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For the Select Few

Fractional ownership of vacation homes, also called private residence clubs, is a relatively new concept that allows you to enjoy four to 12 weeks of home ownership privileges per year at an upscale, luxury resort but at a fraction of the cost of whole ownership.

If you want to own an impressive second home complete with personalized services and located in an expensive resort area but can’t quite justify the expense because you’ll only be using it a few weeks or months of the year, this type of real estate arrangement may appeal to you.

Amenities Galore

Most private residence clubs offer extensive amenities. These may include an extravagant clubhouse and spa, plus five-star hotel services, the kind you couldn’t expect to have in a wholly-owned vacation home, high-end condo or timeshare.

Imagine this: You are going on vacation and you call ahead to the staff at your private residence club home. At your request, the staff shops for your groceries, dry-cleans your clothing, makes your restaurant reservations, heats your private splash pool, and places knick-knacks and favorite pictures of family members around your residence. You are met at the airport by a staff person who shuttles you to your home where a just-detailed Jaguar is sitting in your parking space for use at your disposal.

Get the picture? Private residence clubs are NOT your ordinary second home.

Outstanding Locations

Fractionals or residence clubs have sprung up in exclusive, world-class resort destinations worldwide. St. Thomas, Virgin Islands, Puerta Vallarta and Mexico are popular locations.

In the U.S., the first fractionals were in major ski areas out west, particularly Colorado where real estate was so costly that wholly-owned second homes were out of the question for most people. Eventually they spread to northeastern ski areas. Since then fractionals have begun appearing in golf-oriented communities like Hilton Head Island, South Carolina and popular beach states like Florida.

Some of the most popular fractionals can be found in Jupiter, FL; Aspen Highlands, Bachelor Gulch, and Aspen Snowmass, CO; Lake Tahoe, CA; and Whistler, British Columbia. Fractionals located in the U.S. usually offer good access to major airports that allows for easy transportation arrangements.

Management by Five-Star Companies

The key to the success of fractionals is their professional management. Most are operated by well-respected hospitality companies known worldwide for their world-class resorts. Among them are Ritz Carlton, Four Seasons, Starwood, Intrawest and Millennium, brands known for their five-star services and amenities.

Hassle-free Ownership

Part of the appeal of fractionals is that they are completely hassle free. In addition to having a staff for personalized service at your disposal, at a private residence club you never have to worry about repairs, maintenance or housekeeping. Everything is included in the price and annual fees and taken care of by the professional management company.

Appreciation Potential

To date there have been very few fractional resort developments. The demand is high. As a result, it is likely there will be substantial appreciation, rather than the depreciation that usually occurs with timeshares.

Real estate experts say that the outlook for investment appreciation appears excellent. You can expect at the very least an appreciation parity against other real estate in the resort area in which the fractional is located.

Prices

To buy a fractional, you pay a one-time purchase price and then a yearly upkeep fee that covers all of the expenses associated with property ownership and its use and services.

What do fractionals cost? Prices vary based on the size, amenities and location of the individual property. But most are in the $100,000-$500,000 range. Keep in mind that these are truly top-of-the-line homes that would cost you two to five times as much if purchased outright as wholly-owned vacation homes.

Comparison of Fractionals to Timeshares

How do fractionals compare with timeshares? They really don’t. Fractionals are far more exclusive and include many more luxury amenities and services than timeshares. They tend to be larger homes, usually three to five bedrooms. Timeshares usually allow you use for just one to two weeks per year. Fractionals offer from two to 13 weeks, and those don’t necessarily have to be consecutive weeks. Pick the weeks you want.

With regard to financing, obtaining a bank or mortgage company loan on a timeshare is difficult. Rates are high, regardless of how good your credit. That’s because it’s a well-known fact that most timeshares depreciate over time. Conversely, banks and mortgage firms consider fractionals to be appreciating assets and will often treat them like any other second-home purchase.

Why do fractionals tend to appreciate while timeshares usually depreciate? There are a couple of reasons. With fractionals, more of the buyer’s dollar goes to high quality finishes and “bricks and mortar” vs. sales commissions which can be as high as 40%-50% with timeshares.

Furthermore, timeshare values have historically been poor because of the large number of resales on the market, not to mention a continuous stream of new developments. The fact is the secondary market for timeshares has never really developed.

Conversely, there are a limited number of fractionals on the market. Most likely, that number will stay small because fractionals are built in only the very best, most highly desirable locations. Therefore, demand outpaces supply and results in property appreciation.

Comparison of Fractionals to Condo Hotels

Fractionals (private residence clubs) differ from condo hotels in that you have a set amount of time when you can use your vacation home. Condo hotels are in fact, condos located within hotels. You can use your unit whenever you want, and place it in the rental program when not using it. Fractionals do not offer rental program participation.

