I have my younger brother, John to thank for this post’s inspiration.
You see, my brother has a computer repair, maintenance, and installation company in Texarkana, Arkansas. The business started as a hobby with a bit of supplemental income but has now become a terrific revenue generator and space hog. John’s garage, living and dining room can no longer sufficiently house his burgeoning business so it is time to look for a location.
Enter older brother. Although I won’t assist John in his site selection in Arkansas…the commute would kill me…even by SoCal standards, I was able to provide some helpful counsel on the PERFECT commercial real estate investment.
John is considering a commercial real estate investment that he will partially occupy and rent out the balance for income.
So just what should a new investor in commercial real estate consider when analyzing a deal. In my opinion, these six factors should be considered.
The income stream: The tenant(s), the rent that is collected…not contracted, the relationship of the rent to market rents…higher or lower, the tenant(s) business, the vacancy in the market, the credit worthiness of the tenancy, the length of the remaining leases, the expenses…property taxes, insurance, maintenance, tenant improvement costs…ALL form the income model of a commercial real estate investment. In my opinion, the income stream is the MOST important consideration in a commercial real estate purchase. The reason is simple, if there is no income, there is no investment! Sure, he can buy an empty building and lease it, but that is a whole different kettle of fish. Be prepared to invest a significant amount of your future rental income originating a new lease. You can read more about that here.
Purchase price: I recommended that John have a complete understanding of the price and how the price related to market comparable sales. You definitely want to purchase commercial real estate below the latest round of comps…even if the market is increasing. The price you pay determines your property tax assessment forever and your ability to fill a vacancy in the future also depends upon your basis…the price that you pay. Always try to buy below replacement cost if possible.
Capitalization (Cap) Rate: I walked John through a simple computation of the cap rate for a commercial real estate investment. Take the gross income (the rent that the tenant(s) pays) and subtract the expenses. This yields a net operating income. Divide the net operating income by the purchase price and voila, you have the cap rate. Notice that I mentioned cap rate third on the list. This is not by accident, as I believe too many commercial real estate investors place too much emphasis on this metric…see Income Stream. What can appear as a great return (cap rate) will evaporate if the tenant cannot pay the rent. The opposite would be true of a dramatically under market rent. The return (cap rate) would look measly. But, if you can move those rents to market, a great investment may bloom.
Financing: I advised John to pay cash vs. leverage the purchase with new financing. Many would disagree with me, but he’s my kid brother and I want him to send me a Christmas gift. If he does decide to get a loan…the term, interest rate, recourse or non recourse nature of the loan, amortization, and pre-payment penalty should ALL be vetted.
Exit: Is the plan to pass the property to his heirs (hold it forever) or lease the vacancy and sell the building? I told John to always have an escape route in case the investment should not unfold the way you planned it. As an example this escape hatch could be selling the building to the occupant.
Those things you don’t think about: Reserves for vacancy and improvement costs, structure of the purchase…due diligence and closing, lease documents, condition of the property, environmental issues, zoning and use restrictions, pool of potential occupants, etc. You just never know when one of these snakes will bite you…so be prepared.
So good luck in your foray into commercial real estate, baby bro! And remember us little people that helped you along the way…
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