Absorption: The second reason repositioning projects fail is the misjudging of absorption

What if it takes you 50% longer than you planned to fill your repositioned property with tenants? How much longer would it take to reach your break-even point (see Encyclopedia Topic A, Buying), where you are paying all the expenses and the mortgage? At some point, you are not going to be able to sleep at night knowing that you are going to run out of money. Absorption is the amount of time it takes to fill vacant units in a market based on the number of units available. Absorption can be your friend in an up market or your enemy in a down market. Unfortunately, it is based on the whims of supply and demand for that property type. The number-one reason repositioning projects fail is the owner overspending for the potential return on the investment. The second reason is misjudging the absorption rate.

Absorption rates for a commercial property type are positive, negative, or flat. Multifamily property absorption rates are measured by the number of units vacant on the market divided by the total supply of units during a specific time period. The rate for office, retail, and industrial space is based on the amount of square footage vacant in the market divided by the total square footage of the total supply in the market of that property type during an allotted amount of time. Give a commercial property appraiser a call and ask them about absorption rates for your property type in the market. You can also call your commercial banker, who will have many recent appraisals and can look this up for you. Your repositioning pro forma is going to need market absorption rates to be accurate.

The worst scenario for absorption is when midway through leasing a repositioned property a recession hits, greatly slowing down absorption. I can tell you that my clients who had four to six months of working capital to cover all expenses and mortgage payments for their property made it through this hurdle.

• Positive Absorption: There is more leased than vacant space in the submarket.
• Negative Absorption: There is more vacant than leased space in the submarket.

Adaptive Reuse (Repurposing): Taking an old building, using it for a different purpose, and making it beautiful

Did you know that old historical buildings—even warehouses that have been repurposed as office buildings—often get the same, if not higher, rents than Class A properties in the same neighborhood? This is because they usually have so much more character. They provide an aesthetic and artistic experience that top-of-the-line new properties cannot compete with. Often these repurposed old properties have amenities such as indoor and outdoor common areas, grand lobbies, conference rooms, gyms, and cafés.

Adaptive reuse is when you take an existing building and repurpose it for another use. In many mid-size or smaller towns you will find what was once an old abandoned train station with a lot of historical character turned into a classy restaurant. Repurposing an old obsolete property can be close in cost to new ground-up construction, but is usually less. It really helps if you can obtain the building for as close to the value of the land as possible to make the project economically feasible. Be sure to allow extra time if the property has to be rezoned or a local variance has to be obtained.

Appreciation, Forced: I know we are told not to force things, but forcing your rents up will raise the property value

Appreciation of a commercial property is an elusive concept. Sure, you can buy a property and hang on to it long enough, like 7 to 10 years, and it will likely go up in value. But if you want control over this and want your property value to go up fast, the best way to accomplish this is to use forced appreciation—and the best way to do this quickly is through repositioning. Forced appreciation is the method of increasing rents and lowering expenses in a short amount of time, thus dramatically increasing the net operating income and property value. This involves making just the right upgrades to the property and then raising rents as quickly but intelligently as possible. Buying a property for less than it is worth is difficult during an up market. But finding a property that has under-market rents that can be repositioned is always doable. This is because procrastination in raising rents is so common. Many landlords just don't want to confront longtime existing tenants with rental increases. It's interesting, but when these properties sell, the new owner doesn't seem to have a problem with this.

I have clients who have become wealthy by specializing in forced appreciation by implementing lower-cost operational and cosmetic repositioning (see the Cosmetic Repositioning Checklist and Operational Repositioning Checklist later in this Topic) upgrades. The best properties to buy for repositioning are those that have been poorly managed and owned by worn-out owners. These properties are notorious for having under-market rents and over-market expenses. Finding properties that have higher-than-market vacancies, rent collection problems, and the overuse of rental concessions are great for creating forced appreciation through repositioning.

Ballpark Quotes: These just about always underpriced quotes could put you into a pickle financially

I have to be blunt about using ballpark quotes or estimates when buying a commercial property that needs constructional repositioning. Sure, this can work for light cosmetic changes such as painting and new floor coverings as long as you have the measurements. But when making your decision to buy a property that needs expensive constructional changes, don't even think about basing it on ballpark quotes. Many of my clients have started out their projects this way. The problem is that all, and I'm not exaggerating, all of them ended up paying more for the work. We are talking about 20% to even 50% more. This is because a contractor has to have a detailed list of all the work needed, and actual measurements to quote each item accurately. The only way to know what the project is going to cost is with a construction bid or contract. You can get away without architectural drawings, but a design drawing is a must to get a construction bid for a rehab project. Sure, go ahead and tie a property up based on a ballpark estimate for the constructional work. But until you get a property condition report and an actual bid from a contractor, you will not know if the project is economically feasible.

