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NEWSLETTER Prime Locations

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Valuable Lessons from the Past as We Face the New Year...

MARK TWAIN once said, “History doesn’t repeat itself, but it rhymes,” and it is valuable to make rhyme and reason of the past in order to make good decisions concerning commercial real estate investing in the coming years.

I remember 2007 when the Dow Jones peaked at about 14,000 only to plummet to 6,500 in early 2009, essentially cutting the value of the United States economy in half in the eyes of the investment community.

The next two years were dismal but by mid-2011 we began to see some improvement, and the economy and the commercial real estate sec-tor have been on the mend since.

With 2015 upon us, new opportunities to invest in commercial real estate will present themselves but in order to be confident in our investment approach, we’d be wise to heed some of the warnings of the past.

The economy is cycli-cal, much like nature’s seasons, and 2008-2011 was a really cold, dark winter. More recently, we’ve been experiencing a spring-like season, a recovery.

While there are some economists and experts predicting inflation or the next great crash, I believe we’d be well served to compare where we are now to years past to see where there may be similarities and dif-ferences before jumping on the doom and gloom (or rah-rah) bandwagon.

In certain major mar-kets we are seeing some of the same practices that we saw during the last “summer” season, between 2005 and 2007, before the downturn.

For example, institu-tional investors in areas like Seattle, Los Angeles and Dallas are now pay-ing the equivalent price for properties that they were in 2007. We’re seeing such inflationary pricing that the only way these investors will ever make a decent return on these assets will be if rental income increases faster than expenses. My main concern with this approach is the fact that the purchasing

power of the middle class hasn’t increased much since 2008 and they will only be able to handle so much of their income going towards their housing. If you look at why the housing bubble burst, it was due, in large part, to people owning homes they couldn’t afford. Well, if rental rates continue to outpace the purchas-ing power of the mid-dle class and they can’t afford housing, these investors will be left holding the proverbial bag.

To give you an example, in

Seattle right now, they are building micro-unit apartments that are 200 to

250 square feet with rents of up

to $1200 a month. It is the middle class they are relying on to fill those units and pay those rents, so I’d hate to be the last guy com-ing out of the ground to build one; they just don’t seem sustainable.

I am also intrigued by the recent increased use of commer-cial mort-gage-backed securities (CMBS), the

major conduit loans that were hugely popular but highly volatile and part of the reason for the crash. It may not be a precursor to a problem, but if you look back to

THE PURCHASING POWER OF THE MID-DLE CLASS HAS NOT

INCREASED MUCH SINCE 2008

We are in a spring-likeseason of

economical recovery

TOO MANY REAL ESTATE INVESTORS OFTEN BANK ON AN UNCERTAIN FUTURE

2007 and compare it to what we are doing now, the paths are a bit more parallel than I would prefer to see. Anytime we start investing heav-ily in derivatives across the board, it worries me.

Earlier, I mentioned inflationary prices. I’d like to give you an idea of how we determine price in the industry. One of the main indica-tors commercial brokers look at is capitalization rates or “cap rates”. In its simplest terms, if an investor purchases a $1,000,000 prop-erty at a 6% cap rate it would mean the investor could expect to receive $60,000 in cash flow from that investment in the first year.

Ben Graham, consid-ered the father of value investing, has said a

public company’s earn-ings yield (similar to our cap rate) would have to be double the average AAA corporate bond yield in order to justify even considering an investment in a stock. I think in terms of applying that principle to real estate. Right now, we are seeing sub-4% capitalization rates in major markets for apart-ment buildings. But I can buy a AAA-rated corporate bond that pays a 4% return with very little risk, so why risk investing in real estate?

There are reasons but if you don’t know exactly what they are, you should probably take a pass, or find someone who can explain them to

you.

So, can you see why I’d be concerned with investors taking on that kind of risk when buy-ing real estate?

The cap rates we’re see-ing in the major cities for Class A assets are as outrageous as they were before the crash. Too many real estate inves-tors often bank on an uncertain future. They might invest at a 5.5% rate of return now,

leveraging the investment with a loan and banking on increased rents over time, which would increase their return.

