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How Does Real Estate Business Work

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Real estate is made up of many skilled professionals who play different roles within the larger context of the industry. Some typical professions in this industry include brokerage, appraisal, site selection, and mortgage securitization. Real estate professionals can also be found in non-real estate companies that happen to require the use of real estate in their operations, such as merchandisers.

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Brokerage is one of the most visible parts of the business. As intermediaries between buyers and sellers in the real estate market, real estate brokers are responsible for bringing interested parties together and providing whatever support is necessary to ensure the deal is completed. In return for their services, brokers earn a living off of commission from the transaction. Commissions are typically a certain percentage of the gross sale price and paid for by the seller. As fiduciaries, real estate agents have the following duties toward their clients: confidentiality, obedience, accounting, loyalty, disclosure, and care. To become a full-fledged real estate broker, candidates usually must first obtain a salesperson license and then a broker license, after which they are permitted to operate a real estate brokerage business independently. However, in North Carolina there is only the broker license, although there are several categories of broker license. In order to earn this license, candidates must complete a 75 hour pre-license course and pass an examination, in addition to meeting other requirements.

Many of the guest speakers who spoke to our class held CCIM designation. Through exposure to these speakers, I learned more about what CCIM designation means and the process behind obtaining it. The CCIM network includes members from varying professions in the real estate industry. CCIMs are proficient in financial analysis, market analysis, user decision analysis, and investment analysis for commercial investment real estate. Before receiving CCIM designation, candidates must submit a resume demonstrating significant experience in the commercial investment field. In addition, candidates must enroll in core CCIM courses and pass the examination. Holding CCIM designation grants real estate professionals a higher level of trust and credibility when working with clients because of the rigorous selection process associated with it.

One of the guest speakers I was particularly interested in was David Hillman, a real estate lawyer. His talk exposed me to the legal side of real estate and to the role that lawyers can play in real estate transactions. David described real estate as a versatile industry, containing a wide variety of clients with diverse needs. Some of the responsibilities of a real estate lawyer include drafting contracts/leases and guiding negotiation of specific line items in these documents. David stated that he typically has around 40 open cases that he is working on at any given time. From this fact, it is evident that real estate lawyers must possess strong multitasking skills.

Another interesting speaker was Frank Reed, the director of ReStores. Frank shared insights on the importance of real estate to merchandising companies. He emphasized the need for smart site selection when building new stores. Interestingly, he chose to focus on a donor based approach as opposed to a customer based approach—ReStores typically selected sites located within 15 minutes of where most of their donors in the area would be. Their justification was that without donors, ReStores would have no merchandise to sell.

The leveraging of income producing commercial real estate has many tactics associated with it. Two broad tactics are utilizing commercial mortgage-backed securities (CMBSs), which are publicly traded, and utilizing institutional/individual investors, which leads to privately held debt. CMBSs are a type of mortgage-backed security backed by commercial mortgages rather than by a pool of residential mortgages. It is an attractive source of capital for commercial mortgage lending because the bonds backed by the pool of loans are usually worth more than the sum of the value of the whole loans. During the Great Recession, CMBS delinquency rates peaked at 8.4% but have since retreated to lower rates. Lenders use their own tactics in creating these commercial mortgages. For example, lenders usually make commercial mortgages shorter in term than residential mortgages and also penalize prepayment. These commercial mortgages can be fully amortizing, partially amortizing, or interest-only loans. Fixed-rate, partially amortizing mortgages with balloon payments are the most commonly found payment structure.

Key metrics in commercial real estate lending are used to evaluate the financial risk—the probability that the net operating income of the property will not be sufficient to cover the mortgage payment obligation. This is particularly important to lenders because their main goal is to receive the payments that they were promised and to reduce the risk of the borrower not paying. Examples of metrics used in these evaluations and calculations include debt coverage ratio, loan-to-value ratio, debt yield ratio, net operating income, and annual debt service.

Finally, there is a wide spread of outcomes that can result from commercial real estate lending. Ideally, the borrower fulfills their obligation and is able to make the agreed upon payments on time. However, it is important to remain aware of the possibility that an unforeseen event could have huge impacts on the borrower’s ability to pay—a black swan. This is precisely what happened during the Great Recession, when delinquency rates began to rise as soon as commercial real estate values fell and the economy slowed. Loans had been originated based on incorrect assumptions about the future, and as a result, many lenders lost large amounts of money or went bankrupt.

While there is no policy that our lending company can adopt to completely eliminate risk, there are a combination of actions that can be taken to reduce it. First, we would require borrowers to have high debt coverage ratios. A higher debt coverage ratio implies a better ability of the property to produce a sufficient income stream to pay off the debt service. In addition, we will require that their loan-to-value ratio cannot exceed 80%. This will limit our risk and protect us from excessive loss of capital in the event of default and foreclosure. We will include both a lockout provision and prepayment penalties in order to reduce our reinvestment risk. Thus, we will not have to spend additional time and effort reinvesting the capital. It will also help prevent borrowers from prepaying loans with above-market rates, which would force us to reinvest at a lower rate. Finally, we would lend a maximum of 10% of our capital to any one borrower. This will protect us from black swans that negatively impact a specific borrower, although it would be less effective against industry-wide black swans.

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