Building Wealth

A Broker’s Guide to Investing in Real Estate

June, 2010

So, you want to be a real estate tycoon?

If there’s one thing we’ve learned from two years of stagnation in Hawaii’s real estate market, it’s that there’s more to investing than simply buying low and selling high. That’s speculation. Experts will tell you investment is much more calculated. That means if you want to be a real estate investor, you’ll need to know a lot more. More about the property. More about the market. And, especially, more about yourself. Which is why the brokers who specialize in advising investors often start by asking, “Why do you want to invest in real estate?” In the end, your success as an investor probably depends on the answer to this question.

What Size Investor Are You?

It’s sometimes convenient to think of real estate investors in three categories: beginners – often successful businesspeople – who have saved up money and are looking for a place to park it; medium-size investors who are beginning to see that it’s possible to make a living in real estate; and large, sophisticated investors who sometimes preside over a diverse portfolio of property.

Real estate professionals often elaborate on this theme. For example, Matt Bittick, a prominent local broker who recently founded Bishop Street Commercial, sketches out a matrix of these three kinds of investors. Along one axis, he places investors A, B and C, and along the other axis he puts corresponding larger levels of investments. Of the smaller, A-level investor, he says, “Maybe it’s their first one, or first couple of transactions. They’re definitely putting in less than 50 percent of the equity in a large investment, or buying a much smaller property for a much smaller price.” In any case, they’re usually unsophisticated and acting alone.

If they continue to invest in real estate, as they accumulate property or experience, they become more efficient. “The B-level investor,” Bittick says, “is the category where you have enough property to handle property management in-house. This investor is kind of developing a team that he can support from the income that the property produces.” The B-level investor has also learned a key tool: leveraging the equity in one building to buy others.

“At the C level,” Bittick says, “you have the capacity to sell and buy any kind of product. You’re able to compete at all levels: It’s being able to buy, sell and close multiple deals with multiple resources on financing, and the capacity to take down larger assets.” To do this usually means having a well-developed professional staff. More importantly, it implies a network of relationships in the investment community. “You may have the relationships to bring in equity partners, relationships with debt partners.” Typically, C-level investors weave an elaborate pattern of corporations, limited partnerships and holding companies out of these relationships.

Bittick sums it up this way: “A, you’re on your own; B, you’ve got managers; C, you’ve got partners.”

Not everyone subscribes to this outline. Some, like Eric Smith, president of local brokerage The Kaulana Corp., thinks the truth is simpler. “I think there are really only two kinds of investors,” he says. “There are active investors who are trying to upgrade or increase the value, or otherwise create more than they bought. And then there are passive investors who buy products that have a cash flow. They’re not looking to dramatically change the property one way or the other.”

Smith, like many brokers, is also an investor and developer. And although he, like many of his peers, prefers to hold his cards close to the vest, he gives a short list of examples from Kaulana’s portfolio: “We had a building in Kaimuki. We fixed it up, re-tenanted it, held it for a long time, and then we sold it. We have a property in Kalihi that we renovated and we’re looking to redevelop, to add value. We have a property in Waipahu that we increased the value on; now we’re asset managing it. We did a small deal up in Kunia where we changed the use of a retail building and then we sold it.” In other words, there are many ways to approach real estate, but, as an active investor, Kaulana’s strategy is always to add value.

Other brokers see investors as a more diverse group. “I see many more levels than that, personally,” says Ray Hulick, president of Commercial Real Estate Services. “I’m a real transactional commercial broker, so I see a lot of transactions.” He points out that people invest in real estate for many different reasons. “There are some people who may make a living at it, who invest in themselves, and are very successful at it,” Hulick says. These people correspond neatly with Bittick’s A- and B-level investors. Hulick also describes some of the C-level investors: “There are larger companies that need larger acquisitions to fuel the corporate structure. They have to constantly make acquisitions.” But he notes that there are other investors who blur the lines: wealthy, sophisticated businessmen who decide to take a stab at real estate; kamaaina families trying to diversify their portfolios; or serial investors who buy one property, fix it up, sell it, and move on to the next. “And I represent a lot of business people who just want to buy a building to move their business into,” Hulick says.

