Commercial (Retail) Analysis Components

27 Replies

So I know there are a lot of "Rules of Thumb" on the Residential side of Real Estate.  As I try to transition into Commercial (Retail) I find that I have no idea on how to perform the proper analysis.  

What are the Expenses that one needs to account for on Retail Commercial Spaces?

What are the "Rule(s) of thumb" that an investor should run quickly to evaluate a property?

What are some of the signs that the property could be a diamond in disguise? 

Medium logo640x400Troy Fisher, Lanika Home Inspections | [email protected] | http://www.lanikahis.com

Expenses are much higher and I plan for at least a year of vacancy. Brokers I work with charge up to $4per sq ft to get tenants in ($2 for the tenants broker and $2 for my broker). Monthly management is similar to residential ranging from 5% to 10% of gross rents. Negotiations with tenants have more dimensions including build out costs, free rent, length (I look for at least a 5 year lease with established companies). We split a build out on a small 2k sq ft retail space. Total build out cost was $22k. It can get pricey but depending on the market and the tenant, that can be tenant paid.

Larger retail the management fee can go down to 3 to 4%. 3% especially if you give them multiple centers to manage.

I am talking larger centers that are 6 to over 10 million in price etc.

The smaller centers I can see 5% management to 6%.

The larger centers tend to have more national tenants, franchisees, and just  a few mom and pops. The smaller centers have more of a local tenant base.  

Medium allworldrealtyJoel Owens, All World Realty | [email protected] | 678‑779‑2798 | http://www.AWcommercial.com | Podcast Guest on Show #47

As far as rules of thumb, look up cap (capitalization) rate and debt service coverage ratio. I think there are way more "diamonds in the ruff" in the commercial space but I might be biased. I'm also talking about retail and office spaces that are smaller in size maybe 30k sq ft or less. I haven't dealt with big box stores. My impression is that the big money with cash buys those to make above Tbill returns. I need a little more to overcome a mortgage cost. I love half vacant properties. A lot of them are from older owners that don't really care anymore. The great thing about commercial is that you buy it based on the rents. If you fill the vacant sections, the vale goes up something we call forced appreciation.

Originally posted by @Greg V.:

Expenses are much higher and I plan for at least a year of vacancy. Brokers I work with charge up to $4per sq ft to get tenants in ($2 for the tenants broker and $2 for my broker). Monthly management is similar to residential ranging from 5% to 10% of gross rents. Negotiations with tenants have more dimensions including build out costs, free rent, length (I look for at least a 5 year lease with established companies). We split a build out on a small 2k sq ft retail space. Total build out cost was $22k. It can get pricey but depending on the market and the tenant, that can be tenant paid.

 Management Fee - 5 - 10%  (Check!)
When evaluating a property, in your analysis do you budget a certain % for TI?

Medium logo640x400Troy Fisher, Lanika Home Inspections | [email protected] | http://www.lanikahis.com

Troy,

When I underwrite a commercial loan, I will typically set up a reserve account for TIs and leasing commissions.  Also, I will take into consideration a reasonable management fee.  On retail above 5 million, I know you could go down to 3-4%, but we will use 4% as our criteria.

Mark

With the market right now, I probably won't be paying for any tenant improvements unless it's a national tenant with a 10 year lease. Right now we're repurposing a family restaurant and banquet center to multi unit office space. We priced out the cost to section off the space and have that in reserve. For us, assuming a certain TI is tough because everything's a negotiation and we're looking long term and value stable tenants. I want to have the best negotiating position if we get in a bidding war with another landlord.

Originally posted by @Joel Owens:

Larger retail the management fee can go down to 3 to 4%. 3% especially if you give them multiple centers to manage.

I am talking larger centers that are 6 to over 10 million in price etc.

The smaller centers I can see 5% management to 6%.

The larger centers tend to have more national tenants, franchisees, and just  a few mom and pops. The smaller centers have more of a local tenant base.  

Joel,
This property is the first Commercial Retail that I am evaluating, it's 77k sq/ft.  Having been in the QSR industry for a while, that seems to me to be a "Large" Center  With some tenants occupying 14,500sqft and 28,500sqft.  But with a 10% cap rate the property is underperforming with rents as low as .15c.  My gut tells me there is a huge upside potential but I'm not confident enough on how to evaluate the future costs of operating the property.

Medium logo640x400Troy Fisher, Lanika Home Inspections | [email protected] | http://www.lanikahis.com

Originally posted by @Greg V.:

As far as rules of thumb, look up cap (capitalization) rate and debt service coverage ratio. I think there are way more "diamonds in the ruff" in the commercial space but I might be biased. I'm also talking about retail and office spaces that are smaller in size maybe 30k sq ft or less. I haven't dealt with big box stores. My impression is that the big money with cash buys those to make above Tbill returns. I need a little more to overcome a mortgage cost. I love half vacant properties. A lot of them are from older owners that don't really care anymore. The great thing about commercial is that you buy it based on the rents. If you fill the vacant sections, the vale goes up something we call forced appreciation.