That’s all well and good, until it doesn’t work out that way.

Thankfully, for us investing primarily in

EDITORIAL

A Word fromZach Kosturos

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A WORD FROM ZACH CONT.

the secondary markets (like Thurston County), pricing hasn’t spiraled out of control. That’s one of the major dif-ferences I see now compared to 2007. In 2007, every-thing, eve-rywhere was overpriced. Not so today. In Thurston County you can still buy properties at a 6% to 9% cap rate, depending on asset qual-ity and expect a solid return.

It all comes down to find-ing a great property at a fair price. Remember, price is what you pay and value is what you get. In real estate, the most important variable is location. A well-located property, in a prime loca-tion, enjoys the biggest competitive advantage in the industry, one that can never be taken away.

I am convinced that we must use proven investment strategies to

maximize returns and minimize risk. We must underwrite our invest-ments conservatively if we

are to protect our principal and gener-ate adequate returns.

Despite the overpriced parts of the market, there are still deals out there worth investing in.

If you’re looking for an adviser who understands investments from more than just a real estate point of view, who knows how to find worthwhile invest-ments to diversify your portfolio, I’d be happy to have a conversation with you about your goals and objectives.

Feel free to contact me, Zach Kosturos, at 360.943.9922.#

interest rate rises from 4% to 7%, you probably haven’t paid down enough of the principal or seen significant rent growth to make up for the increase you’ll experience in your mortgage payment. That means your 6.5% return could be cut to 2.5% or 3%, the equivalent of holding a Treasury bill today (only with WAY more risk).

Real estate investment trusts (REIT), the pub-licly-traded investment

vehicles for commercial real estate, traditionally are leveraged less than 50%. REITs today are over-leveraged at 60% and a huge interest rate change without sig-nificant rent growth will slaughter their returns.

The point is, you have to understand that if real estate isn’t underwritten and purchased properly, you can be left with what equates to a large risk with limited upside.

with more tenants, the risk is spread.

I would have to have half of those tenants move out of that apartment complex to lose money. To “beat the market,” we bought the property with rents 20% under market, but we paid based on the in-place income. Let’s just say we paid a price equivalent to a 7% cap rate on current income. Because we put a lot of money down, we reduced our risk of losing principal, and when we raise rents over the next 12 months, the same 7% cap rate, if we decided to sell, would equate to over $1 million more than what we paid. That is a successful strategy. Low risk, high reward.

Too often people just hire a broker to buy a property, but don’t think through these critical strategies. If you’re thinking about investing in commercial real estate, find someone who can help you identify a potential upside in the current market, not the market three years from now. Make sure you have enough capital to invest and, while there is no guarantee that you won’t lose money, you certainly put the odds in your favor with a well thought-out strategy.

You’ll never eliminate all

the risks, but underwrite the risk according to what you can handle and in a way where you reduce the chances of losing money. To make up for lost money you have to make astro-nomical returns. When you buy the right kind of product, property or stock at the right price, even if you just make a modest return, you’re way ahead.

Did we learn anything from the past several years that we can apply to the coming one?

We learned that we must be careful and smart. We can’t control everything, but as individual inves-tors we need to be aware of what’s going on in our local market, be aware of the risks as we move into the next economic season and use expert strategies to minimize those risks.

Those are pretty good les-sons for any season.

We wish you prosperity and investing success in the coming year.

Zach KosturosOwner/Designated BrokerPrime Locations, Inc.

Smart Strategies Improve Returns and Minimize RiskMANY ARE wary about getting back into real estate investing because they got crushed six or seven years ago, but I believe many people could have avoided those losses with a smarter investment strategy.

All of our Prime Location properties have not only profited, but profited well with the exception of one. Warren Buffet doesn’t make money on every business that he buys, but he does on most. It’s because his strategy is dif-ferent. A successful strategy is one that minimizes risk.If a dentist wants to buy a

commercial building and has $300,000 to buy a one million dollar building, he’s going to have leverage of 70% and equity of 30%. Let’s assume the building is multi-tenanted and will pay him an 8% return on his capital upon closing.