Fractionals tend to be larger than most condo hotel units. Most fractionals offer three to five bedrooms, while most condo hotel units are studios, one bedrooms or two bedrooms. Currently, most condo hotels are located in Miami and other surrounding cities in South Florida. Fractionals are most prevalent on the West Coast, particularly in ski areas. However, both types of real estate are rapidly gaining popularity and soon there will likely be more of a supply across the country to meet the growing demand.

Having rehabbed over 470 properties in the last seven years and collected over 600 apartment units I’m often asked, how can I become wealthier faster investing in real estate?

While most investors concentrate on some aspect of single family houses, I was always interested in multi-units (apartments) first, and then single family homes as a means of getting more multi-units .

From the very beginning of my investing in real estate, I liked the idea that a group of people (the tenants in a building) would get together and pool their money to pay down the mortgage on a property, and I liked the idea that they would also pool their money together to pay for all of the maintenance work for a building.

I especially liked the idea that they would give an owner so much money that the owner would have a bunch of money left over at the end of every month that could be used to either re-invest, save or to go out and have a good time with.

Essentially, I like the idea that other people were willing to help make me wealthy. I liked it even more when I started using management companies to manage my properties and no longer had to have contact with my tenants.

I soon came to realize that I could also wholesale, retail, pre-foreclosure, rehab, subject to and lease option apartment houses as well.

I also realized that there were certain advantages that investing in multi-units buildings had over single families.

* The first was cash flow. Cash flow on a multi-family is always greater than that of a single family. Simply because you have more rents coming in.

The more units you have under one roof, the less risk you have. If you have a single family house and you lose your tenant, you’ve lost 100% of your income. In some instances, this could be your entire profit for the year. If you had a three family and lost a tenant, you still have two rent coming in to pay your expenses.

* Economies of scale are in mulit-unit buildings. If you have six single family houses opposed to one six family, you have six roofs to be replaced or repaired, six lawns to be maintain, six tenants spread out through out your city or town.

In your six family you have one roof, one lawn and your tenants are centrally located. Economies of scale are in your favor.

* There’s a lot less competition than there are in single family houses. Why? Because no one is out there teaching how to do it and all the single family guru’s make flipping single family houses sound as easy as chewing gum in the dark. The smart investors put multi-units in their portfolios along with single family houses.

* Because of the bigger cash flows, you can afford to hire management companies to manage your tenants, thus eliminating that hassle while you go out and do what you do best (or should do best), find and finance them.

* Your pay days are a lot bigger when you finally sell your property. This is because an apartment complex cost more than single family homes, because of this they obtain a greater dollar amount of appreciation. For example, a $100,000 single family house will in a market that appreciates 10% will be worth $110,000 while a three family house worth $300,000 in the same market (10% appreciation) will increase to $330,000. That’s $20,000 more money in your pocket!

You’ve know a few people who have made a lot of money flipping single family houses, but if you think of the all the people you know who have become extremely wealthy through real estate, you’ll realize that they did it through owning multi-units (apartments).

These are the five biggest advantages to investing in multi-units, there are many, many more. If you are interested in creating more wealth at a faster rate, adding multi-unit to your portfolio is the way to do it!

Redevelopment and change-of-use is one of my favorite deal strategies. Many properties are functionally obsolescent, or the market has passed them by for that property type. These properties are often producing income, but not at the level of the highest and best use of the land.

A reader sent me a good example recently. The property is a six unit apartment building, about thirty years old in rough condition, with a low-end rent roll and loads of deferred maintenance. It’s located on a main thoroughfare that had developed as a commercial strip with a traffic count of 30,000 vehicles per day, and this property sit on the corner of a signaled intersection. With a deal like this it’s possible to get “paid to play”. The existing income stream carries the property while you’re solidifying the plans for redevelopment. The steps to investigate the feasibility of a change-of-use redevelopment are not at all complicated.

Step One: The Planning Department
The first stop should be the local planning department, either in person or online. We need the street address, tax parcel number, or other identifying information for the property to proceed. (Many jurisdictions now have GIS systems that are accessible online with all the relevant tax data. Some also put the zoning and subdivision ordinances online as well. For those that don’t a trip to get a hard copy will be necessary.)

Verify the existing zoning district for the property. If it is already zoned for commercial use you’re in luck. Look in that chapter of the zoning ordinance for a list of permitted uses, maximum density, maximum height, and development standards (e.g. setbacks, green space, # of parking spaces, etc.). That’s the information we need to determine the maximum amount of developed space, and type of space, that can be built on the property. If it is not zoned appropriately for the use desired, then you’ll need information regarding the rezoning process. At this point a general overview is sufficient, required forms, any required engineering, exhibits (e.g. site plan, survey, etc.), and a rough idea of the time required to go through the process.

Step Two: Estimate Total Cost of Improvements
Now we’re ready to crunch some numbers. But don’t worry, this is not rocket science. We know how much space can be built (per the zoning ordinance), and the required site improvements (e.g. parking, storm water, utilities, landscaping, etc.). Using local building costs, or a rough estimate of per square foot costs from a local contractor, we can do a preliminary estimate of the development costs. To that add the demolition costs for the existing structures. Again, a local contractor can usually give you a ballpark estimate of what it will cost to remove the existing structure(s). Together, the sum of cost of development and the demolition costs is the total cost of improvements.

