills to pay, and want to take home a paycheck on Friday, just like the grocer and the truck driver.  Finally, there is a fee for servicing the loan, which has to be added to the top before you hear about the retail rate.  W-a-a-a-a-y back when I started in this game, that fee was statutorily set at 55 basis points, or 0.55%.  Thus, if you had paid 10.55% for your mortgage (not a bad rate back then), the point-five-five part went to the people who collected the monthly payments, kept the books, made sure you paid your taxes and insurance, and handled the foreclosure if it came to that.  The remainder — the 10% part — went down the pipeline to all the investors.  The laws were changed a number of years ago, and the servicing rights have become competitive (in other words, the fees have dropped).  However, it’s still a real, positive number.

Probably the more interesting question is what happens to mortgage rates before, during, and after a recession.  Since everyone seems to think one is coming, how should we be prepared?  Here is a chart of mortgage rates (high, low, and average) versus the years in which we had a recession.

Recessions and mortgage rates

We’ve actually had 7 recessions since 1970, but a couple of them ran into one another, so this chart only shows five recessionary periods.  No matter, for our purposes.  Note that in the first two, we were going thru a period known as “stag-flation” where the impacts of the recession were exacerbated by high inflation.  Since the 1980’s, inflation has more-or-less been throttled, so those recessions are more useful as predictors.  From 1989 until 1992, average mortgage rates dropped about 2 percentage points (from 10.32% to 8.39%).  From 2000 to 2002, spanning the shortest of these recessions, rates fell about a half of a percentage point (from 7.44% to 6.97%).  Before-and-after the recent housing melt-down and recession, rates fell from 6.41% in 2006 to 4.69% in 2010 — a difference of slightly over two percentage points.

The average 30-year, fixed-rate mortgage in 2018 was 4.54%.  Today, most lenders are quoting a rate of 3.75% on that same mortgage.  Could rates drop two percentage points (to 1.75%) in an incipit recession?  History suggests that is entirely a factor of the length of the recession.  A brief dip, such as happened in 2001, might have little impact on mortgage rates.  A longer recession would probably have a more dramatic impact.  Notably, of course, there is an absolute floor, and it’s not at zero percent.

Written by johnkilpatrick

November 2, 2019 at 10:41 am

Posted in Uncategorized

Great news!

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I am particularly pleased to announce (brag?) that the Washington State Economic Development Finance Authority (WEDFA) will be honored with the Excellence in Development Finance Award by the Council of Development Finance Agencies at the upcoming National Development Finance Summit.

I’ve had the very real pleasure of serving as a Director of WEDFA for several years now, at the behest of Governor Jay Inslee.  WEDFA is an independent agency within the executive branch of state government, created by the state legislature to act as a financial conduit to businesses through the issuance of nonrecourse revenue bonds.

WEDFA was honored for the Columbia Pulp project, a wheat straw-to-paper pulp facility in Columbia County, Washington. Farms in this area (known as the Palouse region) generate post-harvest wheat straw in quantities too large to effectively till back into the soil. This represents a very real waste issue for the region. A significant portion of that wheat straw will go into an environmentally friendly pulping operation developed and commercialized by Columbia Pulp I. Paper pulp will be sold on the open pulp markets. One major use of the project’s output is expected to be compostable food containers and straws. Although not yet in full commercial operation, the project has brought about 100 new long-term industrial jobs to a county of 2,000 people. Project construction activity also added a powerful two-year economic stimulus to the area.

The Columbia Pulp I project was made possible by a coordinated efforts of institutions and individuals, including wheat farmers, scientists, mill specialists, institutional debt investors, equity investors, local economic development groups, tax credit providers and state and local government. The Washington Economic Development Finance Authority was able to facilitate the project’s debt financing through the issuance of $198,755,000 of Environmental Facilities Revenue Bonds. The bonds were issued in three limited sales to institutional investors, the final piece of which was issued in 2019.

“This year’s recipients are model examples of what is currently taking place in the development finance industry. We are proud and excited to honor this year’s recipients at the 2019 National Summit in Tampa, Florida” said Toby Rittner, President & CEO of the Council of Development Finance Agencies.

Written by johnkilpatrick

November 1, 2019 at 3:07 am

Posted in Uncategorized

Baby Boomers and Housing

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In an on-line forum, I was asked recently, “In the USA, how will the aging of the “baby boom” generation affect the future of the housing market.”  My answer was as follows:

Well, there’s an old joke in economics — “How did the French revolution affect world trade?” Answer: It’s too early to tell.

Without question, the baby boomers spent a LOT of money on bigger houses, more vacation homes, and lots of other conspicuous consumption toys (boats, airplanes, etc.). It is becoming clear that the subsequent generations do not have the same taste in housing. This is going to mean some radical shifts in the nature of home ownership. Conversely, the boomers are living a lot longer than prior generations, and living independently longer. This means that the aggregate demand for housing is a function both of the size and the shape of the demographic “baby boom” bubble.

Consider that the boomers in the USA are often referred to as the “pig in a python” generation. The birth rate in the USA took off like a rocket about 9 months and 15 minutes after the end of world war II. (Think about it). The birth rate collapsed, more or less, about 9 months and 15 minutes after the introduction of the birth control pill (not exactly, but the analogy is useful). As such, this pig-in-a-python demographic is moving thru the economy, and refuses to get old and die. (I write this as someone born at the absolute crest of that wave.)

US Birth Rate 1909-2008

Note:  Baby Boom Generation shown in red.

The future implications for housing, housing demand, and the mix of housing demanded by the market, will be dramatic. However, we don’t yet know all the details and shape of that demand, and may not know for some years to come.

Written by johnkilpatrick

October 27, 2019 at 8:29 am

Posted in Uncategorized

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