 The property is a 10% Cap Rate (Check!)

The DCR depends on how it's financed and what the reserve costs are going to be.
Of course forced appreciation and future value is something that I am looking for.

Medium logo640x400Troy Fisher, Lanika Home Inspections | [email protected] | http://www.lanikahis.com

Originally posted by @Mark Creason:

Troy,

When I underwrite a commercial loan, I will typically set up a reserve account for TIs and leasing commissions.  Also, I will take into consideration a reasonable management fee.  On retail above 5 million, I know you could go down to 3-4%, but we will use 4% as our criteria.

Mark

Do you do TI & Leasing Commissions as a percentage of GSI? A flat amount?

Medium logo640x400Troy Fisher, Lanika Home Inspections | [email protected] | http://www.lanikahis.com

Hi Troy,

How much money do you have to buy this property??

I typically advise my clients to stay away from what I call the big three or  four top spaces.

I see some clothing stores where people can go online and buy cheaper. Those large 3 unit older buildings the breakeven occupancy on servicing the debt is not good. You can have one tenant go out and you are starting to throw money at the mortgage. With a 10 unit strip you would need to lose 4 out of ten tenants to get the same affect plus many more business want the smaller spaces so they do not sit as vacant for long.

If the large tenants are national tenants with corporate guarantee for a long period of primary lease term the I will take a look. Generally there is a just a few years left primary and a larger risk. Lenders will require extra reserves swept from your bank account to cover the DSCR falling if the space goes dark and also have larger existing reserve requirements.

Medium allworldrealtyJoel Owens, All World Realty | [email protected] | 678‑779‑2798 | http://www.AWcommercial.com | Podcast Guest on Show #47

Wow. With that size space Joel's your man for advice. That is a large space for your first commercial. I wouldn't personally feel comfortable with that size as my first commercial but I guess it depends on your bank account. With 77k sq ft, personally my wife and I would need at least $250k to $500k cash reserves to sleep at night but it would depend on the tenants. As far as DSCR, I should have mentioned that banks look for 1.25 but I've had them go down to 1.1 if there's empty space that can be filled.

Originally posted by @Joel Owens:

Hi Troy,

How much money do you have to buy this property??

I typically advise my clients to stay away from what I call the big three or  four top spaces.

I see some clothing stores where people can go online and buy cheaper. Those large 3 unit older buildings the breakeven occupancy on servicing the debt is not good. You can have one tenant go out and you are starting to throw money at the mortgage. With a 10 unit strip you would need to lose 4 out of ten tenants to get the same affect plus many more business want the smaller spaces so they do not sit as vacant for long.

If the large tenants are national tenants with corporate guarantee for a long period of primary lease term the I will take a look. Generally there is a just a few years left primary and a larger risk. Lenders will require extra reserves swept from your bank account to cover the DSCR falling if the space goes dark and also have larger existing reserve requirements.

 Joel,  

    with 30% down at 10% Cap, this property pencils out to just under 1.8mil and I'd be in for just about 600k.  I'd be looking to wrestle up some partners or Private Money to make up the difference.  I'd be looking at 5 people @ 150k or 4 people @ 200k so that there are cash reserves to be held in the partnership. For now, this is an exercise for me to learn how to evaluate these larger properties and learning the more in depth steps.

Here's the pro forma: (BP won't allow any HTML Tables so this is ugly, first # is soft, second is monthly rents, and third # is the rent/sqft

Automobile Repair

9400 -- 3000 -- 0.32

Church

14300-- 2000 -- 0.14

Jerky

25600 --- 3500 -- 0.14

Restaurant

3127 -- 1750 -- 0.56

Listed as Rented buy Google says is Vacant

2400 --- 0 -- 0

Rock Climbing Venue

2000 -- 1200 -- 0.6

Smog Shop

2600 -- 1500 -- 0.58

Gym

7000 -- 1300 -- 0.19

Vacant

11000 -- 0

Totals:

77427

14250

0.21

Calculations:

Listed Price $1,710,000.00

Listed NOI $171,000.00

Listed Cap Rate 10.00%

DP 30.00% =  $513,000.00

Financed $1,197,000.00

Debt Service @5.5% $95,760.00 (15yr Amortized 30)

Cash Flow $75,240.00

COC 14.67%

Debt Service @3.5% $83,790.00 (15yr Amortized 30)

Cash Flow $87,210.00

COC 17.00%


A couple things to note:

1 - There's a wide swath of Tenant Classes 

2 - I am aware of the environmental concerns of the Smog & Automobile businesses. they are on the back side of the property away from the retail in a separate set of steel warehouse buildings.