Step Three: Total Project Cost
Now we add an estimate of soft costs such as engineering, architectural, loan fees, appraisal and third-party reports, developer’s fee, etc. You’ll have to make some calls to local engineering and architectural firms to get these estimates. Some may want to know more details than you are prepared to give at this point, in which case you can ask for the average cost per square foot, per parcel size (i.e. per acre), or per project. Don’t worry if the estimates are a range. That is the usual case, and will allow you to later establish the margin of error for your estimated costs. Add the soft costs to the cost of improvements. Then add the purchase price of the property and the answer is the total project cost.

Step Four: Calculate the Projected Income
Use existing market rental rates and expenses to construct a rough pro forma projected income statement. For rental rates in the market you can use the “For Lease” side of Loopnet.com. Estimated expenses can come from other property listings, your own experience, or from an appraiser. Calculate the first year NOI (Net Operating Income, gross rent – operating expenses = NOI). Divide the NOI by 1.25 (the typical minimum debt coverage ratio for lenders). The answer is the maximum allowable annual debt service (DS).

Now estimate the loan terms (rate and amortization period) available for this type of deal using typical bank financing. (This is where having a relationship with a banker that knows commercial real estate is invaluable.) Once you have the loan terms, divide the DS by the loan constant. (for direction in how to calculate the loan constant, see the article “What’s it Worth”). That’s the maximum loan amount. Add any equity you’re putting in the deal to the maximum loan amount. If that sum is more than the total projected costs, you’ve got a viable project.

I also use one more calculation at the end to establish feasibility. Figure the cash flow by subtracting the DS from NOI. The result is the cash flow, and if you divide that by your minimum required return, the answer will be the amount of equity that can be put into the deal and meet your requirements. Add that amount to the maximum loan, and if the answer is at or above the total cost, the deal is worth pursuing.

With interest rates headed upward yet again with the latest round of belt tightening by the Federal Reserve, and the stock market falling with no bottom in sight, many people are crying doom and gloom. I hear talk of watching for a rise in foreclosures due to stock market losses. Builder friends are convinced they are about to be ruined. In my opinion, this is no time to rush for the exits. The fundamentals of real estate investments are sound. A short history lesson may prove worthwhile.

My experience goes back to 1980-82, when I was a single-family homebuilder. Now that was tight money. With prime in the high teens, very few deals made any financial sense for lender or borrower. Then came the 5 years of favorable tax treatment that made dumb and dumber deals look good… until Congress pulled the plug on passive losses. Then we had to re-learn an old lesson, if it doesn’t cash flow, it’s not a deal. The recession of 1990-91 was a cakewalk for those who weren’t over-leveraged… I wasn’t one of them, and paid dearly for the mistake.

Fast forward to 1998, we were riding what has now become the longest economic expansion in history. Asia went ape, the Russian ruble turns to rubble, and the markets gave a physics lesson… what goes up, does come down. The Fed cut rates, everything settled down, and for the most part it was business as usual on Main Street. But for the first time we got an up close and personal look at how interconnected this global economy has become.

Now it’s the year 2000. Y2K turned out to be a non-event, though it took the blame for a general slowdown in activity in fourth quarter 1999. Gas prices are at record levels, yet spending remains strong. Why? Are we heading for recession? Does it matter? How do we plan for the next five or ten years?

One fact remains constant for the real estate industry. Our health and well-being has always been tied to the availability and the cost of debt capital. That is to say that as long as we as investors have access to reasonably priced financing for our properties, we can survive in any market. I learned in 1991 that it wasn’t enough to have equity, property has to cash flow as well. I also learned that when I can present my company as a stable enterprise, insulated from the uncertainty of highly speculative investments, lenders will roll out the red carpet for my deals.

Always Follow the Money

If then we are dependent on debt capital to fuel our operations, it is important that we as investors understand what influences and moves the markets in way that affect the cost of our funds.

The first thing to know when listening to the gloom and doom reports in the media, is that they have little knowledge about any business other than reporting what people tell them is important. When they report the Dow Jones Industrial Average (DJIA), they are using the implied credibility of a well known financial measuring stick for a good news/bad news sound bite under the assumption that you know what it means. Most of us don’t. The DJIA is made up of thirty companies, picked to represent a cross section of the economy. To put that number in perspective, there are 3090 companies listed on the NYSE, 771 on AMEX, and over 6500 on NASDAQ. The DJIA companies represent approximately one fifth of the value of all US stocks, and about one fourth of the value of the stocks listed on the NYSE. This “average” isn’t designed to predict anything, but rather to track the general trend of where the market has BEEN. Trying to gauge where the economy is headed by watching the stock market is much like dressing for Alaska with only the knowledge that it has an average temperature of 55 degrees.

The result, as Nobel-laureate economist Paul A. Samuelson put it: “The market has predicted nine of the last five recessions.”