But he agrees with Smith’s distinction between active and passive investors. “Most sophisticated investors are looking to convert the property to create value,” he says. Real estate professionals call this yielding. “Some of the stuff that was really successful several years ago was when people were buying warehouses and converting them into retail space.” This kind of change means you can charge higher rents, raising the building’s income stream – in effect, increasing its yield. “And when you’re dealing with sophisticated investors in larger acquisitions, they’re looking at several different ways to create profit centers so it works for them,” Hulick says. Frequently, for example, they know their experience and economies of scale mean they can manage the building better and cheaper. One thing is certain, though: They run their numbers scrupulously.

Anatomy of an Investment

Most brokers say that inexperienced investors have no idea how much work goes into real estate investment. “The biggest area they don’t understand,” says Hulick, “is the due-diligence side – what it takes to thoroughly analyze a property to make sure you minimize your risk. That means really understanding what it’s all about: knowing if the building has economic problems, obsolescence problems or environmental problems, what its intended use is for the investor.” He points out that all of this information comes with a price. “If you’re really going to do an acquisition correctly, you really need to hire some people and spend some money during what they call the inspection period. So it costs you money. It may cost you thousands of dollars to inspect it to make sure what you’re buying is real.”

Much of this means relying on other professionals. “That means you’re probably going to buy a Phase-I environmental report to make sure there’s no bad dirt,” Hulick says. “You may or may not need that for financing from a bank. You’ll want to have an architect walk through to make sure there are no code violations. You’ll want to make sure you understand the condition and shape of the building – what they call its functional obsolescence – when a building needs a new roof, or it’s not laid out correctly for the market, and what it’s going to cost to convert it.”

Hulick adds that the same kind of due diligence goes into the existing tenants, if any. They represent the building’s prospective cash flow. “You want to understand if the rent is above or below market, what’s going to happen when the lease reopens, and how your investment is going to be treated. So the strength of the tenant is critical. And in a downtown office building, you might have 40 to 100 tenants in your portfolio. You’d have to look at each one and make sure each is meeting its objectives, paying its rent on time. You have to consider all of this to understand how this investment is going to yield over the next five to 10 years.”

All this effort separates the true investor from the dabbler. But it’s expensive. “You’re probably going to spend between $5,000 and $15,000 to consider buying a building,” Hulick says. Maybe more important is the cost in time, and serious investors must balance these costs with the potential rewards. Developers like Kaulana, for example, receive numerous offers over the transom. “We get sent maybe 100 properties a month,” Smith says. “Of the 100, maybe 10 are worth a second look. And of these 10, maybe one deserves serious investigation.” There is, in other words, a lot of weeding in the garden of real estate investment.

That means investors have to be disciplined. “I don’t think you can be successful by just doing the shotgun approach,” says Bittick. “You need to be more calculated. Focus on certain price-range parameters, certain market segments, maybe a certain market area.” With some admiration, he points to Kaulana’s investment strategy. “They wouldn’t bid for large assets. If it’s over $5 million, forget it; I don’t care what the return on investment is. They want to own and operate the asset themselves. It’s got to be on Oahu, probably east of the airport, but not in Hawaii Kai. And it cannot be industrial.” This kind of focus, Bittick points out, is the essence of expertise. “They can learn about that particular kind of real estate and become a mile deep and an inch wide,” he says. “And they can save themselves a lot of time and money.”

Bittick also points out that, as investors grow more sophisticated and add to their team, scale is important. “If you start doing that,” he says, “and you have mouths to feed and salaries to pay, you need a larger property to support that.” In other words, growth usually implies larger, not more, investments.

Hulick puts it another way: “Over time, you realize that it takes just as much work to buy a $3 million building as it does to buy a $25 million building. Same amount of work; same amount of time. So, as you rise through levels of sophistication from a single acquisition to several acquisitions, you realize what bite, or what size, investment fits your needs or your growth criteria.”