Building Codes and Permits: Be prepared to bring old properties up to current building code standards when doing major rehab

Be aware that making constructional repositioning changes to a commercial property will most likely trigger the need for building permits, inspections, and, if the configuration of the space has changed, a new occupancy permit. Where it really gets expensive is when changing major systems like the structure itself and having to bring the entire building into compliance with current building codes, including fire and safety. Usually, if you do not build on to the structure, construct or remove walls, or add new plumbing or electrical work, a building permit will not be required. I had a client who put in a new HVAC system in an office building. The cost of bringing the ductwork up to current fresh air flow standards added a third more to the cost.

Competition Analysis: Is your property more tired and worn out than your competitors'?

To raise rents and bring your repositioned property to its optimum, do a competition analysis. Take a look at your subject property's condition and amenities to compare it to the most successful commercial properties of the same type in the market. By comparing three to five of your top competitors, you can determine what needs to be done to the subject property. To stay competitive, commercial properties usually need to be renovated every 10 years. Here are some items to analyze:

1. How old is your property and when was it last upgraded? Have your competitors improved their properties more recently?
2. How does the overall condition of your property compare to the competition? Is it out of date, grossly worn out, somewhat exhausted in spots, or just a little tired? Take a look at the entrance, lobby, common areas, interior and exterior finishes, parking lot, walkways, and landscaping.
3. Does the best of the competition have special amenities that your property lacks like enticing parklike outdoor common areas, comfy furniture, a workout room, or a café?
4. What are people saying about your property and the competition on social media?
5. How does the traffic count of your property compare with the best of your competitors?

To answer these questions, get the assistance of an experienced commercial property-leasing broker who specializes in your property type. They can tell you which of your competitors have recently repositioned their properties, exactly what they did, and how much rent they were able to get. They might even arrange giving you a tour of one of these properties. Get their opinion on how much you can raise rents if you upgrade the property to the level to your top competitors. Then determine the cost and whether the improved net operating income will justify the expense and achieves your rate of return goals.

Constructional Repositioning Checklist: Check off your ideal constructional improvements

Constructional repositioning usually involves light or major rehab and replacement of one or more major systems. Often building permits are required and sometimes rezoning and a new certificate of occupancy may be required. Constructional changes can include adding more rentable square footage, creating appealing outdoor common areas, or adding a fitness center, playground, dog park, café, covered parking, or storage units.

• ___ Electrical system
• ___ Plumbing system
• ___ HVAC system
• ___ Roofs
• ___ Sewage and septic
• ___ Foundation work
• ___ New siding
• ___ Stonework
• ___ New decking
• ___ New walkways
• ___ New insulation
• ___ New fencing
• ___ New framing and trusses
• ___ New windows and doors
• ___ New gutters/downspouts
• ___ Handicap access
• ___ New tubs and showers
• ___ Tiling work
• ___ Drywall installation
• ___ Parking lot resurfacing
• ___ New subflooring
• ___ Carports
• ___ New landscaping
• ___ Swimming pool
• ___ New outdoor area
• ___ Fitness room
• ___ Playground
• ___ New lobby
• ___ New rec building
• ___ New security features
• ___ New square footage
• ___ Storage units

Cosmetic Repositioning Checklist: These items can really give your property a whole new look and raise your rents, without breaking the bank

Cosmetic repositioning upgrades are moderate in cost. They can dramatically change the look and feel of a commercial property attracting a much higher-grade tenant willing to pay higher rents. They do not require building permits.

• ___ Restriping the parking lot
• ___ Repairing cracked walkways
• ___ Manicuring the landscaping
• ___ New interior and exterior paint
• ___ New bathroom vanities
• ___ Painting kitchen cabinets
• ___ New kitchen cabinets
• ___ Repair fencing
• ___ New fixtures
• ___ New floor coverings
• ___ New appliances
• ___ New kitchen countertops
• ___ New window coverings
• ___ New lighting fixtures
• ___ New bathroom fixtures
• ___ Replace fencing
• ___ New furnishings in common areas
• ___ New signage
• ___ Refurbish the rental office
• ___ Install gas barbeques
• ___ New appliances
• ___ New baseboards, moldings, and trim

Design Drawings Versus Architectural Drawings: For constructional repositioning you might be able to use a designer instead of an architect and save a bundle

When making constructional repositioning changes to a commercial property, you will need drawings to get a construction bid and contract. For many projects, design drawings done by a drafter will be adequate. For major constructional changes requiring engineering, a licensed architect will be required. Drafters charge between $50 and $80 per hour, whereas commercial architects charge 6% to 10% of total project costs or an average of $150 per hour.