But the market is an indicator of the collective perceptions of the investment world. When political turmoil hits, as we saw in Asia and Russia in 1998, money will flee quickly to safety and liquidity. Money doesn’t care who owns it, but it despises instability and uncertainty. “Tight credit” is another way of saying “minimize risk”. Stocks carry risk, and therefore when things get dicey, money moves into low-risk investments, causing the price of stocks to fall. The present tech-stock fallout is another indication that the market perceives the risks to outweigh the potential rewards.

Conversely, as the low risk investments, namely government bonds also known as T-bills, come into higher demand because they are both safe and liquid, the price of those bonds will rise. As the price of a bond rises, the yield drops. Many commercial and residential mortgage loans use the yield of government bonds (or T-bills) as the index for the interest rate charged on the loan. The interest amount over the index rate is known as the spread, generally quoted in basis points (100 basis points = 1 percentage point) over the index rate.

This is the element of commercial lending that falls into chaos in a scenario like we witnessed in 1998.

Again, a lesson from our recent past can best illustrate the point. As the benchmark 30 year and 10 year T-bills soared to record prices, the yields dropped to record lows. Lenders, especially the conduit programs for Commercial Mortgage Backed Securities (CMBS) on Wall Street, were caught in a classic squeeze. They had untold millions of dollars committed at spreads agreed upon months earlier with no warning of any trouble on the horizon, and were faced with funding these commitments at interest rates below their cost of funds. The market took six months to readjust to the new paradigm, and spreads have returned to manageable levels.

But the most interesting development to the Wall Street debacle was the way commercial banks and credit companies moved quickly to fill the void. Since the waves in the market were not from any instability in the collateral, i.e. real estate, the money became available from other sources. In short, the markets corrected the inefficiencies, and money flow resumed when certainty and stability were again in place.

What does this mean to the average real estate investor? It means that money continues to be available for deals that make sense. That rates are a tick or two higher will not in general make a strong deal weak, or a weak deal undoable. It must make sense.

So how do we determine which investments actually do make sense?

Main Street vs. Wall Street

The fundamentals of the real estate industry have not changed. The Wall Street players, and the relatively recent use of the CMBS to capitalize real estate, have not captured so much of the market as to control access to debt capital. Commercial banks, insurance companies, and to a certain extent pension funds, are still the mainstay of real estate funding. However, some sectors of real estate are going to be harder to finance due to the effects of other market factors, and may be best left to those players big enough to weather the storm.

Hotels, for instance, have been on the brink of overbuilding for the past two years, and the alarm was sounded for a slowdown in room growth completely independent of the global financial problems or the cost of oil. This is not to say that there will be no hotels built for the next year. But the ones that are built will most likely have a strong franchise, a killer location, and a verifiable market. In short, the deal will make sense from a hospitality business standpoint, not as a speculative real estate project.

One side note on oil: We must be aware that this one commodity has the power to move our markets in ways we don’t even fully fathom. Being in the hotel business, I watch the price of gasoline for the obvious effect it has on travel. I started getting nervous last December when prices topped $1.40 and no one was saying anything. In mid-January OPEC intimated it would vote to increase production at its spring meeting in Geneva, but that the increase would be too late to affect prices during the summer travel season. I was still concerned, but relieved that OPEC was not going to take a hard line ala 1973. Then the media, in their usual clumsy manner, finally noticed the price of gas in late March and sounded the alarm. Mind you, the problem was already solved, and now the media and the government wanted to get in front of the crowd and take credit for fixing a problem they hadn’t even noticed until it was over. Some say the clumsy handling and belated pressure from Washington actually made it harder for OPEC to do what they had already planned to do, lest it look like they were caving into pressure from the US. I get nervous when government actually acts. I’d much rather see gridlock.

Watch the Right Numbers

For the market as a whole, the base demographics that real estate relies on remain solid. Looking at the industry through the lens of a few select property types can offer insights into where we are headed in general, as well as highlight specific islands of opportunity.

Mobile Home Parks remain strong, and are in fact category killers when it comes to valuations. The REIT’s have scarped up most of the investment grade parks, and are now homing in on the larger parks of B and C grade to soak up the cash being made available for the product. This serves to drive up the valuations of formerly unattractive parks, and ever-restrictive zoning standards across the country combine to give this property type one of the highest potential returns available in real estate. The demand for affordable housing continues to grow, and mobile home sales are predicted by the Manufactured Housing Institute to continue to comprise about 30% of single family housing sales.

Commercial growth and development remains strong. Reacting to a perceived threat from Internet sales, traditional retailers have found they can compete in a hi-tech, hi-touch environment, and that online activity in fact boosts in store sales. Online spending has in fact created a mini-boom in warehouse and distribution facilities. Commercial occupancies reported to the International Council of Shopping Centers are averaging in the nineties. Retail spending remains strong. Consumer credit, while higher in dollar amounts, is in fact the least we have seen in recent years as a percentage of income. The income and employment levels of the population as a whole are the strongest in history, which in turn drives spending, and are the key indicators for the near term economy.

