Choosing Commercial Real Estate As an Investment Alternative

Real estate investing is considered to be a safe investment over time. This is one reason why many do this as a full time profession. One can also invest in real estate and not be involved full time. Most people think of real estate investments as homes or condos or multi-family properties. Commercial real estate is another excellent choice when it comes to investing in real estate.

Commercial real estate investments typically allow the owner to continue their day to day unrelated business while their hired professionals upkeep and maintain their commercial property investment. Although most people think of commercial real estate as office buildings, retail stores, or industrial facilities, there are a lot more property types in the commercial real estate.

Some examples include properties such as health care centers, retail structures and warehouse. One of the most desired and financed commercial property is called residential. More specifically, apartment buildings (real property that consists of more than four residential units) are considered commercial real estate.

Most people consider commercial real estate difficult to enter due to financing and larger down payments than residential property. Although this is true to an extent, there are many commercial financing programs that will offer up to 90% financing and some even up to 97% financing for small commercial properties up to $1 million dollars. Of course, commercial mortgage loans go significantly higher to $500,000 and more.

Commercial real estate investing can be significantly profitable due to increasing rents, inflation and material costs. An investor must be able to analyze an opportunity more thoroughly in commercial real estate versus residential real estate. Some initial analyzes involve the rent rolls, pro-forma statements, and operating income. These numbers are crucial to the lenders to determine the amount of financing you will receive. Once you know the amount you will receive from the lender you can easily determine if the investment is worthwhile. You could take up commercial real estate for either reselling after appreciation or leasing out to residential tenants or retail tenants.

If you research and learn there will be substantial commercial growth in the area (due to tax breaks or gentrification), it may be wise to evaluate the potential for appreciation in commercial real estate and then seek out a good investment. If you find that a multifamily or office property, for example, is available but too expensive for you to buy alone, you may want look at joining or creating a small investor group and acquire it together. In another example, you might find it lucrative to purchase a commercial property that you can change to a warehouse which you can then rent to small businesses. As you have learned here, there are many creative ways to achieve success in commercial real estate investing.

Commercial Mortgage Refinance - 6 Issues That Can Kill Your Deal

There are several potential issues that can delay or "kill" your commercial mortgage refinance. Some of which will just tack on a few days or weeks to the process while others will completely eliminate the lenders interest in funding your loan. A prime example of this is value and environmental issues.

1. Title Problems. A forgotten lien on title can have a major impact on closing. Perhaps the dollar amount of the lien is substantial and cannot be rolled into the loan amount. Or the borrower may challenge the lien and will have to get it removed/resolved before the lender will fund the transaction.

2. Value. When the borrower and lender negotiate a loan term sheet, one of the most important components is the loan to value ratio. For example, on a refinance virtually all banks will not go beyond 80% loan to value. In other words, if your property is worth $1,000,000, your potential loan cannot exceed $800,000. If after your appraisal has been complete and the value comes out at say $900,000, you have a problem and a dead loan.

Besides the obvious frustration due to the canceled loan, there can be much disagreement with exactly how the value was determined. Appraisal reports are not perfect and have a subjective component to them. Deciding which comparable recent sales to use and how exactly to add/remove value from these comps is up to the discretion of the appraisal company.

3. Sudden Change in Business. Lenders sometimes call this "Adverse Change". Basically what it means is that there has been some type of borrower change from the time of initial loan approval to the closing. With some commercial mortgage refinances taking as long as 90 - 120 days to complete, much can go wrong in that time.

For example, we had a transaction where the borrower had to purchase a small fleet of trucks for his business. The truck loan was personally guaranteed and was reported on his personal credit report. The additional debt dragged his score to the minimum acceptable levels for the funding bank. In addition, the cash flow was tight to begin with and this additional debt also affected the numbers. It created some tense moments for all involved, but was resolved.

4. Environmental Issues. The liability for the lender having to take back a property with environmental issues is huge. No one wants to be stuck with the bill and cumbersome process to clean up a property. Not to mention the possibility of being sued by neighboring owners. It is not unheard of for these costs to exceed the value of the real estate itself.

In regards to a commercial refinances, most environmental issues are not on the scale of Chernobyl. What typically happens is that the results of the Phase One come in with concerns and a recommendation for a Phase 2 report, which typically requires borings and soil samples. The cost on the Phase One is around $1,800 while a Phase 2 is much more expensive. It is not unheard of for that report to be approximately $10,000.

The borrower will have to pay for this report upfront and in cash. He could be reimbursed this cost at closing, but will have to get there - if the results of the Phase 2 shows more issues the borrower could be in a very bad position and may have dead loan and be out the $10,000.

5. A Disaster. It goes without saying that if there is some type of damage to the subject property or perhaps a death to one of the partners, that this will have a substantial delay in the least, to the refinance.

6. Insurance. The subject property has to be insured. To some this may seem painfully obvious but we have seen many refinances get delayed because of this. This problem is especially relevant on refinancing out of private mortgages and or seller financing. Many private lenders don't confirm that proper insurance is in place or simply do not care. Also, on cash out refinances the borrower may have to increase the insured amount as the loan increases which can create issues in and of itself.

Commercial Property Value - How to Determine

In residential real estate, the listing price is determined by the seller. Comparables "comps" are analyzed for a myriad of variables including price per square foot, bedroom count, bathroom count, number of garages features (pool, central vacuum, etc), location (cul-de-sac, corner, busy street), views & more.

Adjustments are then made to the subject property to render it equal with those comps. For instance if the subject property has one fewer bedrooms and 500 fewer square feet of living space, it's price will be reduced by the value of the extra bedroom and the reduced square footage.

