Diving into Commercial Real Estate

[Tim Rostro]

Hello BP Community,

I have been a residential investor for the last 10 years with a small portfolio of 5 properties, in TX and OH, a mix of SFH and duplexes. I've decided to take the next big step and scale up even higher. I'm pulling profits from my stock market holdings and pivoting to commercial properties, specifically in the Dallas/Fort Worth area. After having lived in TX for over 10 years, I've seen such tremendous growth in that state. And the pandemic has seen more growth as people have flocked there. From my research, the barrier to entry for commercial properties is enormous. Not your run of the mill residential investment. You need a couple of hundred thousand dollars for a down payment for just a single unit but the profit is huge and you don't need to deal with individual persons (and drama), just a business that sign multiyear leases.

A friend of mine, one of my former Soldiers, is currently a realtor there, and has been sending me listings, around the top suburbs of the Dallas/Fort Worth metropolitan area. I spent this past Saturday learning what a triple net lease (NNN) was (wish individual renters were subject to this), price per square footage (where is the monthly rent?), and focusing on a specific commercial property. That would be professional services such as a law firm or tax preparation and medical services such as dental, physical therapy, or a general practice. I've ran the numbers and they manage to be favorable, profitable, despite the high interest rates (I can always refinance in the future). My next steps are to find a bank, a property management company, and set up an LLC in TX as I don't want to be the owner, the LLC will be the owner and me as it's sole employee for now (and receiving a W-2 in the process). I'm hoping to purchase my first one by the late fall.

Apologize for the long post.  For those with commercial properties, what advice would you offer to someone just starting off?  Thanks!

[Henry Clark]

A. Is there a logic behind paying taxes twice? LLC and as an employee?

B.  You say the numbers look reasonable.  But you haven’t done commercial before.  Recommend you do a post on your numbers and see if anyone has advice.  Did you factor the cost of switching from a law office to a dental office?  Do you have capex budgeted?  What period do you have budgeted for not being rented?   Etc

[Michael K Gallagher]

@Tim Rostro I work mostly in retail site selection for commercial properties, all over the country, and I'd say the biggest thing to wrap your head around is the concept of the value coming from the income of the property.  Meaning that the lease on the building that is currently there is the real value, and that the future plans or future uses are the future value of the property.

Also, when it comes to being the LL of these properties there is substantial investment you'll traditionally have to make in the form of TIA or tenant improvement allowance when the unit turns.  You don't have to do this, you can lease spaces in an "as is" state, but that will impact the $$/SF you can get for the space.  

Commercial leases and deals truly need to be looked at from a "holistic" view, its not just the rent, or the NNN expenses, but the total view of the lease in place. Things like cancelation rights, or first rights of refusal, etc can impact your valuation and lend-ability on the property, so I'd say your next "homework" is to study some leases on this property or others and learn the ins and outs of the lease dynamics and the different levers you can pull in these days to make them better/worse etc.

[Lucia Rushton]

@Tim Rostro is your realtor friend in commercial ? If not, I would encourage them to partner with a commercial broker that does retail. You just don’t want to miss something. If they need referrals, let me know.

[Scott E.]

I too have been trying to focus more on commercial over the past couple of years. But due to the higher barrier to entry that you mentioned, it's been tough.

I've done 2 commercial deals so far (1 office, 1 medical). Here are some highlights from my experience:

-You say these deals are profitable despite high interest rates. I find that hard to believe. In most larger markets (like Dallas/Forth Worth) the cap rates on quality commercial deals are still hovering in the 4-6% range. Meaning there is no cash flow if you're using leverage.

-The leases on these deals are cleaner in the sense that you as the landlord will have less responsibility. But the lease paperwork itself is much more complicated. You'll need an attorney to review.

-Speaking of hiring an attorney, your due diligence (feasibility period) is going to be intense when you get one of these under contract. Out here in AZ you get 30 days to conduct inspections, etc. And there is a lot more to look at and analyze over these 30 days compared to when you're buying a residential deal.

Plenty more to talk about but those are the highlights from my experience.

[Tim Rostro]

@Scott E.

Thanks for the response.  Here are my numbers I have so far and they are rough numbers.

