Basics of Commercial Real Estate Investment
An individual investor is almost always marginalized, cannot outbid institutional investors on large, urban properties; and as a rule, loses out to end users on small, sub-urban properties. Large investors with a stockpile of low cash, grab large properties with credible tenants and stable cash flows. In case of smaller properties, banks prefer owner occupied buildings over investor owned buildings. Hence, end users will outbid individuals on small, sub-urban properties. To add this, an individual is always tempted to apply their knowledge of residential real estate.

As compared to Residential Real Estate, commercial real estate is tough to understand and involves complex analysis. In most cases, rent alone decides the value of a commercial property.

Cap Rate is the most frequently used decision tool. Cap Rate is net rental income expressed as a percent of acquisition cost. For a property that is owned and leased, the more the net rent, the higher is the cap rate. For an investor making an offer on a commercial property, the higher the cap rate expectation, the lower is the purchase cost.

Investor Expectations

Individual investors, under tight market conditions and when interest rates are high, expect a 10% cap rate on their commercial investments. In a good market with low interest rates and easy availability of funds, an 8% cap rate expectation is normal. For great properties with good leases in place, sometimes even a 7% cap rate would be acceptable. Very rarely individuals will be willing to accept a cap rate less than 7%. This kind of reward is required because of inherent risks associated with small commercial properties tenanted by local and regional businesses. Cash flows from properties acquired at a cap rate of 9 or 10% could yield an annualized IRR of 14% if held for five years prior to selling.

How is an individual investor marginalized by Large Investors?

In most cases, individual investors would want a cap rate of 8%. During times of high interest rates, and tight money supply, the cap rate expectation could be 9%. Cap rate expectations vary across investor types.

Pension funds and institutional investors for whom money availability is relatively easy, cap rate expectation could be as low as 6%. This is so because their cost of funds is very low. In view of low cap rate expectation, such investors will successfully grab high quality commercial real estate with long term tenants in place. High rise buildings, shopping malls, large retail or specialty buildings in urban, and upscale communities are some examples where large investors outbid individuals.

Individual investors, seek a cap rate of at least 8%. This is so because their cost of funds is relatively high. Also, individuals’ ability to raise debt funds is limited. Hence, individual investors’ cap rate expectations are almost always higher than those of large investors. In view of this difference in cap rate expectation, individual investors cannot compete with large investors. Therefore, large investors can capture large properties tenanted by national tenants in urban markets or central business districts. As a result, individuals’ choice of investment is limited to smaller properties tenanted by regional or local tenants in sub-urban markets. Neighborhood strip centers, office condominiums, medical office parks are some examples that individual investors seek out. But, individuals face stiff competition from owner occupants on such properties.

How do owner occupants outbid individual investors?

Individuals will have to compete with small business owners for commercial properties like strip centers, office condominiums, and small retail units. Small business owners can get commercial loans at competitive rates for their owner occupied properties. Therefore, business owners, at the slightest of the opportunity, would prefer to own their place of business. So, they strongly compete with individual investors for small commercial properties

Office vs Retail – which is a better investment?

Retail tenants, due to their inherent need for working capital would want to rent their stores than to buy. Retail tenants usually commit for longer lease terms – typically 10 years or longer. Customer loyalty is linked to the location, hence retail tenants do not want to vacate.

Office tenants, their cash flow permitting, would prefer to own their real estate than to rent. In case of office properties, today’s tenant is tomorrow’s owner. Every small business tenant of an office building, will seek out opportunities for ownership. This could result in more frequent turnover of tenants. Lease terms on office properties are usually shorter. Higher tenant turnover means higher risk of vacancy loss.

Challenges / Risks of Owning Commercial Properties:

It is widely known that securing a commercial loan is not as easy as securing a mortgage loan for either a primary residence or investment home. What does it tell?

Loan to value ratios in commercial real estate will be as low as 50% which means the loan amount is only 50% of the purchase cost or appraised value. Compare this with 80% LTV in case of residential investment property. Why banks limit LTV on commercial loans?

The answer is commercial real estate is riskier than residential real estate. To be able to pay off principal and interest, a commercial property has to be either owner occupied (with healthy business operations) or actively managed and remain occupied all the time. Lenders would want to make sure that the borrower has enough cash flows to pay principle and interest even if the building remains vacant for extended periods. In case of owner occupied buildings, lenders would make sure that the business has enough cash flows to pay for interest and principle. It usually takes longer to fill a vacant commercial property than a residential property. Vacancy risk is therefore higher than that of residential real estate. Having said this, lease term is usually longer in case of commercial real estate. So, tenant turnover is less.

Commercial real estate is more dependent on external factors and economic cycles. Demand for commercial property depends on the health of the neighborhood. If the neighborhood around the property is on the decline, or if the shopping center does not do good business, vacancy rates rise. During times of vacancy, the owner may not be able to pay principle and interest.

But, if you look at residential real estate, there is always a renter for a residential property even when a neighborhood is on the decline. Rental activity continues even during periods of high unemployment. The need for housing is less impacted by economic cycles than the need for retail or commercial space. When the economy is bad or the neighborhood is on decline, businesses downsize or close. It takes several years and many times political intervention to revive the communities that have declined. Richardson and East Plano are good examples.

Life span of a Commercial Property

Ideally, investors would want to recover their full investment within 10 years, from rental income. If a property is purchased at 10% cap rate, full asset value is recovered in 10 years. At the end of year 10, value at risk is only cost of investment or interest. Such returns are required because, occupancy is uncertain. Like individuals, communities do have life span and a life cycle. If the town and neighborhood is built out and people age, demand for goods and services diminishes and hence, business slows down which could mean closures and downsizing. Hence, during times of uptrend, commercial activity occurs after substantial residential activity. But, during time of downturn, fall in commercial activity occurs prior to decline in residential activity.

When does commercial real estate peak?

Commercial real estate peaks when a town is substantially built. Businesses need people in the neighborhood to sell their products and services. When the town is fully built out, commercial real estate reaches maturity and stagnation. As the demographics in the vicinity grow older, and as their demand for products and services diminishes, commercial real estate declines. It is not uncommon to find virtually dead commercial zones. Good economic performance, geographical location, environmental factors and government policies are some other factors that could influence the growth of commercial real estate.

Bottom line

Since commercial real estate investment is more risky, investors should seek a cap rate of at least 7% or more. Cap rates depend on the occupancy of the building, lease terms, and the quality of tenants. A building fully occupied with high quality tenants and for longer lase terms, will command 6% or 7% cap rate. Again, prevailing interest rates will influence cap rates. It is easy to secure a bank loan on a fully leased property. For this reason, owners of fully leased properties would rather secure a loan than sell. Because, cashing out via loan has tax incentives as compared to cashing out via sale. Purchase of vacant commercial property has inherent risks, especially if the shopping center is not doing good business or has witness high tenant turnover.

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