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A Primer on Investing in Commercial Real Estate

 
 

Written by on May 4th, 2017
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As the prices of residential real estate continue to ascend at a rapid rate on Central Vancouver Island, there are fewer and fewer viable residential real estate investment opportunities. Without a substantial down payment on single family homes or apartment style condos, cash flow is nearly impossible. While the numbers may still work on small multi-family buildings, if you can find a decent one on the market, please let us know. With investment yields on other asset classes (stocks, bonds, etc.) so low, there has been a significant increase in demand for multi-family residential property, and in most cases, the best options are transacting off-market. Meanwhile, the number of books, websites, and real estate related seminars continue to sing the praises of investing in apartment buildings, further exacerbating the demand, with little concern for the supply shortage that exists. In this extremely competitive space, cap rate compression continues, and valuations continue to soar making what would have been viable options a few years ago look less and less attractive.

So what do you do if you’re trying to generate passive income? The returns on your investment portfolio are marginal, you can’t find cash flowing single family residential property, and quality multi-family residential is nearly impossible to find…Consider an investment in commercial real estate…Hold on…did you say commercial…Isn’t that heaps more complicated??? Well, let’s dig into it and find out.

Valuation: Commercial property is valued based on capitalizing the return it is producing. Currently on Central Vancouver Island, cap rates for retail (strip malls/plazas) fall in the 5.5% to 7% range, offices slightly higher ranging from 6% to 7.5%, with industrial currently in the 6% to 7% range. From here, you have options such as mini storage, motels, hotels, etc., which all command cap rates north of these levels. Capitalization rates basically imply for a given level of risk inherent in a specific asset class, a certain return needs to be produced to justify the risk taken on in making the investment. Basically lower risk = lower cap rate, higher risk =  higher cap rate. Cap rates also apply to multi-family rental apartment buildings, however right now in Nanaimo cap rates are sub 5%, reflecting the low-risk level, and strong investor demand. Applying a cap rate to value a property basically works as follows: Gross Rental Income – Vacancy/Bad Debt Allowance – Any Expenses Paid by the Landlord (not including financing costs) = Net Operating Income (NOI). The cap rate is then applied to the net operating income (NOI/cap rate) to arrive at an implied value. For example if the Net Operating Income of a commercial space was $100,000 and a cap rate of 6% was applied, $100,000 / .06 = $1,666,666.67. Given this function, if you want to increase the value of an income property, look for opportunities to increase the income, and/or reduce expenses. For example, you could take over an absentee owner, poorly managed property, invest in some cosmetic upgrades, utilize some modern advertising methods, and possibly increase your NOI by $10,000 or $20,000 relatively quickly. If you increase your NOI to $120,000, a 6% cap rate implies a new value of $2,000,000. Your value is not subject to the whims of the residential market, you have much more control over your investment.

Lease Structure: Residential leases are typically gross leases. The tenant pays you $1,000 a month to rent your apartment, and from those funds, you pay property taxes, insurance, maintenance, property management, and potentially some utilities, depending on your agreement. If you have financed your purchase, you will also have a mortgage to pay, which may or may not leave you with some money left over for a rainy day. With commercial leases, while there are a few different structures, the vast majority of leases are structured with a base rent (straight to the landlord’s bank account) + additional rent on an absolute net or triple net basis. The triple net is comprised of the property taxes, insurance, and maintenance for the unit being leased. Yes, you read that correctly, the commercial tenant is responsible, in the vast majority of cases, for these expenses. While the commercial landlord may choose to finance the property, which would be taken from the base rent, this is the choice of the landlord, and often leaves far more left over than would be the case in a gross rent residential scenario. If you have ever looked at a listing for a commercial space and it said $15.00 psf + triple net, what this translates into is you are going to pay base rent of  $15.00 annually (divided by 12 for monthly payments) for each square foot of space you are leasing. On top of that, you will likely receive an estimate of the annual triple net expenses broken down per square foot, which you will be charged in addition to your base rent. What this structure ensures is that the landlord receives a fair return on their commercial real estate investment.

Interior finishings: With residential rental properties, the interior is finished, and you as the landlord are responsible for repainting, recarpeting, replacing appliances, etc. With commercial properties where business needs of tenants vary, tenants are responsible for their tenant improvements. While you may provide an allowance to induce quality tenants into the space to help offset the cost, you as the landlord are only required to provide the shell space, and they take care of the flooring, painting, space planning, trade fixtures, etc., at their cost. When they leave, you are left with what remains. In some cases, it has some value and another tenant can move right in.

