So, what’s the story with commercial real estate?
Several times per month a residential investor or broker asks me this question, “How do I get into commercial real estate?”
They seem to have a fascination with it. Why might that be?
Well, the deals are bigger, and there’s a much wider spectrum in terms of product type. But there’s also much more to know in order to understand it. It is tough to know where to start.
You might assume that you need to jump in and start figuring out cap rates, rent comps, etc. Instead, if you find yourself interested in commercial real estate, I challenge you to first consider this question: Which type of investor are you?
Which Type of Investor Are You?
Figuring out what type of investor you are (or aim to be) will be the basis for your commercial real estate investment journey and influence your analysis and decision making. The way I see it, there are four types. Let’s dive into each.
1. The Speculator
For the speculating investor, price is THE factor. Their underwriting is focused on what the price is going in, because they are “speculating” that through their knowledge and efforts, they will be able to create value in a property ahead of what the market will do on its own. This could be through increasing rents, lowering expenses, remodeling the property and completing capital improvements, or re-tenanting and thus improving the cap rate.
There are any number of ways to influence the value of the property, but at the core, it is increasing the net operating income (NOI). The speculator relies on their knowledge of the market and has the expertise to create and execute a business plan.
For example, let’s take Sam the Speculator. Sam drives by a retail building every day that is approximately 10,000 square feet. The building has 2,000 square feet of vacancy and lots of deferred maintenance. Sam calls the owner to see if they want to sell. Sure enough, they do.
The property is valued at its current income, which is $80,000 ($10/sq. ft. multiplied by 8,000 square feet). At an 8 percent cap rate, this property is valued at $1,000,000.
Sam knows the market and knows that the rents are under market. She also knows the deferred maintenance is contributing to the vacancy. She develops a plan to improve the property by investing $200,000 into a remodel, new landscaping, HVAC, and lighting and brings a higher level of management and leasing to the property. Through her efforts, she fills the property and slowly brings the other spaces to current market rent. She ends up lifting the rents to $13/sq. ft. for all of the spaces and brings the total NOI to $130,000 per year.
At the same 8 percent cap rate, she now owns a property worth $1,625,000. With her original purchase price and her renovation budget, she is now into the property for a total of $1,200,000, creating $425,000 in equity. Not bad, right?
To become Sam the Speculator, it is critical to know the market. What are the current rents, cap rates, and vacancy in the area? Know your costs for capital improvements, renovations, and tenant improvements. Study comps in the area and dive into what your expenses are. Remember that every $1/sq. ft. you save in operating expenses are potential for rent. All of these factors can impact the value of the property and can help you increase NOI and force appreciation of the value.
This is an area I have spent most of my career in. I love commercial real estate. One of the biggest reasons is because you are rewarded by increasing NOI. It is exciting to see an existing asset improved and repositioned to help reach its full potential.
2. The Traditional Investor
The traditional investor is typically a long-term holder who pays fair market value. They are focused on assets that provide a reasonable return and stability they can rely on—essentially they are a “coupon clipper.”
For example, let’s take Tom the Traditional Investor. He’s not interested in the speculative play that Sam the Speculator made. In fact, after Sam is done stabilizing her property, she calls Tom to ask if he is looking for new acquisitions.
Tom is the perfect buyer for Sam’s asset. Tom has approximately $400,000 available that he would like to invest. He gets a loan for $1,225,000 at 5 percent with a 25-year amortization and a 10-year balloon. As we learned above, Sam’s stabilized property generates $130,000 in NOI. Tom’s annual loan payment is approximately $86,000, which leaves $44,000 in cash flow and gives Tom an 11 percent return on his money ($44,000 divided by $400,000).
Tom doesn’t have the appetite to put the work in that Sam does, but he still wants a reasonable return on his investment. He benefits from a stabilized property and all the tax advantages that come with it, while continuing to get a solid return on his investment.
3. The Developer
The developer creates the most value but also takes the most risk. Let’s put this into context with the same 10,000-square-foot building discussed above.
