Podcast: Defining Value in Commercial Real Estate

Updated on September 3, 2020

The Private Equity Real Estate Podcast – Show 11

               

               

Summary

On today’s episode, we have the cofounders of First National Realty Partners, Tony Grosso and Chris Palermo, discussing how they define “value” in commercial real estate. 

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Announcer:
You’re listening to the Private Equity Real Estate podcast, brought to you by First National Realty Partners, where investors learn from private equity experts and insiders. We share our own real world experiences so you can know exactly what it takes to be highly successful at investing in passive commercial real estate opportunities.

Nick Cucci:
Hey everybody, welcome back to the Private Equity Real Estate podcast, brought to you by First National Realty Partners. This is the ultimate resource for passive real estate investors. I’m your host, Nick Cucci, and on today’s show we’re going to look into defining the meaning of value in commercial real estate. We have the co-founders of FNRP with us today, Tony Grasso and Chris Palermo, and they are going to be discussing what value in commercial real estate means to them. Enjoy.

Tony Grosso:
In my opinion, all value in business, whether it’s commercial real estate, whether you’re buying a firm, in any industry, it all comes down to a cash flow stream. That’s what everybody’s after, whether you’re a developer, who’s looking to buy a piece of raw land and build something on it and then get out of it and sell it, he’s ultimately building to a cash flow stream. If you’re a biotech investor and you’re investing in a company with no earnings currently, the ultimate end goal is to get out of that company significantly higher based off of its ability to earn cash flow. And in commercial real estate, that’s the name of the game. It all comes down to cash flow. And there’s really three important things I look at when it comes to cash flow when you’re looking at an income stream. It’s the longterm or the year-over-year growth of that income stream. What are its prospects to go higher and higher and higher? How long does that cash flow stream look like? It’s going to pencil out. How long is it going to be around for?

Chris Palermo:
Sure.

Tony Grosso:
And then ultimately, what is the actual strength of that cash flow stream? In the commercial real estate business, is it Joe Blow, the plumber who’s on skid row, who can go out of business any day now? Or is it a multinational corporation with a healthy balance sheet that always has a tendency of paying? So that’s what it comes down to, values, is ultimately a cash flow stream. How long is it going to be around? How strong is that cash flow stream? And what is the ability to grow over time as far as that cash flow stream is concerned?

Nick Cucci:
Chris, did you want to comment on that?

Chris Palermo:
Yeah, I think that value is literally you’re buying something at a perceived, let’s say price or value that you think that you can get more out of it, whether it’s value in somebody’s ability to add value, value in a specific tangible piece of property where you can buy it, and let’s say it’s worth $10, but you can get it for $7, and you know you can get $10 out of it, or value is having something that may not even be producing, but you can add in a few certain things to be able to drive value. So value takes many definitions, but it’s being able to get something less than that you know that you could be able to get rid of more than.

Nick Cucci:
Right. That’s a great perspective. Did you want to add something, Tony?

Tony Grosso:
I think in commercial real estate, we look at cap rates in each market. You might go to Manhattan, and a building might be trading at a four cap. And if you took those same exact tenants and that same exact building structure… Let’s say it’s a million feet… and you moved it into the middle of the country, the cap rate might be higher. So what the cap rate’s way of valuing a particular piece of real estate, what it basically does is give the marketplace’s opinion of those three things that I mentioned earlier and what the marketplace perceives as the value. I’ll give you an example. In commercial real estate, rental rates going higher all comes down really to population growth and being in a market where people are coming into, which ultimately drives more commerce, which drives rents higher. So people that are on the coast in some of these markets like Miami and Manhattan and let’s say San Francisco, they’re willing to pay a much higher multiple of cash flow. They’re willing to overspend or spend more money than, say a guy in the Midwest might because that income stream is perceived to be stronger, more durable, have more life going on at the time. So ultimately, what a cap rate is is the marketplace’s determination of that income stream and how long it’s going to be around.

