Commercial Real Estate versus Residential Real Estate Investing

[Lakshay G.]

Hello All,

I'm on my way to start a new career in real estate investing. My question is based upon generality and personal opinion (hopefully in Tri-State Area of MD, VA and DC).

Until now, I have been working on finding residential property, primarily multifamily buildings. And now trying to find a small shopping plaza (3-6 shops).

But I wanted to know that what is the Cash ROI difference between them. I understand I'm going to need more partners on commercial to afford it but at the end of the day, will my ROI be similar to residential one.

Is there considerably less maintenance on commercial properties (as a tenant will be responsible for maintaining the property, for example, a restaurant owner will be responsible if a water leak is caused by an employee in the kitchen versus a residential apartment tenant, will call me and I have to get it fixed).

I hope my question is not too complicated, all opinions are welcomed.

[Giovanni Isaksen]

@Lakshay G. One of the big differences between multifamily (5+ units) and retail is the complexity and length of the leases. Apartment leases are pretty straight forward and many times standard forms available from your local landlords association are used. The terms tend to be 12 months or less although I've seen some that were up to 18.

Commercial on the other hand and particularly retail leases have many more moving parts. The first is the term which tend to be multi-year and up to ten or twenty years with tenants having the option for one or more renewals at set rates and terms.

Because of their long term nature many commercial leases also have built in increases in the rent which may be either a fixed amount, a certain percent or based on some sort of inflation index.

The next piece is the structure of the lease which can range from Gross (tenants pay rent and utilities, similar to an apartment lease) to true Triple Net (or NNN where the owner pays the debt service and maybe the property tax but the tenant pays for everything else)... and everything in between.

Another component is Tenant Improvements or TI and who pays how much for it and who performs the work. In some cases the tenant pays for all the TI subject to the owner's approval of the plans. Often the owner provides a fixed allowance that the tenant combines with their own funds to complete the work. Other times the plan is negotiated and the owner (using either in-house workers or outside contractors) does the work. The amount of the TI allowance ties into the length of the lease since an owner can't make money putting up new TI funds every year or two.

Another issue that ties into TI is how much control the tenant has in what kind and size of signage can be put up and how much they can alter the exterior look of their space. This can be a very important issue when the owner is doing what architects call 'placemaking' where the idea is to create a look and feel that draws not just customers but the public as well who are at least potential customers.

For retail leases an often important piece is Percentage Rent where the owner receives a base rent plus a percent of the tenant's revenue. This helps align the interests of the owner with the tenant although tenants don't often see it that way. However this can help a tenant during startup or slow periods by having a lower base rent than a straight market rate. Whether the percent is based on gross sales or something closer to the tenants bottom line will determine how far into the tenants books and business the owner must crawl, hopefully they both have good accounting and accountants.

Are there any outs for the tenant and what happens if the tenant wants to sell their business before the lease expires are among numerous other provisions that need to be dealt with as well.

All these things and more can be negotiable depending on how much demand there is for the space. The negotiable nature of all these moving parts also puts a premium on the owner's ability to analyze the deal to make sure when it's all done that they're making the money they need.

Beyond the lease terms there are a couple other considerations for the owner which includes finding a tenant mix that helps increase everyone's business. A restaurant can be a good draw but are rarely very profitable and tend to turnover regularly. A restaurant broker I know says that most of the small restauranteurs he deals with are just buying a job, not building a profitable business.

In my mind are also the big questions of what is the future of retail and how much future does it have? There are two big disrupters in retail, the first of course in online sales but the other one on the way is 3D printing. When consumers can have almost anything custom made for them on the spot, what kind of space will the tenants require, what will it look like and will current zoning allow those activities to take place in current retail locations are some of the issues that play into those big questions.

I'm an apartment guy by nature but so much of what we're doing these days is urban mixed use that I'm having to deal with the retail side and it's much more complicated. If not for the trend of demand I would stick to apartments and avoid retail all together, especially stand alone.

But since we must, the key is to have a very good and experienced commercial leasing broker who represents owners on the team.

Good hunting-

[Lakshay G.]

Thanks a lot @Giovanni Isaksen

I appreciate your opinion and the time you took out to write in details. :)

[Joel Owens]

"A restaurant broker I know says that most of the small restauranteurs he deals with are just buying a job, not building a profitable business."

Before going in commercial real estate I was in the restaurant business for over a decade as a manager and as a restaurant owner.

What the restaurant broker is saying is true to a certain extent. When I look at buying a restaurant most sellers want 3 times profit for a purchase. So it goes something like showing 50,000 profit they want 150,000. Typical is 50% or less down and the seller carries the remaining note. Most buyers try to purchase at 2 times earnings.

The problem is most of that 50,000 profit is because the seller works as the owner there 5 days a week. If I have to now pay a manager because I will not be there all the time that is 30k to 40k. Now if food costs rise just slightly and my margins go down I am not making 50,000 a year but breaking even for nothing. The other part of this is I do not like it where I am going to be paying increased rents paid to a landlord. Buyers of restaurants do not factor in re-imaging costs every 5 to 10 years to make it pop again. The equipment and interior becomes old and dated causing operational problems with the business. I like restaurants where I can have a fixed loan and own the building and the land. If a restaurant is located in a retail strip center then try to buy the center as well. If the restaurant goes down later on you have a bankable asset in the strip center for your hard work over the years (if you bought right).

