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Fools,

I have been casually looking around the RE market in my area for the last couple of years and am just now finding myself in a position to make a move. The residential market here does not allow high enough rents to make houses a worth while investment. But just the other day I stumbled across a person I know that is looking for a commercial space that is similar to one that I know is for sale. The deal is a ways off, but I am going to run this past you all to see what you think.

The commercial space is 1350 ft sq. and is listed at $185,000. It has been sitting empty, in a high vacancy town (poor economy), for the last 8 months. It is in a two year old building and the space is strata title with four other 2000 ft2 titles in the building. The location is great with high traffic and good parking available.

It would be my first investment and unless I could work some vendor financing I would have to go with 25% down. I beleive that I could get it for $170,000. With 25% down ($45,000), $125,000 mortgaged at 7.5% for 25 yrs would leave me with a monthly payment of around $915 a month.

The occupant is a large investing firm that would be interested in the office for a somewhat long term lease (~5 years) for a satelite office. They are interested in putting some money into the space for improvements. Having a good location, a newer building and good parking I beleive that I would be able to get around $11-12 a foot2 which would be somewhere between $1230-1345/month on a triple net lease. If I end up in the lower end I would still be getting over $300 above the mortgage payment. I know that I have to be sure that I am getting a few extra $$'s to cover unforseen costs, and I think that $300/month would do it.

So.......let me know what you think! It seems like a relatively good deal for the area that I am in, but I am still a REI virgin so I though I'd check with 'The Fools' for your thoughts.

Thanks,

ThePup
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Let's look at this a different way.

First of all, when I do that computation, I come up with a PI of $959.71 per month (300 months, 7.5%, 125K mortgaged). You will pardon me if I use my number rather than yours.

If you put down $45K and have a positive cash flow of $300/month, then you are getting a pretax ROI of 8% on your money. You will have a straight line depreciation of 27 1/2 years on the building (not the land...you can't depreciate land). Probably the land value will be taken as about 25% of the purchase price, so you will be depreciating $125K at a rate of 378.78/month. So you will have an excess depreciation of $78.78/month which will protect other income of yours, saving you about $22.06 in federal tax per month (presuming you are in the 28% bracket. This $22.06 adds an additional $264.72 to your annual income, adding another 0.6% to your yield, for an effective 8.6%.

Now, you will have a payment on principal out of that money. In the first 12 months (using your assumptions), you will pay $2,216.74 in principal. This represents a yield of 4.9%, giving you a total yield of 13.5%.

Let us assume that your building appreciates in value at 1% per year. We would normally assume appreciation at the rate of inflation, but you have already indicated that the economy in the area is bad. So, we will say 1%. That is an appreciation of $1700 in the first year, which is added to your effective yield (though you don't see it until you sell, if then). This 1700 is a 3.78% bump in your effective yield, giving you a gross effective yield on your $45K investment of 17.28% per year.

Pretty good, huh? ;-)

But, you forgot a couple things which we have to consider. First, your specified $300/month cash flow is based on your payment of PI. But you are going to have property taxes and insurance. Taxes vary widely from area to area; I have no clue what yours might be. But you need to find out. Similarly, insurance varies quite a lot; again I have no clue.

I would expect your property taxes to run at least $2000/yr on a building with that valuation, and your insurance to run about a grand. So you are looking at - let us say - $3000/yr in taxes and insurance. This comes out to $250/month, leaving a net positive cash flow of $50/month, and reducing your effective yield from cash flow to 1.3%. OTOH, your excess depreciation allowance is increased by that $250/month which saves you an additional (at 28%) $70/month in federal tax, increasing your effective yield by 1.87%.

So, after factoring in the taxes and insurance, your effective yield is 12.45%, of which $50/mo is cash, and $70/mo is tax savings.

Now, let us look at your risk. Commercial clients tend to remain in place for a long time (plus) but when they move, your property tends to sit empty for a long time (minus). If your property sits empty for an extended period, its value will drop, wiping out your paper gains while also neatly eliminating your REAL gains (you gotta pay the mortgage, and it takes a lot of months of $50 cash to make up for one month of $959.71 PI. How much minus are you willing to accept for your 12.45%?)

I'll give you a hint. I wouldn't touch it. No return and more risk than I want. Your $45K would make close to 8% with basically little risk in junk bonds, and would make better than 5% with no risk in treasuries.

When I do the computation I just went through here, I expect to see an effective annual yield of better than 50%, with something on the order of 15% cash (AT LEAST!!) yield for my money invested.

So, you either need a much lower selling price, or substantially higher rents.
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I know I didn't pose the question, but thank you for that excellent analysis with your answer. It has helped me think about how to analyze commercial real estate investments (no, I don't have any, but I like to read and think...).

e
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That was great. I'm looking at a similar property.
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Jim,

Thank you for taking the time to give me such a complete reply, it is fantastic. I learned a little more than I already knew, which is really what these message boards are intended for.

Two things. First, the reason I came up with a PI that was lower than yours is that I am a Canuck and in Canada mortgages are compounded semiannually which would account for the difference. Sorry that I forgot to mention that.