Nick Cucci:
Yeah. That’s a great explanation. So ultimately when it comes down to value, you’re saying you look at three areas, right? You’re looking at the tenants. You’re looking at the length of the leases and the area of the property, and all have different, I guess, areas of value and have different multiples of value depending on the situation?

Tony Grosso:
Sure. And Chris, you mentioned something earlier that I wanted to kind of circle back on. And before I even do it, it’s funny because we look at a lot deals. We’re always looking. We’re always in acquisition mode, and you always see brokers… It seems like for every deal nowadays, you see there’s a value add deal. And Tony, you actually mentioned something on one of the other episodes. They’re going to add new countertops in an apartment building, and all of a sudden it’s value add, and everything else. Going off that notion, Chris, the idea of value add, what area do you like to see within a deal itself that you could potentially add value to that’s most valuable to you specifically? Is it in a lease up of more space or maybe getting extra rent or better tenants? What would you see as your focus?

Chris Palermo:
Well, what’s funny is that in real estate and acquiring real estate, whether you’re in multifamily, flex, retail space, there’s always some metrics of value that you think you can bring to the table. And the reality is that there’s no aerial view photo answer for that. It really isn’t a deal-by-deal basis. Sometimes it might be tenants that are currently there that are well below market rents in need of a fit-out, and which you can, number one, extend term, like Tony was talking about, plus also add more rent. Or let’s say you have a deal where you have some vacancies. You might be able to fill some of the vacancies and add value that way. But in any deal, in any transaction, even outside of real estate, especially if somebody wants [inaudible 00:06:11] work, you want to be able to try to identify and see how you can specifically add value. So it comes in many shapes and forms.

Tony Grosso:
I think that there’s really three ways that you can add value to a specific building. Number one is you can increase the net operating income, whether that’s through a couple of things that Chris talked about, simple as adding a new tenant, taking your net income from a million to a million one hundred thousand. It’s as simple as that. The other way is you increase the term of some of the leases. The theory is that a longer term lease, the tenants are actually going to be there, they’re going to pay that term, there’s a little bit more predictability than a guy who even might be in a great market, has a six-month or one-year lease. And then the final way that you can do it is you can add better tenants. Like I talked about earlier, a Fortune 500 company with a great balance sheet is looked at in the eyes of real estate investors differently than Joe Blow who’s been in business for six months. He’s a startup. He’s a high-risk situation. So that’s it. I mean, just like the three things I talked about. You either increase your net operating income, you increase the length of term on the leases, or you increase the strength of that cash flow by putting in tenants that strengthen that income stream, so to speak. That’s how you increase value, in my opinion.

Nick Cucci:
Yeah. No, it’s a great perspective because ultimately, I mean, when you said it earlier, and you hit the nail on the head, you’re buying an income stream, and you want to be able to increase the income stream you’re getting. So whether that be add a tenant or increase the rent that the tenants are paying or get longer lease terms to make the deal more financeable down the road.

Tony Grosso:
And it’s crazy is there’s a phenomenon in commercial real estate, which is, let’s say you bought a building 50% occupied, and you leased it up to 95%. Obviously, you’re, in theory, increasing your net operating income. Let’s say it’s $2 million. You lease it up. Now it’s three and a half million.

Nick Cucci:
Of course, yeah.

Tony Grosso:
But an investor, since that situation is now stabilized, you might have bought the property at a 10 cap, but because the thing is stabilized, you can now turn around and sell it at a five cap because it’s perceived as a stable situation. Comes back to what I was talking about, the stability of that income stream. So what you can do is not only increase the value of your building by just simply increasing your operating income. You also have a cap rate flip because you’re not selling it at the same 10 cap multiple. Now it’s stable. You’re selling it at a five cap multiple, just 20 times earnings. And guys, this is just an example, but there’s really two ways that you can look at it. It’s the increasing of the income stream and then ultimately decreasing the multiple. Or it’s just increasing that multiple of income to get more profit on the exit.

