Many real estate investors who recently began their investing journey reach out to a commercial broker, like our team, after painting one too many apartments subsequent to a tenant damaging the unit, or being woken at 2am to deal with plumbing issues wreaking havoc on the property. The call usually goes,

“I’d like to not have the hassle of renting and managing my apartment building. I’d hire someone but I’d lose all my cash flow if I hired a third party.  Commercial properties seem like they would be much easier to manage, but I don’t know how to fill those units, how to find those opportunities, or how to even know if I am getting a good deal.”

To the first two concerns, our simple answer is to hire a commercial broker. The last one is only something the investor can decide is a good deal. There are a number of factors involved, so that when you are selling an apartment complex at a 7% CAP and buying a retail building at a 7% CAP , there are key factors to consider if you really are getting that rate of return.  Here is the simplified version of what commercial investors should take into account when evaluating cash flow of an investment property that is not residential in nature.

Step 1: Understand the market and product type you are thinking of investing in. 

This may sound obvious, but most people think commercial properties are all the same in terms of leasing, managing, and growth in a market.  This is simply not the case. Much too over simplified, but office and retail space are still in high demand in the seacoast. These tenants, however, are requiring less and less space to handle operations. In a world of cloud computing and one day shipping, the excess paper & inventory is really not necessary like it once was. And while we are seeing industrial/warehouse space in high demand for manufacturers and online retailers higher than ever before, the rental rates have not caused a lot of developers to build this type of building, which is also a statement of what the potential upside is in this market. In other words, the cost of building a facility like this may not be supported by the rents that can be attained on a PSF basis. Also, factors like distance to highways and airports are key in determining how marketable industrial space will be. So it is important to do the research, understand the market trends, and confirm your ideas from brokers, other investors, landlords, and other professionals who can lend insight on the market.

The statement, ‘real estate historically and over time, has always increased’ may be true, but I think we can see clearly that depending on the location and type of residential or commercial building, you could be on the wrong side of a deal fairly easily. But, with the correct assistance from someone with the knowledge of the market, you can also end up on the positive side. Please don’t let this step deter you from making this journey into commercial real estate investing because you can see many people have made tremendous profits in this industry, but be aware of where you want to buy and what properties will be easier to fill with tenants now and in the future.

Step 2: Be able to evaluate what the true cash flow will be for a property.

Just coming in and looking at the Pro Forma Net Operating Income (NOI) and what Market Cap Rate is, may get you a purchase price that might not be properly accounting for all different factors. Where a lot of investors miss the market is not understanding what true vacancy will be. They either guess far too high and never are able to buy the property (as their cash flow projections are wildly off), or very optimistically look at 12-24 month trends and are not considering long term market conditions, which is very important in commercial space.  What are the points to be considering when thinking about vacancy in a commercial building? 

• General Vacancy – how much of the market has empty space right now or over the past 2 to 5 years? 

• Absorption  – concessions made in order to attract a commercial tenant which can include free rent for a period of time 

• Turnover  – How many of your commercial tenants leases end during the projected time you are holding the property and on average how many tenants in your market renew their lease?

• Re-Lease Cost  –  How much will it cost you if one of your prime tenants leaves? 

After looking at a first year 7% CAP you might find the effective CAP rate might be over 1%, lower or higher when you are considering more than just the general vacancy rate. The data is key when trying to come up with these projects, so be sure to have key partners in the market who can lend insight on what to project in the market. Also, you should consider each of these aspects as a ‘best case’, ‘worst case’, and ‘typical case’ scenario, and weighing the averages based on your projections on the market.

Continuing on Step 2, please remember that capital improvements generally can have greater costs and more often in frequency than in residential.  It is not just simple roofs, heating systems, or a new kitchen for commercial buildings. Some tenants will need new walls and layouts which affect lighting, flooring, sprinkler, updated electrical, HVAC systems and many more items.  Depending on market conditions, sometimes the tenant is paying for these or portions of these improvements but sometimes the landlord will have to make these investments in order to attract a new tenant, and sometimes to simply keep the tenants they have in place.  This is simply one of the costs associated with leasing that can be high, but also depending on the market, could see improvements to your building and its value.

To put some numbers to what we are talking about, here’s an example. A 10,000 SF space that is leasing at $10/SF loses a tenant, but gets a new tenant that is willing to pay $15/SF.  If you must invest $250,000 into the space for improvements, that might sound steep. However, that rental increase, in a market that trades at a 7% CAP, would increase the value of that space by about $715,000. Very few investments outside of real estate are this stable, or have this potential for upside.

The last thing to not forget when figuring out cash flow on a commercial building is to account for commission expense.  Our team at KW Commercial, has the type of professionals you want to partner with to help fill these spaces quickly (decreasing vacancy expense) and at the highest dollar amount.  Of course, like anything that adds value to your business, there is a cost associated with that service. Be sure when evaluating the true Pro Forma, that you:

• figure out how many tenants leases end during the holding period

• what is the likelihood of each of them staying

• how much it will cost to get new tenants who sign leases for 5, 10, or 20 years. 

Getting the right tenant into your building, quickly, with the least out of pocket expense possible is tremendously valuable. Be sure to vet whomever you hire to assist with this to the highest level because making the wrong decision could decrease the value of your property by 10% very easily.

Step 3: Understand the lending and best accounting practices. 

Interest rates in commercial real estate are very low right now, but important factors are how long you can fix that rate and how much it will cost to get it that low. Closing costs, points, and the Loan-to-Value are all important items to consider.  Also, how you decide to depreciate a commercial property can drastically affect your cash flow. If you have lots of improvements to make early on and plan to hold for a long time, it might make sense to use straight line depreciation. If you are looking to maximize cash flow early on, then cost segregation might be a smart investment to make and take advantage of, for your commercial building. Speak with your accountant or ask your commercial broker about Cost Segregation Specialists who can help assist you in this process.

The truth is, do not be afraid of commercial real estate investing because it is simply another avenue to grow your wealth. It will require more knowledge, more homework, but is worth the effort. More so than another investment type,  having the right team of lenders, lawyers, accountants, financial advisors, commercial brokers, property managers, insurance agents, and other real estate professionals is key to avoiding the mistakes that cause people to lose in this industry.  

Happy Investing!

– Written by Dave Garvey & Ethan Ash, based on “Not All Clash Flows Are Created Equal” by Steve Massell, Broker (KW Commercial Leadership Council)