Tagging @J Martin -because he wanted to stay in the loop on this.

Updated over 3 years ago

Edit: Had to fix the formatting.

Medium logo640x400Troy Fisher, Lanika Home Inspections | [email protected] | http://www.lanikahis.com

Originally posted by @Greg V.:

Wow. With that size space Joel's your man for advice. That is a large space for your first commercial. I wouldn't personally feel comfortable with that size as my first commercial but I guess it depends on your bank account. With 77k sq ft, personally my wife and I would need at least $250k to $500k cash reserves to sleep at night but it would depend on the tenants. As far as DSCR, I should have mentioned that banks look for 1.25 but I've had them go down to 1.1 if there's empty space that can be filled.

 I don't want to repeat the same mistake I made in the beginning.  I let my fear of things being too big from starting off bigger and spending all my cash on smaller properties. If I had started off bigger the first time out I'd be much further along in my goals than I am now.

Medium logo640x400Troy Fisher, Lanika Home Inspections | [email protected] | http://www.lanikahis.com

@Troy Fisher  ,

Thanks for keeping me in the loop.

As many mentioned, savings reserves for TI's and commissions is important.

Be sure to review all the leases, and eventually get tenant estoppels stating what they pay, and/or verify the numbers yourself. Is it triple net? Or all gross? The expenses paid by the tenants are going to have a HUGE impact.

What's the traffic? Visibility? Competition in area?

What does a potential lender think about a new "Sponsor" that's not familiar with retail? Many lenders want to see the track record of the operator, or a higher downpayment (or higher reserves). What do you think @Joel Owens  ? In this sub-$2MM deal.. How much will the lender care about experience in commercial/retail?

What are the pro-forma rents and vacancy rates? How long will it take and how much money to get there? This is probably most crucial on the value..

Good luck! And let me know how it goes!

Medium logoJ. Martin, SF Bay Summit | [email protected] | 510‑863‑1190 | http://www.sfbaysummit.com

Do I need to get all cash on a commercial deal to do a 1031 exchange? A broker told me that if I carry any part of the paper I can't do a 1031??

Confused

Hi Craig,  You absolutely can do a 1031 exchange even if you carry back a note.  You may or may not have to pay some tax. In order to do a total exchange The IRS requires that you reinvest all of the proceeds from the sale in the next purchase or purchases.  However you can take some of the proceeds (think of the owner carry note as part of the proceeds) as what is called boot and only pay tax on that amount.

Here's an example.  Say you were selling a $2mm retail center that you had paid $1mm for and are carrying back a note for $400K. Your exchange account has two proceeds in it - $600K in cash and a note for $400K.  You have a couple of options.  You can pay the tax on the 1mm gain (not fun).  You can do a partial exchange ( you would pay tax on the $400K note but shelter the remaining $600K in gain from tax which is better than a sharp stick in the eye but still meh!).  Or you could find an alternative source of cash and buy the note from your exchange account so your 1031 account has $1mm in it which you use to purchase replacement property - no tax.   Now outside and unrelated to your 1031 account you have a note for $400K secured by the property you sold and here's the great part about it - You paid $400K for it (remember you "bought" it from your exchange acct) so the only tax you will pay on it will be on the interest it produces.  

Yes, do the  exchange and carry some paper.  There are several ways to do it.

Medium ergDave Foster, Exchange Resource Group | [email protected] | 850.889.1031 | http://www.erg1031.com

I knew,deep down, there was a way! Excellent! Thank you!

Where did the 10% cap rate come from?  Is that just a made up number?  If market comps suggest 11% you'd overpay $150, 000! 

Originally posted by @Bob Bowling:

Where did the 10% cap rate come from?  Is that just a made up number?  If market comps suggest 11% you'd overpay $150, 000! 

 The prevailing Cap Rate for commercial retail space in that market is 10%.

Medium logo640x400Troy Fisher, Lanika Home Inspections | [email protected] | http://www.lanikahis.com

Originally posted by @J Martin:

@Troy Fisher ,

Thanks for keeping me in the loop.

As many mentioned, savings reserves for TI's and commissions is important.

Be sure to review all the leases, and eventually get tenant estoppels stating what they pay, and/or verify the numbers yourself. Is it triple net? Or all gross? The expenses paid by the tenants are going to have a HUGE impact.

What's the traffic? Visibility? Competition in area?

What does a potential lender think about a new "Sponsor" that's not familiar with retail? Many lenders want to see the track record of the operator, or a higher downpayment (or higher reserves). What do you think @Joel Owens  ? In this sub-$2MM deal.. How much will the lender care about experience in commercial/retail?

