5 unit commercial strip, is this a deal?

30 Replies

Hey BP,

I was out yesterday doing some shopping and the owners of the store I was in approached me about selling their other location. I'm a frequent customer and they know I buy real estate which is why they asked. They own the building their other location is at. It's a 5 unit strip center in a good location with two nationally franchised tenants, their store, a hair salon that has been there for a long time, and in the process of signing on the last unit which will be a nail salon. They have owned the building since 1997, and it was on a 99 year ground lease with roughly 65 years remaining. 

I'm posting here in hopes of learning a little bit about this ground lease and what the pros and cons of such an investment would be.  I invest for the long term for cash flow. They are asking 500k which is about 100k/unit, and at that price it didn't seem outrageous or anything. It's not currently on the market, but they are older and are tired of dealing with it. I don't know all of the numbers for income/expenses yet, but I'd like to know if this kind of deal is common and if it would make sense before I sit down with them to get more details.

Does this sound like a deal to you? What would you do? They are motivated and as far as I know I am the only one looking so far.

Thanks!

Jarred

The deal is quite common and with 65 years remaining on the ground lease jump in and grab the numbers . The only danger in ground leases are when they close to renewal.

They told me they tried to buy the land as well but the owners weren't ready to sell yet. Could you explain what could happen at renewal? With 65 years left, I'll likely be dead at the end of the term, so I am kind of unsure about what kind of strategy I should be using here. 

Your ground lease is in force for the sixty five years base all your numbers on the lease taking in account cost of living increases built into the lease  the only danger is what happens at lease expiration or if the owners sell the land You could be in for a steep increase sixty five years for now or have a buy out offer form the new owners in case of a sale As i said before get a copy of the ground lease, and the rents rolls for the tenants and run it by an experienced commercial lender No need to worry until you get the facts You have an inside deal which can be the most profitable or might make a good wholesale sceanrio

Find a local commercial broker that specializes in small retail. The key will be if the sellers will cover their commission.

A local bank will only look at this property. With retail most non-bankers lenders start at a 2 million loan balance.

If they are older and do not want to deal with it maybe an owner finance situation? Is the building paid off? If it is not is the loan assumable? Does the loan have a pre-pay penalty?

What is the store that is there? Is it a gas station? I would worry about a clean phase one. I typically do not like gas stations attached to other retail units for this reason. 

@Joel Owens , I thought about an owner finance situation as I don't have enough cash on hand for a down payment. However, I'm not sure I understand enough about the ground lease.  I understand that sometimes the building can go to the land owners at the end of the term. If that's the case, what exactly is happening with the cost of the building in the first place? Where exactly is the equity?  What am I truly buying in the deal?  If I pay 500k for the deal, and pay that off, is that truly an asset if it just ends up being owned by the land owner in the end? 

There are no gas stations. It's just a typical 5 store commercial strip. There is a subway, an AT&T store, a hair salon, the owners business, and one vacant unit they are working to lease for a nail salon. I was told they are all leased for the next 3-5 years, and are NNN leases.

Thanks for commenting!

@Jarred Sleeth

You are essentially buying a leasehold estate.  What that means is that ultimately you don't own the land, nor do you own the building.  You simply have rights to the building for the next 65 years.  In those 65 years, you are welcome to lease out the building and make improvements (depending on what the ground lease says), and collect revenue.  However at the end of the 65 years, the land and the building reverts back to the owner of the land, unless the owner extends the term of the lease.

The situation isn't so different from a business leasing out a commercial space.  For instance, let's say, the Subway signed a lease for 5 years.  In those 5 years, Subway has the right to use the space to produce revenue and profits.  After those 5 years are up, the unit reverts back to the building owner unless the owner extends the lease.  

So, why do ground leases even exist?  It's the same reason that Subway would choose to lease the space rather than buy their own building - lack of capital (or better use for capital).  The developer that built that building, instead of coming up with the needed capital to buy the land and then develop it, can cut his capital needs greatly by leasing the land with the rights to build on it.  

I should add a bit about valuation:

You should value the property not as if you are buying real estate, but rather you are buying a stream of cash flow.  The value of that ground lease is dependent on the cash flow for next 65 years.  The typical financial tool would be to utilize the discounted cash flow method to arrive at present value.  Obviously there are a lot of projections that need to be made, but you can at least start with what's on the lease and current rents.  The further away you get from present day, the less it matters (future money isn't worth as much as present money).  

Just as an example, if your NOI is $50K every year, with a discount rate of 10% (you expect to earn 10% on your money invested), over 65 years, it would arrive at a value of roughly $500K.

@Daniel Chang

Thanks for the information. I'm wondering how useful this type of investment would be for me. The acquisition cost seems to be a sunk cost in the end, and the value would actually decrease over time rather than increase. Am I getting this right? For what reason might an investor like myself purchase a deal like this rather than a commercial deal that includes the building and land together?

Thanks!