Now, if the building he buys only has three tenants, all paying the same amount in rent and one moves out, he’ll be lucky to break even. If the building is half full and one tenant moves out, he’s likely losing money.

Warren Buffet has two rules of investing. Rule

number one is, don’t lose money, and rule number two is, don’t forget rule number one. So how do we go about investing in com-mercial real estate in a way that substantially reduces our risk of losing money? Well, there are multiple ways and today I’ll share one…

Some par tners and I recently bought an apart-ment complex with about 45% equity and 55% debit. We have over 60 tenants. The risk profile is more in favor of the investor (us) in an apartment complex or a self-storage facility because

Interest Rates are a Critical Part of the EquationIn commercial real estate, investors typically lever-age their investments with financing. The loan is not fixed like a home loan for 30 years; it’s typically due in five, seven or ten years. If your property currently returns 6.5% and you have a five year loan and, upon refinancing, your

In Thurston County you can still buy

properties at a 6%-9% cap rate.

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MARKET REPORT Prime Locations

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Local Market Report

THE MULTI-FAMILY MARKET We’ve had a sub-2.5% vacancy rate across almost a thousand units that we manage at Prime Locations for the last year and a half.

In 2009, the vacancy rate was up to almost 8% coun-tywide because many of the tenants in apartments

moved in with their par-ents, lost jobs, etc. When people started losing their homes though, they even-tually moved back into apartments.

We are in “summer” in the multi-family sector locally—rents are grow-ing, vacancies are low and investors are making lots of

money. It is because there is a near perfect balance of supply and demand. As you drive around town, though, you may see a lot of new apartments going up. We must be careful not to cre-ate an oversup-ply and throw everything out of balance.

THE OFFICE MARKET here is the polar opposite. There is an absolute over-supply, with more than a million and a half square feet of vacant office space in Thurston

County.

We don’t have any solid data on vacancy and absorption like exists in some of the bigger coun-ties, but we do the best we can to put the pieces together for you. I would estimate that our office market vacancy rate is still between 14 to 17 percent compared to 2 percent in multi-family.

Prices have plummeted because of oversupply. Remember, one of the main drivers of the price of anything is scarcity. When you can go down the street and have your pick of office buildings to either lease or buy, prices are low because there is no scarcity. In most cases, landlords are struggling, and they just want to put somebody in their space. Office pricing varies based on the age, construction type, use, amenities and location of the building. For instance, a dental prac-tice that decides to build a new building could pay $400 per square foot. Whereas, a normal office user like a mortgage com-pany could probably build something in the $200 per square foot range.

An existing building built in say, the 1970s, could

likely be pur-ch a s ed f o r $130 to $150 pe r squ a r e foot. We are in an environ-

ment where you can buy an existing structure for sometimes less than half of replacement cost. In the Woodland district, across the street from our office,

IN THURSTON COUNTY we’re really just starting to come into our “spring” season in commercial real estate. But that is not true of every sector of our market. For a realistic analysis of the Thurston County commercial market let’s review each major sub-catego-ry—Multi-Family, Office, Retail and Industrial—with a look at the unique factors that impact our local economy.

LOCAL NEWSUpdates from the surrounding areas

QUICK FACTS

Currently there’s an over saturation of office space in Thurston County

You may have noticed that Office De-pot on the Westside has closed and that’s because a new Providence Medical Clinic will be moving in there.

There will be an enormous Outlet Mall moving into Hawks Prairie. It’s planned to be about 400,000 square feet. It will be bigger than the Woodburn Outlet in Oregon, from what we’re being told. The master planned community, in total, will be about 250 acres when it’s done in 20 or so years.

The new outlet mall will significantly change the dynamic of Thurston County because it will attract people. It becomes a destination. The interior city of Lacey and the Westside of Olympia are going to have to work hard to compete with that kind of a draw.

In other news, there is a new La Quinta Inn being built in Tumwater above the Valley Athletic Club on Capital Way, fronting I-5.

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LOCAL MARKET REPORT CONT.

