By Robert McLeod
Commercial real estate involves different classes, different tenant needs, and different management models compared with residential real estate. If you’re considering moving from residential to commercial, the three questions you should ask yourself first are:
- Why do I want to try something that is not residential?
- Considering that I’m likely going to need more money to invest, is my return really going to be that much better than the same amount invested in what I know… my residential business?
- What goal am I trying to achieve with commercial real estate that I’m not attaining in my residential business?
I only recently started adding office and industrial real estate to my portfolio. Up to now I have only owned singles, multi and whole apartment buildings for probably the same reasons as most of you. My office product is the office building I have my company in. With the challenges in our market we are now breaking up the spaces into smaller furnished offices. I have also added industrial real estate consisting of small bays. What I have come to learn from these acquisitions is that anyone who’s somewhat new to investing or doesn’t have the backing of big pension fund money should plan with these two points in mind:
- Commercial properties may be vacant far longer than residential properties
- A bigger cash cushion is required to make deals work.
So, let’s say you are thinking about buying a warehouse bay, nothing sexy, a box designed for a myriad of businesses. A few tips to remember about commercial are:
- Signage and visibility are always on the list of the top three things tenants want;
- Zoning and/or bylaws dictate the kind of businesses that are allowed in your bay; and
- In order to make a deal work, improvements that your tenant wants for his/her specific business might be required.
You’ve decided on the warehouse; you’ve done your due diligence and found that perfect bay for $500,000. You put 30% down and are now looking for the ideal tenant. Remember, vacancies in commercial can be quite a bit longer than in your residential portfolio, so you’ve been patiently waiting and in month four along comes the dream tenant, a carpet store. Here’s what you can expect for your return (using an actual building we are marketing):
Mortgage payment: $1980/month
Estimated Rent: $14.50 per square foot per year
Estimated Operating Cost: $6 per square foot per year
So you’re going to generate $20.50/square foot/year. Assuming the space is 1750 sq.ft., that’s $2990/month. A good chunk of the $1010 you see in positive cash flow is the operating cost of the space. The hook to buying commercial for most investors is that you get to use a triple net lease, with your tenant covering all your operating costs. Just remember that it impacts lease affordability, so it’s not always as simple as passing on 100% of the costs; you still have to be competitive.
What you now need to consider is that although you already have $150,000 in equity in the bay, the tenant wants a $10/ square foot tenant improvement allowance upfront. There are many ways to build this into the lease, but to keep this simple, that’s another $17,500 up front you need to credit in order to make the deal work.
So now your total equity is $167,500 and your annual cash flow is estimated at $2,400. Add in your principle reduction, market growth and then ask yourself if you are that much better off.
I like to put it this way. Upfront you are not really that much better off. Commercial investing is much more equity intense than you may be accustomed to; however, 10 to 15 years from now, put your small apartment block up against your small block of warehouses or retail units… you will see a different story. Long term, having a mix of triple net leases can provide the cash flow to balance your portfolio.
With your residential portfolio you have some limits to your upside, whereas with commercial you may be able to add square footage by adding mezzanines, or you may be able to rezone to add more value to your land. At the end of the day, a substantial amount of the value added and improvements made to your space are all at the expense of the tenant. No such upside is quite as easily made possible with residential properties.
When considering commercial, keep in mind that what you buy is tied much more to a narrower sliver of the economy than residential rental property. When you are starting out, buy what you can afford to hold. Look to areas that are established and offer a mix of services like retail, office, and industrial so you can weather what the market throws you. Always ask yourself, “How can I add value?”
Robert F. McLeod is the Associate Broker with Re/Max Real Estate as well as the Founder & CEO of McLeod Project Marketing. Robert has collectively sold over $750M in residential and commercial real estate and sits on the Board of the Commercial Division with the Realtors Association of Edmonton.