The National Association of Homebuilders predicts single family housing starts to fall somewhat in 2000, but still average over 1.3 million starts, more than double the starts in 1982, and 50% higher than the 840,000 starts in 1991. This is good news for rental property owners without being bad news for builders. Apartments have both permanent and bridge financing products available to fit almost any scenario. Rates can range from the mid 7% range to a point higher in most parts of the country. Debt coverage ratios on even marginal properties are in the 1.15-1.25 range, certainly not an indication of overly tight money. Rents are rising faster now, due in part to rising residential mortgage rates, which are cooling home sales. Occupancies remain strong as a reflection of the record low unemployment rates we have enjoyed in the past several years.

These are the fundamental demographics that control our industry. In short, if a deal is really a deal, it will make sense on these factors, and it can be funded and profited from, global financial hiccups and market swings aside.

The Roaring 2000’s

I recently read a book titled The Roaring 2000’s, by Harry S. Dent. In it he predicts that the greatest economic expansion in history will occur in the first decade of this new century. He bases his predictions on the population curve and spending patterns of the baby boom generation, and a multitude of other long-term trends that are operative in our economy. I tend to agree with his analysis, (and highly recommend the book) and believe that some of the highest appreciation gains in real estate ever seen will occur in the next eight to ten years.

Now is the time to position our income real estate for maximum valuations. That means making capital improvements with the cheapest money we can find, and raising rents on the strength of the completed improvements. Take this opportunity to examine service contracts, evaluate expense trends, and check utility consumption. If you’re looking at an acquisition, make sure it makes good business sense. The formula for growth now, as in the past, is “Create stability to attract funds.” Remember that lenders are in the business of loaning money for the purpose of gaining a return… and they’re counting on us to bring them deals that make sense for all parties.

Unless the world can solve Asia’s debt problems, bring political stability to Russia, hold up the weather in Mexico, and turn the Eurodollar into the United States of Europe, all in the next year, there is no where else but the US for world money to hide. And once it gets here, it won’t be happy with a 4.5% T-bill yield for long. Will we be ready? Will we have the product available to invest in when the time comes? As the market weeds out the uncertainty, good deals will get better, and the quick will reap the profits.

I intend to be in front of the line.

While residential investors are at the mercy of the market for appreciation, commercial real estate (CRE) investors can actually make their properties appreciate regardless of market conditions.

We’ve all been hearing about the decline of the housing market. The residential investor’s equity is eroding away right before his/her very eyes. Until market conditions improve, residential investors shall remain at the mercy of the market for their profits.

Although appreciation resulting from market conditions is a consideration to the CRE, investor, CRE can be increased in value by increasing the cash flows called Net Operating Income (NOI) from the property regardless of market conditions.

Because property value is based on NOI, if you can increase the NOI, you can not only increase your cash flow, but you can also increase the property’s value.

Let’s take an example. A 100 unit apartment complex producing $100,000 of NOI in a 10 Cap market is valued at $1,000,000.

NOI/Cap Rate= Value

$100,000/.10=$1,000,000

By increasing that NOI to $190,000, in that same 10 Cap market (meaning the market pricing that investors will pay for that income (NOI) hasn’t changed), POOF, the property is now valued at $1,900,000.

$190,000/.10=$1,900,000

So in addition to putting $90,000 per year more cash in your pocket you just increased your equity by $900,000. Sound good?

Are you amazed by way I quickly manipulated those numbers to make the example fall into place? Are you saying to yourself, “Well Karen, that’s all good on paper, but how could I just magically increase the NOI by $90,000?” Well, after all of the articles I’ve written as an authority on CRE, you should just trust me but since you’re the skeptical type, I’ll show you!

As stated previously, if you can increase NOI, you can increase the value of the property. There are 2 ways to increase NOI.

1. Take in more money
2. Spend less money to operate the property.

Notice I didn’t say, reducing the debt service paid to the lender. Although this will ultimately increase your cash flow before taxes, it has absolutely no effect on the value of the property. The property is worth the same amount of money whether it has a mortgage or is owned free and clear. Make sense?

Let’s just say that after you purchased this 100 unit apartment complex, as the leases expired and were either renewed or the units re-rented, you increased the rent by a mere $25 per month. That’s a monthly increase of $2,500 and a yearly increase of $30,000.

$25 x 100 units = $2,500 per month

$2,500 x 12 months = $30,000

So poof, you just gave yourself a raise of $30,000 per year. Congratulations! That is the beauty of commercial real estate!

By the way, how much would you have gotten if you increased by $25 a single family house? That’s right… $25!

Now, let’s just say that to reduce operating expenses you make the capital investment into individually metering the units with their own utility meters so the tenants can pay for their own utilities instead of you, the landlord. If the savings to you is a mere $50 per month, that would equate to $60,000 increased NOI because of decreased expenses.