Legislation: If you have been a residential landlord in BC, you are well aware that the opinion of most residential landlords is that the Residential Tenancy Act is slanted largely in favour of the tenant. Commercial, not so much. For example, you control your rent increases, deposit amount and return conditions, you have no obligation to mitigate if the tenant breaches the lease, and you have the ability to seize the tenant’s belongings and sell to cover rent in arrears.

Lease Term: While the majority of residential tenancy agreements are periodic, often month-to-month, commercial leases tend to be fixed-term with an option for renewals. 5 and 10-year commercial leases are very common, sometimes even longer given the substantial amounts businesses invest in their tenant improvements and the fact that customers become familiar with businesses being in a certain location, and a move can sometimes have a detrimental effect. What this means is for 5 or 10 years, you are not advertising and cycling through tenants, papering tenancy agreements, and experiencing periodic vacancies. Naturally, this structure can reduce the number of tenant induced headaches you may have to deal with.

Financing: With single unit or small multi-family typically less than 6 units, your ability to qualify for financing is based primarily on you and your personal financial situation. With commercial property, it is primarily based on the income earning potential of the unit. If you have a strong tenant locked into a long term lease this will go a long way. With this in mind, you are not going to cap out at the typical 3 residential rental properties. If you can cover the required down payments and the numbers work, you can grow as large of a portfolio of commercial properties as the underlying property financials will support.

So right about now, if you’re still with me, you may be wondering why would anybody choose to invest in residential rental properties as it appears that commercial real estate is superior in almost every way. Well, there are a few potential drawbacks that you may want to consider. Vacancy rates can be substantially higher in small to mid-sized communities.  Have you ever noticed “for lease” signs tend to go up and stay up for a long time? That’s because each business has a very distinct space need, factoring in size, location, zoning, parking, proximity to other commercial activity, etc. The other factor is since most businesses have signed long-term leases, a business may only have an opportunity to relocate every 5 or 10 years and even then, they will consider whether they want to again have to incur the cost for tenant improvements and take on the hassle of a move as opposed to focusing on driving revenue in the current location without the tenant improvement costs. So yes, lease up time can be longer, leaving the landlord on the hook to cover the costs during these periods. Also, when the time comes, selling a commercial property can often take longer as the pool of buyers is far more limited than with residential properties.

So you may be wondering, what would it cost to get going with your first commercial investment? While you may be surprised to find out… Right now in Nanaimo, $282,000 would buy you a 23-year old townhouse in North Nanaimo that would rent out for $1,200 to $1,300 per month. Splitting the difference, $1,250 per month x 12 months grosses you $15,000. From this, you pay $2,382 in strata fees, $1,761 in property taxes, and $12,127 in mortgage payments with a 20% down payment at 2.50% on a 25 amortization. If you are scoring at home, that means you have negative cash flow to the tune of $1,270 per year from day one.

Alternatively, for $279,000 you can buy a brand new commercial strata office in Pacific Station, a Westmark Construction built mixed-use development where a thriving business community has emerged in an ideal north-end location. Base lease rates for new north end commercial space with excellent exposure and access would reasonably be expected to be in the low twenties per square foot range. So this particular 1,042 square foot unit would conservatively at $20.00 per square foot command $20,840 annually, and your tenant would likely be signing at least a 5-year lease. Remember this is your base rent. Your tenant is paying the strata fees and property taxes via additional rent. If you finance your purchase with a 20% down payment at 3.00% on a 25 amortization, you are going to pay $12,672 towards your mortgage out of your base rent. What is left over…$8,168 positive cash flow…You also likely have a long term tenant and no responsibilities for fixing broken toilets, replacing appliances or any of the other headaches that go with investing in residential real estate.

So why don’t more people invest in commercial real estate? It’s actually very simple, they don’t understand it…Because everyone either owns or rents a home, they (often falsely) believe they understand residential real estate. But, don’t those same people quite possibly have other investments in stocks, bonds, and mutual funds? Do these people fully understand those asset classes in order to make prudent investment decisions? Right, right, that is different, their Advisor takes care of that. And how about taxes…April 30 just passed, did all the people that don’t fully understand the Canadian tax code decide they just weren’t going to file their taxes this year? Oh, right, they had their accountant take care of it for them…Ladies and Gentlemen, you have highly educated commercial real estate advisors in our very fine city waiting to hold your hand and guide you through the intricacies of an investment in commercial real estate. Interestingly enough, their services on the buy side of the transaction will likely cost you absolutely nothing.

If you are considering an investment in real estate or need some assistance in developing a plan of action, put our team to work for you. Contact us anytime for your complimentary consultation at 250-751-0804 or info@jahelkagroup.com.