Low Basis–The First Commandment

Low Basis

This is a brief overview of the first commandment of commercial real estate; Low Basis.

Acquiring a property at a low basis is an industry term for buying cheap.

Property that cannot be bought at a low enough basis can have a number of undesirable things happen—primarily the partnership goes bust or the buyer is stuck with a zombie (non-performing) property.

There are four ways to make money in commercial real estate: appreciation, depreciation, amortization and cash flow, it is important to be able to maximize success by giving yourself the largest room for error, black swan events or other market downturns. The single best way to do this is by buying cheap.

What happens if property is not purchased at a low basis?

It doesn’t matter if the property is stabilized in Coronado, California a ground up development in Lee’s Summit, Missouri or a value-add opportunity in Louisville, Kentucky if the property is bought at “retail” price (that is the full fair market value) the property may never cash flow and any sort of appreciation will be stunted compared to buying at a great basis.

Let’s get to the meat of it without involving numbers.

If a property is purchased at full retail price then the amount of debt placed on the property will squeeze any cash flow that would go to the partnership and unexpected costs or downturns will leave the partnership coming out of pocket every month for the privilege of owning the property.

In the same high cost scenario, if the partnership is banking on the appreciation approach as in many costal, gateway and other high demand MSAs then whatever bull market is running will have to continue to run to make the returns that the investors were promised. Since no one person can control an MSA, and certainly not in a gateway city like New York or Miami, the risk is significant.

Conversely, if a partnership was to acquire at a low basis then there is plenty of cash flow for the partnership to profit from or weather any economic storm that may occur. As I write this, we are experiencing a global lockdown due to Covid-19. The properties that are in our portfolio are still cash flowing while others are going bust in a big way. Simply because we honored the first commandment of commercial real estate!

Conclusion

Finally, while playing the appreciation game a property acquired at a low basis can be bought one day and sold the next day and the partnership will make a healthy profit. This is essentially an arbitrage technique and can be used at any time and has been successful for millennia—no need to change this tactic.

Any appreciation above and beyond; from organic (market) growth, cap rate compression or forced appreciation is bonus money and always makes the equity partners happy.

Below is a video that delves into the subject a little bit deeper:

Calculate your adjusted cost basis here, the National Association of Realtors provides a good worksheet to get you started.  Adjusted Cost Basis Worksheet

Next we will explore the second commandment of commercial real estate:  Be Dispassionate.

If you have any questions on whether you are getting a property at a low basis, Clarity would be happy to talk to you about your individual situation, the goals of the property, and to engage in a table-top or deep dive underwriting of your potential acquisition. Make sure to CONTACT US!