One result of this phenomenon is the tendency for Hawaii investors to look to the Mainland once they reach a certain size. In part, this is a way to manage risk. “Their decision is to diversify from just having all their eggs in one Hawaii real estate basket,” Hulick says. But there also simply may not be enough options for them in the Islands. “As investors become more sophisticated, it’s harder and harder for them to find more of the same property in Hawaii. There’s more competition, and the yields may be different. To solve their growth requirements, they may have to go to the Mainland.” That’s certainly been the case for most prominent local investors, from Alexander & Baldwin, to the Shidler Group, to kamaaina family companies such as Watumull Properties.

Why Hawaii is Different

Part of the problem for local investors is that there really are no bargains in Hawaii. In depressed markets like Las Vegas, Southern California, Florida and Phoenix, cash-rich investors are buying foreclosed commercial property at 30 percent or 40 percent discounts. Even given the considerable decline in rents in Hawaii, local investors haven’t seen those kinds of opportunities. One reason is that most large Hawaii landlords have deep pockets. “A lot of these guys are not in any hurry,” says Al Kauwe, president of Kauwe & Associates brokerage. “They’ve paid down their building quite a bit; their debt service is light; and even with a falling income, they can still pay their mortgage. So they’re thinking: ‘Why should I sell?’ It’s still what they call a cash cow.”

Even as prices remain high, cap rates – the income properties generate – are declining. This further dampens enthusiasm for investment. “The big investors,” Kauwe says, “they’re kind of holding off because they’re watching rents drop. Rents in every aspect of commercial real estate – industrial, office and retail – are off, maybe by an average of 30 percent, over the last two years. A lot of the investors are standing by because they don’t want to pay $5 million for a building based on office rents at $1.50 a square foot, and then a year from now find their rents are only $1.25. So they’re waiting for rents to stabilize.”

So, for all you would-be real estate tycoons, these are challenging times. Yet, many brokers evince a strange optimism. Real estate, after all, follows an inevitable cycle of ups and downs – even in Hawaii. Within those cycles lurk tremendous opportunities for those with the means and smarts and daring to exploit them.

“I think we’re in that kind of cyclical path,” says Ray Hulick. “And whether you’re a 50-year-old person or a 20-year-old person, you only have so many cycles of up and down in the stock market or up and down in the real estate market, so you really have to be sensitive to those cycles.” Half in warning, he adds, “Because each cycle may last 10 to 12 years.”

 

Peter Savio’s Seven Creators of Wealth

By Dennis Hollier

Peter Savio, one of Hawaii’s biggest and best-known real estate investors, offers these seven steps to wealth.

“I’m going to tell you how wealth is created in real estate,” Savio says. “If you understand these principles, you’ll know why you want to buy real estate. You’ll know how you can make money when the market is going up, and when the market is going down, because you’ll know where the value is being created.

“Just to put this in context: When I first came into real estate 40 years ago, the house was a brand-new, three-bedroom, two-bath home in Hawaii Kai for $25,000. It was unaffordable. People couldn’t qualify for the loan; they couldn’t save up the down payment, which was an astonishing $2,500; and the monthly payment was an unaffordable $250. Forty years later, that same house is worth $600,000 to $700,000. It was a real struggle to buy that house, but the people who bought it, if they managed their wealth correctly, they’re multimillionaires.

“So, what are the creators of wealth?

“The first wealth creator is the concept of appreciation. That’s the one everyone knows. To use our Hawaii Kai example, our house went from $25,000 to $600,000, so it increased in value $575,000. Almost everyone will tell you we buy real estate because of this appreciation. But that’s not true. Appreciation is simply not the greatest wealth creator; it’s superceded by one of the others by five, 10, 15 times.

