NetGain believes the differences in investment characteristics between bonds and income property are sufficiently significant to negate any useful comparisons. With two exceptions, NetGain doesn’t use the bond market for analytical comparisons between bonds and income property. The two exceptions are:

1. Triple net leases with a single tenant: This is not a real estate transaction. This is a credit arrangement with many similarities to a bond. The markets recognize this and adjust the value of the property accordingly to the changing interest rates.
2. Bond premium to capitalization rate: The bond rate yield premium can result from high yields and/or low capitalization rates. Two hundred basis points would be a very bare minimum to consider any analysis. The result of a premium could be a return on investment from the bond that is higher than the property. This is a viable analysis when the holding periods are minimally five-to-seven years, and the rating of the bond is comparable to a subjective rating of the property.

For investment purposes, NetGain believes the capitalization rate serves two critical functions.

1. As a general rule, NetGain doesn’t believe in negative spread (when the debt service APR exceeds the capitalization rate). As covered in NetGain’s essay“Three Strikes and You’re Out, The Real Estate Version,” the result of negative spread is a guaranteed loss when you borrow, and the more you borrow, the more you lose.
2. When utilizing a philosophy that encompasses a positive spread, the capitalization rate identifies what your minimum APR should be. The amount of the capitalization rate’s premium over the APR will determine what your leverage should be. Additionally, getting an accurate capitalization rate forces you to find the real operating expenses and the real income. This is vital for establishing an accurate baseline from which to make your future projections.

The amount of potential loss should be every investor’s first concern. Why? Because recovering from a loss becomes mathematically more difficult as the investment declines in value. For example, when an investment declines 20%, it has to appreciate 25% to break even. When that same investment declines 40%, it has to appreciate 67% to break even. And when that same investment declines 60%, it has to appreciate 150% to break even. All of the aforementioned give no consideration to the significant affect that leverage has on recovery of principle from an income property investment.

The following chart is perhaps one of the most important visuals that investors will ever see. It shows the percentage amounts of appreciation that are needed to break even against the corresponding percentage declines of 10%.

What is investing? Webster’s unabridged dictionary says to invest is “to put (money) to use, by purchase or expenditure, in something offering potential returns, as interest, income, or appreciation in value.” That said, all types of investing can be be put into two categories; (1) real (minimal risk) and (2) fad (high risk).

The difference between real and fad investing is the difference between substance and form. Real investing is based on substance; fad investing is based on form. Real investing is the actual matter of a thing as opposed to an appearance or shadow. When you compare these two categories of investing to operating businesses in a capitalistic society, the profit-and-loss statement becomes the lynchpin that separates real investing from fad investing. The profit-and-loss statement is the key document that real investors use to analyze a business. The bottom-line(s) from the profit-and-loss statement is what real investors use to determine the value of a business.

Real investors hold the past, present, and projected results of the profit-and-loss statement accountable for deciding whether to invest or not to invest. Fad investors rationalize that failures within the profit-and loss-statement are acceptable; then they devise a whole series of methodologies (none of which have anything to do with value) for determining value.

Why is it important to know the differences between real investing and fad investing?

1) The investment community of our country is moving from a state of fad investing to real investing. The greater fool theory has been tested and failed again. Lenders are coming back to earth. They are looking at the borrower’s ability to meet payment obligations and the collateral securing the loan. Investors are looking at real operating earnings, not the excuses.

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The real test of an income property’s investment merit would be to complete NetGain’s EVS due diligence examination. That said, there are three core income properties: residential, retail and office. The following is a general overview of how income properties rank as investments in the current economy.

Residential: There will be a fallout of subprime borrowers who never should have bought a home. They will rent. Consumer confidence is low. Low consumer confidence translates into reticence to commit to a mortgage and use funds for a down payment. Unemployment is increasing. Unemployed people don’t buy homes, they rent. New construction of rental units is low. This means the supply/demand equation for residential income investment is favorable. NetGain would rank residential income property as a “buy”.

Office: Unemployment is increasing. Work activity has become more portable. Technology has eliminated many office jobs and reduced space needs. Many company’s balance sheets are weaker. Credit is tighter. New construction has been limited. These conflicting issues mean office space is an attractive income property investment, but you have to be very selective. NetGain would rank office income property as an “it depends”.

Retail: Consider the following: The high cost of driving to and from retail stores; the frustration of parking; the increasing number of two income working families not having time to shop; the alternative life activities that many consumers would rather spend their limited time doing. All of these factors plus the increasing growth of e-commerce leave the large piles of inflexible retail concrete with an outdated business model.

NetGain has stated numerous times that the more rapid growth of e-commerce sales will not stop. E-commerce sales have grown from zero percent ten years ago to 3.5% today, and are still in the formative stage. The future for retail income properties is a “no buy”.

Two other income property types worth mentioning are:

Industrial: There are two attractive investment features: (1) Industrial space is very flexible and efficient for accommodating lessees and changing lessee profiles. (2) The lower cost (compared to office and retail) of construction allows for very competitive rents. Industrial income property is a “buy”.

Storage Space: The increased portability of our society has created a need for additional consumer and business space. Lessee flexibility, comparative low maintenance and low capital requirements are strong pluses for investing in storage income property. Storage income property is a “buy”.

The chart below is an income property type investment overview of NetGain’s position as of April 2008.

There’s a quintessential list of clichés for each economic downturn. “This time, it’s different” is one of those clichés, the inference being that this will be the worst. What’s different about this economic downturn? The size of the pain (unemployment, financial loss, etc.) is different. The players are different. The politicians are different. The companies are different. The products are different. The reason they’re all different is that the time frame is different. The average peak-to-peak (for the past 100 years) before each economic downturn has averaged fifty-eight months. That means almost five years pass before each economic downturn.

What’s the same? The cause of this economic downturn is the same: The creation of artificial value through excess. The reason for the downturn is the same: To equalize the markets and marginalize the excesses.

Given these conditions, the markets should bottom out and return to normal within a reasonable period. That hypothesis presumes the politicians don’t interfere with legislation that procrastinates the elimination of excesses to another day.