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STRIP MALLS IN THE AREA ARE

MOSTLY FULL AND MAKING MONEY

HOW SOON SHOULD I START LOOKING FOR A NEW SPACE FOR MY BUSINESS?

Best Buy are starting to move to smaller footprints. It will be interesting to see how investors begin to look at buying a center with one big box store and multiple small tenants today based on this trend.

The coming years should prove telling in the big-box retail sector.

Strip retail, fortunately, is full of businesses that, for the most part, will always be around. Hair salons, nail salons, barbers, tax advi-sors, coffee shops, and res-taurants are never going to go away because they can’t provide all their services online. That makes small shopping centers in the right location a good play.

The Industrial Market

The industiral market is also getting better. We had a lot of vacancies in Meridian Campus and Hawks Prairie. Many peo-ple aren’t aware that there has been about 250,000 square feet of space leased to marijuana enterprises. That has changed the sup-ply and demand curve out there but we still have a decent amount of vacant industrial space.

A huge factor in our favor is that we’re on the

investors paid from $25 to $30 per square foot when they purchased all of those buildings. The land alone is worth that. Talk about getting a steal.

Eventually, those buildings will be filled and when they capitalize the income they m a k e o n them, they will proba-bly be worth around $170 per square foot and they will have made a handsome profit. But, in the meantime, they are going to sit vacant.

We get questions weekly from our landlords: “Has anything happened? And, is it changing?” And I just say, “Unfortunately, it’s not.”

The private sector here just isn’t growing fast enough to absorb all the vacant office space. We don’t have enough private industry to fill such gaping holes. The worst part about it is that the state is still moving and building office space. That’s why we had the situation in the Woodland district in the first place. Those buildings were built for the state government, and they were only paying $15 to $17 per square foot in rent. Then they built the

“Taj Mahal” DES building and now they’re paying north of $40 a square foot. The state would rather own or be in new space than use what we already have, and it’s perpetuating the vacancy problem.

The Retail Market

The retail mar-ket should really be split into two

subsets. There is big-box retail, and then there is the smaller strip mall retail. The little strip malls are mostly full and making money. Rents there have stabilized and even started to rise.

An exciting announcement was made recently that all of the remaining big-box availability has been spoken for! You may have noticed there is a new Sports Authority in Westside Olympia and Burlington Coat Factory opened up in Lacey. There are more coming and this is a great sign for the retail market in Thurston County.

Something worth noting…Last year, retail online sales of the gross U.S. economy were about 7% of all sales compared to 5 years ago when they were 3 or 4%. You’ll see that Walmart and

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I-5 corridor and we’ve got the port. I know that local governments and the Economic Development Council are working hard to bring more manufactur-ing jobs to the area. They succeeded in bringing the Seeley manufacturing plant over a year ago to Thurston County. If we can continue attracting those types of companies, it will help. I think we’re positioned well on the industrial side.

Local Government Can Help

Finally, I wanted to add another significant point about our local economy.

We can no longer rely on state g o v e r n -ment to fill a majority of the mil-lion and a half square feet of vacant office space. We either have to start tearing buildings down, or we will need to start creating more private-sector jobs. That means we’ll need more popula-tion growth in this county. If we want to attract peo-ple and the businesses that employ them, municipali-ties should create an envi-ronment where there’s an

incentive to live and work here.

Growing up, I remember downtown Olympia being a little safer, a little cleaner and a little more family-friendly. The problems with downtown are huge obstacles that keep peo-ple from coming to town and prevent businesses from generating healthy profits and hiring more employees.

The reason Lacey has grown so fast over the last 10 years is because when people consider moving their business there, they say, “What can we do to help?” not because of

greed or a desire to kill the environment but

because it helps pro-vide desperately-needed jobs and contributes to our quality of life as a community.

Municipalities can help solve the problem

if they choose to by creat-ing a culture that encour-ages new businesses and attracts the households that need them. We’ve seen cases where this has worked incredibly well and I encourage the public sec-tor to look at those positive instances and use them as a model moving forward.

We’ll need more population growth in this county if we

want to attract businesses