First commercial opporunity - interesting dynamic

11 Replies

I'm looking at a deal that is relatively close to home. I run a consulting business that makes my money but by nature has no passive to residual income component - thats a whole other discussion ;). I'm interested in investing in commercial as a way to diversify a large tech-heavy equity portfolio and hedge against some market risk. I don't have a lot of time (due to my main business) which has kept me away from residential real estate for a long time until I started looking at commercial properties. This opportunity strikes me as a bit more hands off due to existing long-term tenant and a neighboring bank that appears to control the property, but it has a potential downside.

I am very interested in your opinion on this unique situation. I would be putting down around 400k on a property in the 1.5M price range which should easily get me to around 70-75% LTV.

It's a small stand alone strip mall-ish like building that has 5 units (1,400sq/ft a piece) which are attached to a 2,700 sq/ft bank on the end. The bank portion is not for the sale, everything else is for sale as a whole (the only other 5 units). Currently, 3 of the units were combined and occupied by a franchise gym and the other two were combined as a doctors office. So it's currently fully occupied. The purchase price is about $1,500,000, cap rate 8.40%, NOI $127,000. The building is very close to a large retailer that is a big draw to the area.

The property technically brings in about $180,000 in gross income. Both tenant leases appear to be NNN as ~55k of that $180,000 gross is CAM, (26k), Insurance (1k), Taxes (24k), and Management (5k). Therefore, the 55k is reimbursed (paid) by the two tenants (unless I understand that wrong). What is news to me is that the CAM fee (26k) is stated as paid to the bank that occupies the end of this building. It appears that there is an association that the bank owns over the property and required (when the place was built) that it forever be responsible for maintaining CAM and that the remaining for-sale property is responsible for reimbursement of CAM to the bank. This is likely because the bank needs to control the appearance heavily, snow removal, etc. This makes sense to me as a necessary precaution for any bank to avoid a connected property from turning into a dump. It is also my understanding that the bank may have built the entire building initially and used the other units to subsidies the cost before eventually selling them as a whole. Although, the CAM of 26k/year seems high to me, but I really don't have experience - I also don't see anywhere that excess is returned.

So while the CAM situation is odd, I do think there is large benefit to having the bank on the property as its a big draw, as is the gym. The lease on the gym runs through 2026 and appears to increase each year about 2k with 2 options for 5 year extensions. The lease on the doctor office runs through 2021 with an increase of about 1k each year. Ideally, I would replace the doctor office with my own business TBD in its place and leverage the other tenants to pay the loan. I like the fact that it is fully occupied (hands off for me), but I know it limits the appreciation due to lack of value-add. Ironically, I've also thought about opening up a gym (of the same franchise) so this is a double bonus for me to house the exact one. 

My strategy for this property would be to acquire a 5 yr fixed 20 year amort loan, ride it hands-off until the first lease expires on the doctor office, potentially kick them out and put my own deal in, or if they stay (after I crank up the rent) - I could wait however long until the bank leaves and likely sells the remaining share of the building to me. At that point, I would purchase it and have a nice value-add units 5-10 years down the line. If the bank leaves, the drive-thru and everything else is already setup as part of the building and likely re-purposed for fast food or whatever else could go in there.

Thoughts?

Updated almost 3 years ago

Update, the current property was unfortunately sold. I learned a lot and have some new questions (see lower in this thread).

Sounds like a really good deal. I think you have to look at macro economics of the area, if someone is selling it at 8 cap, do they think it will go down in value? Where is this located?

Thank you, Ronald. Macro economics, the neighborhood is good and I'm familiar with it. The only question mark is some undeveloped land across the street from the property that is for sale, obvious risk there is someone buying and building more business space. I don't know why they would sell with full occupancy that will run for another few years. The best I can think of is that they have maximized the value and are trying to sell it at the peak.

@Jason Miller , I loved the post and it sounds like a good deal. For my education, I would like to ask you about how you calculated your NOI. You said the Gross Income is $180K but the NOI was $127K. I am assuming that the difference is the CAM fees. You said the fee was $55K which would take $180K to $125K (I guessed the $127K is the same number just off by $2K). The CAM fees are reimbursed yearly and even though you receive that money back you did not include it in your NOI. If you did it would take the property from an 8.4% CAP to a 12%. What was the reason not to include the CAM fees in the NOI? Is it a standard practice? Or were you trying to be conservative?

@Price Paramore He's saying the CAM fees are paid directly to the bank, not to him. All NNN expenses are generally reimbursed for exactly what they are and subject to audit by the Tenants so you cannot factor them in to any NOI, especially in this case where the CAM goes to the bank.

