CRE (Commercial Real Estate) Investing: The Basics

First and foremost, what are the types of CRE that one can invest in? There are tons, but these are the most common:

1. Office: Everything from the huge office skyscrapers in Manhattan, to the little roadside house-looking buildings that have been converted into a lawyer’s office or accounting firm. There is a major subset of office real estate that has grown so much of the past few years that it has received its own flashy acronym: The M.O.B. The Medical Office Building. Right now, the MOB world is big business, big money.

2. Multi-Family: Everybody knows somebody that owns a residential property and rents it out. The people who are doing it properly have divided the property in some fashion to have multiple tenants and, therefore, multiple incomes. As soon as there are multiple tenants in the building, it becomes a commercial real estate investment. Owning one or two houses with 4-6 units can provide a very handsome supplemental income. However, once you cross into the world of 20 plus units, that income can become much more than supplemental.

3. Industrial: This type of CRE has several subcategories to it as there are multiple forms of an industrial building.

a. Warehouse/Distribution: This would be the immense one million or more square foot building you drive by and say, “That would take me two days to walk from one side to the other”. Amazon and similar companies have made tons of landlords, industrial brokers, and developers incredibly happy as they continue to put up these massive buildings. You can easily spot them by their size and the countless loading docks for the hundreds of trucks that distribute the warehoused goods across the world. There can also be smaller warehouses used for storing smaller company goods, vehicles, or the millionaire CEO’s boat during the winter.

b. Manufacturing/Production/Assembly: These are the facilities that are usually pouring out smoke or steam and ruining your Instagram picture background. Like warehouses in appearance, but rather than large open spaces for storage inside, they will have more mega millions of dollars of machinery on the inside for fabrication of materials.

c. R&D (Research and Development): Often large buildings that have an additional office component attached to them. Rather than storage or machinery; these buildings are made up of labs, testing facilities, and research departments. Due to the higher levels of build-out required (ie. Intensive climate control, finished flooring, large amounts of water usage, etc.) these tend to be the most expensive of industrial buildings. Recently, these buildings have had more in demand by the growth of pharmaceutical companies.

4. Retail: The malls, outlet centers, strip malls, movie theaters, hotels, casinos, TopGolfs, etc. (you know, all the places where after you visit, you realize you have to work on budgeting).

5. Storage: Referring to the huge facilities we see with hundreds of little garage doors with spaces that people rent to use for personal storage. Perhaps one of the most known companies in this industry that you may recognize is Public Storage.

6. Land: An off-the-radar form of CRE investing. An investor leases the use of his land out to a company. On that land, they may do whatever they want (within the law and zoning ordinances of course). They can build a building, store vehicles or goods, etc. Land leasing is enticing to some landlords because most of the responsibility falls on the tenant, plus the lease terms are usually much longer than a standard building lease. For example, it is not uncommon to see land lease terms of 20, 30, 50+ years, whereas the standard building lease is anywhere from 3-10 years.

Now that we have covered the most prominent property types of CRE investing, let us discuss the different strategies and goals that investors may utilize. Please understand that it is extremely rare to see CRE ‘flipped’ like you hear about in residential. The strategies in CRE investing usually go much deeper than “buy it, fix it, sell it”.

1. Distressed Investing – This is as close to “flipping” as a CRE investor will get. In a distressed investment, the newly purchase property will have:

i. Poor occupancy rates – Occupancy below 85%

ii. Extreme deferred maintenance – Examples: unkempt landscaping, decaying building characteristics, outdated features, or structures. In other words, the building looks like its falling apart.

iii. Bad tenants – This issue is seen most in low average income areas

In essence, it will take a lot of time, work, and money to stabilize the property.

b. The Pros –

i. Huge potential upside in forced appreciation (the flipping mentality, except it often takes years to benefit from this in CRE).

ii. Potential of increasing rental rates to increase cashflow and thus, the price of the property.

c. The Cons –

i. Incredibly unstable investment. Certainly, the riskiest of any strategy.

ii. As stated, the upside could take years to achieve.

iii. Usually accompanied with significant amounts of tenant stress and aggravation.

2. Turnkey Investing – this is the lowest risk strategy of CRE Investing. Essentially, you are buying the cashflow of an already established property. A turnkey investment property will have:

i. Recently renovated and upgraded features and structure.

ii. An occupancy rate of 95% or higher with established high functioning tenants.

b. The Pros:

i. No construction costs or concerns.

ii. No work or time needed to achieve returns.

c. The Cons:

i. No opportunity for forced appreciation.

ii. Lower returns on sale of building.

iii. Property will be much more expensive to purchase, which creates a huge risk if the market takes a downturn. For example, consider the position of someone who just bought a beautiful expensive office building just before COVID-19 hit. They paid top dollar for that building, and now tenants are going to leave, rent will decrease, and they will almost certainly be selling the building at a loss.

