Friday, November 09, 2007

Getting into commercial real estate

I am now completing my third commercial building. The three projects have been the Industrial building, the John R. Hayes building, and the new W. Adin Hayes building. I sold the industrial building this past summer. So I have two buildings that I am keeping.

Everything I have learned about commercial real estate has been through doing and reading. I should mention that very little in my MBA prepared me for the commercial real estate world with the exception of a couple of finance classes.

Since I always enjoy sharing what I have learned, here is the first lesson.

Everywhere you look, you will see commercial properties. Some of these are owned by the company who is occupying them. However, most are rental properties. I define commercial rental properties into two groups. The first group is the multi-tenant property. These are everything from strip malls to high-rise office buildings. The second group are single tenant buildings.

While this is a very simplified way to categorize commercial real estate, it works for this lesson.

Making money in commercial real estate as a property owner is not too difficult. First, you need to find a location and secure it someway. I recommend either putting a contract with a few contingencies or purchasing an option on the land. Options are good since they give you more time to bring a deal together, however you are at risk of losing the option and what you paid for it if you take too long to make something happen.

After you have some land locked in, you need to put together a proposal on that land. Maybe it is a speculative building with five office spaces in it. You would want to put together a site plan so you can figure how big the building can be and how it will lay out. Then from that, you could hire a designer to lay out your building. I recommend finding an existing building in a nearby town (similar building codes) and buying that design or modifying it with the original designer. By the way, in some areas you don't need to hire a full architect. A designer who subs out of the structural engineering will do fine.

So now, you have some land that you don't yet own, a site plan (preliminary) that gives you an idea of how the building will lay out, and a building design (exterior only) which gives you some nice 3-D pictures. This is where you need to hustle. First, you should be contacting potential tenants. At the same time, you should be getting cost estimates and financing. All you are going to finance is the shell part of the building and the site work. Make it clear that any tenant upfit will be financed and built after you sign tenants.

Obviously, I have skipped the market research part of things. However, you should know your market very well. Understand what the vacancy rates are, the typical rents, what businesses are there and what is missing. The "missing" is your market. I could spend days talking about this part.

Okay, now you have lots of things going on:

1. An option, contract or piece of land that you have bought.
2. A site plan that is ready to be submitted or has been submitted. (You should already have the proper zoning before you buy the land. Never buy land without the zoning done first!)
3. A shell building design and lots of pretty pictures of it.
4. Bids or estimates of the construction cost from a Class-A contractor (No, you shouldn't play general contractor unless you are one.)
5. You should get some tenants signed up. I recommend a minimum of a 5-year lease.
6. A financing package for 100% of the project cost including interest.

That last part is where people have trouble. This is not your house. This is a commercial building. Therefore, you should be able to build it for a lot less than what it will be worth. That is because you should ultimately appraise the building based on the net operating income it produces. For instances, nationally, commercial properties are valued at about 6.5 to 7% capitization rates. A Cap rate is the rental income after all expenses except for interest, depreciation and taxes divided by the purchase price. So say a building generates $120,000 per year, has operating expenses of $20,000 per year, and was purchased for $1,400,000. Then the cap rate would be 7.1%.

Here is the neat part, if you are building right, you should be able (depending on your market) to get a building going for less than what it is worth based on the cap rate. That is the goal anyway.

If you can build a property that generates $100,000 per year for about $800,000 and borrow $900,000 then you would have a loan to value of $900,000/$1,400,000 or 64%.

If you achieve your financing goal, then you have been able to build your property without any money down. Now you have to figure out how to make money at it.

Using the example above, let's get you a $900,000 note with a 20 year amatorization at 7% at your local bank. They will likely put a 5-year balloon on it so they can milk points out of you every now and then. With that funding, you would have a mortgage payment of $83,732 leaving you about $12,000 in free cash. But wait, there is more. You get to write off the interest, and depreciate the building over 39 years.

If you are smart, you will get leases with inflation kickers that move the rent up a little each year. This is very important since you will want to increase your rents over time. Once your building is full, you can either sell it based on the cap rates or hold it and eventually pay down the debt to have a nice retirement nest egg.

I could go on more about this, and I will--later.

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