@Jason Miller This does sound like a pretty good deal to me. What do the financials on the gym look like and what style of gym is it? If your NOI is $127,000 with all NNN leases in place, your debt service is going to be around $94,000 Leaving you with $33,000 a year in actual cash flow or an 8% return on your cash. Seems like a sweet deal. In regards to the CAM charges, 26k does seem slightly high, I would ask to see the last years NNN expenses as well as this years budget to see exactly where those dollars are going, but since the Tenants pay it anyways, not a huge issue.

Gyms heavily fail all the time so I generally do not like them as a tenant. They can also take up lot's of parking for blocks of time and impede other customer tenant traffic to the center.

The doctor and gym sound mom and pop type tenants. Anytime a gym franchisee I want to see their membership numbers and how they drive revenue. If they drive main revenue from memberships only that tends to be bad as people pay very little and the machines are often leased or if owned they wear down fast due to volume and needs lot's of maintenance. The power bills can be really high as well.

Good gym operators tend to have nutrition bars, personal training, etc. for multiple revenue streams to boost profit.

I look at liquidity and net worth to prop up the business. Especially regional to mom and pop tenants. Look at rents per sq ft as the box size rises the sq ft should go down.

Example you see some retail centers where market rents are 30 a foot. Then on the rent roll you see workout place in a 10k sq ft center with a 4,000 sq ft space at 30 a foot when the 1,200 sq ft space there is paying 30 a foot. The larger box size the rent should be lower such as 20 a foot etc. Some landlords pay for TI and then have tenants pay above market rent for that box size. If a buyer purchases and then tenant defaults then you can lose a lot of down payment equity as the rent drops with the second generational tenant for the space.

It's great if all rents are way below market. You usually win buying at a high cap rate that way because tenants will pay good rent increases in the lease and likely never want to leave. If they do leave you make double bonus and raise rent for the next tenant.

If rents some are above market then I discount to current market or below and write off that income as unsustainable.  

Thanks all for your comments. I have a learned a lot. Unfortunately, the property I was looking at sold. It sold for even less than the 1.5M, around 1.34M. Apparently there were 3 owners involved. The owner of the entire property, the owner of the bank, and the owner of the remaining units in this small strip mall. I learned some things from the agent. It was apparently condo'ed out which is how the bank retained ownership of it's unit and why there is a management fee to whoever owns the complex. This was the property LoopNet. I'm already off to look at what else is out there, but I learned quite a bit from this experience. I am looking in the 1.5-2M range and I've been calling around to agents on properties to get a feel for how they negotiate and how these commercial deals differ. There appears to be a lot more room than I ever though in purchase price negotiation.

My thinking is that, based on a Debt Coverage Ratio of about 1.3 (which I assume is what most banks want to see), I'm always shooting for a minimum CAP rate of around 7.5% for a property to cash-flow well enough with my debt cost @ a 6% 5/25, 75% LTV . Moving forward I am basically using that 7.5% CAP rate to back into what I believe a properties actual purchase price should be (obviously excluding all the other factors like rent roll, lease lengths, macro economics of the area, etc). I'm not sure if this is the best way to hunt for properties or make offers but it has helped me adjust some property prices into what would be an acceptable place to even start negotiating.


Questions


1) What do you think about me working back from a ~1.3 DCR, into a CAP, and then using that to compare properties and arrive at sensible purchase price?

2) I am most comfortable with a property that has a couple retail shops and leased residential tenants on the 2nd floor. This seems to me to be even safer hedge against losing one of 2 or 3 retail tenants that may be in the unit.

3) At a 1.5M-2M purchase price I could put more than 25% down, but I read somewhere that its not smart to "buy more cash-flow". I can understand that and how powerful leverage is. In some cases I do feel a bit more comfortable having more equity in the property (maybe 30%) in the event a tenant leaves and I have to start paying part of the monthly loan myself.  At least, at that point, it won't be as large of a monthly payment. Thoughts?

4) I was looking at another close property in an area I am very familiar with. It is standalone building for one of the major autoparts retailers. It is corporate guarantee NNN and the lease has another 7 years on it. Oddly the current CAP rate on it is only in the low 6s. The agent said they wouldn't sell for much higher of a CAP. When I do my calculations on that property with the 1.3 DCR - I cash-flow hardly anything and it becomes a pure play on appreciation due to the location being very prime at a busy intersection. What kind of buyer are they holding out for, a cash only buyer who is fine with a 6% return? Curious to hear thoughts on buying properties that have a single, large, corporate tenant. I assume the low-risk tenant may also factor into why the CAP is lower, perhaps they can negotiate lower rents being such a large company.

5) I also looked into a standalone restaurant property, been around for 10 years and has two locations. CAP rate of around 8%, I don't understand why the restaurant owner wouldn't buy the property themselves. I assume those types of deals are big risks for a newbie.