3. Value-Add Investing – Our personal favorite and that’s an opinion widely shared across the CRE investing world. It is a perfect mix of the two previous strategies. A Value-Add investment property would be:

i. Not in complete shambles at purchase, but also have opportunities to be upgraded to add value to the building (hence, Value-Add)

ii. Good tenants in a strong market, which will enable the investor to add the value and increase the rent without intimidating the tenants.

iii. Not as much potential upside from forced appreciation as a Distressed Investment, but a lot less time, work, and money at risk.

iv. Not as much immediate cashflow as a Turnkey Investment, but there will be cashflow, plus the opportunity to increase it.

So, with all the different properties and strategies, what should the goal be? What are the important things to look for?

As with most investing, there is endless data and information that needs to be analyzed. Focusing only dealing with basics, let us talk about the where to pay attention to when conducting a professional and formal financial analysis of a potential investment property.

1. Cap Rate: This evaluates on an annual basis, how much income the property produces in comparison to the price of the property. The cap rate is particularly important to all investors, but most important to a Turnkey investor. A lower cap rate usually suggests a lower amount of risk. For example, if you were to buy a true Class “A” building that was 100% occupied by an extraordinarily strong company that just signed a new 10-year lease, the cap rate would be quite low. Meaning, you are going to pay more to get that cashflow. How is it calculated? Here is an example: Amazon just signed a 15-year lease in a magnificent building that was constructed last year (extremely low risk). They are paying $10,000/month in rent, or $120,000/year. The owner wants to sell the building at a 3% cap rate, which would make his asking price $4M (120K / 3%). Now, let us say Joe S. Inc. leases the same building for the same price, but the lease term is only three years. That creates more risk because who is Joe S.? Also, they may leave in three years at the end of the lease, which leaves a buyer with no income at all. The owner would never be able to sell that building at a 3% cap, but he would be okay selling at an 8% cap ($120k / 8%). That brings the sale price all the way down to $1.5M.

2. Cash-on-Cash Return: A similar calculation to the cap rate, except it deals only with the amount of cash the buyer had to put down to buy the building. For simplicity, let us assume the buyer gets a loan amount of 75% from his bank. In the Amazon scenario (4M), that would require him to put down $1M (25%) in cash at settlement to buy the building. $120,000 / $1M = a cash-on-cash return of 12%. Not the worst we have seen, but not amazing. In the Joe S. scenario, 25% of $1.5M = $375,000 of cash down at settlement. Same calculation to the income as before gives a cash-on-cash return of 32%. Now we are talking! Is it worth it for the risk of the tenant? Only the investor can decide, but it remains an especially important question.

3. Internal Rate of Return (IRR): In essence, you can think of IRR as a compounded annual rate of return over a specified period. When conducting financial analyses of an investment property, many CRE investors use a staple of holding the asset for 10 years, with a ‘forced sale’ in year 11. They may end up selling the property before or after year 11, but that is not the point. The point is to see how much the value (cashflows and appreciation) of the building will increase over a 10-year period.

As you may start to see, any of these three factors may hold more weight to one investor over another depending on their strategies. A Turnkey investor, who is practically buying the cashflow of a property, would have a heightened focus on the Cap Rate, while still considering the other two. Whereas, the forced appreciation coming from a Distressed investor is not easily calculated or forecasted and therefore, the IRR will be a softer number for him.

So, ask yourself, “what is best?”

Well, stocks or bonds? Day-trading or long stock? Options or securities? Mint Chocolate Chip or Cookie Dough? It depends on an investor’s strategy, tastes, patience, and willingness for risk. In our experience as a broker, We find few better feelings than finding an investor client the perfect Value-Add opportunity.

Here is why:

1. Just enough risk involved to create very favorable returns, but not enough risk that you could come out of the investment at a devastating loss, barring a major mistake.

2. It usually requires the perfect amount of time and energy from the investor. A Distressed investment can quickly become a full-time job if not handled properly, or perhaps even worse, you’ll have to hire so many people to take care of the different problems that you start hemorrhaging money on a daily basis. With a Turnkey, as soon as you sign the paperwork at closing, you can kick back and relax and wait for a check every month (keep in mind that you would be paying heavily for that relaxation in the purchase price). A Value-Add property will require some leg work, decision-making, and strategy execution; just enough to basically become a hobby. Saturday comes around, you spend 4 hours on the golf course, an hour at the bar, 3 hours managing the property from your couch through your broker, kids soccer game, dinner with the family, boom. Done.