Where you can make money with a restaurant is buying larger ones. These have sometimes decades of proven track records and management in place and still make a few hundred k or more a year profit. I don't have to be there everyday in those cases. These are more individual restaurants and not big chains or concepts.

In some cases franchised concepts want crazy amounts of liquidity. I have seen some sandwich shops want 200k for build outs and franchise fees which is nuts. The business might pull down 60k a year profit gross and so it would take almost 4 years just to break even and the sandwich brand might not be as hot by then. I just do not see value in those deals. In fact I know some friends who will watch someone use their retirement savings for 250k buying into a Jersey Mike's subs for example and then it's not what they thought it was. Fast forward a year later and you buy there 250k build out for 70k....... : )

What kills the small time restaurant operator is they do not have fixed food service contracts like the big guys. As an owner of restaurants food costs, rent, and labor will make or break the business. Sure you have to have the right concept for the area with demand, excellent food at a fair price, and excellent customer service to drive sales but if food cost, rent, and labor is too high you still will not make much money.

Retail Is not going to kick the bucket. I see more of (need) retail storefronts. So if I was looking at buying a retail strip center I want online proof businesses as a majority of my tenants. For instance a dry cleaners, restaurant, barber shop, doctors office, etc. I want destination type customer places where they need to go there to do something versus businesses that are IMPULSE type shopping items from businesses where you can find that on the internet. I tell my clients to stay away from big box like Best Buy and Office Max etc. unless they are a big fund that wants to value play those at high caps 9 to 10 and can stomach them if they go dark because they own so many other locations.

[Bill Gulley]

Good post @Giovanni Isaksen

Another issue with commercial, retail, warehouse, industrial is knowing a bit of the business of the tenant. Beyond understanding the financials, seasonal issues and markets, you need to understand environmental issues, the liabilities that may arise. These aspects are usually not a point to make to those buying such properties, if you've been in business you are normally aware and rather astute, it's more to those who think of going into commercial and lack the accounting, business interactions Giovanni mentioned and legal aspects. Understand too that leasing a house to a school teacher might be one thing, leasing to a some old business guy with resources, an law and accounting firm and specialists in his industry, you think you're negotiating with similar knowledge? Negotiating can be at another plateau.

Good point made by Giovanni is in selecting complimentary businesses in a building or strip center, allowing a competitor in some areas of retail can be complimentary, in some case you can contribute to a tenant's demise. This is generally addressed in a lease as your tenant will insist on some protection, but they can't rule your acceptance either. In other words, you can shoot yourself in the foot and in some cases be liable for bad decisions.

Insurance is another world too, you'll need to understand any perils that may effect you and ensure your tenant is properly insured.

All depends on the size and scope of what you're saying when you say "commercial". :)

[Giovanni Isaksen]

@Joel Owens Thank you for the behind the curtain look at the restaurant business. I can tell there is a lot of hard earned wisdom in your post.

Your comment: "I like restaurants where I can have a fixed loan and own the building and the land. If a restaurant is located in a retail strip center then try to buy the center as well." reminded me of the what the research for the original edition of The Millionaire Next Door discovered; That most of the millionaires in the US were small businesspeople who owned the real estate where their business was located.

Also agree with you that retail is not going to disappear but selecting the right type and mix of tenants is critical going forward as online and 3D printing make larger impacts.

[Giovanni Isaksen]

@Bill Gulley Thanks for your comments. Great points about having to know how about the business of potential tenants and the related insurance issues. Being relatively new at commercial leasing one thing I do know is how important having an experienced leasing broker is.

[Adam F]

I'm in mfg, so the majority of the properties I own are industrial with some commercial. What I've found is that its very easy to keep NNN industrial leases in place, as long as the building size suits the customers. A lot of industrial companies CANNOT shut down and resetup somewhere else without loosing a lot of money and customers. So I've been acquiring buildings as my customers either need to move or I find new customers that need suitable and cost effective space. It's niche, but low vacancy, steady income and minimal maintenance.

The strategy looks something like this: BUY for $35-50/sq, RENT for 0.45-0.65 cents per square per month for wrhs space, $0.85-1.10 per square for office. You follow that simple math, and you will do pretty well.

[Lakshay G.]

thanks all for great discussions. What is mfg? Manufacturing?

[Jon Klaus]

Originally posted by @Lakshay G.:
thanks all for great discussions. What is mfg? Manufacturing?

Yes

[James Kobzeff]

Over the years I have worked with real estate investors who specifically invested in just shopping centers, office building, storage facilities, or apartments. It became their niche. Since you're just starting out, I would recommend that you develop a business plan that addresses issues like the amount of risk you want to make, for instance, or the amount of time you want to devote to servicing the property. Then follow that plan.

Hope this helps.

[Lakshay G.]

I was interested in residential properties only but I have found partnered who are ready to invest in commercial property only so it's more hands off than hands on. In residential, it'll be very hands on as the unit number will be less than 40.