“The second wealth creator is the savings account called mortgage. When you think about it, your mortgage is basically a forced savings account. If you take out a $400,000 loan, you’re making a legal promise to save $400,000 over the next 30 years. It’s like a giant piggy bank.

“The next wealth creator is the constant monthly payment. The constant monthly payment is the fact that, when you buy real estate, in effect, you lock in your biggest one-time expense – housing – for 30 years. So, as rents go up, your mortgage payment tends to go up much more slowly. (Although your mortgage stays the same, your insurance and taxes still go up.) So, the person who bought that house for $250 a month in Hawaii Kai, 30 years later is probably only paying $300 a month. But the person who rented for $200 a month because he or she couldn’t afford the $2,500 down payment or the $250 a month mortgage is probably paying $2,000 a month in rent now.

“The fourth creator of wealth is the ability to prepay on the principal on the loan. A lot of people don’t realize that, if you make additional payments on the loan every month – or even just occasionally: $50 here, $100 there, take your $2,000 tax refund and pay it on your principal – it will actually save you tens of thousands of dollars in interest. If you pay an extra $50 or $60 a month, you could take a 30-year loan and bring it down to a 15- or 20-year loan, which means you could save $70,000 to $80,000 in interest. You’re making money by paying it off sooner.

“The next wealth creator is tax savings – the fact that, when you buy real estate, the federal government gives you certain tax advantages. The government subsidizes you anywhere from 15 percent to 25 percent, let’s say, in terms of your monthly payment. So, if you’re renting for $1,000 a month, and struggling, you can probably buy for $1,250 a month and be in the same position. A lot of people don’t understand, that when you pay rent, you’re actually paying twice: You pay rent to the landlord of $1,000, but you also pay $250 in additional taxes to Uncle Sam.

“The sixth creator of wealth is the concept of leverage. Basically, in real estate, you can control a valuable asset for very little cash. Let’s assume you buy a property for $100,000, and you put 10 percent down. That’s $10,000. If you had that $10,000 in the bank at 2 percent, you’d be earning $200 a year. If you take the same $10,000 and buy that $100,000 property and it appreciates the same 2 percent, you earn $2,000. Which deal do you want? Leverage allows you to magnify the return.

“The seventh wealth creator is more complex and it’s going to confuse the hell out of you. Because of the way mortgages are amortized, in effect, when you make principal payments, you’re actually receiving interest, tax-free, on the principal you’ve paid. That’s because, although the amount of your mortgage payment is fixed, each month the amount of interest you pay goes down, and the amount of principal goes up. That’s because you only pay interest on the principal you still owe. Let’s say you borrow $212,400 at 5 percent with a 30-year amortization. Your monthly payment of $1,140 is constant for the whole 30 years. On your first monthly payment, you pay $885 in interest and $255 in principal. The next month, your interest goes to $883, and your principal goes to $257. That extra two dollars added to your principal payment amounts to 5 percent annual interest on the $255 in principal you’ve already paid, tax-free. Every month, this amount goes up, so that, on the last payment, in 2040, you still pay $1,140, but your interest payment is just $5, and your principal payment is $1138. Basically, you’re just paying that to yourself.

“The wealth creators are the same whether you’re buying a home or investing. But, on the investing side, the tax savings is even greater. That’s because, in addition to being able to deduct the interest, the property taxes, and the mortgage insurance, if any, you now get to deduct the maintenance, the advertising, the repairs, even the gas you use to drive over to check on the unit – all the expenses you get to deduct because it’s a business.

“On top of all those deductions, the government also tells you that, by law, your unit is losing value because it’s getting older. So, you depreciate it on your taxes, which gives you another three, four, five thousand dollars. So, the investor has an eighth and ninth wealth creator: additional tax savings and depreciation.

So, of all those wealth creators, which one do you think is the most important? The greatest wealth creator is the constant monthly payment. Because you’ve locked in your rent, as your income goes up, you can use that money to buy stocks, buy bonds, save up and buy real estate, pay off your loan sooner – it will all create wealth for you.”

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Author:

Dennis Hollier