News and Publications

Tallal’s Tips

A Publication by Joseph (Jody) Tallal, Jr.
Volume X, Number 1

September 4, 1992

Is Dallas Real Estate Every Investor's Worst Nightmare or Dream Come True?

Anyone who has had any association with real estate in Dallas, Texas knows that the last 7 years have been a true depression for the industry. What started out as a normal recession precipitated by over supply, soon became every investor's worst nightmare. First came the savings and loan crisis, then the Federal Asset Disposition Association (FADA), and finally the Resolution Trust Corporation (R.T.C.). If you have had the opportunity to participate with either of the latter two government agencies you have seen first hand how poorly the government is equipped to be involved in any form of business venture and how badly it can mess up an industry once it gets involved.

The R.T.C. is an example of the government at its worst. It has developed incompetent policies; designed an unworkable bureaucratic system; performed with the typical governmental open checkbook philosophies which exist with absolutely no regard for making prudent, profitable decisions; and operated with such a disregard for normal business ethics that it has transformed the very method of doing business in the real estate industry. The result of all this has been an absolute bust in the value of real estate in the area.

That's the bad news. The good news is that the R.T.C. is finally packing up its bags and going home.

The old saying, "every cloud has a silver lining" is always true in any investment market that experiences such unusual trauma. As a result, most normal methods of real estate evaluation are no longer applicable today. Due to the government's erratic behavior and lack of regard to making reasonable, sound economic decisions it has driven the prices of local commercial real estate down to where there is no longer economic sense on any scale of evaluation.

This has, however, created opportunities in real estate in this community unparalled to anytime in our lifetimes. I recently saw a high quality office building sell for a 38% cash on cash yield, based on current rents and occupancy (nobody bothers to waste their time creating future proforma projections anymore). We have just repurchased property we sold in 1983 for $12,000,000 in cash for $2,500,000. We even recently negotiated with the government to drop its note position on a prime commercial piece of property at the intersection of two major roads in North Carrollton which was appraised in 1984 for $175,000 per acre down to $16,000 per acre.

Over the next few months the government will be holding several major auctions to divest itself of the majority of its remaining properties. The prices that properties sell for in these auctions rarely have any reality to even today's market prices. As is typical of the government's method of doing business, its right hand does not know what the left hand is doing. The values it has set for each property are established by different people in different offices who have differing degrees of skills and competency. At one recent auction it rejected a cash bid of $175,000 for a property on the North side of the street, and then within a few minutes accepted a bid of $60,000 for a larger, superior tract directly across the street. In its haste to liquidate, such blunders are commonplace. And with the increasing frequency of properties being offered under the "absolute sale" (the property going to the highest bidder), it is not uncommon for the auctioneer to say in frustration "May I please have a bid... any bid at all, for this property."

As has been noted in previous issues, up until recently there has been virtually no commercial real estate development in Dallas during the last seven years. If things run parallel to the last major recession Dallas experienced from 1975-1980, this non-development phase will continue until all available existing prime space is consumed. This means apartment and office occupancy will probably have to exceed 90%+ before any major apartment or office development begins.

During the last real estate cycle, mortgage lenders waited to the point of actual shortages prior to resuming their commercial lending. This created the significant shortage of available space which ultimately was responsible for the record escalation in the real estate's market value that followed. One key factor that the investment market usually fails to remember is the fact that there is an eighteen to twenty-four month contemplation to completion period required to develop any form of new real estate project. This lag time is a result of the time necessary to evaluate, locate, negotiate, and acquire a suitable parcel of land to develop, plus the additional time required to produce architectural plans, secure financing, and finally develop the property. During this initial 18-24 month waiting period, as the market demand continues, rental rates experienced an abnormal market price increase.

In Dallas, after the last recession, this 24 month development lag was responsible for the lease rate of prime office space escalating from $12 to $18 per square foot in a two year period. However, in this last down cycle, due to the government's recent intervention, there has been an unprecedented additional drop in market value which now also has to be rectified.

The market value of any income producing real estate is based on its net operating income stream ("N.O.I."). Such income stream is usually capitalized (Cap Rate) to determine the project's market value. Therefore, a rapid rise in rents, without concurrent increases in the costs of development or operations, translates to a significant increase in N.O.I. Such increases produce very rapid appreciation in true market value. Let's try to see how the current depressed market prices will effect the future value of income producing real estate.

As just mentioned, in a normal market, value for income producing real estate is based on a capitalization of its N.O.I. In a normal market Cap Rates will usually run between 9%-13% depending on several factors: the economy, investor confidence, inflation, tax benefits, etc. Cap Rates are to real estate what the price to earnings ratio is to the stock market.

If one buys an office building with a 35% net, cash on cash, yield (Cap Rate), what will happen to this building value when Cap Rates return to the historical 9%-13% range? The answer is illustrated below using a building purchased today for $1,000,000:

Net Operating Income (N.O.I.) Today at $350,000 = 35% Cap Rate

Building Purchased Today for $1,000,000

Future Net Operating Income of $350,000 = 13% Cap Rate

Future Value of Building $2,692,307

The above illustrations show that if today's unusually low rents only stay the same and do not take the historical bounce normally experienced coming out of a severe down cycle, then this building should appreciate from $1,000,000 to $2,692,307 as Cap Rates normalize. If the acceptable Cap Rate becomes 10% instead of 13% then this building would become worth $3,500,000. However, if rents take the traditional 50% spike that they have in the past following a down cycle, this building's future value would skyrocket.