Chris Palermo:
Because ultimately, what Tony is trying to say is that the cap rates are a measure of risk in the deal. So it’s very simple. More income, more tenants, less risk, the more of a premium a building can sell that. So that’s usually the fundamental basis of a lot of operators like us in this type of business try to follow. So when we’re going into a deal, we always have that value plan on how we’re going to take the situation from X and get it to Y. And it’s 100% of metrics of how long are you going to receive the income? How much are you going to receive? And from how many tenants in a credit worthiness of those tenants that are going to dictate what those numbers are? And then lastly, of course, as Tony was saying, geographical area. If you have a place where you have increasing demand, increasing incomes, increasing populations, it’s going to be more expensive to buy property in those areas.

Chris Palermo:
Nevertheless, you could find yourself in very profitable situations. Like we see a lot of the multifamily operators, they’re buying these buildings that are dated from the 80s. They’re completely re-fitting them with new kitchens, bathrooms. And sometimes in these areas… In California, we see it all the time… by the time they get it back on the market… They bought it at a five cap. Let’s say the rents were at 1500. Now they’re offering rents at 2,500. So the money they laid out to do that space, they’re making 30%, 40% off. And what happens is now they can actually sell it, like Tony was mentioning, at a low cap rate. So you can find the value. You just have to be able to see it.

Chris Palermo:
And what I would say is this, if you have a plan, you have to make sure you can stick with and follow through with your plan. The big challenge with, let’s say construction or reconstruction is sometimes you don’t know what’s behind the walls. You don’t know what issues you could have. You have a specific number budgeted versus a specific outcome. And if you run over those budgets, you might not be able to sell out or refinance out as much a profitability because it cost you more to get in that situation, which we see happen all the time.

Tony Grosso:
And you know what? It really is an age old battle. What do you do? Do you go into a market, a tertiary market, and buy at a higher cap rate, which is going to give you a higher cash-on-cash return out of the gate? Or do you go into a primary market and buy at a lower cap rate? The theory, though, is there’s going to be more demand for a population growth, so rental rates are going to go higher. And there really is no answer. Everybody has their own style of investing. Today’s 12 cap in the middle of the sticks might be tomorrow’s four cap on the purchase price that you actually bought it. Whereas you might go into Manhattan, buy it a four cap, hold it for 10, 15, 20 years. It might not turn into a 12 or 13 cap on your purchase price, which you can now ultimately flip back at that four or five cap rate. So there’s no real answer. The marketplace kind of sets value, but the investor ultimately has to determine is that tertiary market worth stepping into? Is that older building worth buying at a little bit of a higher cap rate, getting a bump, and getting a little bit more cash-on-cash out of the gate? If that makes sense.

Chris Palermo:
Well, you know what’s funny is that I was speaking with one of our investors who invested in a lot of our deals earlier today, and he’s a guy that’s been around for a long time. And one of the biggest values, believe it or not, are the operators, are the guys who actually manage the properties and have specific specialties. So there are guys that specialize in in re-renovating multifamily and getting it in, and they have it down to a science. I mentioned that because he told me one time that he was in Kentucky. He was at a basketball game, university basketball game, and Colonel Sanders, who was the founder of KFC-

Nick Cucci:
The Colonel Sanders?

Chris Palermo:
The Colonel Sanders. First thing I asked, “Well, how did he look?” He said, “Exactly like how we did on the boxes.” So for whatever reason, this guy was a budding entrepreneur at the time. The guy now is in his late 70s. I would guess at the time he must’ve been in his late 20s. And he said, “Well, what made you so successful?” And this is, I guess, as Colonel Sanders was starting to become successful. He said, “We only do chicken.” And he thought it might’ve been an area of real estate. No, he specialized in chicken. He knew he would put a dollar in. He would get a dollar 50 out. For example, it’s the same thing with operators, and that’s why you’ll have certain firms that you hear stories, they’re buying it four, five, three cap rate. They make it work because they understand exactly what they’re doing.

Nick Cucci:
Sure. Yeah, having a specialty is key. And it kind of touches on our last episode, having the right people in place, having the right team around you-

Chris Palermo:
Absolutely.