The property in question is a brand new property in a suburb north of Dallas/Fort Worth. One unit is 1610 SF, office/medical, $26 NNN, $523,000.

I am prepared for a down payment of 30-38% of the purchase price: $157,000-$195,000 (no wonder it's a barrier to entry with these amounts).  I also have the funds for closing costs and capex.  I have budgeted another $50,000-$75000 for this.  I'm going with the 38% down payment.

Using an online commercial property calculator, based on a 8.5% interest rate, 25 year terms, and $195,000 down payment, the final numbers are $2641 per month.  If the interest rate went down to 7.5%, the final amount is $2423.  I'm hoping to buy points if that's possible and refinance in the future.  

As for the rent, 1610 SF x 26= $41460= $3488 per month.  Since I will hire a property management company, that's a further 10%: $3488-$348= $3140 per month.  Based on the difference between the mortgage payment and rent, I can come out ahead by several hundred dollars.

As for the cap rate, using a caprate calculator, 523,000/41460, 35% operating expenses, 5% vacancy rate= 4.9% caprate, bringing at 30% operating expenses, that's 5.3% caprate.  Even with those numbers, I will come out slightly ahead.  I guess the key here is to wait until interest rates go down by several points in order to make the numbers more manageable, preferably down to 5%.    

These are still rough numbers and I know I'm probably missing something or multiple items. Your input would be greatly appreciated.  Thanks.   

[Tim Rostro]

@Lucia Rushton

My friend belongs to a commercial brokerage.  Sent you a DM.

[Tim Rostro]

Quote from @Michael K Gallagher:

@Tim Rostro I work mostly in retail site selection for commercial properties, all over the country, and I'd say the biggest thing to wrap your head around is the concept of the value coming from the income of the property.  Meaning that the lease on the building that is currently there is the real value, and that the future plans or future uses are the future value of the property.

Also, when it comes to being the LL of these properties there is substantial investment you'll traditionally have to make in the form of TIA or tenant improvement allowance when the unit turns.  You don't have to do this, you can lease spaces in an "as is" state, but that will impact the $$/SF you can get for the space.  

Commercial leases and deals truly need to be looked at from a "holistic" view, its not just the rent, or the NNN expenses, but the total view of the lease in place. Things like cancelation rights, or first rights of refusal, etc can impact your valuation and lend-ability on the property, so I'd say your next "homework" is to study some leases on this property or others and learn the ins and outs of the lease dynamics and the different levers you can pull in these days to make them better/worse etc.

Thanks for commenting.  There's more research I need to look up before placing an offer.  This feels like the first time I bought my first residential rental property.  A lot to digest.  Hopefully, the process is much more easier as I continue to make future deals.  

[Scott E.]

Quote from @Tim Rostro:

@Scott E.

Thanks for the response.  Here are my numbers I have so far and they are rough numbers.

The property in question is a brand new property in a suburb north of Dallas/Fort Worth. One unit is 1610 SF, office/medical, $26 NNN, $523,000.

I am prepared for a down payment of 30-38% of the purchase price: $157,000-$195,000 (no wonder it's a barrier to entry with these amounts).  I also have the funds for closing costs and capex.  I have budgeted another $50,000-$75000 for this.  I'm going with the 38% down payment.

Using an online commercial property calculator, based on a 8.5% interest rate, 25 year terms, and $195,000 down payment, the final numbers are $2641 per month.  If the interest rate went down to 7.5%, the final amount is $2423.  I'm hoping to buy points if that's possible and refinance in the future.  

As for the rent, 1610 SF x 26= $41460= $3488 per month.  Since I will hire a property management company, that's a further 10%: $3488-$348= $3140 per month.  Based on the difference between the mortgage payment and rent, I can come out ahead by several hundred dollars.

As for the cap rate, using a caprate calculator, 523,000/41460, 35% operating expenses, 5% vacancy rate= 4.9% caprate, bringing at 30% operating expenses, that's 5.3% caprate.  Even with those numbers, I will come out slightly ahead.  I guess the key here is to wait until interest rates go down by several points in order to make the numbers more manageable, preferably down to 5%.

These are still rough numbers and I know I'm probably missing something or multiple items. Your input would be greatly appreciated.  Thanks.   