In commercial real estate, pricing is determined by the income the property produces. Although physical features (pool, laundry facility, etc) and location (busy street, etc) are factors, they are considered only to the extent that they enable the property to command higher rent or decrease its operating expenses in order to increase the property's cash flows or Net Operating Income (NOI). Secondarily location is considered to the extent of the potential appreciation of the land. In commercial real estate, it is these cash flows and the amount an investor is willing to pay for these cash flows that will determine the price of the property.

Put simply, if the annual cash flows from a particular property are $100,000 and an investor is willing to pay $2,000,000 for those cash flows, then the property is worth $2,000,000 to that investor. If another investor is only willing to pay $1,000,000 for those cash flows, then the property is worth $1,000,000 to that investor.

Investors will consider numerous properties in a given area to determine the standard of how much is typically paid for particular cash flows in that area. The "going rate" in area can be considered its cap rate. An exact definition and explanation of cap rate will be detailed in a subsequent article. This article will address the concept of cap rate.

In this example, the first investor only required a 5% return on investment or yield and therefore could pay as much as $2,000,000 for $100,000 in annual cash flows to obtain his/her 5% desired return. The second investor required a 10% yield and was therefore only willing to pay $1,000,000 for the same $100,000 of cash flows. Different investors require different yields which affect the price ultimately paid for the property.

This one year yield could also be described as cap rate. In commercial lingo it would be said that the second investor requires a "10 cap" and that the first investor only required a "5 cap." This is an oversimplified explanation to demonstrate the concept. The "one year yield" distinction is made as cap rate only accounts for one year yield, usually the following year from when the investor purchases the property. To determine the combined yields of multiple year returns, different measures are used and will be detailed in a subsequent article.

Commercial investors will determine their risk adjusted requirements for their investments and will base those decisions on opportunity costs. Opportunity costs are the costs associated with not investing into something else. For instance, if an investor could alternatively invest in a stock, bond, T-bill CD, or other instrument and yield 15%, why would he/she buy a property which only yields 5%? In order to attract investors the property owner would have to lower the price (increase the cap rate) to give investors a higher yield.

Notice the inverse relationship here. As prices are lowered, the yield to the investor or cap rate to the investor goes up as related to the cash flows. Conversely, as property prices are increased, the yield to the investor or cap rate on those same cash flows goes down. Cap rate only takes into account the first year of cash flows and does not account for the second year, third year, etc.

Notice I have not even mentioned appreciation. The value of commercial real estate is primarily considered based on its cash flows while investing in residential real estate is for anticipated appreciation.

In residential, there is only one way to make money. The market must go up so the investor can sell for more than the original purchase price. In commercial real estate investors are purchasing cash flows. In our example, if the second investor paid all cash, at a 10,cap which values the property at $1,000,000, that investor would be paid back 100% of the initial investment after 10 years and as of the 11th year, the investor would have $100,000 of annual cash flow from that single property. Because there is no mortgage called debt service in commercial real estate, this would be the cash flow before tax to the investor. In other words, other than income tax, this is the spendable cash to the investor on an annual basis.

Hopefully the property will have appreciated as well and the market will be favorable. But in the very worst case if no appreciation occurred whatsoever, the investor would still enjoy the $100,000 of annual cash flows. The beauty of commercial real estate is in the ability to plan. If you buy a residential property, you must sit and wait for the market to appreciate. The problem is that you never know when this appreciation will occur or how much. You can't plan. And, you're at the mercy of the market. In commercial real estate, as long as rents don't decrease substantially and vacancies don't increase, you know ahead of time how much money you will make regardless of market appreciation.

Now consider this. Let's say that the second investor decided not to pay cash and instead leveraged the property with a 10% down payment or $100,000 to purchase the $1,000,000 property. Let's also consider that the remaining $900,000 was financed at 7% for 25 years which is the typical term length in commercial financing. With a fully amortizing loan the annual payments would be $63,000. In commercial real estate, paying debt owed to the lender is called debt service. In residential, it's called paying the mortgage. From the $100,000 cash flows (NOI) from the property the debt is paid leaving $37,000 of cash flows before tax. For simplicity sake, I will not account for tax effects on income or yields.

In this example, in Year 1, the investor has earned $37,000 for a $100,000 cash outlay or a 37% cash on cash return and will do so for 25 years until the debt is paid off assuming no changes to the income. Subsequently, the investor will enjoy the entire $100,000 of annual cash flows as there will be no debt service. To calculate the combined cash flows from multiple years the investor would look at a measurement called Internal Rate of Return (IRR). For the scope of this article I will not address IRR. But remember, Cap Rate is for a single year's return and cannot account for multiple years with different cash flows each year.

Notice again, I haven't even spoken about appreciation which may or may not occur. But even if no appreciation occurs to our example property, this is still an incredible investment! Now obviously during a 25 year period these cash flows will change as rents will likely be increased and capital improvements will likely be needed (new roof, etc). But again, I'm keeping it simple for example purposes.

To summarize: In residential real estate there is only one way to make money. The strategy is to carry the property and hope that the market goes up and that the property appreciates so that the investor can sell for a higher price than was paid. Positive cash flows are typically non-existent and if present, negligible relative to the anticipated appreciation the residential investment will bring.

In commercial real estate properties are purchased for their positive cash flows AND potential appreciation. It is because of these cash flows that commercial real estate is less risky.

It is for this reason that commercial real estate is more stable and can weather the market storms that residential investments cannot and it is for this reason that the super wealthy own residential to live or vacation but invest in commercial real estate to create their massive wealth.