Investment Commercial Real Estate Profits and Pitfalls

Residential investment property is forgiving for the most part. Professional managers exist in most markets and except for the very worst of conditions it is possible to fill most apartments even if it is not at a profitable rate.

The number of residential properties available is large and unloading a single family home or duplex is fairly quick and simple. Many economists consider a six month supply of homes on the market a healthy balanced market.

Things get slightly less forgiving when you graduate to multi-unit apartment complexes. There are fewer to select from, they cost significantly more, there are more tenants to manage and it usually takes longer to sell the more expensive buildings. Not as many investors can swing a multi-million dollar deal or even finance one.

It might not be intuitive, but the more expensive the property the more likely it will be purchased as a cash deal. Big buildings carry big responsibilities and risks, but also are coupled with larger rewards.

Generally the rules are straightforward with residential rental properties. Lease contracts are generally standardized in most states and the landlord/tenant rules are clearly defined. The laws tend to protect the tenant more than the landlord. Still, the landlord, if she bought right, should turn a tidy profit.

Real estate investors usually start small, a single family rental or duplex, moving up to multi-unit buildings later. Most landlords stop at the duplex level with maybe a 4-plex or so tossed in for good measure.

The next leap takes courage. Financing a large deal is more difficult. Only a select number of banks are willing to fund a seven figure project. You need good credit, experience and a documented plan. At the end of the day the multi-unit complex is still a forgiving animal in the real estate world.

Then there is the commercial property.

Rules Change

Investment commercial property is a whole different animal. Commercial property spans a wide range, including: land, farm land, land for development, parking lots, storage units, malls and strip malls, gas stations, office buildings and on and on and on.

All real estate must be purchased right to yield a respectable profit. I encourage you to read this article I wrote on the math of buying residential real estate correctly. Rather than repeat what I already said we can move forward.

There are significant differences in buying and managing commercial real estate. The linked article above is accurate with one caveat: vacancies. It is unusual for residential real estate to remain vacant for more than a few months. Commercial real estate can remain vacant for much longer periods of time, even years.

The office building I own for my accounting practice was empty for a few years before I purchased it. The previous owner was willing to sell or lease the building. It just sat empty.

My personal experience in real estate centers on residential properties. Most commercial properties were purchased for use by a business I own. I love my landlord; I love my tenant. Rarely do things work so peachy when you are not on both sides of the deal.

Without personal experience in commercial property I still have plenty to share. Many clients over the years engaged my services to buy, sell, and negotiate leases for their commercial properties. So I may not have had much commercial property in my personal portfolio, but I have plenty of experience with the mechanics of profitable commercial property investments.

Risks and Rewards

Financing: Once you own commercial property for a while you either go broke or make so much money you tend to pay cash for additional properties. In the beginning you will probably need a bank or seller financing. Commercial loans tend to require a larger down payment (20-30% or more), have a higher interest rate and a shorter amortization period. Many banks have a balloon payment rather than play out the entire amortization of the balance or require refinancing of the existing loan every five years or so. Some of this is specific to certain markets and the lender. The type of commercial property also plays a role. Farmland generally needs 50% down or some other collateral. Office buildings may need 30% down while developments may require bank refinancing on a regular basis.

First you find the right property at the right price then you finance it. BUT, it would be in your best interest to have financing available in advance. If the seller demands they finance the deal (for tax purposes) you are still covered.

Lenders will pick a commercial deal apart and for good reason. The money involved is usually large. Using the above link as a guide to ensuring you purchase a profitable property will help in the process. Payments will be higher due to the higher interest rate and shorter amortization. Since vacancies tend to last longer in commercial property the lender will require greater resources to survive any drought.

Leases: Residential rental rules are standardized with laws slightly favoring the tenant because legislators assume the landlord has more resources, hence the advantage. Not so for commercial real estate.

The landlord and tenant are on an equal footing in a commercial contract. No longer do you have standardized rental rules. Commercial leases are business contracts. Both parties need to lawyer up.

