Archives for June 2021
Lumber Prices Suddenly Move Downward
Builders are feeling relief, unless they had stocked up on product expecting an extended period of elevated prices.
The bigger they are, the harder they fall is an old aphorism that has captured the reality of lumber prices. After an enormous run-up, they’re headed back to earth.
Future prices were down to $996.20 at the end of Monday, June 14, according to data from Nasdaq, finally cracking the $1,000 per thousand board feet floor. The price closed at a high of $1,670.50 on May 7.
The accompanying crashing noise is the soundtrack of relief for some and panic for others.
“I had a subcontractor who quoted a job for me in April and then quoted the same job in mid-May and his price went up 70 grand in three weeks,” Joe Pecoraro, a project executive at Skender, tells GlobeSt.com. “I was freaking out because you commit to the client at the original numbers. Then, last week he got back to me and said, ‘I’m okay at my original price.’”
Just two weeks ago, Nick Minoia, a founding principal at Diversified Properties, told GlobeSt.com about the strategies they had been using to manage spiraling lumber costs. “I have 266 units under construction in Union, N.J.,” he said. “I bought the entire building [stock], a 4-story building, back in February and took delivery in early March so not only could I lock in the price but be sure we had it.”
The people likely reaching for an aspirin bottle are those who stocked up, expecting numbers to remain elevated. “Normally they wouldn’t be buying the material because they had the confidence that material prices would be stable,” Mike Wisnefski, CEO of online commodities marketplace MaterialsXchange, tells GlobeSt.com. “They were forced into covering their needs, generally for a longer shipping period than they normally would.”
While there has been an imbalance in lumber supply and demand, with the pandemic pushing up demand for new housing construction and also hampering the supply chain, the skyrocketing pricing also became a self-fulfilling prophecy.
Wisnefski estimates that many builders were carrying 10% more inventory than they normally would. “When everyone carries 10% more, that makes the apparent demand higher than it would be,” because future purchases are brought forward out of concern about potential increases in price and thin availability.
But will lumber continue to decline back to pre-pandemic levels? It’s too soon to tell. “As we got to very high prices relative to recent history, anyone who could push a project off pushed a project off,” Wisnefski says. But they didn’t cancel, so as postponed building resumes, there could be a rebound in pricing.
Source: “Lumber Prices Suddenly Move Downward“
When is a Leasehold Investment Right for you?
Simply stated, you get your profits sooner with the leasehold investment.
When is a leasehold investment a good option—and more importantly, when is it right for you?
If, like many investors, you would answer with an emphatic “Never!”, you could be missing out on some excellent opportunities to increase your commercial property portfolio yield and cash flow. In this article, we will explore some of the benefits of investing in leasehold estates and how to price them versus their fee simple counterparts.
First, let’s be clear on exactly what we are referring to when we use the term “leasehold investment.” We are referring to commercial investment property that is situated on land that is leased from a third party under a long-term ground lease agreement. During the term of the lease, your leasehold estate will may decline in value each year as the lease term burns off and will eventually have no value at all, at least no value to you-–the investor.
Investing in a commercial real estate asset that is guaranteed to have no saleable value at the end of the holding period is a non-starter for many investors. But, at the end of the day, doesn’t it make more sense to judge the value of any investment based on profitability?
How to value and price leasehold investment
When considering multiple investment opportunities, we will usually choose the one with the highest internal rate of return (IRR). I have heard and read many definitions of IRR, but in a nutshell, I think we can all agree that it measures the profitability of an investment.
Of the four elements that determine the IRR—present value (initial investment), cash flow, time, and future value – we usually only have control over the present value, or how much we pay for the asset. It makes sense, then, that to achieve the same IRR as a comparable fee simple opportunity, we will need to adjust the present value–or purchase price–of the leasehold to compensate for its zero future value.
