Financial Engineering and Real Estate Investing

EisnerAmper recently caught up with Abraham Bergman, Managing Partner at Eastern Union Funding, to get his insight into financial engineering in the real estate market.

EA: How has real estate investing changed?

AB: Rates are starting to rise. Now, with the Fed still offering a decisive “maybe” on the question of a presumed rate hike, some feel the measures taken in response to more stringent lending policies could make the bottom that falls out much, much deeper.

Historically, people bought real estate based on brick and mortar. Decisions were made based on the price per unit or square foot, and raw value was key in the bidding process. That way of thinking is not terribly popular any more.
 
I recently met with a stock market investor who wants to start investing in real estate. The investor’s investment focus is based on the measurement of returns. The measuring stick for the real estate investments hinges on better internal rate of returns than the typical average annual return of stock portfolios.
 
I believe that other investors and other real estate industry players have similar investment strategies. As a mortgage broker, I have seen prices exceed value on a daily basis since the market kicked into high gear. Investors know that even though a building purchased for $11 million might only be worth $10 million from a brick and mortar perspective, at the higher price with the right financial engineering they can earn 9% (in this case) on their money. That level of return is even more than the typical returns originally needed.
 
EA: How does financial engineering affect investing?

AB: Financial engineering essentially means additional cash flow and the flexibility it creates. Thanks in part to low rates and interest-only options, buyers have enough cash flow to cushion the steeper prices with more debt through mezzanine financing and preferred equity. And while banks are towing the line and not lending more than 75% of the building’s brick and mortar value, at 3% interest you can afford to take on pricier layers of debt and bring the financing up to 85%.
 
Historically, when interest rates rise, cap rates rise with them and therefore value goes down. In a normal correction, this would translate into a 10% decline in property value. A building worth $10 million would go down to $9 million. However, as explained above, in a financially engineered market, that same building was sold for $11 million even though it was worth $10 million. When the market corrects itself, the value of the building stands to not just go down -- it stands to plummet, in this case by $2 million.
 
Moreover, void of engineered flexibility, the cauldron of competitive investors shrinks overnight, leaving only regular brick and mortar real estate buyers and shortening demand enough to raise the fear of even further price declines. The result: The question in real estate of “what is this product worth?” will revert back to the old-fashioned mindset of hard and soft costs.