$50 x 100 units = $5,000 per month (decreased expenses)

$5,000 x 12 months = $60,000

So POOF, you just saved yourself $60,000 per year in utility expenses thereby putting the extra $60,000 into your pocket each and every year you own the property. Remember you earn these cash flows year after year, not just once.

Now let’s look at the effect on value in the same 10 Cap market.

$100,000 + $30,000 (increased rents) + $60,000 (decreased expenses) = $190,000.

IF: $100,000/.10 = $1,000,000

THEN $190,000/.10 = $1,900,000

So you can see that you can not only influence the amount of money you earn from cash flow, but you can also control the value of your investment regardless of market conditions.

In residential investing, there is only one strategy. Regardless of how you acquire the property (foreclosure, etc.), the goal is to buy low and wait for the market to go up so you can sell at a profit or refinance.

In this market, residential investors may be waiting a long time… a very long time. Additionally, if they don’t have positive cash flow in the interim, they will not see a return on that investment for years to come.

By investing in CRE, you earn a return on your investment from Day 1 because of the significant cash flows. Additionally, by improving the NOI through your own efforts, you can increase the value of your property regardless of market conditions.

It is for these reasons that CRE is a much safer and more profitable investment than residential investing.

Lenders have developed general classifications of apartment buildings so that they can communicate amongst themselves and other members of the industry with some level of uniformity. The classifications are Class A, Class B, Class C, and Class D.

1. Class A Newer, Institutional Grade

2. Class B Older, Institutional Grade

3. Class C Older, Declining Area

4. Class D Older, Declining Area, Poor Condition

Class A Apartments

Institutional buyers like new, larger apartments in prime locations because of low deferred maintenance. These properties are typically occupied by white collar workers and have amenities such as garages, in-unit washer/dryers, pools, spas, exercise gyms, the latest technology, etc. They are typically between 1-10 years old. Typically they are in the path of progress and as of this writing (July 2008) can be bought at cap rates of 7%. They will likely have less cash flow than properties with higher cap rates but will have greater appreciation potential.

Class B Apartments

Class B buildings are in good areas with many of the same amenities as Class A properties, but Class B buildings are 10-20 years old and occupied by both white and blue collar workers. Class B properties are often owned by investment groups, such as limited partnerships and limited liability companies. As of this writing (July 2008) they can typically be bought at cap rates of 8% – 9%. These properties will have decent cash flow and decent appreciation potential.

Class C Apartments

These apartments are older properties built within the last 21-30 years in working class areas typically occupied by blue collar workers and even some Section 8 tenants(please see my article on Section 8). The properties may be in declining areas but not necessarily dangerous areas. The units in Class C buildings are smaller than those in Class A and B buildings and the projects have fewer amenities. The occupancy rates are typically higher than Class A 0r B because they are more affordable. Individuals usually own Class C properties, which as of this writing (July 2008) can be bought at cap rates of 10%. These properties will have decent cash flow but little opportunity for appreciation.

Class D Apartments

These buildings are older, in declining and even dangerous areas and as a result may have high vacancy rates, deferred maintenance, functional obsolescence and demand a high level of hands-on management from their individual owners. As of this writing, they can typically be purchased for cap rates of 12% but may generate less income than other properties despite their higher cap rates because of higher maintenance and management demands.

Rules of Thumb:

1. Class A & Class B properties are purchased for appreciation potential.

2. Class B & Class C properties are purchased for cash flow

3. Unless you are an experienced investor, don’t buy Class D properties.

The goal is to buy a particular class of property in the same area class. In other words, buy a Class B property in a class B area.

Alternatively, buy a lower class property in a higher class area. In other words, buy a Class C property in a class A area or one in the path of progress. The reasoning is so that you can possibly change the Class B property bought at higher cap rates (lower in price) into a Class A property which can be sold for lower cap rates (higher prices). This “infill opportunity” is typically only possible if the area is better than the property.

After location, zoning is probably the most important characteristic of any type of real estate. It is the obvious starting point for evaluating a parcel’s potential for development because it spells out what you can do with the property. Zoning is a critical piece of the puzzle particularly if you want to be a land developer, an investor or work with a builder in some way. Save yourself much time, energy and frustration by checking out the zoning first, not last.

Local governments enact zoning ordinances and adopt the maps that show the physical boundaries of the zoning districts, and these are modified periodically. To determine the current zoning of a particular property, you would first look at the zoning map to see what district it falls in and then consult the current zoning ordinance. Both of these documents are available for review or purchase at the municipal building. What will you find in the ordinance?

It tells you what land uses are permitted in each district or classification. These classifications generally include residential, mixed residential, mobile home, commercial, shopping center industrial, office, and conservation. The ordinance also lays out other standards and requirements, such as the minimum lot size, minimum lot width, dimension of setbacks, height restrictions and building coverage. It contains definitions that help you understand the terminology used throughout the ordinance. There are general provisions that apply to every zoning district, and these deal with issues like non-conforming properties and uses, accessory structures and uses, flag lots, fencing, signage and minimum lot frontage requirements.