Originally posted by @Jarred Sleeth :

@Daniel Chang

Thanks for the information. I'm wondering how useful this type of investment would be for me. The acquisition cost seems to be a sunk cost in the end, and the value would actually decrease over time rather than increase. Am I getting this right? For what reason might an investor like myself purchase a deal like this rather than a commercial deal that includes the building and land together?

Thanks!

How useful it would be to you is of course a question only you can answer.  Yes, as the years go on, overall the value would decrease because there's less future potential cash flow.  

Obviously, if everyone had their choice, they would own the property fee simple, meaning the building, land, with full rights of ownership.  Sometimes, it's a matter of capital.  The same building fee simple might be $1.5MM, whereas you can buy the leasehold estate for $500K (just an example).  Sometimes, it's the only option available if it's a property that suits your need as an owner user.

If you would earn an IRR of 20% with a leasehold estate, and a 15% for a similar property fee simple, which one would you rather have? Just remember, that it's not worth 0. If you were able to buy the rights for $50K per year for 65 years for a mere $1000, would you? Of course you would! Even though that $1000 is a "sunk cost" as you would put it. So if you would do $1000, then there is a valuation that makes sense to any investor.

Overall, my general recommendation is if you don't understand the investment, best to stay clear of it.  But it never hurts to get the financials and crunch some numbers.

Yeah you do not see these that often. I run into them maybe 5 to 10% of the time. 

I see these sold with not enough years left before the option hits to get the capital back.

I typically like to stick to ground leases or fee simple NNN. NN and also leasehold you better be getting a very high return for the extra risk.

@Daniel Chang

Thanks for explaining. I'm really thinking there is a disconnect in my understanding of how this type of deal is profitable. It seems as though you're buying a cash flow stream that depreciates, and is worth less money over time. And you can't leverage this, or make it grow in value, then at the end of the term you don't even own it anymore. It seems like a great deal for the land owner, and a pretty bad one for the investor.  There isn't much info here on BP about a typical land lease purchase scenario and how that could look for your portfolio over time, so I am having difficulty following. 

Originally posted by @Daniel Chang :

@Jarred Sleeth

You are essentially buying a leasehold estate.  What that means is that ultimately you don't own the land, nor do you own the building.  You simply have rights to the building for the next 65 years.  In those 65 years, you are welcome to lease out the building and make improvements (depending on what the ground lease says), and collect revenue.  However at the end of the 65 years, the land and the building reverts back to the owner of the land, unless the owner extends the term of the lease.

The situation isn't so different from a business leasing out a commercial space.  For instance, let's say, the Subway signed a lease for 5 years.  In those 5 years, Subway has the right to use the space to produce revenue and profits.  After those 5 years are up, the unit reverts back to the building owner unless the owner extends the lease.  

So, why do ground leases even exist?  It's the same reason that Subway would choose to lease the space rather than buy their own building - lack of capital (or better use for capital).  The developer that built that building, instead of coming up with the needed capital to buy the land and then develop it, can cut his capital needs greatly by leasing the land with the rights to build on it.  

 Daniel,

I disagree in saying that a ground lessee does not own the building. It depends on the ground lease as it could very well be the case that the lease gives the ground lessee the right to build and ownership of the physical building in place. Ownership of the buiding could also mean that at the end of the term is needs to be demolished or removed or as previously stated it could turn into the land owner's property.

Josh

How does a deal like this get financed? Where does the equity actually go and what is used for collateral? 

I will try and get some more information on this particular deal this weekend. It seems as though anything could be the case. 

@Joel Owens

Thanks. I agree there does seem to be a lot of risk. The acquisition costs are unsecured and you lose a lot of benefits of investing in a tangible asset that you actually own and control. I'm leaning away from this deal, but I feel that being an insider is beneficial, I just don't know how to take advantage of that so everyone can make some money.

@Jarred Sleeth Here's a simplified model to show the concept. In this magical world, imagine there is no such thing as inflation or taxes.

Let's say that you can buy a conventional (fee simple) property for $100k cash. You anticipate making $10k per year cashflow and selling the property in 10 years for $150k.  So your total outlay would be $100k, your total income would be $250k and your total profit would be $150k. 

Now compare this to the same property on a ground lease with 10 years left on it. Clearly you won't get any money back at the end of the 10 years, so you need to make your $250k income from the cash flow alone. This means the property needs to return $25k per year over the next 10 years in order to be equivalent to the first model.

Moving from this simplified model to your real life situation, here are some complicating factors:

1. You have to take inflation into account. 

2. Cash flow is taxed differently from capital gains. There are also factors like depreciation sheltering and 1031 exchanges that may affect your calculations.

3. The length of the ground lease is much longer so it would not run to zero. But your selling price would need to be discounted from what a fee simple property would sell for, because the next investor after you will be that many years closer to the end of the ground lease.