Nick Cucci:
To be able to actually go out with the plan that you initially put in place. So Tony, I want to ask you… And then Chris, I’ll come back to you in a second… is there a deal that kind of sticks out to you that you’ve done in the past where you saw it as a good value opportunity and you had a game plan and you were able to execute it? Is there one that just kind of stands out?

Tony Grosso:
No, based on what I touched on a little bit earlier, I think one of the areas you got to be careful with is when you’re buying, you’re chasing cap rate, so to speak. I don’t have one specific deal of reference, but when you look out of the gate that a cap rate may be 12 or 13 or 14, and then you get into the deal and you realize, yeah, you underwrote it a 13 or 14, but maybe it’s older, so there’s a bunch of ongoing repairs that you have to do. You didn’t do a full rehab out of the gate. So, I mean, that was definitely a lesson in value. And I think ultimately what it comes down to when you’re getting into these deals is not what is your cash flow today, but what is your cash flow going to be into the foreseeable future? You going to be able to lease the building? You bought it at a 15 cap. That’s tremendous. That’s great, but you can’t lease it to anybody. You’re just stepping into poo, so to speak.

Tony Grosso:
So the more utility there is to the asset going forward is really the most important thing, is that how is the marketplace? How are businesses or people that are renting apartments? How are they going to look at this building going forward? Is it going to have the same appeal that it does now? Is it going to have more appeal? Is it going to have less appeal? And for us, we like to buy in secondary markets that are growing quickly, places like Columbus, Ohio, Boise, Idaho, Orlando, Florida. We like to look at those markets because it’s not so mature, like say San Francisco or New York.

Nick Cucci:
Sure.

Tony Grosso:
But you’re going to get the population growth there. And speaking about cash flow stream, those are the types of markets where the population coming in is ultimately, in our opinion, going to increase the value significantly over time, naturally, not through evaluative component that we’re talking about now, but just natural market forces will take it higher.

Nick Cucci:
No, interesting perspective. Chris, you had something on that?

Chris Palermo:
Yeah, I mean, look, to answer your question directly, every single deal that I’ve executed or that Tony and I have executed as the First National Realty Partners has been a value add. One might’ve been a short-term lease with the anchor that we extended 10 or 20 years. One could’ve been a little bit of vacancy that we filled out, but every single deal that we look at, whether it’s core, whether it’s value add, has a specific component of value. The value could be that the owners of the center are 95 years old, they want to retire, and you’re buying something significantly below replacement cost.

Nick Cucci:
Sure, right.

Chris Palermo:
Every single deal that I can think of, whether it was doing a full fit-out, filling up vacancies, it had some level of value because that’s what you’re in the business for. You’re in the business for buying something that you can either bring to perceive or is worth a dollar for 60 cents, for 70 cents, and know that it’s worth that.

Nick Cucci:
I tell you, Chris, I love that. And before I segue, actually I just want to mention don’t forget you can go to our website, fnrpusa.com. Both Tony’s and Chris’s bios are on there, and you can check out some of the information we have, some of our past podcasts. That’s fnrpusa.com. And Tony, Chris mentioned something, and I want to segue to it because you had mentioned it in something you mentioned earlier too, and that’s the idea of the value that tenants bring. Can you get into that a little bit, the value that maybe a National tenant versus a mom and pop and [inaudible 00:17:03]? Can you get into the tenant itself and the value that they could bring?

Tony Grosso:
Yeah, ultimately what it comes down to is the durability of that income stream. And in commercial real estate, we talk about tenants, but you could look at really any business. Think about it. If you’re in the passenger railroad business, your prospects of cash flow may be completely different a century ago than they are today. Everybody follow me on that? In commercial real estate, the utility going forward is ultimately, or the value of a piece of real estate comes down to not only who the tenants are from a credit standpoint, but will that product type be viable going forward? And will those tenants who are running those businesses be viable going forward? Which is why commercial real estate, it’s constantly a shifting landscape. It’s a slow-moving landscape, but it really does shift one way or the other. One style or one product type may be obsolete to an extent, whereas one today might be booming as time goes on, which is why you see cap rates ultimately determining industrial is hot or multi-family is hot, but retail, big box or regional malls people are staying away from because the real estate is changing.