3. Flexibility with timing and pricing of adding the value. With a Distressed investment, you will be spending a significant amount as soon as you sign the paperwork just to get the property trending towards stabilization (ie. If you do not fix the HVAC, roof, siding, walkways, parking lot, landscaping, etc.; you will never get tenants in your building). With a Value-Add, the siding may need some work, but it does not need to happen right away. Perhaps the roof has about 5 years of useful life left. You would rather focus your attention on upgrading the common area and lighting first, not a problem.

Here is an example of a Value-Add deal I was a part of that closed in October 2019 that exemplifies the Value-Add ideal. 10,000 SF MOB, right on a main drag in a well-established neighborhood that still has a ton of growth potential.

• The two doctors in the building were also the sellers. They occupied 7,000 square feet between the two of them and agreed to sign 2-year leases upon the sale of the building. Leaving 3,000 square feet vacant.

• Building was built in 1980 and very nicely taken care of, but never upgraded.

• Asking price was $2.1M with an annual rental income of $168,000 (8% Cap), and a potential income (if 3,000 vacant SF was leased at same rental rate) of $240,000. Assuming financing of 75% (market standard), the cash-on-cash return of year 1 would sit around 32%.

• As we went through due diligence, we found that the roof had about 2 useful years left, there was some moisture in the walls and siding that needed to be addressed, and an encroachment issue with the neighboring building.

• Knowing that there would be some work required almost immediately, we negotiated the final price of the building down to roughly $1.8M, which created a 9.3% cap rate… solid buy!

• Upon closing on the building, my client established his goals and priorities:

o Hire an architect to design the exterior renovation of the building (So, when we get to step 2, we had drawling of what the building was going to look like within a few months).

o Find a tenant to lease the 3,000 square feet. We were able to find a tenant in about a month that agreed to a 7-year lease at a 12.5% higher rental rate than the existing tenants. This created an annual rental income of roughly $249,000. My client’s cash-on-cash return would be about 45% once this tenant moves in.

o Get warm and cozy with the owner of the neighboring property to have an easement set in place to excuse the fact that our building encroached on his property by 1.5 inches. YES, the tiniest of issues can ruin a deal.

o Renovate the exterior. A project that my client was comfortable with spending about $250,000 on. This renovation would also address the moisture issue.

o Fix the roof ($50,000)

My client now had roughly $825,000 cash invested into the property between cash at settlement, upgrades, and renovations. The KEY to this whole strategy, which we want everyone to pay attention to, is the signing of the new tenant. The tenant agreed to the increased rental rate (from $24/SF to $27/SF) based on the renovations and what the building is going to look like (THE VALUE-ADD). By doing so, we have established the new market rental rate for our building. In two years when the original doctors’ leases expire, we will be able to find new tenants and require a rental rate of AT LEAST $27/SF! The potential annual income is now $270,000 or more.

Therefore, in less than 4 years, our client will make back every dime he is put into the property. Of course, there are mortgage payments and some operating expenses involved, but for the sake of the article, keep it simple and talk gross investment. Now think of it like this, he purchased this building at roughly a 9.3% cap rate. That is relatively high because there was only 70% occupancy and there was some significant work needed for the building (somewhat high risk). Three years from now, with three strong tenants and state-of-the-art renovations, we could have a discussion of selling the building the building at a 7% cap. What does that mean? Take your annual rental income ($270,000) and divide it by the seller’s desired cap rate (7%)… $3.8M!!!

So, who is ready to buy a building? Obviously, not all deals are the same. There was a ton of work, time and energy put into this deal by my client, ourselves as the broker, the sellers, their broker, attorneys, etc. Nonetheless, this deal is an example of a jackpot Value-Add investment. Here is why:

• According to the raw information (30% vacancy, maintenance needed, encroachments, etc.) this was a risky purchase. Therefore, understanding the market you wish to purchase within is crucial. Based on research and knowledge of the market, we knew there was not much risk involved.

• Without any renovations, the building was still a functioning, adequate MOB. We would have had no trouble finding tenants at the lower rental rates. There is a major hospital less than a half mile down the road. Practically a supermarket for medical tenants.

• The township and local community are thriving. The population, average household income, and school district statistics are all increasing, while unemployment is decreasing (pre-COVID). Rental rate increases and appreciation would have happened naturally over the coming years, we just gave it a kickstart… aka value-add.

We hope this article has shed some light on what commercial real estate investing is and how to do it. As an investor, you need make sure you have a clear understanding of what you want, what your strategy is going to be, how much risk you want to take, and how you want to spend your time and energy. You also need to know everything about within what market and submarket you wish to purchase (or find a phenomenal broker that does!). Much like our messages about investing in the stock market, you should get to know everything about a company and how they operate before you choose to invest in them, the same applies to CRE!

8 views0 comments