In last month's installment to this series on commercial real estate investing, we talked about returns on investment ( ROI ) ranging from 5 to 20 percent. That article can be found by clicking here. We also used as an example a one million dollar property purchased by a small group of investors, or one investor, that would require $250,000 of equity (down payment) to purchase the property. Let’s now look specifically at a theoretical case for this size of an investment in a small neighborhood retail strip center.
Let’s assume for this example that this property is a 6,000 square foot building in pretty good shape that’s divided into six rental units, each being 1,000sf in size. Let’s further assume that on average, each tenant is paying a monthly rent of $1,200 in base rent plus their share of real estate taxes, insurance and maintenance, which adds another $100 a month to their rent. They also in this example, would be paying all of their own utility expenses. The $100 a month is a wash since to owner of the property would turn around and pay that money annually for the taxes, insurance and maintenance (often referred to as Triple Net Expenses or CAM -common area expenses). Therefore, the $1,200 a month would come directly to the owner of the property from each tenant for a total of $7,200 a month (6 x $1,200) or $86,400 a year, which is referred to as Net Operating Income or NOI.
Return on Investment
Now if a new investor or investment group were to buy this property for one million dollars, the $86,400 would represent an annual ROI or 8.64% but only if the property stayed 100% leased at all times and if there were no maintenance problems with the building or parking lot which could not be passed on to the tenants as part of the triple net expenses. In todays market an investment returning 8.64% would be pretty good if the property is in reasonably good condition and its in a good neighborhood. But a wise investor would want to plan for one unit in the property being vacant about half a year, or two units vacant for three months each, just to be on the safe side. That would reduce the NOI to $79,200. Then continuing to be very cautious, the potential investor would further reduce the NOI by another $3,200 for unexpected expenses that cannot be passed on to the tenants. Now the remaining NOI is down to $76,000 which of course represents a 7.6% return on investment. In commercial real estate, the NOI when compared to the purchase price, creates what is known as a capitalization rate, or simply CAP rate. In this example the CAP rate would be 7.6%. Now a decent property with a CAP rate of 7.6% can still be a really good investment, particularly if the market suggests that with a bit of sprucing up of the property after the new owner takes control, the base rents can increased over time from $1,200 a month to $1,500 a month. So even with the vacancy factor and additional expenses that we cautiously added to our analysis, this investment could produce an NOI of $99,000. That’s a much better CAP rate as a result of the one million dollar purchase, plus another $10,000 spent to spruce up the property. If we divide $99,000 of NOI into the one million and ten thousand dollars, we end up with a 9.8% CAP rate. Excellent!
It gets even better when we factor in the Internal Rate of Return (IRR) and the tax sheltering, plus the opportunity for a 1031 Tax Deferred Exchange, but all this will be discussed later on in this series.
But this investment group or individual, as you recall, is only going to put up $250,000 to buy the property as the downpayment, and another $10,000 for the spruce up. They’re going to borrow the rest of the money, so the $99,000 doesn’t go into their pockets, but rather only part of it after making their loan payment on the property. Here is how that would work.
Annual Debt Service
The investors would put up $260,000 and borrow from a commercial real estate lender $750,000 which for this example could get them a 25 year loan at an interest rate of 8% with a balloon payment or what’s known as a “Call“ in five or seven or ten years. The shorter the period of the call, the better the interest rate. We will have an entire section of this series on investing devoted to the complexities of commercial real estate finance, so I won’t go into to great detail on this now. But in this example the $750,000 loan would require an annual debt service (ADS) of $69,463. Then subtracting this ADS from the $99,000 NOI would leave a cash flow before taxes to the owners of $29,537. When dividing the $29,537 into the $260,000 investment, the ROI of just over 11%.
So this investment looks pretty darn good if everything turns out as described above. Making certain that everything turns out as expected, is the job of Beacon when representing a client in the acquisition, investigation and analysis, as well as arranging financing and managing the property after purchase to see to it that the property performs as expected. That’s exactly what we do at Beacon.
Next month we’ll do a similar analysis of a repurposed property into a flex space property, also sometimes called man caves. This type of investment is a bit more complicated, but not terribly so. Repurposing of existing commercial real estate can be one of the best and most fun investment projects, but it takes a bit longer to reach the targeted ROI though that ROI is generally towards the higher end of the ROI spectrum. If in the meanwhile you have any questions about any of the information in the first three installment in this series on commercial real estate investing, please call Justin at 720-939-9494 or Stephanie 816-835-3380 at your convenience.
Senior Advisor at Beacon Real Estate Services