Don the developer identifies a one-acre parcel of land that is located in a good area and would make a great development site. Don puts the site under contract for $5/sq. ft. ($217,800) and gets to work on his entitlements (aka government approvals to develop a property) to get the project okayed by the local municipality.
In order to get the project approved, he needs to engage a slew of professionals—such as an architect, engineer, environmental consultants, soil engineers, attorneys, etc.—to get the proper documentation necessary for approval. All in all, this costs Don about $100,000.
This can be one of the riskiest parts of Don’s journey to develop the property. He will be risking all the funds he pays for soft costs during the entitlement process. If the project isn’t approved, he will have lost these funds.
Once the project is approved, it needs to be built. He finds his contractor, who estimates $175/sq. ft. ($1,750,000) to build the building and complete the site improvements. He designs a beautiful building, and due to the great location, he has three great tenants who want to rent from him.
Since the building is only core and shell, he offers to contribute $25/sq. ft. ($250,000) in tenant improvement allowances to help the tenants build out the space. So, if you are playing along at home, Don has a total of $2,317,800 into the property. For the location and new construction, his rents are far higher; he ends up getting $25/sq. ft. for each tenant, creating a total NOI of $250,000. The improved tenant mix also justifies a 7 percent cap rate, making the value of the property $3,571,428 and creating $1,253,628 in profit!
Now, you might be asking yourself: based on the profit developers can make, why would you want to be any other type of investor? But it is important to remember the risks along the way. Until the project is complete and the rent checks start coming in, Don is spending money—not making it.
There are also an incredible number of variables that need to be accounted for. For instance, markets can shift, interest rates can move, tenants can change, costs can go up, entitlements can take longer than expected (or not come through at all), and much, much more. When I worked on a mall development project, it took five years from start to finish and had incredible twists and turns along the way. We experienced skyrocketing construction costs, weather delays, tenants who had signed long-term leases file bankruptcy, and a national tenant delay opening for entire year, which sent a ripple effect through the leasing efforts for the rest of the project.
The project ended up being a success in the end, but it was a roller coaster the entire time. And if not for the strong capitalization and a LOT of experience leading the project, it may have been a major failure. If you want to be Don the Developer, it is important to ask yourself how much risk you are comfortable with and how you can limit risk.
4. The Owner/Occupant
Why am I including the owner/occupant as one of the investors? It is important to know not only who you are, but also who else may be competing against you in the market. The owner/occupant is most concerned about the property fitting their needs and can pay the most for a property.
Let’s take Olivia the Owner/Occupant. Olivia has been renting for the past five years and her business is doing great. She is ready to expand.
She is in 6,000 square feet and needs 10,000 square feet. She sees the same 10,000-square-foot building come up for sale that Sam the Speculator was looking at. The building would be perfect for her! It is a great location, has ample parking, and is a building that fits her business perfectly.
While the building is valued at $1,000,000 based on current income, she is more concerned with how the building will help her business grow and be a great investment for her in the long run. She is currently paying $12/sq. ft. NNN (with NNN standing for net-net-net, which are the pass through costs such as property taxes, insurance, and common area maintenance) to rent her current space ($72,000 per year).
She runs the numbers based on putting 25 percent down at 5 percent interest and a 20-year amortization. She determines that she could pay $1,200,000, and the annual payment would be $63,135, saving her close to $9,000 per year in rent. She would also be able to take advantage of the tax deduction for owning the business, as well.
Sam the Speculator can’t believe that someone would pay 20 percent more than the asking price, but Olivia found a building that worked perfectly for her business. Plus, by using the building for her business, it allowed her to make a smart investment while helping her business long-term.
It is critical that you know yourself—and that you also know who else you may be up against—to succeed as a commercial real estate investor. Personally, as a speculator, I have lost out on properties to owner/occupant investors. They simply outbid me, because the deal still made great financial sense for them.
So, which type of investor are you? How does knowing your type inform your strategy?
Let’s talk in the comment section below.