To determine by how much you will need to adjust the purchase price, you must first ascertain what the unleveraged IRR would be if the deal were a fee simple investment. Then, calculate the present value of the projected sales proceeds using the fee simple investment’s IRR as your discount rate. The answer to that calculation will equal the amount by which you will have to adjust the purchase price of the leasehold deal to get the same IRR as the fee simple deal. To keep you from having to re-read this paragraph five or six times, let’s consider the following example.
You are considering purchasing a 25-year NNN lease with a credit tenant. The net rent for the first five years is $60,000 and the rent increases by 10 percent every five years. The deal appeals to you because it is being offered at an attractive 7 percent cap rate and you know this tenant and lease structure usually trade around a 6 percent cap rate. You learn that the property is on a long-term ground lease that runs concurrently with the tenant lease.
You know that if the deal were fee simple, it would trade at a 6 percent cap rate resulting in a purchase price of $1,000,000. You would enjoy a pre-tax cash flow of $60,000, beginning in year one. Because of the rent increases, your cash flow would increase by 10 percent every five years. After 25 years, you project that you will sell the property and net $1,500,000 after costs. If you plug that scenario into Excel or a financial calculator, you will learn that the unleveraged IRR for the fee simple deal would be 7.58 percent (Table 1).
Unleveraged Fee Simple IRR 7.58%
| N | |
|---|---|
|
0
|
-$1,000,000 (6% cap rate) |
|
(1-5)
|
$60,000 |
|
(6-10)
|
$66,000 |
|
(11-15)
|
$72,600 |
|
16-20
|
$79,860 |
|
21-24
|
$87,640 |
|
25
|
$1,587,460 |
Now let’s consider the leasehold investment. The only difference between the two, are, that with the leasehold, at the end of the 25-year term you will walk away without receiving any sale proceeds.
When we deduct the $1,500,000 from year 25, the IRR drops to 4.87 percent (Table 2).
Unleveraged Leasehold IRR 4.87%
| N | |
|---|---|
|
0
|
-$1,000,000 (6% Cap Rate) |
|
(1-5)
|
$60,000 |
|
(6-10)
|
$66,000 |
|
(11-15)
|
$72,600 |
|
16-20
|
$79,860 |
|
21-25 |
$87,640 |
If we increase the cap rate to 7% per the asking price, that only gets us to 6.33 percent (Table 3).
Unleveraged Leasehold IRR 6.33%
| N | |
|---|---|
|
0
|
-$857,143 (7% Cap Rate) |
|
(1-5)
|
$60,000 |
|
(6-10)
|
$66,000 |
|
(11-15)
|
$72,600 |
|
16-20
|
$79,860 |
|
21-25 |
$87,640 |
To make the leasehold deal as attractive as its fee simple alternative, we need to calculate the present value of the $1,500,000 projected net sale proceeds using a discount rate of 7.58 percent (the IRR of the fee simple model).
Your answer will be a negative $241,436. This means that if you paid $241,436 less than the $1,000,000 fee simple model, or $758,564, your IRR would be equal to the fee simple deal (Table 4).
In this case, the leasehold would have to be purchased at a price representative of a 7.9 percent cap rate for it to be as attractive as a fee simple deal at a 6 percent cap rate, unleveraged.
Let’s assume the seller accepted your offer, and logic, and take a look at some of the benefits you can expect to realize.
The benefits of a leasehold investment
First, positive leverage will have a much greater impact on the IRR and CoC of the leasehold investment than that of the fee simple deal.
let’s apply a 25-year loan with a 5 percent interest rate and 75 percent LTV to each scenario. Table 5 shows the cash flow of the leveraged fee simple investment while Table 6 reflects the cash flow of the leveraged leasehold investment.
Applying leverage to the fee simple deal increases the IRR from 7.58 percent to 10.5 percent. The same loan applied to the leasehold deal increases the IRR from 7.58 percent to 13.11 percent.
The fee simple deal starts out with a cash-on-cash return of 2.95 percent for the first five years and eventually grows to 14 percent during the last five years.
The leasehold starts off with a cash-on-cash return of 10.59 percent for the first five years and grows to 25.17 during the last five years.
