THIS IS MY SEVENTH POST ON UNDERSTANDING MONEY TOOLS
Money! Money! Money!
Let’s talk about commercial real estate and investing in that
industry. Books can be written on
the subject, therefore we will only touch upon the investment. We will look at existing property versus new builds. Commercial real
estate comes under the “C” designation of municipal zoning. There will be a number after the “C” as
to what is permitted and each city might use a different designation. Commercial/retail can vary from a small
one unit building to a very large shopping center.
The big property owners including Real Estate Investment
Trusts (REIT’S), many of which are publicly traded stock companies, want the
large properties. There is also
economy of scale. All costs of operating a company need to be amortized into
their holdings. One type of real
estate ownership would be to buy publicly traded stock in a REIT. It can be a nice diversification in a
stock portfolio and many times yield a return higher than corporate stocks.
However, in weakened economic times vacancies will play a big part, thus lower
revenues and lower values to the fund,
and yields will come down.
As with all investment real estate the larger properties
having more tenants spreads the investment risk with vacancies. Also, economy of scale comes in with
property managers, maintenance, city tax benefits, bank financing, etc.
When buying a commercial building it is best to work with
experts in the field, e.g. real estate agents who specialize in commercial
property. As with all real estate purchases consult with a lawyer who
specializes in real estate law….best money spent! If you are not a cash buyer,
consult with your bank on financing possibilities ahead of time.
Now, let’s look at age of building. Old buildings may be sold because they
have been depreciated on the books and an accountant has advised a sale or
trade of the property. The
possible benefit of a trade is that taxes are deferred to a future date of
sale. If you think capital gains taxes
will be going up, it is probably wise to pay taxes now (long term Federal
capital gains tax is 15%).
Is the property needing work and has general maintenance
been neglected? Use a well-known
contractor for an inspection report before buying. Do a market report for yourself or have one done. This would include demographics of
population growth or decrease, traffic count, income levels of people, growth
of residential living to bring more buyers into area, etc. Is there an anchor
or major tenant? Lease
expirations? You want a balance of
leases coming up for renewal. A
person should also look at the balance of types of stores, what industries do
they come from, are they small owner operated or national chains. Try not to
overlap, or offer that a tenant has exclusivity against other competitors
coming in. For small stores
seeking to be a tenant, or if you are buying the building ask for the retailers
Dunn and Bradstreet (D&B) or ask the realtor representing them. Also, obtain a credit report on the
owners of the small stores.
Most stores have a national association that will release or
discuss the norms as to what a store is capable of paying per square foot in
relation to gross income. It is
better to decline a tenant than end up with a vacancy needing a lot of
refurbishment and an eviction of premises. Here is an example of square footage to gross rent. Let us
assume that a tenant’s rent should be in the 10-12% of their projected annual
gross sales income, and the tenant believes the store can gross $250,000. He only needs 1,000 square feet. You can be comfortable in this
illustration charging rents of about $20./square foot.
Most retail stores will need a build out to their
specifications. Most owners
allocate a certain dollar amount up front to assist the new owner, this may
include drywall, electrical, plumbing, lighting, etc. Make certain that everything is done under construction code
with the city or county. Require a
copy of the contractor’s Workman’s Comp Insurance and Liability Insurance. Retail
stores will also need storage area for inventory which can be very utilitarian.
In today’s lower market rents in some areas of the country I
have seen people buy buildings, especially small medical buildings, and the
owners cannot afford the cost to build out the space for a tenant. I know of one dental building, space
for two operations within the structure.
A build out of one side would cost about $70,000 for a doctor or dentist
and the market rents are only in the $15./square foot range. In this case, they are sitting with
empty space until the market returns as the economics aren’t there.
There are several types of leases for tenants. One common lease is a triple net where
the tenant pays for most of the build out of the space to their specifications,
electric, air conditioning, (unless it is common interior), and a percentage of
exterior maintenance expenses inclusive of real estate taxes (the latter here
known as CAM charges or common area maintenance charges).
There are a couple commonly used methods for quick financial
analysis on commercial properties, these being determining a capitalization
rate (CAP rate) and the other being a gross rent multiplier number (GRM). To
determine a CAP rate:
1)
Find properties that have sold in the area and an average
comparable, or the value of said property
2)
Obtain net operating income.
3)
Divide the net operating income by the estimated value of
property. The result is the cap
rate.
Illustration would be:
- Net
operating income: $33,000
- Value
of property: $500,000
- $33,000
divided by $500,000 equals .066 the cap rate or 6%
This is the projected return on investment for one year on a
cash on cash basis. If there is a mortgage in this case the net income would
come down and the CAP rate would adjust accordingly.
To determine a GRM or gross rent multiplier:
1)
Determine the value of a property
2)
Divide the property value by the annual gross rent. The result
is the gross rent multiple.
Illustration would be:
- Value
of property: $500,000
- Annual
gross income $70,000
- $500,000
divided by $70,000 equals 7.1 the GRM.
Conversely if you know the gross rent multiple common to an
area, let’s say this 7.1 and the gross rent of a building is $70,000 then the
asking price or value of a property should be about $500,000.
There are other ways of determining value:
- Price
per square foot on a general market basis
- Replacement
cost basis if the property is fairly new
- Internal
rates of return
- General
market value, but this is most common for residential properties
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