Use a Smart Head Start
To Beat the Competition

Some investors are taking the notion of a head start to a whole new level.

Many investors in commercial real estate, whether institutions or individuals, miss out on deals they never even knew existed. That's because other investors trying to get an edge over the competition have been using creative pre-emptive strategies, making offers and buying buildings before they even go on the market. Two such current trends are pre-sales and short sales.

Pre-sales are those in which investors agree to buy a building before it is built in order to secure the property before the rest of the market has the opportunity to bid for it. The actual purchase is made either when construction is complete or when the property has achieved some agreed-upon occupancy level after completion. Pre-sale buyers are primarily big investors such as institutions and real-estate investment trusts.

The theory is that the developer is guaranteed to make a sale when the project is finally complete and the investor is guaranteed to have a building. "There's a lot of competition for [existing] Class A properties in Class A locations," says Matthew D. Lawton, a senior managing director in the Chicago office of Holliday Fenoglio Fowler LP, a Houston-based real-estate investment banking firm. "This is a way for well-heeled buyers to pre-empt the process...and fill their acquisition pipelines in advance."

But a big risk with pre-sales is the possibility that the developer doesn't complete the project on time, holding up the investment the investor had been counting on. Mr. Lawton says there's also risk in banking on the market's future performance. "You're making assumptions on market performance over a two- to three-year period," he says. If the market gets caught in a downdraft when the building is completed, it won't be as valuable an investment and the returns will be less than what the investor had counted on, he adds.

On the opposite side of the spectrum are short sales, which are primarily done by individual investors. These are deals in which an investor buys a property that is in danger of being foreclosed. (They are sometimes called pre-foreclosure sales.)

When the sale takes place, it "usually means the owner gets nothing at closing and the bank will agree to take less than is owed on the balance of the loan," says Martin Stone, broker and owner of Buckingham Investments, an El Segundo, Calif., real-estate company. Lenders sometimes prefer this option to the expense and time of foreclosing on a property.

For the individual investor, this is a way to beat out competition for foreclosed properties, which are usually auctioned. It also can allow individual investors to pay less than they might if the foreclosed property was marketed. Lenders decide whether to approve the sale, and they tend to have strict "economic hardship" tests the owner of the property must meet to get approval.

Sometimes, however, property owners involved in a foreclosure won't agree to a short sale, says Thomas J. Lucier, chief executive officer of Home Equities Corp., a real-estate firm based in Tampa, Fla. One reason is that lenders don't allow property owners to receive any proceeds from a short sale. Also, any amount of debt that's canceled by the lender is subject to federal income tax. Canceled debt isn't taxable when the borrower is bankrupt or deemed insolvent by the Internal Revenue Service.

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