Provisions for a specific zoning district can often include both “by right” and “conditional” uses. For example, single-family detached dwellings, agricultural uses and governmental recreation areas may be permitted in a district. A privately-owned riding academy, stable for horses, public or private day schools, 18 hole golf courses, places of worship and day care facilities are permitted in that district only when authorized by the municipal Zoning Hearing Board as a special exception. This latter group of uses is not permitted automatically, and to get a special exception, you would have to demonstrate that your use falls within those defined in the ordinance and also complies with any requirements, such as minimum site area, building and paving coverage, and buffering, specific to that conditional use.

It would be helpful to remember some key points about zoning. Land use and regulation laws vary from state to state. Terminology and nomenclature vary from municipality to municipality, even within the same county in the same state. For instance, the “R-2” zoning classification in one municipality may mean that single-family detached housing is permitted on a minimum lot area of 35,000 sq. ft., with a lot width of at least 125 feet, and front, side and rear setbacks (yards measured from the parcel boundaries to define the area where a structure can be built) of 60, 20 and 80 feet, respectively. Go to another municipality, and you could find that the R-2 District permits single-family detached housing on 43,560 sq. ft. lots 150 ft. wide with front, side and rear setbacks of 60, 25 and 80 feet. You should not assume that the same name used for a classification in different municipalties means the same thing and when marketing land to potential buyers, be sure to include information on the permitted use and requirements for minimum lot size and width. Describing the zoning of the property only as “R-5”, “MR-1” or “C-2” is meaningless.

Finally, some words of caution. Zoning and other types of ordinances are available online. Do not, I repeat, do not rely exclusively on online ordinance information. Go to the primary source (the municipality that enacted the ordinance) and check it out to be sure you have the most current and accurate information. Always page through the entire ordinance because municipalities often enact amendments that can be printed in the back of the original ordinance (without cross-referencing the original provisions that have been amended). If the provision is somewhere in the ordinance, it applied. Just because you didn’t see it doesn’t mean that it doesn’t apply.

People often ask me how I got started in commercial real estate, and I tell them that it was a conscious decision for me. Most people who begin investing in real estate start off with single family residential properties because that is what they are most comfortable with. They tell themselves, “All I need to do is a couple of deals a month. I’ll make myself five or ten thousand dollars, then at the end of a very few months most of my problems will be taken care of.”

They do not really understand everything that is involved in getting these properties going. They think they are going to be making big money, but before long, oftentimes they end up with a lot of problems and a lot of headaches. They might have traded in their job for a perceived higher paying job, but find that it is really taking a toll on their lives.

If you belong to a real estate investment group, take a look around you. Look at the people who have done twenty-five to fifty houses or more. Are they living the life of their dreams? More importantly, are they living the life of your dreams? They may be better off than you are now, but is this really what you want to work towards? I know so many people who have a large portfolio of properties but really haven’t achieved the type of freedom, success, and wealth that they truly desire.

How can you change this? In my opinion, the answer is commercial real estate. When I decided to start investing in real estate, I stopped and took a look around. I realized that the people who were making the big money in real estate were the people who owned buildings not houses. People who owned the large apartment buildings, the large office buildings, the large warehouse and industrial space – those are the ones who really seemed to be living a lifestyle that I wanted.

They didn’t have to be there tending to their properties; they had property managers who took care of that for them. Yet, they were the ones spending the checks, catching planes to exotic locations and destinations, and living the lifestyle that I desired so much. After looking at this for quite a while, I decided that there must be a way of getting this done. They couldn’t have been much smarter, have learned much more, or have had access to more resources then I could.

Even though I didn’t know how immediately, I knew I could figure out a way to do it. I sat down and took the time to learn how to invest in commercial real estate, which is what I would recommend that you do. I studied and figured out exactly what it would take, and as I learned, commercial real estate became less and less of a mystery to me.

How can you start? First of all, let’s talk about why you would want to do it. What are the benefits of commercial real estate? First of all, one of the biggest benefits is that commercial real estate is valued differently. By “valued differently”, I mean the amount of income that a property produces is directly proportionate to its worth. So if a property produces more income, then it is worth more. It has very little to do with “market comps”.

Second, along the way you are going to get a far greater cash flow. Imagine if you were to buy a $200,000 home. That $200,000 home may rent for somewhere in the neighborhood of $1,500 per month. The underlying mortgage on that home may be somewhere between $1,000 and $1,400 per month. So you end up struggling to gain between $100 and $500 per month in positive cash flow. That’s not a very high number for the amount of work you have to put in, and it certainly is not going to get you on the jet set.

Now, let’s take a look at a similar investment from a commercial standpoint. That same $200,000 investment may end up yielding you an 8-unit apartment complex, based on $25,000 per unit to acquire the property. Let’s say each of those units were two bedrooms, which could rent in most areas of the United States anywhere between $400 and $600 per month. For simplicity’s sake, let’s use an average of $500 per month.

