🚨 There may be a CRE crisis brewing...

Hello, Best Ever Community!

In today’s newsletter, CRE Daily sounds the crisis alarm, Joe Fairless unlocks the power of depreciation, and we reveal how one investor achieved a 45% property value increase in under two years.

Plus, if you haven’t already, make sure to sign up for the Best Ever Book Club. November’s book is Stillness Is the Key by Ryan Holiday.

This week’s newsletter is brought to you by Rentec Direct, the property management software that offers an all-in-one platform for accounting, marketing, tenant screening, rent collection, and much more. Learn more about Rentec Direct here.

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Off we go!

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TOP 5 HEADLINES

🧠 Elon Musk’s Smart City: ​​Several billionaires have announced plans to build their own smart cities in recent years. But so far, some — like Elon Musk’s planned city of Snailbrook — have run afoul of residents and regulators.

❄️ Rent Rises Cool, Inflation Follows: According to the Consumer Price Index, inflation was flat in October, bringing the annual inflation rate to 3.2% — its lowest pace since June — amid cooling rent increases.

🏦 Fed Senses Trouble: The Fed's November report calls out risky commercial real estate lending as a problem area despite asserting banks' overall soundness and adequate capital/liquidity levels.

🧐 SEC Wants Answers: A real estate investor is the subject of a government inquiry into an offer to buy 51% of WeWork for $9 per share, a sizable premium to its share price.

🏆 Office Vacancy Tops GFC Record: The office vacancy rate increased by 30 basis points for the second consecutive quarter and sits at 16.7%, putting it 40 bps higher than the record high during the Global Financial Crisis.

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MEZZANINE FORECLOSURE SURGE SIGNALS CRISIS

Presented by:

The commercial real estate sector is experiencing significant distress, evidenced by a rising surge in foreclosures, particularly in high-risk mezzanine loans.

Mezzanine Loan Distress: So far this year, there have been 62 foreclosure notices for mezzanine loans and other high-risk loans, more than double the number for last year. The increase in mezzanine-loan foreclosures provides a real-time indicator of distress in the CRE market compared to the longer process of traditional mortgage foreclosure cases, which can take years to surface.

Filling the Gap: Following the 2008–09 financial crisis, mezzanine loans emerged as a key financing option. With big banks becoming more risk-averse due to regulatory pressures, property owners turned to alternative sources like smaller banks and nonbank lenders for these high-interest loans. This trend was further fueled by firms such as Blackstone, KKR, and Starwood Capital, who found the high yields of these loans (often exceeding 10%) particularly lucrative compared to the low returns on long-term government bonds.

When the Tide Goes Out: However, the recent decline in real estate prices has led to a wave of defaults in mezzanine loans, revealing new vulnerabilities in property finance since the 2008–09 crisis. Terri Adler of Adler & Stachenfeld notes that borrowers increasingly cannot maintain their investments, prompting lenders to reclaim properties. The opacity of mezzanine loans, which aren't listed in property records, makes tracking their total volume challenging.

Case in Point: The Margaritaville Resort in Times Square, a celebrated 32-story tower with a pool, fell victim to the mezzanine loan crisis. Opening in July 2021, its developer, Sharif El-Gamal, secured a $57 million mezzanine loan on top of a $167 million mortgage when interest rates were low. By March this year, he defaulted due to rising interest rates, tight capital markets, and unoccupied retail space. The property was recently acquired through a foreclosure auction.

➥ THE TAKEAWAY

Why It Matters: The sharp increase in interest rates for mezzanine loans, now often exceeding 15%, has significantly heightened the risk of defaults and foreclosures in the commercial real estate sector. Previously, these loans were more manageable with rates around 10% to 12%. The difficulty in refinancing these high-cost loans upon maturity is leading to a growing number of financial crises, reminiscent of the complex, multi-layered mezzanine loan structures that funded large deals prior to 2008. This trend marks a concerning shift in the landscape of commercial property financing.

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FROM JOE FAIRLESS

For active real estate investors seeking to gain a deeper understanding of the tax implications for passive investors, five crucial elements are essential to comprehend: the depreciation benefits, accelerated depreciation via cost segregation, depreciation recapture, capital gains tax at sale, and the 1031 exchange.

📉 Depreciation: Depreciation is the amount that can be deducted from income each year as the depreciable items at the property's age. The IRS classifies each depreciable item according to its useful life, which is the number of years of useful life of the item. The business can deduct the full cost of the item over that period.

💵 Cost Segregation: Cost segregation is a strategic tax planning tool that allows companies and individuals who have constructed, purchased, expanded, or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring income taxes. 

🔍 Depreciation Recapture: Depreciation recapture is the gain received from the sale of depreciable capital property that must be reported as income. Depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis. The difference between these figures is “recaptured” by reporting it as income.

Grasping the intricacies of tax considerations for passive investors provides valuable insights into maximizing your investment strategy and optimizing your financial outcomes, making it an essential knowledge bridge for a well-rounded real estate portfolio.

👉 Read the full article for more. 

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45% PROPERTY VALUE INCREASE IN UNDER 2 YEARS

Drew Breneman increased this property's value by 45% in under two years and sold it after six years at a 2.3x equity multiple and 45% IRR. Here's how he did it. 👇

🏢 Property Details: Six units in Chicago, IL (Logan Square) purchased in 2015. Class A/B, 100% occupancy, 2012 build.

💸 Finances: Purchase price was $1.65 million with $400,000 in capital raised. Freddie Mac SBL, five-year fixed, one-year interest-only, 3-1-0-0-0 prepay.

💼 Business Plan: Bought from a local condo developer with rents well below market. Moved all rental rates to market rates, charged separately for parking, and obtained multiple property tax reductions.

🍾 Results: Sold in 2021 for $2.15 million with a cash yield of 28%, 45% IRR, and 2.3x equity multiple. 20 months after the acquisition, Drew closed on a refinance with a loan balance of $1,912,000, above the initial purchase price by $262,000. From the date of purchase to the date of refinance, he distributed 165% of the initial cash equity invested in the project.

If you have a deal you'd like us to feature, share it with us!

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FREE DOCUMENT DOWNLOAD

💸 The Three Main Apartment Syndication Accounts

Embarking on an apartment syndication journey? Understanding the key accounts involved in asset management is crucial for a smooth and successful operation. In this article, we'll delve into the three main apartment syndication accounts that play pivotal roles in the management of your investment.

👉 Download now!

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Hope you have a Best Ever rest of your week!

—Joe Fairless