Tony Grosso:
And it ultimately comes down to the tenants and then the strength of those tenants and the viability of their businesses going forward. And what’s going to happen to rental rates going forward comes down to those tenants and the viability of their business. We like to work with National brand tenants when possible for two reasons. Number one, it’s easy to have a relationship and do new deals, but more importantly, they have the credit, they pay on time, and short of them going in solvent, you’re not going to have issues. When you have more mom and pop guys that don’t have that same credit worthiness or that same financial clout, it’s a little bit more difficult for them to pay rent sometimes, say the National guys. And it’s not to say that… I’m a small business owner. It’s not to say that small business owners don’t have the ability to pay. Just as a rule of thumb, working with National guys, they have that strength. It gives that income stream tremendous amount of durability. And when you go to sell, like Chris was talking about investors, look at that tremendously.

Chris Palermo:
Yeah, and I just want to say, to his point, though, you have to be very careful also with National brands and where you’re located. Sometimes having a National brand that has a big majority of your center per se, you have to make sure that there isn’t other more suitable sites that they want to go through. So you have to look at where your tenants are. Where are they looking to go? What size space are they in now? And is that a part of their business model? It’s just like anything else. We’re giving you the fine brushes to it, but the art of it all is being able to put it all together and to perceive what you have ultimately is the value that you think it is.

Tony Grosso:
And one of the biggest contributing factors is what Chris just talked about, is the actual site, that income stream durability. Is it going to be around a long time? You talk about market. You talk about sub market, but let’s just talk about retail. If you’re on the best hard corner and the best market and the best sub market, best part of town, your income stream is going to be looked at differently than if you’re on a highway with no corner and you’re back off the road a little bit with poor visibility. So the actual site and the location obviously is huge when it comes to determining, not only your net operating income, because your rental rates based on that site are going to be high if it’s a great site, but also the durability going forward if tenants are going to do well in this space.

Nick Cucci:
Yeah, that’s a good point. So not only on better locations can you get higher rents for your tenants, but also the risk you take on of a tenant leaving, it’s easier to backfill that space with somebody when you’re in a prime location versus in the back of the woods or off a highway with no traffic signal or something like that. So yeah, no, that’s a good point in terms of the value. What I would also be curious to get your kind of thought process on is the length of leases, because you mentioned that earlier, and that’s another component that brings value to properties, the length of the leases. What’s the ideal length for you? I mean, how long do you typically like to sign your guys on for? Is there a set period where you’re looking… Or I want to get a five-year extension, 10-year extension. I don’t want to go past a certain amount of time. I mean, what’s your thought process for the length of leases?

Tony Grosso:
We want leases to be as long as humanly possible with as much increases as humanly possible. That being said, you don’t want to kill any tenants. You want them to be able to pay their bills and be there a long time. You don’t want to do a one-sided deal. Everything you do has got to be a win-win. The same thing comes down to when you do your leases as well, but ultimately, an investor values a property based off the term of the lease, especially out of anchor tenants or if it’s a single tenant deal, the length of that lease [crosstalk 00:21:44] because at the end of the day, like I said, we’re talking about here, you’re buying an income stream. You can go after a center. Let’s say you’re going after a 200,000 foot grocery anchored center, and the grocer’s in, say 60,000 feet. If they have one year of term left on their lease and you have no insight to how they’re doing and no relationship with that tenant, you’re buying it sight unseen. That’s a risky position.

Nick Cucci:
Sure, yeah.