Distressed Property: Be wary of buying a distressed property in a bad neighborhood

A commercial property is considered distressed if it has 80% occupancy or less in a market that has 90% occupancy or more for that property type. Distressed properties are often an eyesore as well. If the condition is due to poor management, this can be a great opportunity for repositioning. Usually these properties just need inexpensive operational and cosmetic changes. A new property manager who rules with an iron fist and is more aggressive at leasing might be just what is needed. A distressed property that is in an undesirable location or low-rent area may not be a good candidate for repositioning. Maybe the property is better off left as a Class D with the rents kept low. You don't want to overimprove the property and not be able to raise rents because the average wage earner in the neighborhood cannot afford it.

Economic Obsolescence: Be careful that the property you are thinking about repositioning is not going to be economically obsolete

Economic obsolescence is a drop in property value caused by factors outside of the property itself. Probably the best example was the glut of office space on the market after the COVID-19 economic crisis and recession. So many workers got used to working in home offices and their bosses learned to love saving money on rent. Another major factor is too many same-type commercial properties being built and coming on-line at the same time. These new properties have much better amenities and although they have higher rents, they pull tenants away from older worn-out properties. The opposite circumstance can also cause economic obsolescence. This actually happened in the three most expensive neighborhoods in Portland, Oregon, in 2016, when too many new high-end luxury multifamily units entered the market at the same time. Occupancy, rents, and property values took a plunge for three years. Another cause is a change in the economy where major industries nearby have laid off workers.

In an up seller's market, be wary of properties that appear to be a good deal and are priced lower than other like properties are. These commercial properties might be experiencing economic obsolescence resulting from a rise in crime in the neighborhood. This can lower a commercial property's ability to attract better-quality higher-rent-paying tenants. During a recession, be careful to check the number of units or spaces available for rent in the market of the subject property's type. If there are too many, you have a renter's market where rents are freefalling. Worse yet, market vacancy might be so high that the property you are interested in purchasing might have become or will soon become economically obsolete.

Energy Management System (EMS): These systems are amazing in how they lower your energy bill by themselves

When repositioning, one of the best ways to cut down on utility expenses on your commercial property is to install an energy management system, which monitors the consumption of energy, lowers it, and curbs waste. It is a computerized system with sensors that collect data so that you can make informed decisions. The system will analyze energy consumption and make recommendations to reduce energy use. It will also monitor your HVAC and lighting. Some of these systems can tell you how much you are spending on energy consumption in real time.

If you have an older building with no energy controls or monitoring, consider installing smart building control sensors. Electricity consumption can be lowered by as much as 25%. Heating, cooling, and lighting are turned off when rooms are not occupied. HVAC systems are monitored to run economically. Check to see if there are energy grants in your area to help pay for the cost of the system.

Functional Obsolescence: See if you can find a property that has become functionally obsolete. They can be great candidates for repurposing

In 2011, a client of mine needed to refinance a 60,000-square-foot single-tenant warehouse on the outskirts of Colorado Springs. A food distributor had occupied it for over 30 years. The loan I had done on the property 10 years prior was maturing in three months. Because the tenant had just over a year left on their lease, I could not do another permanent loan without the tenant signing a longer lease. They kept stalling and would not renew their lease early. I had to place an emergency two-year bridge loan on the property. Due to stiff new competition, the distributor went out of business in less than a year. Now the building was 100% vacant. My client could not find another tenant. The problem was that the facility had become functionally obsolete because the ceilings were only 18 feet high. Times had changed and distribution facilities wanted ceilings to be 30 feet high so they could use the latest computerized racking systems that are designed to save space. My client ended up losing the property.

Functional obsolescence occurs in a commercial property because of design features that are out of date. These can be excellent opportunities for repurposing if they are located in the right place for the right price. However, these properties have often been vacant for a long time and redeveloping them may not be cost-effective.

Master Lease Agreement

If you are lacking the down payment or credit to buy a property that has been neglected and needs repositioning, consider acquiring it with a master lease agreement. This is a lease with an option to purchase a commercial property. Sellers are the most open to doing this when a property has been on the market for a long time and they need to sell due to financial hardship or low motivation to maintain the property. A master lease option can be a great tool during a recession when conventional financing is more difficult for buyers to obtain. Here's how it works:

• You approach a seller to take over all the financial and operational responsibilities of running the property by putting it on a master lease. You tell them that you can only put 10–15% down on an agreed-upon purchase price because you will need to put money into improving the property. In exchange, you will be getting an option to purchase the property at a set price in three to five years. You will receive equitable title and the seller will retain legal title.
• You receive all the income from the property and pay monthly payments to the seller until you purchase the property or the master lease agreement expires.
• You are responsible for managing the property and paying all the expenses for the property, including taxes and insurance.
• You have control over doing operational, cosmetic, or constructional repositioning upgrades at your expense.
• You also receive the tax benefits of the property.
• You can purchase the property at any time during the agreement and receive legal title. If your repositioning project fails, you have to continue making payments to the seller, but you can give the property back when the master lease agreement expires.