I probably should have gone into a little more detail on my question, but I think I mentioned that the lease would be triple net(not sure if that is Canadian terminology). This means that the taxes, maintence costs and insurance is all the responsibility of the renter.

This changes the situation somewhat and puts me back at a gross effective yeild of a little over 17%. If this were the situation, is it still something that you would pass up?

Thanks again for the post, I am beginning to think more critically about REI.

ThePup
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This changes the situation somewhat and puts me back at a gross effective yeild of a little over 17%. If this were the situation, is it still something that you would pass up?

Asking these kinds of questions is always good, but only you can really answer for yourself. Keep in mind Jim is in the middle innings of his game and probably has a significant Net Worth. He might not want the risk others might willingly take, and he might demand a higher return than others. If you are young, or starting out trying to build, it's often necessary and even prudent to take higher risks and lower returns to get started.

Think of your first job. Even if you were sitting next to someone doing the same work, if your neighbor had 20 years invested, she would be getting higher pay.

You work hard for fewer dollars to get started. What you never need, however, is scary high risk.

Rick
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Two things. First, the reason I came up with a PI that was lower than yours is that I am a Canuck and in Canada mortgages are compounded semiannually which would account for the difference. Sorry that I forgot to mention that.

Oh. Well that certainly does make a difference. What about your income taxes? How do you do depreciation? My calculations were all based on the US system.

I probably should have gone into a little more detail on my question, but I think I mentioned that the lease would be triple net(not sure if that is Canadian terminology). This means that the taxes, maintence costs and insurance is all the responsibility of the renter.

I did catch that, but not having any such properties I read it as tenant is responsible for all maintenance/upgrades. My bad; I should have caught that.

This changes the situation somewhat and puts me back at a gross effective yeild of a little over 17%. If this were the situation, is it still something that you would pass up?

It still looks skinny to me. Off the top, without doing a detailed calculation, in a circumstance where I don't have to pay taxes, insurance, or maintenance I would be happy enough with a 30% return. Allowing for a long term lease (and presuming the Lessee is solid and stable) I might shave another 5 points off that, which would put me at 25% ROI.

Don't forget that downside. If things go sour, will you be able to pay the $9 - something - hundred per month, plus the taxes? You should maintain an exit strategy if you need one.

Oh, and Rick is right. My risk tolerance is probably somewhat different than yours. I have taken lots of risks over the years; some have paid off handsomely and others have been expensive. At this point, I am more interested in making things cash flow handsomely than in expanding rapidly. So I am a bit risk averse right now.



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Jim and Rick,

Thanks for the thoughts, you have given my alot to chew on for the next while. I realize that I need to weigh the position that I am in for myself, and can't have anyone else make my decicion for me. You have definitely helped me along in my journey.

I'll keep you posted on new revelations with this deal and others as they arrive.

ThePup
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As one who has contemplated leasing commercial property (but never executed) in an arrangement much like pup has been talking about, I'm enjoying this exchange immensely. The contrast between Jim's (relative) risk aversion & resulting high ROI standards and those of a beginner are also illuminating.

I'd have to say one thing: that the vacancy of commercial property in an area of questionable demand can kill you. If there's one thing the action of the stock market should be teaching us, it's that you cannot synthesize demand. You stated there were three other (I assume roughly equivalent) spaces adjacent to the one you have your eyes on. That could be your future if things go in the toilet.

Keep your eyes open.

AL:LA
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A couple of the posts in this thread have suggested that my requirement for 50% ROI is high and therefore very conservative.

Not really. I would like to point out that I have done deals where my ROI was infinite. Since I invested nothing, any return I received was an infinite percentage return.

So let's take a quick look at a typical deal that I did a few years ago. I put up $65K to purchase a $445K property. In the first several months, I spent about $15K in repairs, but that all came out of cash flow.

I had purchased below market, and the repairs let me immediately (and fairly) value the property at $470K, for a $25K paper gain immediately. In the first 12 months, the property had a positive cash flow of $6K (after those repairs), but the depreciation for the property wiped out $13K in income, so that money was tax free and I had a $7K shelter which saved me an additional $1960 in tax. This was a hot area, so I take a 3% escalator in property value over the first year ($14K) and I paid down about $8,500 in principal. So, my $65K paid me back (cash and non-cash) $55460, for a return of 85%.

The rest of the story; a few years later (about 3 years ago) I took advantage of favorable conditions to refi the property, pocketed $90K, kept nearly the same payment, and went and bought some other things. The most recent appraisal values the property at $590K, and the annual gross rents on the place are almost $90K (was about 72K when I purchased it).

This is not the best deal I have done, although it is one of the better ones.
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So let's take a quick look at a typical deal that I did a few years ago. I put up $65K to purchase a $445K property. In the first several months, I spent about $15K in repairs, but that all came out of cash flow.

Nice deal. But did you have to wear a flack jacket to collect rents?

Rick
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Nice deal. But did you have to wear a flack jacket to collect rents?

Upscale neighborhood. Mostly yuppies.

There is an absolutely beautiful municipal park right across the street. My property stretches along the road from the baseball diamonds to the tennis courts.
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