Commercial Properties

When most people think of investing in real estate, they think residential. Everyone's familiar with houses, condos, and apartments. In contrast, many potential investors lack knowledge of commercial properties. Or they think such properties cost too much.

But, individual investors now realize that in today's real estate market, many commercial properties offer lower prices and higher yields (i.e., higher cap rates, higher cash on cash returns) than houses, condominiums, and small apartment buildings. Read through the sampling of "for sale" office and retail from around the country (Figure 15.2).

As you can see, none of these commercial properties is priced above $325,000. Their cap rates range between 6 and 12 percent, which is typical.

Property Management

Depending on the type of property and the terms of your leases (see later discussion) you may not need a property management company. Likewise you may or may not need a leasing agent.

For example, say you own a medical office condominium that is leased to a doctor for a remaining term of 5 years. This M.D. has three 5-year renewal options. If she chooses not to relocate, you enjoy a long-term, virtually carefree investment. The condo association maintains the building common areas. The doctor accepts maintenance responsibility for the interior of her offices.

The Upside and Downside

One strong upside of commercial properties is that (in most but not all situations) your tenants operate businesses or professional practices. They establish themselves in a set location. Therefore, commercial properties typically experience low tenant turnover. On the other hand, when you do get a vacancy, that vacancy can last for months—or if you own a specialized property (or a property in an inferior location)—a vacancy can last for years.

When you buy a commercial property with expiring leases on the near horizon, verify the marketability of the units (price and time on market). Do not naively assume that you or your leasing agent can quickly rent those vacancies.

Opportunity for High Reward

As a rule, vacant (or high vacancy) commercial properties sell at steep discounts. When you value a zero (or depressed) NOI by using a high (risk-adjusted upwards) cap rate you naturally get a relatively low price. (Of course you would also use the comparable sales and replacement cost

Longview, Texas

Status:

Active

Property consists of approx. 4 acres of land

Price:

$185,000

with two separate income-producing buildings.

Bldg. Size:

6,374 SF

Cap Rate:

11.87%

Primary Type:

Office-Warehouse

Apopka, Florida

Status:

Active

This is a 1,540 sq. ft. 2-unit office building

Price:

$289,000

located in Wekiva Commons Office Park in

Bldg. Size:

1,540 SF

Apopka, Florida. It was completed at the end

Cap Rate:

6.50%

of 2004 and is fully leased with 3-year terms.

Primary Type:

Office Building

Naples, Florida

Status:

Active

This highly visible retail center with up to

Price:

$225/SF

seven condominium units is situated in a

($264,825)

very high growth area with 107,000 residents

Bldg. Size:

1,177 SF

within 5 miles.

Cap Rate:

8.00%

Primary Type:

Retail (Other)

Ridgecrest, California

Status:

Active

A 2,970 sq. ft. professional office building. It is

Price:

$180,000

divided into 4 independently metered office

Bldg. Size:

2,970 SF

sites. Suite A & B are leased by a medical

Cap Rate:

7.20%

doctor.

Primary Type:

Office Building

Edison, Georgia

Status:

Active

7,500 sq. ft. Dollar General completed in

Price:

$295,000

February 2001. Dollar General has a 10-year

Bldg. Size:

7,500 SF

lease with three 5-year options. Year 6 of

Cap Rate:

8.14%

initial lease (2/2006).

Primary Type:

Free Standing Bldg.

Roanoke,Virginia

Status:

Active

Historic rehab of early 1900's Queen Anne

Price:

$319,950

Victorian with all of the modern conveniences.

Bldg. Size:

4,980 SF

Internet cabling and telephone wiring

Cap Rate:

7.80%

throughout.

Primary Type:

Office Building

Orem, Utah

Status:

Active

Two-story office building.

