There are 5 things you should know before you buy commercial real estate. Click next to discover the pros and cons of putting your money in real estate…
Do not buy real estate just because you have heard that a lot of people have made money in it. There are just as many people that have lost money in real estate as people that have made money in real estate. At Advantage Commercial Brokers, we want you to make an educated purchase decision. Many of our brokers have personally owned investment properties, and are glad to offer guidance and advice at every stage of your investment process.
First of all, why put your money into real estate? What are the pros and cons of investing in real estate vs. other investment vehicles such as stocks, bonds, and mutual funds? For our example, let’s suppose you have $100,000 cash to invest.
Let’s compare what would happen if you were to invest this money into real estate vs. the stock market…
Question 1: How much can you buy?
With $100,000 cash, you can buy exactly $100,000 worth of stocks. While a very select few individuals can buy stocks on margin, for most people, you can buy exactly $100,000 worth of shares with $100,000 cash.
Let’s compare this with real estate. How much real estate can you buy with $100,000 cash? Well, you can get a loan from the bank to buy real estate, which is something you cannot do with stocks. Suppose the bank is willing to lend you 90% of the purchase price of the building. That means with $100,000 down, you can buy $1,000,000 worth of real estate by getting a $900,000 mortgage.
Question 2: The minute you buy the investment, how much is it worth?
You have purchased $100,000 worth of shares with $100,000 cash. The minute you buy it, how much are your shares worth? Well, the stock market is extremely efficient, and the price you pay for the stocks is determined by the point where all the willing buyers and willing sellers meet, and the computer system tells you how much the stock price is at every minute of the day. That means your stocks are worth exactly $100,000 the minute you bought them.
Let’s look at the real estate example now. Is it not possible that you pay too much for the property? Conversely, is it not possible that the sellers are desperate, and you end up buying a piece of property that is really worth $1.5 million for $1 million, using $100,000 cash as down payment? Absolutely! There are many reasons why the sellers would sell their properties to you below market value. They may be moving out of town due to a job transfer, and need to sell their property quickly. The building may be an inheritance, and the children simply want to sell the building fast and split the proceeds. The seller may be too cheap to get an appraisal to see how much the building is worth. He may have bought the building 10 years ago for $200,000, and thinks he is ripping you off by selling it at $1 million, when in fact it is really worth $1.5 million. We can continue and list more reasons, but the point is – it is entirely possible to use $100,000 cash to purchase a building for $1 million that is really worth $1.5 million the minute you bought it.
Question 3: What can you personally do to increase the value of the investment?
In the stock market example, you have purchased $100,000 worth of shares with $100,000 cash that is worth exactly $100,000 the minute you bought them. What can you personally do to increase the value of your shares? Well, not much. You can try to buy as many of the company’s products as possible, or write a letter to the company’s management team wishing them good luck, but there is not much you can do to make the stock price go up.
In the real estate example, what can you personally do to increase the value of the investment? You can do a lot of things. You may be able to increase the value dramatically simply by mowing the lawn or giving it a new coat of paint. You could raise rents to the current market rate if the previous owner has been charging below market rents. You could perhaps add storage, or charge for parking if parking is scarce. You can add covered parking and charge more for parking. There are lots of things you can do to increase the value of your property, and it is entirely possible that with $100,000 cash, you purchase a $1.5 million building for $1 million, and within 30 days, you increase the value of the building to $2 million.
Question 4: How do you get your investment capital back?
Suppose that your stocks have doubled in value from $100,000 to $200,000. How can you cash in your profit? Well, you have to sell your stocks. If you think about it, it is a little counterproductive, because you want your assets to grow, but in order to cash in your profits, you have to sell the assets, which are the very things that generated you the profits in the first place.
Let’s take the real estate example. Using $100,000 cash, you bought a $1.5 million building for $1 million, and increased the value to $2 million by doing some renovations. Your investment of $1 million has doubled to $2 million. What can you do to cash in the profits? Do you have to sell the building? No, you do not have to. You can simply get a new appraisal, and the bank is willing to lend you up to $1.8 million (assuming that the bank lends 90% of the $2 million), and you can use the additional money you get from the bank to buy another property. In other words, you do not have to sell your assets to get your investment capital back. Think about it. Your investment capital was $100,000, and you borrowed $900,000 in the first round. Now that the building is worth $2 million and the bank is willing to lend you up to $1.8 million, you can borrow another $900,000.
With the $900,000 you just borrowed in the second round, take $100,000 for yourself to compensate for your original investment capital, and use the $800,000 to buy another building.
Are you beginning to see the power of real estate? Real estate tends to have a snowball effect as you buy more and more buildings. You can borrow money against the first building to buy the second building, and borrow money against the second building to buy the third building, and the process goes on and on. You do not have to sell your asset in order to buy more assets, which is one of the beauties of real estate. By the way, when you sell your stocks and cash in the $100,000 profit, do you have to pay taxes on that? Oh yes, you need to pay capital gains tax on your profit. Compared that to the real estate example, where you borrowed an additional $900,000 in the second round. Is the $900,000 taxable? No, because it is not income. It is borrowed funds, the interest payments of which are supported by the rents you collect.