6) I was thinking about holding the property and titling it in my LLC/S-Corp that my consulting business resides in. This would be a LOT easier from an admin overhead and tax perspective than starting up another LLC to only purchase the property. The bank seems to always require a personal guarantee regardless, I would qualify personally and could put it in a brand new LLC. If I use my existing business LLC/S-corp to title then (apparently) they will also evaluate its financials - also not a problem. I know risks of co-mingling an asset like this with another business, if the business is ever sued and I bankrupt the company, they could go after my commercial property. On the bright side, the consulting has no real assets, all the funds pass-through to me almost immediately - I'm not afraid of a lawsuit stemming from the property resulting in much seizure of any assets at all related to the consulting business. I'd like to put them both in the existing LLC, but I know many attorney's out there likely hate that idea. Is there any other benefit I'm missing here? One that I can think of is that if I did buy the property through another LLC I could potentially lease a portion of it back to my business (for storage ,etc) and use that as a way to pull money out of the business.

Thanks all. I am learning a lot. I really want to stay away from residential buy, rehab, etc (popular in my friend circle).

Jason you are a new buyer buying in a low price range. Your desired cap rate dictates that you will be going after more mom and pop tenant with HAIR as we call it on the deal.

The more HAIR a deal has the harder it is to close it and the longer it takes.

So it becomes a time/risk reward for a broker.

Example on a 1 million dollar property with 8 mom and pop tenants there is a tons of heavy lifting and analyses for a 25k to 30k check for a broker. I know it sounds like a lot but in the commercial space it is not. That versus a Starbucks with 1 lease to look over at 2 million to make 40k to 50k commission.

The STNL properties versus retail centers are underwritten differently for loan purposes. The lower the primary years remaining the higher the cap rate tends to rise as it is harder to finance. If it is financed the lenders at best give double the amortization so if 7 years left then 14 year amortization period. They want to accelerate the principal pay down on the loan with the cash flow so if tenant does not renew option and they have to foreclose they can get close to the value of the remaining mortgage versus the value and land as it sits vacant. This way the bank doesn't take a huge loss on a defaulted loan that was foreclosed.

Anything 2 million and below there are lot's of cash buyers. They would LOVE to get 6 plus cap rates and over the years blend up the cap rate to the 7's and 8's.  

@Jason Miller   - sounds like an interesting deal! I could have misinterpreted the first paragraph you wrote, but it sounds like you are strapped for time. Is there a reason you're looking at an investment like this vs. something more passive that won't add to your already-busy schedule?

@Joel Owens - I completely agree with you. I'm shopping for a kia at the BMW dealership. When you say broker are you referring to the listing agent / advisor on the property? I don't have a broker I am using to identify properties, I am doing that myself with the intention of bringing in some expertise once I have zoned in on something and need to do some due diligence / put an offer in. I've purchased homes without agents and I don't want to waste their time during this process, I know how new buyers can abuse them when they don't know what they want yet. If you understand you correctly, STNL properties (NNN tenants) are not favorable for a bank and terms would be less favorable from an amortization perspective. I assume this is because of the single tenant issue and the potential that it could be hard to re-purpose the property? At least in this case, its just a basic box property with nothing special going on, it actually used to be a Blockbuster before the auto retailer. I've started debating internally the future of an auto retail in light of Amazon selling auto parts, but that is likely a problem that will surface 5-10 years from now. I'm thinking I may just need to put more cash down in this price range. Originally, I thought I could still benefit from some leverage, but it does appear that in the < 2MM range it is mostly a cash business. A solid 6% CoC return on 1.8M isn't bad, but once you throw financing in that becomes questionable.

@Spencer Hilligoss - This is true I am strapped, but I don't like the amount of risk in the equities space and I want to take some of my, relatively large earnings over the last 8 years (i.e., I owned a lot of Amazon stock, which is ironic looking at commercial retail properties) and pile it into a safer investment. The consulting business is a cash cow but it is purely active income that you must do something with to obtain a passive component. The idea of having a commercial property appeals to me because it affords me some options in 5-10 years to explore operating my own business out of it, it's something I've always wanted to do and if I had the financial freedom I would do it. This is part of a much larger picture that may developed 10+ years down the line. My motivation now is that I think (perhaps I am wrong), that the market is still on the rebound a bit and I should take advantage of still historically low interest rates. If I wait 10 years I may have even less options. Instead of jumping right in and opening something up, I recently became interested in the idea of owning a property now that gives me the potential to do that down the road with less risk (i.e., free rent potentially subsidies by other tenants).

Broker the listing broker or the buyers broker.

I have clients nationally where I am typically the buyers broker and the seller pays my fee or the listing brokerage has a co-op they share.

I would talk to an expert for guidance on the markets and debt obtainable to see if what you want to do is feasible or practical.

I look at about a thousand a week for clients on retail properties. 

@Jason Miller - makes sense

more recently i've come to appreciate truly passive options like private lending, note investing, LP in syndications, etc... as a compliment to ownership, since you can (theoretically) endlessly scale your time. our gameplan is also to GP some commercial projects, as well.

best of luck with your strategy!