Tony Grosso:
By having a longer term lease, you take a significant amount of risk off the table. And that’s ultimately what we’re talking about here because that income stream is perceived as being around much longer, let’s say it’s a 20-year lease or a 10-year lease, than if a guy is in there for a year. Now, look, people default. Things happen. Not everybody holds up to their end of the bargain, but value is all about perception. And that long-term lease is literally what can take a property… You’ve could the same exact property, the same tenants, the same net operating income. If your anchor’s there for 10 years, it might trade at a five cap, whereas if he’s there for one year, it might trade at a nine cap, which is why if you’re an operator, you’re an entrepreneur, you have a relationship with these tenants, you’re willing to go the extra mile, you can go into with. We do this all the time, and we see that they’ve got a year left, but we know that they’re going to stay. We’re working behind the scenes to execute a extension or an option. You talk about value. There you go right there.

Chris Palermo:
Yeah, and I think it’s an art of being able to negotiate. You hear people say, “Well, if you sign a 20-year deal, and let’s say a level deal, well, inflation is going to rise over that period of time.” I 100% agree. The key is to try to be able to be creative in a way where you’ll always have increases, even if the tenants don’t realize it. We’ve done in the past, we’ve had a couple of pharmacy-anchored centers that wanted to do level deals, but they wanted to go term, which for us is phenomenal because we’re going to get that huge value. We’re selling it at a lower cap rate that we bought it, which is the best of the best. But what we did was, is where we put it in there and our contracts that we can increase the cabs so that we’re able to keep pace with inflation. So each year the base rent is going slightly higher to keep pace with inflation. So we try to work different deals in, but ultimately you want to be able to have a term. You want to be able to be creative. And if you’re able to accomplish that, you’re not only reducing your risks, but you’re making the property more marketable because, again, like Tony said, a hundred times during this cast, it’s all about buying an income stream, and that’s the most important thing.

Tony Grosso:
And we’ll do from time to time, and what a lot of savvy operators will do, they understand value. That’s what we’re talking about here. Sometimes you’ll give a tenant a break. You’ll even reduce their rent to get more term out. You say, “Well, why would you ever give somebody a break or decrease your income stream?” At the end of the day, a lot of times the length of the income stream is more important than the actual number. Now, you can’t go crazy and bring your rental [inaudible 00:24:35] to zero. There’s got to be some cash flow to run a multiple offer, but sometimes having term, having security, having a longer, more durable perceived income stream is better than having an actual higher one from a dollar standpoint.

Nick Cucci:
Yeah, phenomenal point.

Tony Grosso:
Which is why guys go into deals, and they’re willing to go into California at a four cap, or they’re willing to go into Manhattan at a four and a half or five cap, because the perceived notion of that property is that longer term, it’s going to be worth significantly more. Otherwise, everybody will go into the weeds and buy 12 and 13 cap.

Chris Palermo:
Yeah, and that’s why I love parceling nothing more than getting one of these tenants on a short term lease and spending money back into its space, because instead of going, let’s say lower or leveling, you’re going to increase the rent, but the money that you spend, you’re going to get a huge return on on an annual basis. And the appreciated value is… A lot of properties we’re buying at, let’s say a below 10 cap rate. So you’re making it a higher metrics of what you invest. It ends up becoming a super home run for us because we’re showing on our income statement a higher income for a longer period of time with new construction going in, which means we can sell it out the back door, refinance it, or value it at a significantly lower cap rate, which means a higher price.

Nick Cucci:
Right, phenomenal.

Chris Palermo:
That’s phenomenal.

Nick Cucci:
Yeah. No, that’s a phenomenal point because it’s just like you said earlier, Tony, I mean, getting 50,000 less in income to maybe be able to get an extra three points in the cap rate… Maybe before it was a nine cap. Now you’re getting a six cap. Even though your income stream is lower, you’re getting that better cap on the purchase price or the value on the property is better, even though your income’s lower because you had the stability from the length of the lease. I love that point. And Chris, yours was duly noted also. Tony, one question I have for you. When you guys are looking at deals, how do you know you’re getting value? When you’re looking from deal to deal, from the offer standpoint, you’re comparing things. I mean, how do you really know that you’re getting value on a property, that you’re eventually going to pull the trigger on, and this is going to be the one?