Price:

$251,174

Bldg. Size:

4,096 SF

Cap Rate:

9.00%

Primary Type:

Office Building

Figure 15.2 Sample Listings for Small Commercial Properties

Phoenix, Arizona

Status:

Active

Property is a small freestanding retail/office

Price:

$325,000

building with street frontage on Hatcher Road.

Bldg. Size:

2,816 SF

Cap Rate:

8.00%

Primary Type:

Office Building

Denver, Colorado

Status:

Active

Free standing office in downtown Denver

Price:

$250,000

golden triangle. Leased to bail bond office for

Bldg. Size:

1,300 SF

1 year. Great upside potential. Own a piece of

Cap Rate:

6.00%

downtown.

Primary Type:

Free Standing Bldg.

Figure 15.2 (Continued)

Figure 15.2 (Continued)

appraisal techniques to value this property.) Nevertheless, after balancing the three appraisal methods, you can still negotiate a low purchase price.

Now turn this lemon into lemonade. Through your research of the market, you should have a profitable tenant (or use) for the property in mind. Bring that idea to life and you're created value two ways:

1. You raised rent collections and

2. You've reduced the riskiness of the property (which warrants a lower cap rate).

If you can see realistic leasing possibilities that others miss, you will be richly compensated for your insights.

Commercial Leases Create (or Destroy) Value

Generally tenants who rent residential units sign leases of one year or less. If you don't like the lease (or the tenants) of the previous property owner, no problem. You can get your own lease and tenant policies up and running within a short time.

With commercial properties you probably face a different situation. Many commercial leases run for 3, 5, 10 years or longer. Plus, commercial tenants often enjoy the right to renew for multiple periods (e.g., an original 5 year lease with 3-5 year renewal options)

Just as important, commercial leases can differ greatly in their terms. Even tenants who rent units within the same office building or shopping center might have signed very different leases. That's because the terms of commercial leases depend on the market conditions when the lease is signed and the negotiating powers of the tenant and the property owner.

You can bet that tenants who sign office rentals in Silicon Valley today negotiate much sweeter deals than those tenants who signed at the peak of the tech boom in 1999-2000.

How Leases Differ. Lease terms determine your NOI. Great leases keep your NOI high. Leases with adverse terms drive your NOI down. Here are several examples:

1. Who pays what? In commercial leases, property owners often shift some (or all) of the property's operating expenses to the tenant. In some leases—especially long-term, single tenant properties—the tenant pays for operating expenses, building repairs, and major replacements (e.g. roof, parking lot, HVAC).

2. On what space does the tenant pay rents? Commercial tenants frequently pay rent p.s.f. But the rentable, square footage may exceed the tenant's private usable space. Some leases require tenants to pay rent for hallways, common areas, HVAC rooms, storage areas, public restrooms, etc. The lease may even specify the precise way the space is to be measured. The method of measurement can add or subtract 5 percent (or more) to the quantity of rentable space.

3. Are the rents inflation protected? If the property is leased to a tenant for 5, 10, 15 years (or longer) will your rent collections increase with inflation? When and by how much?

4. Are the property owners entitled to percentage rents? Especially in retail, leases may require tenants to pay a base amount of rent plus a percentage of the tenant's business revenues (which also should be precisely defined—e.g., must the tenant pay a percentage of their off-premises sales?)

Read Each Lease Carefully. I don't want to make this issue of leases sound too complex. Some owners of small commercial properties write relatively simple, three or four page leases that involve month-to-month tenancies. However, unless you actually read through each existing lease, you won't know what pitfalls may be lurking within the fine print.

You do not want to buy a property and then learn than an undesirable tenant still has eight years to run on his lease at a rent level $6 p.s.f. under market. You don't want to buy a small retail center with the idea of bringing in a Dollar General store only to learn that an existing tenant had negotiated an exclusive "general merchandise" clause in its lease.

Note: To learn more about leases for small commercial properties, I recommend Thomas Mitchell, The Commercial Lease Guide Book, and Janet Portman and Fred Steingold, How to Negotiate Leases for Your Small Business.

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