In the January edition to this series on commercial real estate investing, we talked about returns on investment (ROI) ranging from 5 to 20 percent. In the February edition, we discussed a 6,000 sf retail strip center. We showed how that investment could have 9.8% return on investment for an all-cash purchase. Now we’ll look at the same size investment but instead of a retail/office strip center, we’ll consider a flex space commercial property. Then we will talk about the financing of both investments and how that impacts the actual return on the cash invested.
Flex Space Example
Flex Space is generally found in industrial zoned areas, rather than in neighborhoods where you would find strip centers. This type of property has a strong appeal to plumbers, electricians, tile setters, roofing contractors, and just about any other trade related to construction. The design of these buildings include a large roll-up door for delivery truck access, storage, and a small office space. This type of commercial property is also appealing to the hobbiest looking for a place to store cars, motorcycles, boats, RVs, wood working equipment, or other toys. Often times these units are called a "Man Cave" but they could certainly be used as a "She Shed". Because this type of property can be used for a variety of purposes, we refer to this type of property as flex space.
Flex space is a wonderful type of real estate investment because of its versatility of use, which means that in good times and bad, this type of property will have renters of all kinds. Therefore, this is one of the lowest risk types of real estate investments that one can have, plus it has far less management issues than apartments, retail, or office space.
In this example we’ll use a 10,000 sf metal building, which we plan to divide into five units, each being 2,000 sf. Each with a personnel door in front and both a personnel door and a roll-up door in the back. Let’s assume that the cost to divide this building into five units, build bathrooms in all five, and build a small office in three out of the five units, would cost $100,000 after acquisition. Let's say the building is for sale for one million dollars, and is currently generating a gross rent of $15/sf. This would be $12,500 per month or $150,000 per year, when fully occupied. But since this is a gross rent, the landlord must pay the operating expenses such as taxes, insurance, utilities, management and all maintenance. These costs will generally average about $60,000 per year, which would be the same if the building was 100% occupied or 50% occupied. That’s an important note. At 100% occupancy that would leave a Net Operating Income (NOI) annually of $90,000.
So once again the investor, when analyzing this investment, would want to factor in a prudent vacancy factor. Let me say here that vacancy factors are not plucked from the air, but rather based on a careful analysis of the market around the property to determine the occupancy level of comparable properties. But for the sake of this example lets assume one unit is vacant on average half of the year. That would reduce the gross income from $150,000 to $135,000. Then subtracting the operating expenses of $60,000 leaves the investor with an NOI of $75,000. Based on the one million dollar purchase plus the additional $100,000 for repurposing, the NOI on an all-cash purchase would leave the investor with a return on investment of 6.8% ($75,000/ $1,100,000), which is respectable. If the property can be well maintained but at a slightly lower overall cost than $60,000 a year, that savings would add to the NOI. Also if the vacancy is less than 10% (a generous vacancy factor), then that additional income would also serve to increase the NOI.
Now over time, in most markets, and certainly in most Front Range markets, the rents will be able to be modestly increased from year to year. At the same time, the operating expenses will increase as well, but with good management and skillful leasing, the rent increases will outpace the operating expenses by a couple percent per year. Over time that will really add up!
Financing
Between the February edition and the example above, we have looked at two simple types of commercial real estate investments that produce sound returns on investment and both with potential for increasing the net income to the investors. But in both cases, our investment group that Beacon Real Estate Services put together with its clients, decided to cobble together 25% of the acquisition cost of each investment by gathering together five or six like minded investors, and then borrow the balance of 75% to acquire the property. BRE is skilled at arranging commercial real estate loans and would help facilitate this for the investment group.
For both of these investment examples, lets assume that we can arrange 25 year financing at an interest rate of 8%. In the case of the retail strip center, mentioned in Part 3 of this series, a 75% loan would be a loan of ($1,000,000 x .75 = $750,000). The investment group would have invested $260,000 of equity in the Retail building. Also, in Part 3 we showed that the strip center could, after sprucing up, produce a NOI of $99,000. The next step in analyzing the investment is to consider the Annual Debt Service (ADS). In this case on the annual debt service would be $69,463, which would then be subtracted from the NOI, leaving a cashflow to the investors before taxes of $29,537. That cashflow would represent a 11.3% return on equity (ROE) invested by the investment group ($29,537/ $260,000 = 11.3%).
In the case of the repurposed flex space building which had a total cost of $1,100,000, the investors would infuse equity of $350,000 and have a loan of $750,000. The ADS on that loan would still be $69,643. When subtracted the ADS from the $75,000 of NOI, that would leave them with a cashflow before taxes of $5,537. Based on the equity invested by the group in this flex space building, that would represent a 1.6% ROE. At first glance, this looks like it might not be a very good investment.
Wrapping Up
On the surface, it would seem without a doubt that the better investment would be the retail strip center over the flex space building, but in fact there are other factors that need to be analyzed to determine if one is actually better than the other for the term that the investment group plans to hold the property. The differences can be significant based on a holding period of five years verses a holding period of twenty years, when you analyze factors such as potential rental increases that can be achieved over time, maintenance issues, property tax increases that are anticipated, etc. So in the next installment of this commercial real estate investment series, we will look at how over a period of time, one investment may actually out perform another investment, even though in year one it had a lower ROE. Sometimes these commercial real estate investments that initially have low returns on investment are overlooked by buyers but the truly savvy investor with the guidance of a truly knowledgeable and experienced commercial real estate agent, can buy a property at great prices and then add significant value over time to achieve not only great annual cashflow but also increase the value of the property for future re-sale. For more information, contact Justin or Stephanie.
Author:
Craig Rathbun
Senior Advisor at Beacon