Typically the landlord has her attorney write the lease and the tenant’s attorney reviews the proposed lease before requesting changes. Many of the details of the lease are known in advance because the prospective tenant starts the process by providing the landlord with a Letter of Intent outlining the property they want to lease and the terms. Negotiations take place before the lease is written. The LOI looks a lot like a legal contract, but is not binding on either party.

Commercial leases frequently are triple net or nnn-leases. This means the tenant pays the property taxes, maintenance and building insurance in addition to utilities. This is something you never see in residential rentals.

Triple net is nice for the landlord. Once a property is leased the only real expense for the owner is the mortgage and maybe the property manager. Major repairs such as the roof, HVAC, parking lot or other major repair over a certain value may still be the responsibility of the landlord.

Commercial leases tend to be for a longer period. Whereas residential rentals are generally handled with a one-year lease, commercial leases frequently extend five years or longer, sometimes much longer. The longer term lease allows the tenant to feel comfortable they have continuity for their business and the landlord is happy because she has a long-term tenant.

The one thing to remember about commercial real estate is that business law applies. I cannot express strong enough the need for legal counsel in managing a commercial transaction. As smart as I think I am when negotiating a multi-million dollar deal for a client, I know my legal team must be involved every step of the way.

All this said, not all commercial real estate is equal. Farmland will not follow the above facts I list. Most farmers rent land for a set rate per acre and the landlord pays the property taxes, or, if agreed, the property taxes are included with the lease payment. Farmland rent is usually paid once per year or semi-annually at most.

Storage units look and act a lot like a residential rental unit, but it is still a commercial lease. There is no triple net with storage units. The biggest difference between a residential rental and a storage unit is that storage units are generally month-to-month leases.

With a storage unit your attorney will probably draft a template lease which you can use with each lessee without going to the attorney for each unit.

The larger the office building or leased space the more elaborate the lease can become. An experienced negotiator should be involved in the process. Small strip malls and office complexes are handled by a property manager specializing in such properties. Large buildings require an experienced team handling the process from beginning to end. You will usually not be involved in the actual negotiation; your team handles that.

It is vital you have an experienced team on your side. I have played point in negotiations where several accountants and attorneys are sitting on opposite sides of the table. My ability to see the big picture inside the negotiation has earned me the trust to lead teams in these matters. However, I always have counsel available to me.

The Good News

Commercial real estate looks like a lot of work. It can be. Usually you have a team in place to handle most of this stuff for you. Your job is to buy the right property and let the professionals handle the rest for you.

Commercial real estate has its unique challenges, but the rewards are worth it. A fully leased commercial building can pay the owner the value of the property every 7-10 years. Since many leases extend this long, one tenant can buy your entire building for you, cash, and you keep the building so you can do it again. The downside is the thing might sit empty for three years before the money starts rolling in. Commercial is unforgiving to the ignorant.

Reserve requirements for commercial property are larger. Most repairs are paid by the tenant, but when a repair bill is the responsibility of the landlord it is usually a very big amount involved. Resources are also required to handle the long periods of vacancy.

The best part about commercial property is that once it is leased you don’t do much. Lease payments are often times paid by EFT; you don’t even have to go to the bank and cash the check. A property manager handles finding a tenant and your accountant or attorney handles the transaction. As unforgiving as commercial real estate can be, the only real work involved is buying the right property at the right price. Professionals handle the rest.

As a final note: Don’t rush to buy commercial property. It might be best to start with a small commercial property or have an experienced partner early on before going out on your own. You will need a local attorney, accountant, banker and property manager. A lot of money is involved. Do it right and you should be very happy with your commercial real estate investments.

Do it wrong and you could end up bankrupt.

Owners of real estate purchased for $250,000 net of land need to read the following posts I wrote previously:

Cost Segregation

Applying Cost Segregation on a Tax Return

The best part of owning real estate is the tax advantages. Most investors leave tax dollars on the table. If you want to discuss cost segregation benefits contact my office (there is a consulting fee) using the contact link on this page or call Randy. His contact information is provided in the above linked posts.