Tony Grosso:
So when we’re sourcing acquisitions and we’re looking at deal flow, we’re running models, we have a good handle on what the marketplace is determining value. Let’s say the market that we’re looking at is saying that this property should trade a seven cap. What we try to do is always buy at a great discount to intrinsic or market value. So we’re not opposed to going into Manhattan doing deals. We’re not opposed to going into Amarillo, Texas and doing deals. We do deals all over the country. Each market is a little bit different. You have to really understand the markets that you’re buying. Now, you might go into Manhattan, and let’s say you’re looking at a building, and it should be valued at a four cap. If we can pick it up at a six or a six and a quarter, we’re willing to do it all day long.

Nick Cucci:
Yeah, that’s great value.

Tony Grosso:
Whereas you step into a different market. Let’s say you’re in Texas somewhere or in the Midwest somewhere… And Texas is hot. It’s a bad example, but somewhere in the Midwest, and a property might be trading at an eight cap, but you say, “You know what? This thing should be trading at a 10 cap. We’re not going to touch it.” So for all the reasons that we’ve been talking about, it all comes down to buying below intrinsic value. We say we try to make our money on the buy every single time out, and it’s absolutely true, which is why a lot of times we find ourselves buying core deals from very motivated sellers, because we don’t have to get in and do a lot of work to create that value. We’re able to work hard, source a lot of deal flow, find a guy that’s very motivated, and literally just buy at a discount to intrinsic or market value. And that’s a bonafide strategy. You want to add to that?

Chris Palermo:
Yeah, I mean it’s very simple. And this is one of the sound real estate principles. You want to be able to buy below replacement cost. If you’re able to buy what it’s going to cost somebody else to come in and build something new, you’ll always be more competitive on the rent. Everything else is a prerequisite. When it’s all said and done, you want to try to be able to buy below replacement cost, I think, is a real big one, especially centers that are immediately cash flowing.

Tony Grosso:
Yeah, and just to elaborate what kind of a Chris is saying there is, let’s say it costs $200 to build in a market, and you’re able to buy a center for $100 a foot. Now, if somebody comes in, they build a brand new product, same exact style of product at $200 a foot, they’re probably going to be newer. They’re going to have maybe a nicer facade, or they’re going to have more amenities if it’s an office building, but by buying a 50% of replacement cost and that situation, it’s almost impossible for them to keep up with your rent. You could get in there, you go spend $30 or $40. You bring it up to standards of, say a $200 building that it would’ve cost per foot, you’ve got the same exact product now. You only had to spend 30 or 40 [inaudible 00:29:26] for 130 or 140. So by buying below replacement cost, you take a lot of risk off the table when you’re going into a market because nobody can come in and develop and nudge you on the rent. Whereas some of these markets that are smoking red hot, guys can literally build and rent for cheaper.

Nick Cucci:
Right. And then what do you do?

Chris Palermo:
And some of these areas, they’re creating new heights in markets. In our neck of the woods, we’re actually seeing it up in a North Jersey, right outside of Manhattan, that people are buying buildings. They’re making minor fixes, and they’re creating different markets. Not necessarily my cup of tea, but again, it goes down to the Colonel Sanders theory. That’s what they specialize in. They understand it. They’re comfortable with it, and they’re becoming very successful with it.

Tony Grosso:
Yeah, in my opinion, in a market where you can buy well below replacement cost, you want to be a buyer. If it’s a smoking hot market, you want to be a developer. If cap rates are very low, you want to be in there repositioning or developing. If cap rates are very high, that’s where you’re going to find the value buying. And I mean, for that marketplace. Each market’s a little bit different, but that’s a good generic rule of thumb, and that kind of ties into buying below replacement cost.

Chris Palermo:
Yeah, and if you’re in areas, let’s say with less population, you want to make sure that, and you’re the only center in town, that you will only be the only center in town. There are many perceived values for many different ways. You have to be able to identify, number one, what the value is. And number two, most importantly, you have to be able to execute.