The answers to our discussions above are the reasons why most wealthy people either made their wealth or hold their wealth in real estate. Click next to discover the type of commercial buildings you can buy.
There are 4 main categories of commercial properties:
Let’s explore these one by one.
Office buildings are classified into Class A, Class B, and Class C. Class A properties are the most modern, and demand the highest rents. The skyscrapers downtown are generally considered Class A office buildings. Class B and C properties are generally older, not as functional, and command lower rents as a result.
Office buildings are also categorized into low-rise, mid-rise, and high-rise. Starting from ground level, 6 stories or less are considered low-rise, 7 to 25 stories are considered mid-rise, and 26 or more stories are considered high-rise.
Industrial properties may contain office or storage space, and are divided into several categories:
Retail properties are designed for the tenants to sell goods and services. The general categories include:
Any residential dwelling units or apartment buildings with 5 or more units are considered commercial property. Multi-family properties tend to experience lower vacancy rates than the other types of commercial property, because businesses can shut down when the economy is not doing well, but people always need a place to live.
The disadvantages of multi-family properties include the lack of long-term leases that are typical in office, industrial, and retail properties. Also, the landlords of multi-family properties are responsible for much of the operating expenses such as water, sewer, garbage, taxes, insurance, and common area maintenance, while many of these expenses are the responsibility of the tenants in office, industrial, and retail properties.
There are many investors that hope to make their profits in real estate through appreciation, and effectively realize their profits when they sell the building since the building has gone up in value over the years. While this strategy may have worked for some people, it is not the preferred strategy by most sophisticated investors.
Sophisticated investors do not like to count their profits on appreciation, because doing so is pure speculation. Property values can go up just as well as down. Most sophisticated investors base their investment decision on the cash flow of the building, and make their profits on the buy rather than the sale.
To determine the value of a commercial building, you should examine the income and expenses of the property. For the purposes of illustration, let’s use a multi-family property example.
What are all the sources of income? Rents are your number one source of income. However, there may be other sources of income such as vending machines, parking, storage, laundry, utilities charge backs etc. Next, list all the expenses associated with the building. There may be taxes, insurance, advertising, maintenance and repairs, operating reserves, property management expense, and building vacancy etc. The only expense you should not include is your mortgage payments.
Now, take all your income and subtract from it all of your expenses (except the mortgage payments). The result number is called your Net Operating Income, or NOI for short. Your NOI is the amount of money you have to pay for the mortgage payments. If your NOI is $8,000 per month, that means your mortgage payments should not exceed $8,000 per month, or you will have to take money out of your personal bank account every month to cover the mortgage payments. Suppose your NOI is $8,000 per month and you have managed to get a mortgage with a monthly payment of $6,000. That means you will bring home $2,000 a month as passive income.
What kind of mortgage would give you a monthly payment of $6,000? Well, there are many mortgage options. Assuming the bank is willing to give you a 30-year amortized mortgage at 8% interest, a monthly payment of $6,000 means that you are borrowing $817,700.96. If the building is selling for $910,000, it means you need to come up with $92,299.04 cash in order to make the purchase (since the $910,000 purchase price is made up of the $817,700.96 loan from the bank + the $92,299.04 cash from you). This means if you invest $92,299.04, you will get $2,000 a month as income, which is $24,000 a year. That is a 26% cash on cash return on your money, since $24,000/$92,299.04 = 26%. Is 26% a good return on investment? Yes, it is! There are not too many investments that can generate you a solid 26% return year after year.
If this sounds confusing to you, do not worry. The commercial agents at Advantage Commercial Brokers are happy to help you with the purchase decision.
Loans on commercial real estate typically require a larger down payment than the loans on residential real estate, although smaller, local community banks and portfolio lenders tend to be more flexible when it comes to loan options.
When it comes to getting a loan from the bank, think of it as shopping for loans. In the past, the bankers used to be very powerful and you would be happy if they approve you for the loan. Today, lots of banks want to fight for your business, so when you call the lenders, they are trying to sell you on why you should get the mortgage with their bank.
There are several questions you should ask the lender when you shop for loans:
When you are applying for a mortgage, it pays to go to 10 banks. Prepare a professional package on the building as well as your financial background, and send the package to 10 banks. See what each bank is willing to give you the best terms, and you will be surprised that getting a mortgage is not as intimidating as it might seen if you have never done it before. Again, the commercial agents at Advantage Commercial Brokers are happy to assist you with the process.
If you already have a set of investment criteria, let us know and we will phone you as soon as we see a property that fits your criteria. If this is new to you and you need help developing a set of sound investment criteria, the commercial agents at Advantage Commercial Brokers have the knowledge and experience to help you with this endeavor. Remember, sophisticated investors make their profits when they buy the property, not when they sell. A set of sound investment criteria is critical to ensure a good buy.
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