What are the pro-forma rents and vacancy rates? How long will it take and how much money to get there? This is probably most crucial on the value..

Good luck! And let me know how it goes!

1 - Argh! I know! I'm just trying to find out what people use as to budget TI, when purchasing? $100/sqft? 10% of sales price? 10% of NOI? 1MM? I've never seen a Rule of thumb.

2 - Since I don't have an offer in, and this is (currently) just a thinking exercise, my assumption is at such low rent rates that yes it is NNN.

3 - I have a call in to the city to see what kind of traffic survey information I can get from them.  I would have thought that a serious seller trying to get top $ would have that information ready to go.   I'm still putting together a market research about available retail space. Google Street View:

https://www.google.com/maps/@37.6357551,-120.99648...

4 - I'd love to hear more of the insight that @Joel Owens can bring about the financing part.

5 - All the numbers in the thread are pro-forma.

Medium logo640x400Troy Fisher, Lanika Home Inspections | [email protected] | http://www.lanikahis.com

Originally posted by @Troy Fisher:

not confident enough on how to evaluate the future costs of operating the property.

 Can't you use your cap rate comps expenses to project this?

Troy the lender reserves are based on the deal itself. If the space is vacant and the seller is providing an master lease the lender might require an escrow for TI's etc.

If for instance a center has some strips but larger buildings mixed in and the larger building have just 5 years left on primary lease term or less then the lender might require extra reserves. The lender wants to protect against a default event on the loan by having extra reserves calculated for if things go wrong. The lender doesn't want the borrower spending all the cash flow without adequate reserves and then an event happens for which they do not have funds to prop up the property etc.

It's all based on the deal after the lender has reviewed the Om package and the operating statements in pre-screen as to what terms they will offer or if they will even give a loan on the property. This is for CMBS loans. Loans at bank are underwritten a little differently.

Hope it helps. 

Medium allworldrealtyJoel Owens, All World Realty | [email protected] | 678‑779‑2798 | http://www.AWcommercial.com | Podcast Guest on Show #47

Originally posted by @Bob Bowling:
Originally posted by @Troy Fisher:

not confident enough on how to evaluate the future costs of operating the property.

 Can't you use your cap rate comps expenses to project this?

Great advice! 

The listing sent to me from the broker shows a NOI $80,000 higher then what the proforma rent rolls suggest. So I broke it down to examine if this was a diamond in the rough, with a bad broker, and a tired owner. No expenses are listed, and I am assuming that the leases are NNN. I know about assuming.

My coffee just kicked in.  Initially (the above paragraph) was in response to a different question that I read - "Can't you use your cap rate (to determine) expenses to project this?"

But, your suggestion was, "Use the Properties that you are drawing the Prevailing Cap Rate from to draw a conculsion on what expenses you are going to bear."

In response to that my initial response is:
1 - There are no other Retail Spaces in the Downtown Core that are of this size, and are at such submarket lease rates.
2 - The downtown market is gentrifying into a professional office space market (Broker suggest best play is a development play)

But I definitely will drill down into these other properties and see what I can find.

Thanks!

Medium logo640x400Troy Fisher, Lanika Home Inspections | [email protected] | http://www.lanikahis.com

Originally posted by @Joel Owens:

Troy the lender reserves are based on the deal itself. If the space is vacant and the seller is providing an master lease the lender might require an escrow for TI's etc.

If for instance a center has some strips but larger buildings mixed in and the larger building have just 5 years left on primary lease term or less then the lender might require extra reserves. The lender wants to protect against a default event on the loan by having extra reserves calculated for if things go wrong. The lender doesn't want the borrower spending all the cash flow without adequate reserves and then an event happens for which they do not have funds to prop up the property etc.

It's all based on the deal after the lender has reviewed the Om package and the operating statements in pre-screen as to what terms they will offer or if they will even give a loan on the property. This is for CMBS loans. Loans at bank are underwritten a little differently.

Hope it helps. 

 I love the knowledge!  Let me target a couple more questions back at you:
"The lender reserves are based on the deal itself" -- How then do you evaluate what your strategy and endgame are going to be if when you are evaluating a deal where in expenses you have: Lender Required Reserves:  <UNKNOWN>?

"It's all based on the deal after the lender has reviewed the Om package" -- Om, does that mean Offering Memorandum?

"and the operating statements in pre-screen as to what terms they will offer or if they will even give a loan on the property."  -- So know what your bank is going to loan on, and have different banks for different strategies?

"This is for CMBS loans." - CMBS?

Medium logo640x400Troy Fisher, Lanika Home Inspections | [email protected] | http://www.lanikahis.com