If all of these assumptions are correct, then this sounds like a great deal. New construction. 7.92% cap rate based on projected rent. The only downside is your cash-on-cash return is going to be like 2.4%. (you're making $500 per month on cash $250k invested).

The 2 biggest concerns I see are...

1. It's a single tenant building. Not a deal breaker but this is a risk

2. If the broker is advertising $26/SF NNN rent, the actual rent might be closer to $23/SF NNN. Which would kill this deal. So I'd spend a lot of time studying comps to get some more confidence in that rent potential.

You say you will hire a property manager. That's not necessary on a small single tenant NNN deal in my opinion.

[Sean Constable]

@Tim Rostro speak with some lenders. Most commercial loans are for shorter periods. The payments may be amortized over 25 years but you will have a balloon payment at end of loan term.

[Ronald Rohde]

office condos are terrible investments. You don't have control and the market for tenant is very tough. Medical office is strong right now though.

I only invest in industrial NNN in DFW. I'd look for a larger building, small commercial is the worst investment ever.

We're happy to chat if you need a lawfirm for the closing, lease review, etc.

[Dylan Speer]

Have you considered exchanging some properties into a DST?

[Tim Rostro]

Quote from @Henry Clark:

A. Is there a logic behind paying taxes twice? LLC and as an employee?

B.  You say the numbers look reasonable.  But you haven’t done commercial before.  Recommend you do a post on your numbers and see if anyone has advice.  Did you factor the cost of switching from a law office to a dental office?  Do you have capex budgeted?  What period do you have budgeted for not being rented?   Etc

Thank you for commenting. I had just finished consulting an attorney from a law firm based out of Dallas who also deals with LLCs and you are absolutely correct with Point A. The LLC will be taxed under Schedule E on my taxes. The C Corp would pay me as an employee and he advised that not be beneficial. As for the numbers, I posted them to another BP member in this forum.

[Ash Patel]

I have been a non-residential commercial RE investor for over 10 years. When people think of commercial they usually gravitate towards NNN because of the allure of mailbox money. We have done office, retail, medical, industrial, mixed use, restaurants, flex and ground up development. We will do any non-residential deal that makes high returns. Purchasing fully lease NNN properties is parking money vs. growing it. Ideally we would look for a retail strip center with a mix of national tenants, mom and pops and vacancy. This leads to tremendous upside. I am not self promoting but the link below is a number of solo podcasts I have done to try to educate people and motivate them to get into commercial RE. @Ronald Rohde is correct, office condo's are terrible investments for a number of reasons. I also run a mastermind teaching people how to take down CRE deals. I would strongly encourage all of you to avoid the ridiculous competition in Multi-family, self storage and RV/Mobile home parks. The level of competition has saturated those asset classes and a lot of those operators have pivoted into car washesh and laundromats. The result is car washes and laundromats have compressed cap rates to levels where it is difficult to compete. Start by evaluating a small strip mall near where you live. Run the numbers and you will see the returns are often higher than any other asset class.

[Amir Khan]

@Tim Rostro I hear you about feeling the barrier to entry into the commercial market (I went through that as I have a similar story as yours). You can certainly enter commercial multifamily real estate without requiring a very large down payment. You can start with smaller commercial multifamily 6 - 10 units. I agree that you won't find them in DFW area at high enough cap rate and this size units. But there are other parts of Texas where you can. DM me if you like to chat..

[John McKee]

I like retail condos that are on the ground level of a busy street.  These can be converted to office or medical if need be but ideally if you are in a retail district they should do okay.  It's all about the foot or car traffic.  Medical condos are probably the second best assets class in the condo category as these tenants are a bit sticky, however like office you have to be careful about the oversupply.

I would stay away from the business districts and focus more on the neighborhood districts that have 24 x 7 traffic.  With medical it would be ideal to be near other medical facilities and operators such as a hospital.

 Your interest rate seems a bit aggressive and you won't need a property manager for this type of asset.  

@Ash Patel  PM me your link on your podcasts.  Love to hear you.

Those are my 2 cents.

[Ash Patel]

@John McKee - Agree with your opinion on condo's.  I dislike them because their sales are usually bound by comps vs. income approach.  That being said, already built out medical condo's that command higher rents are great!  Will send you a PM.  My link was understandably removed.