At $500 per month times eight units, you’re bringing in $4,000 per month – more than double the rent that you could expect to get from that same $200,000 single family home. Your underlying mortgage payment would be very similar to what you would expect on a residential property; for this example, let’s use $1,400 per month. Your cash flow on this 8-unit apartment building will be $2,600 per month ($4,000 per month income, minus $1,400 mortgage payment). Now that will make a difference in just about anyone’s life.

Third, and most essentially, you’re now spreading out the risk over eight tenants, as opposed to one. If your single-family home goes vacant, you’re on the hook for the entire mortgage. Every penny of that mortgage, all of the maintenance, and everything that goes along with it is now your responsibility. If the house is vacant for two months, you’d better be planning on spending a minimum of $2,800 to cover that mortgage plus miscellaneous expenses including maintenance, utilities, taxes, and insurance.

Potentially, you’re looking at a very heavy negative cash flow. On the commercial property, however, if one of your eight units goes vacant at $500 per unit, you’re still bringing in $3,500. So you get slightly less positive cash flow but you’re certainly not experiencing negative cash flow. Say three units go vacant – you’re still covering your mortgage and experiencing positive cash flow.

For the fourth and fifth reasons why to invest in commercial real estate, and how you can get started, see Part 2 of this article. Until then, make sure your “pot of gold” is filled with the real stuff!!

What would it be like to have an extra $11,472 a month coming into your life each month. Imagine what you could do with that extra money!

You could buy a bigger house, travel, and/or give more to your church or a struggling loved one.

An investor I know is doing just that because he closed on a deal where he is now pocketing $11,472 in positive cash flow each and every month for the rest of his life (actually it will get higher and higher) or for as long as he holds on to the property.

He did this by taking over an apartment complex using a Master Lease Option. Does that mean he has to deal with a lot of tenant hassles? Absolutely not! He pays a management company to do that. The only thing he has to manage is the manager. It sure is easier managing one manager than a bunch of unruly tenants wouldn’t you say?

This investor found this deal in the local classified section of his newspaper. The owner had the apartment complex advertised for a quick sale because he was burnt out (he was managing it himself), had poor cash flow (it was 62% occupied) and he wanted out.

The investor, being a true investor was looking to get into the property with no money down and structured the deal the same way you would structure a lease option for a single family.

He signed a Master Lease for the entire complex and agreed to pay the owner a certain figure each month. He took over all of the income and expenses on the property and anything above what his expenses are and the lease amount is his to pocket.

He also signed an Option To Purchase the property. Anytime with in the next five years, this investor has the right to buy the property for the stated amount in the option.

When the investor took over the property, it was cash flowing but not by much due to the high vacancy. Using a very good management company and a having them spruce up the outside, he was able to get it at 90% occupancy in eight months time!

Now remember, every month he owned the complex he had positive cash flow. As the management company put more and more tenants into the building his cash flow grew bigger and bigger, to the point where it is now over $11,000 per month.

A lot of investors don’t realize that you can buy apartment buildings the same way you buy single family houses. You can do “subject to”, lease option, wholesale, and pre-foreclosure just as easily and the best part is…the paydays are much, much bigger!

The true goal of every investor should be to create as much massive passive income as soon as possible.

Passive income means just that, money that comes into your house month in/ month out without you having to do a thing to get it. How can you accumulate massive passive income quickly?

Well, if you went out and bought a couple dozen single family houses and kept them, you would create a decent income. Good but not great.

Its’ going to take you a little time to find all of these deals and then you would have to manage all of those tenants.

What If You Put a Couple Dozen Units in the Same Property?

Then you would only have to find one deal and then a few more to create a great passive income.

I know what you’re thinking. Oh no, not apartments! I don’t want to deal with the tenant hassles! And I agree with you, you shouldn’t be dealing with any tenants, wouldn’t it be better if you could just sit back and collect checks while someone else deals with all of the management headaches?

Those people are called management companies and they make a living shielding investors from the day to day management of their properties so you can go out and continue to do what you do best, find more property and create more cash flow!

But Aren’t They Expensive?

It’s true that management companies are paid a percentage of the gross collected rents, somewhere between 6% and 10%, though if you factor this cost into the deal, as long as the property cash flows with these fees, you’ve got yourself a winner!

Not only have you found a property that will get you one step closer to true freedom, you don’t have to hassle with a single tenant.

But Don’t the Management Companies Nickel and Dime All of Your Profits Away?

While it’s true that there are some bad management companies out there, you can be assured to find a good one if you follow these simple steps.

Go to www.irem.com. That’s the Institute For Real Estate Management, a great resource. When there, go into the search box and search for a Certified Property Manager (CPM).

These are owners and managers who have taken time out of their busy schedule and taken a series of required courses to improve their management knowledge and skills. Upon the completion of these courses, they take a big test and then they are awarded the CPM designation.

These managers are the cream of the crop and these are the ones that you want to have managing your properties. They will send you a summary report each month, telling you how the property is performing and the only thing you have left to do is to go cash you’re checks while you’re out finding more properties for your portfolio!