4. If you need a lender, you have to adjust the figures to account for leverage and also paid down equity.

With all this in mind, the only true way to figure out the value is with a discounted cash flow model. I would probably start with a handy DCF spreadsheet from BP or elsewhere, and upgrade to a paid REFM model to verify during due diligence.

@Jarred Sleeth No problem. I would add that the hairier this situation looks, the better it may be for you. A local strip mall does not typically attract the kind of investor who will be comfortable with a ground lease situation or a DCF calculation. So you will have very limited competition.

Also, the owners clearly like you or they would not have approached you. So my feeling is that you may be able to get this deal at an attractive price.

Jarred,

What is the annual lease payment on the land? I would agree that the value of the property will go down relative to current rates as the leasehold burns off. Do you have a NOI for this property? Where is the property?

Mark

@Nick L.

You may be right. That does raise some more questions, though. What should I be seeing that should make ME feel comfortable with this deal?  Sure we all know what a good residential deal should look like for a buy and hold, but what should a good ground lease investment with a bunch of time on the clock look like?  Are there guidelines on what expenses should look like in relation to the cash flow? Admittedly, I haven't yet looked at the DCF proforma calculations, so maybe it will become obvious there, but I do wonder what kinds of numbers should I be looking for that would make an investor want to buy this kind of deal.

@Mark Creason

I don't have all of this information yet, but hope to learn more soon. The only concrete numbers I have right now are a gross operating income of 125k, and they are looking for 500k with ~65 years on the clock. It's not enough to make any judgements I don't think. The strip is located in a suburb of Baltimore.

@Jarred Sleeth I hear you, it's tricky. While the only "right" answer comes from DCF, here is how I would think about it on a rule of thumb/heuristic basis. 

First, decide how long you want to hold the property. Let's say it's 25 years, which is long enough to pay down a commercial mortgage and still sell to another investor who can get a full term commercial mortgage.

Mentally fast forward 25 years to your sale point. How much (in today's dollars) would a future investor pay for that same property with 42 years left? Don't forget that this future investor is making the same calculation as you are now, and his future investor only gets 17 years. For the sake of discussion, let's say that your future investor would pay $250k in today's dollars because he knows it will be nearly worthless by the time he comes to sell.

Now you have to figure out how much money you have to make over your ownership period for the investment to be worthwhile. I would probably figure I need to make 10% average return on equity before tax, or $50k a year average over the life of the investment. Since I'm going to be selling it for $250k less than I paid for it in today's dollars, I actually need to make $60k per year cash flow in today's dollars. 

Well actually your discount rate (the rate at which you can reinvest profits) is hopefully a lot higher than inflation, so you should tack on a bit... without firing up Excel let's say you need to hit $70k per year cash flow.

Lets tack on a bit for your lost opportunity cost/hurdle rate and say you need to make $80k per year cash flow. That's after leverage of course. Without firing up Excel that's probably about a $60k NOI.

A fair cap rate for the type of shopping center that you describe might be 10-12%. So a conservative estimate might be that you have to purchase the strip mall for about $500K to make the math work, or less to get a good deal.

Funnily enough that's about exactly what the sellers are offering. Of course this is just hand-waving math so I might be off for quite a bit but it sounds like you're in the right ball park. 

If the real/DCF math comes in about the same, you would be doing pretty well at this price and better at anything below it. My guess is that if they cold-approached you at $500k you could get it for $400k.

But hey, I'm 2 glasses of wine down so you should probably review my logic with a critical eye :)

@Jarred Sleeth

Just repeating some wisdom passed along with me to an individual I met with for breakfast a week or so ago.  (He built his net worth from nothing in the early 80's to 25-30 million, company plane, the whole 9... in the 2000's and was an early developer for Wal Mart among other things over the years...looking forward to getting to sit down with him again.)

He felt his greatest asset was the ability to think outside the box -- not saying anyone here is not doing so and that I am by what I propose below.  But what if you are the guy who talks to the land owner and gets them to sell the land to you?  Get creative with it.  I'm sure the landowner has their motivations for supposedly not wanting to sell or sell, or maybe they're advanced in age and need the cash flow for now, but would be willing to sell later etc ... who knows??

Why not get a contract with the owners of the strip center, build in your due diligence period and work in a contingency that you will only purchase if you are able to negotiate sale of the land with the present land owner... then pound the pavement and sit down with the owner of the land, see if you could strike a deal or an option to purchase at a set point from today - 10 years, or whatever time frame you build in.  Maybe you'll be chasing your tail but sounds like you don't have much to lose.  The bigger fish out there won't take the time to do this.  Could be an additional competitive advantage. 

@Nick L.

This is very helpful. A few questions. When you say after leverage, what do you mean? I understand leverage but I'm not sure I followed this in your scenario. Also, could you expound on your comment about discount rate and reinvesting profits? What would this look like? Thirdly, since you seem very knowledgeable in this area, can you come up with a few examples of how the financing could work if I were to purchase the deal? 

This is good stuff. A lot of learning happening here.