Nonperforming Mortgage Note Purchasing: You can get up to 30% free equity in a property buying a nonperforming loan

Another way to acquire commercial properties that need repositioning is to buy nonperforming commercial mortgage notes from banks with the intention of foreclosing. This might sound like a mean and predatory way to build your commercial real estate empire, but if you have the appetite for it, it can be highly profitable. These notes can often be purchased for 90% of their face value, so you could be earning 10% equity out of the gate. For more in-demand properties, you have to pay 100% of the note value. Then, once you foreclose, you acquire the property owner's equity, which is often 20% or more. These properties have often been mismanaged and are ripe with repositioning opportunities.

The best time to pick up a nonperforming note is seven months to a year after the start of a major recession. Bank regulators will pressure banks to get new valuations on the commercial properties they have on their books. If they have gone down in value, and they usually do, the bank will call the loan due and payable (yes, they can do that even if the borrower is current) and give the borrower on average three months to refinance elsewhere. If the borrower is not able to pull this off, the bank will likely prefer to sell the note than to further distress themselves and the customer.

Once a borrower has missed three payments, the mortgage is considered nonperforming. The bank will then refer the loan to their special asset department. It's strange to call these bad loans special assets; I am told that the intention here is to fool shareholders. “Special assets” listed as an asset on a bank's balance sheet sounds like something special, doesn't it? Banks sell these notes when they need to increase liquidity to meet regulatory requirements.

To purchase these notes you have to have either cash or a line of credit. You can also use a hard-money lender, who will take a collateral assignment of the note. If there is 35% or more equity in the property, you can sometimes borrow with very little down. It's best to get the loan for a minimum of two years to give you more than enough time to foreclose on the property, and it's best not to buy a mortgage note in a small town where it can be difficult to keep the property occupied. Stick with communities of 75,000 or more, which will also make it easier in case you need to sell the note. Call a commercial loan officer at any bank and ask to speak to their special asset manager to find out if they have any commercial mortgage notes for sale. You can also subscribe to distressedpro.com, which can refer nonperforming notes to you, along with the name of the decision maker at the bank or credit union holding the note.

Operating Budget Pro Forma: This is your blueprint for how you expect the property to do once it reaches stabilized occupancy

Creating an operating budget for the property you are repositioning for once it reaches stabilized occupancy (see Encyclopedia Topic B, Due Diligence), is critical for maintaining goals for rental income and expenses after repositioning is completed. This is so important because a budget creates the expectation for hitting and maintaining a net operating income that will increase the property value. Start out by preparing a pro forma of rents for each unit or space. Then project rental income and expenses month by month for the first two years after the property is stabilized. Prior to doing the operating budget pro forma, you will need this to create your repositioning pro forma (see later in this Topic), which shows how the property will perform during repositioning.

A property manager who has experience in your commercial property type can help you determine market income and expenses for the budget. They will research existing leases, vacant spaces, lease rollover, and rental concessions to come up with a realistic budget for rental income. Then analyze historical expenses, vendor contracts, and planned capital improvements for the budget. Your permanent loan lender will require you to submit an operating budget with your loan package. You can find an example of a seven-year budget pro forma (the Seven-Year Month-to-Month Budget and Summary Spreadsheet) in Appendix A and a downloadable Excel version on my website: https://apartmentloanstore.com.

Operational Repositioning Checklist: These can greatly increase property income and value without costing much at all

Operational repositioning changes give you the biggest bang for the buck since most cost only your time. Go through this list and choose as many as you can to implement. Most either do not cost anything or cost $250 per unit or less.

• ___ Raise rents and lower expenses
• ___ Make units or spaces rent-ready
• ___ Fill vacancies
• ___ Clean and remove junk
• ___ Replace poor-quality tenants
• ___ Renegotiate longer-term leases
• ___ Change signage
• ___ Rebrand the property
• ___ Design a new website
• ___ Change the tenant mix
• ___ Change management companies
• ___ Implement a water conservation program
• ___ Lower property taxes
• ___ Add vending machines
• ___ Rent parking spaces
• ___ Install security cameras and security signs
• ___ Charge a pet fee
• ___ Lower insurance cost
• ___ Competitively shop vendor contracts
• ___ Instigate a ratio utility billing system
• ___ Create a new Facebook page

Raising Rents: Higher rents mean a higher net operating income, which means a higher property value

You have to raise rents when repositioning to increase property value. It is a false assumption that just making a commercial property look good will create a higher appraised value. This is because the income approach in a commercial appraisal is king and will overtake any first impressions the appraiser might have about how great the property looks. The capitalization (cap) rate originates from this approach in the appraisal. Read on about why this has the most influence on appraised value.