I recently had a Letter Of Intent (LOI) accepted by a very motivated seller, who responded to one of my Direct Mail letters, and is willing to finance 100% of the purchase price. We were about to finalize the contract and open escrow until the property's existing income and expense situation changed. I had a primary exit strategy in mind, but due to the change in income, I'm considering changing course and would like some feedback to see which exit strategy works best for me in this situation.
This commercial property is a 10,115 square foot multi-tenant office building in the Los Angeles area, which is positioned in a great location with great exposure. The existing tenants are long-term and consist(ed) of a pharmacy, medical clinic, dentist, law firm, bail bondsman, and 4,000+ of vacant space. Although I noticed some obsolescence, in regards to the reason the vacancies were never filled, it doesn’t have much of a deferred maintenance problem. It was just heavily mismanaged.
At the time of acceptance, the property was barely breaking even:
GOI: $122,400
Expenses: $39,800
NOI: $82,600
Mortgage: $80,400
Cash flow: $2,200/Yr
Although the seller agreed to finance 100% of the purchase price, I suggested that I purchase it “Subject-to” the existing financing and just take over payments, due to the lack of positive cash-flow. But the seller was firm on his price ($1.4M), yet he did agree to let me take over payments of the existing balance ($990K) and he would carry the difference with no interest or payments until I can cash him out.
Upside: The seller purchased the property over 10 years ago for $1.4M and has never increased rents, fill vacancies, or off-set expenses to improve the value and Net Operating Income.
Exit Strategy #1: Buy & Hold. My primary exit strategy is to stabilize the property and raise the value, then refinance to cash out the seller and hold this property for long-term cash flow. My plan is to start raising rents and negotiate with existing tenants on 3 year leases, with extension options and incremental rent increases to catch up with the parity of market lease rates.
I know some may think that I could be scaring the tenants away by raising rents, passing along the expenses, and adding incremental rent increases to the leases, but the good thing about this situation is that the tenants have been there for a long time (30+ years) and have established themselves at this location. It would be more costly to pick up and move to a new location, which may demand more per square foot and maybe need tenant build-out. And, taking into consideration that they've already made a killing throughout the years with low rent costs to their bottom line, I don't think raising rents a little at a time is going to scare them away. I also plan to cure the vacancies by getting them rent ready and marketing the property for new leases. In addition, I want to gradually off-set expenses by putting them into the leases and having the tenants pay for their own utilities, insurance, and maybe even their portion of the taxes over time. Eventually, I will want to have this property as a NNN lease or Absolute Net lease property with practically no or very little management required.
Exit Strategy #2: Stabilize and Flip. My second exit strategy would be to sell the property at a reasonable cap rate of 7.5% after filling vacancies. Filling the 4,000+ sqft of vacancies at $1.50/sqft (market rate: $2.20/sqft) would bring the total NOI to $145,000, which at a 7.5% Cap rate, would increase the value and sales price to about $1,940,000 for a quick sale. I would be able to pay off my seller $1.4M and be left with remaining net proceeds of about $400,000 for the next deal. Estimated timeline for this exit strategy is 12-24 months.
Exit Strategy #3: List For Sale on MLS. My final exit strategy, if I have to sell fast, is to use the Pro forma and list the property on the MLS for a quick sale. This strategy may generate substantially less of a profit, but it can be a quick turnaround.
So these were my three exit strategies prior to finalizing the deal, then I recently got the bad news that the dental office has vacated due to retirement. No heads up during two months of negotiating. I found out during my physical inspection. Good thing that it's only $700/month loss in income, but I think it prevents me from going with strategy 1 or 2, because then I'll have to eat about $600/month until I can fill these vacancies. The bad part about the vacant space from the dentist is that it's suited for a dentist. Otherwise, I'll have to demo and present it in a vanilla box, which can get expensive. I'm using my own capital reserves for these types of issues and "just in case sh*t happens." I was also considering bringing on a JV equity partner in case I ran out of reserves from the costs of tenant improvements, tenant leasing, deferred maintenance, and/or unforeseen expenses. I am heavily considering just listing the property and using the Pro forma and location to market its potential for a quick sale and profit.
So what do you all think? Any feedback is greatly appreciated. I hope I was thorough and concise, and not all over the place. Excuse the mixing of past and current tense (is/was) because I'm still undecided. Did I miss anything?