Now let's look at the impact all of this has on commercial undeveloped land values. Land values are a floating variable within the fixed development equation. For example, if a developer expects a 12.5% total return on an investment (Cap Rate), he would take his projected N.O.I. and divide it by his projected development costs as illustrated below:

N.O.I. = 12.5% return on Total Development Costs Investment

Let's assume in this example that the N.O.I. is projected at $500,000 when the project is 95% occupied and that the total building costs are projected to run $4,000,000. Applying the numbers to the above equation would produce the anticipated 12.5% total return referenced and make this a viable project.

Total development costs for any project can be broken down into three different categories. First, there are the soft costs such as architectural fees, loan brokerage points, building permit fees, interim financing, etc. Next, there are the hard costs of the development, i.e., concrete, steel, lumber, electrical, plumbing, windows, doors, etc. Finally, there is the cost of the land. Since the hard and soft costs are relatively fixed, based on a competitive market, the variable in this equation becomes the land costs. In other words, if the hard costs of this project were projected to be $2,250,000 and the soft costs to be $750,000, then the land should be worth the remaining $1,000,000 (please see illustration below):

Total Development Costs
Hard Cost
Soft Cost
Land Value

The point of this illustration is to see what happens when rental rates dramatically increase in a short period of time, from $12-$18 per square foot, like what occurred in 1980. What is the direct impact of these rent increases on land values? Will the value of land equally rise 50%? Let's use our above illustration to see.

If our net operating income in the above illustration was based on rents of $12 per square foot which then, subsequently, increased to $18 per square foot (over a 2 year period), then the N.O.I. would grow from a minimum of $500,000 to $750,000. This, of course, is making the unreasonable assumption that all other operating expenses (electricity, taxes, management, repairs, etc.) also increased 50%.

Now if we take the same project using a $750,000 N.O.I., let's see what happens:

$750,000 N.O.I. = 12.5%
$6,000,000 Total Development Costs

The developer under these new income projections will now see this as a project capable of supporting a $6,000,000 Total Development Cost. However, neither the hard or soft costs should have escalated very much.

The rapid rise in rental income is due to the fact that mortgage lenders waited too long to re-enter the market and, as a result, allowed the market supply to dry up. The escalating demand for space produces real shortages which result in the increased rents.

Using the same illustration as above, we can determine the effect a 50% increase in N.O.I. has on undeveloped land values.

Total Development Costs
Hard Costs
Soft Costs
Land Value

The land value has increased in this example from $1,000,000 to $3,000,000 (a 300% increase) due to an increase in N.O.I. of only 50%.

The validity of the formula was documented in the rapid increase in land values that occurred in Dallas after 1979. At that time we witnessed land values doubling and tripling in such a short period that this fact alone was responsible for much of the subsequent growth that followed until the end of 1985.

The difference today in the value of undeveloped land, due to the RTC's dumping is 10-15 cents on the dollar of what it was in 1984. If the rental rate of commercial realty returns only to its previous level, land values should go up 7-10 times just to get back to normal! The same factors that were in place in Dallas in 1979 are currently present again in 1992, only in stronger proportions.

The forthcoming boom has already started here. Front page news articles are regularly written about Dallas and money is beginning to flow in from Canada, Hong Kong, and Europe. This, coupled with a renewed interest from the pension funds industry, should have a major impact on the value of Dallas' real estate.

It is important to note that the potential investment returns I have referenced in this newsletter are based on the theory that real estate values will return to the levels prior to the bust. But, many people are saying, "Those were the good old days. Prices will never return to that level again."

Interestingly enough, I have heard this same philosophy expressed three distinct times in my life about Dallas real estate. In fact, each time was immediately following one of the last three major real estate recessions in Dallas. During 1975-1979 the mere mention of real estate equity on one's financial statement was almost viewed as a liability as opposed to an asset. Yet just a few years later, bankers were beating the bushes looking for people in the real estate business to whom they could loan money.

This "those days are gone forever" feeling is always present at the end of a bust in any investment industry. However, if it were true, and "prices will never go back to where they where during the last boom", then the Dow Jones would still be under 1,000 and real estate prices would still be what they were in the 1950's.

The reality is that every successive boom, following a major bust, not only returns to the previous high values of the preceding boom, but then usually explodes way past that level to new, unprecedented highs. That is why the Dow is currently over 3,000 and land values for property in downtown Dallas exceeded $200 per square foot in 1985.

You see, this escalating cyclical occurrence is the unprojectable side of the investment equation. It is responsible for creating the true wealth that is usually experienced by those who possess the logic and presence of mind to get into an investment market at the end of a major bust, instead of waiting until the market is so well defined that everybody wants a piece of the action.

I would like to extend to you the possibility to take part in the Dallas investment phenomenon as it occurs during the next several months and rely on my expertise through which to participate in this market. As most of you know, I have purchased over $100,000,000 of commercial property in the Dallas/Ft. Worth market over a period of the last 18 years. The investment yields I produced cumulatively on all properties acquired from 1975-1985 prior to the crash exceeded 65% IRR per year for that decade. I project the profits that can be earned in the next 5 years will dwarf that.

Now that the government is leaving, the market value of real estate has to return to some level of normalcy. I can't imagine office buildings being purchased on a 30+% cash on cash yield in Dallas five years from now, can you?

Jody Tallal