Nick Cucci:
So ultimately, basically, what I’m hearing from both of you guys, there’s a lot of layers to the idea of value. Everyone has got their own idea of what value is, different perspectives in different areas that value can be added at the end of the day. So I think you guys kind of hit on it. It’s up to the operator. How competent are you as an operator, as an investor? And how experienced are you to really navigate through your game plan and get the value that you thought you were going to get?

Chris Palermo:
Yep, 100%. Every deal has a sense of value, or else you don’t do a deal.

Tony Grosso:
Well, the marketplace is always going to determine value from a generic standpoint. The marketplace is going to say cap rates should be trending around this range. What I love about commercial real estate is that you can kind of sidestep that and find situations where you can just, for whatever reason, buy well below intrinsic or market value. Whereas when you’re in a traded securities marketplace, there’s a million buyers and sellers, the market sets the price. In the commercial real estate space, that’s true to an extent, but if you work harder, you hustle around, you can find situations where you can find gaps in that pricing. And that’s where savvy guys try to step in and make money.

Chris Palermo:
Yeah, and the stock market, the value that you perceive is what you think is going to be value. With commercial real estate, there can actually be specific identifiable value.

Nick Cucci:
Right, in terms of being able to raise the rents and leasing space and things like that?

Chris Palermo:
Give you an example. Literally buying at a competitive price because a seller is motivated is value. Whereas the stock market, you’re buying in at a perceived execution versus the perceived earnings versus what has already happened today. You can’t get Apple for say below what it’s trading today. With real estate, you can. Make sense?

Nick Cucci:
Yeah. No, it’s a great point, Chris. You guys both brought up good points to wrap things up.

Tony Grosso:
Yeah. I think just in closing, to kind of talk about and sum everything up that we’ve been talking about, is that all value in business, whether it’s in traditional business or commercial real estate business, it all comes down to an asset’s ability to produce cash flow. Whether it’s today, whether it’s some number in the future, whether you’re buying off of future perspectives or you’re buying for today, an asset’s value comes down to its ability to produce cash flow. And to take it a step further, it comes down to the perceived growth of that cash flow stream going forward. Is the stream going to go higher? Or is it going to go lower? Where’s the economy taking things? How is this piece of real estate going a fair moving forward in the marketplace? It comes down to the perceived potential length of that cash flow stream, which in our business, we talk about as traditional leases. And then it ultimately comes down to the actual strength. Are the tenants that are paying the rent? Are their businesses viable? Do they have good margins in their businesses? Does the product type have some utility going forward?

Tony Grosso:
And when you look at those three things, it gives you value. And that’s what the marketplace is predominately looking at, and that’s what we’re looking at. And I think that if you have a good handle on what value is, you’re going to be ahead of the game. Whereas a guy who doesn’t is probably going to get slaughtered, maybe not on every deal, but the chicken eventually will come home to roost.

Chris Palermo:
And in closing, and as I said a couple of seconds ago, it’s being able to be creative. It’s being able to identify the value and ultimately being able to execute to bring that value to life, whether it’s extending leases, filling vacancies, buying right, hiring the right people, saving the right amount of time. All of these are dimensions of value, which added up will create the ultimate value, which is being able to either A, sell your property at a huge profit, B, refi your property, or C, secure your income for a longer period of time.

Nick Cucci:
Just amazing thoughts from Chris and Tony on defining value inside of commercial real estate. I hope that everybody listening was able to find value in this. And we really appreciate you guys for giving us a listen. Thank you as always. This show is brought to you by First National Realty Partners, one of the top syndicates of private institutional quality commercial real estate in the country. If you’re interested in learning more about FNRP or would like to get access to our private offerings, please click the link in our show notes or visit fnrpusa.com. Remember that this show is for educational purposes only and should not be considered a solicitation to purchase securities or be construed as tax, legal, investment, or accounting advice. Thanks again for listening, and we’ll see you again next week.

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