Simply stated, you get your profits sooner with the leasehold investment.
There is also a higher level of predictability with the leasehold investment. You can predict the sale price at the end of the holding period to the penny with nearly absolute certainty. You know going in that it will be zero.
The $1.5 million we used as sale proceeds in our fee simple model is just our best guess. What happens to your IRR if you can only sell the building for $1,200,000? And how good are any of us, really, at predicting values 25 years from now?
Perhaps the best benefit to a leasehold investment is that you will not have to worry about selling the property at the end of the lease. You will just walk away with a smile on your face because you will have already received 100 percent of your investment profit. There will be no sale expenses, no time or hassle to sell the property, and no brokers to hire.
Finally, if you are considering a leasehold investment, you will want to discuss the tax ramifications with your trusted tax advisor.
According to experts I have consulted with, if the investment has a shelf life of 25 years, as in our example, then we may be able to justify a 25-year depreciation schedule instead of the normal 39 years for commercial property. This would have a significant positive impact on the after-tax cash flow. In addition, 100 percent of the leasehold investment should be depreciable.
The bottom line
If your motivation for investing is to build wealth, think “Fee Simple”, unless you have a very good plan to reinvest your cash flow. On the other hand, if your motivation for investing is to generate cash flow, then a leasehold estate could very well be the perfect vehicle for your situation.
More Evidence That Reducing Office Space Is Losing Its Appeal
Thirty-seven percent of tenants surveyed said they were reducing space needs.
Add yet another survey to mix that attempts to decipher how office tenants are thinking about space after the pandemic.
In a survey of 3,115 US office space decision-makers and influencers, BOMA International (in conjunction with Brightline Strategies and supported by a grant from Yardi), 55% of tenants said they were reassessing space needs. That was a decline from 61% in BOMA’s Q4 2020 survey.
Forty-eight percent of those respondents likely to reassess needs said they would reduce their square footage. In Q4, 54% said they were reducing space needs. Looking at overall responses, 37% of tenants surveyed said they were reducing space needs. To minimize space, companies were looking at reducing the number of private offices, hoteling desks for flex workers and reducing the size of common areas.
“While this indicates the potential for nearly 4 in 10 tenants to consider some reduction—demanding attention from owners and operators—the numbers are trending toward more stable space utilization,” according to BOMA.
Another recent survey shows similar trends. By comparison, a recent CBRE survey indicated that just 9% of companies plan to significantly shrink their office portfolios, a figure that’s far less than last year’s 39%.
Of the 185 companies surveyed by the CRE giant in its Spring 2021 Occupier Survey, a whopping 85% say they expect employees to spend at least half of their time in a physical office. The majority of large companies—72%—appear to be planning for what CBRE calls “modest” office-space reductions, a significant increase from CBRE’s September 2020 survey results (45%). And smaller companies report they’re more likely to keep their portfolio the same or grow it.
The BOMA survey also showed other interesting trends. It found that almost two-thirds (62%) of survey participants believe that the pandemic will ultimately transform how they do business and is a “tremendous inflection point” for their workplaces.
Compared to its Q4 study, the number of respondents seeing less value in their office space has gone up to 42%, a 12-point increase since the Q4 2020 study. Still, tenants reassessing office needs fell from 61% in Q4 to 55% in the most recent study.
Before the pandemic, 80% of employees were in the office full-time. Over the next 12 to 18 months, that number is projected to drop to 58%. Twenty-six percent of respondents say their offices will mostly telework 12 to 18 months from now. Part of that acceptance of telework probably stems from the feeling (from 69% of respondents) that teams have remained productive while working from home throughout the pandemic.
One way to keep wavering tenants is with investments into the buildings. Sixty-four percent of respondents want their building teams to invest in amenities that increase organizational culture, connectivity, productivity and well-being.
But tenants still believe that the office is necessary. Seventy-eight percent said that office space is vital to conducting business, an increase of four points since the previous study.
Source: “More Evidence That Reducing Office Space Is Losing Its Appeal“
