It’s been weeks, or maybe months, and the big announcement you’ve been waiting for has finally come: “XYZ Company” is moving its headquarters to Greenacre. All the experts agree: it will be a “game-changer” for the area, creating new jobs, new commerce and the kind of demand for surrounding real estate that investors and speculators dream of. Time to pay the premium, put up that down payment and get in on the action? As with most questions asked of a lawyer, the answer is an unsatisfying maybe. But we won’t leave you hanging there. As many of you have inferred by now, the “XYZ Company” announcement is inspired by Amazon’s planned HQ2 in Long Island City, which unraveled with alarming speed after Amazon’s executives determined that the political climate was not as favorable as initially thought. We know that there are a lot of people out there who suffered losses as a result of speculative buying in the Long Island City area, and below is a simple (non-exhaustive) list of issues to look out for when deciding on an area to invest or speculate.
Betting on the New Big Player in Town:
Let’s start with the obvious (which was maybe not so obvious a few weeks ago), whenever it is rumored or even “officially” announced that a big new user of space is coming to town, it is tempting to buy around the target area as early on as possible, betting on there being big upside when other users come flocking to the area to supply housing for new employees, restaurants, and other goods and services needed by all the new workers and residents in the area. The problem with getting in early, is that unlike stocks, bonds or any other number of easily traded investment instruments, real estate is illiquid and comes with high transaction costs (brokers, attorneys, transfer taxes, etc.), and if the big deal expected to be the catalyst for demand craters, you will be left with an expensive piece of real estate that you will plan to either hold for an indeterminate amount of time, or sell for a short term loss. Neither is a good option, so make sure before you jump into an unknown market to speak with local real estate brokers who have worked in your target area through several economic and political cycles. Googling real estate deals in the area or perusing Loopnet may help you to graze the surface, but nothing will give you insight like speaking to a real estate professional who has been burned, or seen others burned, when local residents and politicians get up in arms about over-crowding, gentrification or changes in use for local property.
It’s also a good idea to study employment statistics, demographics, prices and historical returns for the area prior to the introduction of a big catalyst like a planned Amazon headquarters. If the cap rate or return that you would have expected to receive without the introduction of the catalyst justifies the price you are paying, that gives you some added assurance that prices and returns will likely revert back to those past levels once the shock of any bad news wears off. Consider using free resources like the bureau of labor statistics or U.S. census bureau data to determine the historical employment rate and demographic patterns in the target area.
Unless you plan to invest in property that does not need to be changed or further developed in any way (e.g., a multi-family residential building that you plan to buy and continue to operate as a multi-family, hopefully at higher rents), it is critical that you have a strong understanding of local zoning laws, and what the odds are that variances can be obtained if needed. In this case, it is important to consult an experienced local architect who can explain the local zoning laws and what can and cannot be built without a variance. A variance is essentially a form of government permission to deviate from the normal zoning regulations, so while a good architect can probably tell you what you can build in line with current zoning regulations, they will be speculating a bit (hopefully based on past professional experience) as to whether a variance will be granted in your particular case. Get the best understanding of your odds of success and then get comfortable with the remaining uncertainty before deciding to forge ahead.
In New York City and many of the surrounding areas, local boards control, or have a big influence on the approval or denial of variances, so in addition to consulting an architect, you should once again tap experienced local real estate brokers and zoning attorneys to get an idea of the types of projects the local board in your area has historically favored or disfavored. Some areas of New York City have been dubbed “special districts”, and in these areas there may be added resistance to any plans to change the use or size of structures.
Legal Structure of Ownership and Thinking Outside of the Box:
Another big consideration is the existing or planned form of legal ownership for the property you are purchasing. By now, use of the term “think outside of the box” is so clichéd that most of us probably would have to strain to remember a time when it wasn't in use to describe creative thinking. However, in the world of real estate, it is an especially appropriate descriptor for how you should think about the “box” or “boxes” you are buying or developing on land or within a building, and how you can change the number and usage of each “box” to maximize profit.
Still with me? Consider this real life example: Client is seeking to invest in a brownstone in an area of New York City that has been appreciating in value over the past decade or so as it slowly became a hot area.* The brownstone that they identify as a target acquisition is in need of repairs and is currently set up as a four family apartment building. The obvious play here is to buy the brownstone and seek to vacate each apartment as each lease expires or is able to be terminated, make capital improvements to each unit as it comes on line and re-rent each unit at now market rates. Once fully leased up, the client would have the choice of holding the brownstone and receiving the cash flow from rental income, or putting the fully leased brownstone on the market and sell it for a gain (a sophisticated “flip”, if you will). What client opted to do is far more interesting. Client is still in the process of vacating each unit as quickly as possible and making capital improvements and needed repairs as each unit is ready, but instead of seeking to re-rent the units, client is in the process of converting the building to condominium ownership, so that each apartment can be sold separately. There are a few benefits to doing it this way:
· As the condo sponsor you get to retain control of the project and roll out each unit while waiting for the others to be vacated and improved – this allows you to maximize the time value of the gain from each unit by selling the unit as quickly as it is ready, rather than waiting for all of the units to be ready for market.
· As each unit is sold, the client also has the option of using the sale proceeds to help fund the completion of the other units. The project takes on a self-funding element that could be equated to a developer building a tract of houses in the suburbs in phases as earlier houses are sold off.
· With a carefully worded offering plan, the sponsor also has the ability to hold on to, and rent out, some of the units. This can serve as a hedge against unexpected stagnation in the apartment sales market because the sponsor can capture rental income for the unsold units while they weather market conditions.
· If you have little interest in navigating the difficult business of being a landlord, it is a way to “flip” the building piece by piece, a minimize the amount of landlording you need to do on your way to capturing your short term gain.
Of course, before putting any money at risk on this kind of investment, it is important to do your diligence and make sure that the economics make sense. You will, once again, want to consult with a knowledgeable real estate broker to make sure that the separate sale of each apartment, after conversion costs, will net you more than the sale of the whole building, and you will need to discuss the costs, timeline and logistics of creating the condominium with a knowledgeable real estate attorney. To form a condo an offering plan and declaration need to be drafted, approved by the NYS Attorney General’s Office, and properly recorded and filed.
Hopefully this article serves as a good starting point when thinking about some of the risks and opportunities to consider before speculating on real estate. No matter how much the world changes, there will always be opportunities to make and preserve fortunes in real estate, you just have to go into it with your eyes open and a good sense of the risks to be navigated, hopefully with competent professionals at your side!
*Footnote: Many readers will doubtless be wondering how does one recognize that an area is a “hot area” to invest in? Obviously no one has a crystal ball, so all we are all left with two choices when trying to deploy capital for an investment in an uncertain future: 1) look at the features of other areas that seem to have been responsible for appreciation in value (e.g., lot size, zoning use or mix, proximity to the city, proximity to public transportation, influx of trendy bars or restaurants, etc.), or 2) wait until prices in an area are obviously trending upwards and, instead of trying to get in on the ground floor, invest on the way up and hold until it’s obvious that the trend has reversed. It’s counterintuitive to wait until an area is getting expensive before buying – after all, we humans love feeling like we got something at a bargain price – but real estate cycles tend to be a lot longer lived than bull and bear cycles in other, more liquid, asset classes, so you may find it makes sense to take advantage of an area that is obviously trending upward, rather than trying to find the “next hot area.”