AN INTRODUCTION TO INVESTING IN
COMMERCIAL REAL ESTATE

By Narender G. Reddy


 

Whenever I attend social or community events, people often ask me for tips on investing in Commercial Real estate. They enquire what kind of property would give the best returns on their investment. When I ask them the basic question, ‘What size of cash investment do you have in mind’, usually their reply is ‘There is no limit’. My first thought at such a response is, ‘Even Bill Gates has a limit’. Not to belittle their enthusiasm, I politely explain to them that it doesn’t work that way. I ask them to come up with a budget from their resources, and figure out how much they could invest in commercial real estate and have some idea on what kind of returns to expect on their investment.

Just like any business venture, investing in real estate is a venture that could also turn into an adventure. To avoid mishaps, I strongly advise all the beginners to get a good education on commercial real estate by attending seminars, reading books and learning the terminology.

Most importantly, I advise people against watching those late night infomercials where the host, a self proclaimed ‘multi-millionaire’, surrounded by pretty bikini clad women next to a swimming pool or beach, screams about how he could teach you all the secrets of becoming a millionaire with out any down payment money. After you are done ordering that expensive package by calling a toll free number flashing on the screen, you’ll not be left with any money for down payment any way. Till today, I haven’t met a lender who has offered me a 100% loan to buy an investment property without requiring any down payment. And not that I’m complaining but those pretty bikini clad women never came my way either! 

Many beginners have started investing in real estate by buying houses and renting them. For a small investor possessing handy man skills, that is an excellent investment. People like me who see blood when they work with even a screwdriver and depend on hiring a handy man for every small repair to their rental properties it is a bad investment. Houses do need frequent repairs, from pipe leaks to a dishwasher going berserk, or an air conditioner refusing to provide any comfort to the tenant resulting in that dreadful phone call to the landlord in the middle of the night. 

Since I’m fully aware of my capabilities or lack of, I never invested in houses for rental income. Also, when I looked around, I realized that the people who were making the big bucks in real estate were the people who owned buildings not houses. People who owned large apartment buildings, large office buildings and huge acreage of land were the ones really increasing their net worth rapidly.

Benefits of investing in commercial real estate: Passive income is the key to investing in Commercial Real Estate. The way that commercial properties are managed and the way they allow for a concentration of efforts lets you put someone in place to manage those properties. You should also be investing in commercial real estate because of a concept called “forced appreciation”. Forced appreciation refers to your expertise in doing things that will increase your income and decrease your expenses. Remember that the more income your commercial property brings in, the more it is worth. The secret is to keep the property in good condition, and have quality tenants with long-term leases. 

Another reason to invest in commercial real estate is the fact that with the federal Tax Code allowing credits for depreciation of the property as an expense against the income the property generates, you’ll have the potential to increase the rate of return on your investment. Also, capital gains tax is a fixed 15% compared to federal income tax of 28% or higher depending on your tax bracket. Another important factor is ‘peace of mind’ as you’ll not receive mid-night phone calls from the tenants. Since, you have a property manager on pay roll and that expense being a straight tax deduction, dealing with tenants on a day-to-day basis is not your headache any more.

Income Properties: Investors who are planning to invest their money and also borrow money from a commercial bank are more likely to be interested in investing in income producing properties. There is no hard and fast rule about what kind of property is safe and can give high returns. Most investors consider apartment complexes, shopping centers, and industrial warehouses as good investments. Each market reacts according to the local conditions, especially with supply and demand, when it comes to giving a healthy return on your investment. Your job is to make sure that you are consistently aware of the changing market conditions in the relevant categories of commercial real estate.

Apartment Complexes: A few years ago, it was Apartment complexes in Atlanta that were the most attractive investment ensuring a safe and higher return. However, due to low home mortgage interest rates, most apartment dwellers became first time homeowners. Added to this, construction of new apartment complexes with modern facilities has increased the supply of more units than it could absorb. This resulted in a glut. The vacancy rate at one time had jumped to 17%. The current vacancy rate in 10 years old or older apartment complexes is much higher. Consequently, investors have experienced the disappearance of returns on their investment. Many of them are surviving only because of a chance to refinance their loan balances at the lowest interest rates of all time. If it was not for that, many apartment complexes would have ended up facing foreclosure. For the past few years, I have steered my clients away from investing in apartment properties.

In this column, I’ll limit the discussion to considering Shopping Centers as investment.

Shopping Centers

Shopping centers and Retail developments have become the key investments today, in real estate in the Metro Atlanta area. However the investor has to be cautious about the location, local market’s supply and demand factor and especially vacancy rates. Properties worth over $4 million are more attractive to institutional investors like REITs (Real Estate Investment Trust), Pension Funds, Insurance companies who expect a lesser CAP rate (percentage of return on Capital) on their investment than an individual investor or a private investors group. These institutional investors are very aggressive with huge reservoirs of cash at their disposal and can invest even at lower rates of return. For the past few years Atlanta real estate has remained an attractive market for institutional investors to invest billions of dollars.

PROS: Shopping centers are easy to manage with a leasing agent cum property manager on the payroll. In most cases, all the expenses like common area maintenance (landscape), property taxes, management fee; utility bills are calculated at the end of the month and collected from the tenants. The leasing agreements specify that tenant shall pay a fixed rent plus CAM (common area maintenance) charges. Normally the rent is charged on each square feet of space occupied by a tenant and the CAM charges are proportionately allocated. The investor is protected from taking a bite from his profit for any rapid increase in property taxes. It is the tenant who will be taking on the burden and the investor’s return on his/her investment is not affected. The leasing agreements also specify a fixed percentage of increase in rent per year usually linked to CPI (Cost price index), which is normally between 2 to 3.5 percent that helps the investor’s return against inflation.

CONS:

For any income generating property it is very crucial to have a financially strong tenant either people with an established business or franchise owners. In a typical neighborhood shopping center, the tenants are mostly mom and pop business owners. The leases are mostly for 3 to 5 years. Some of these businesses may close down resulting in an unexpected empty space in the shopping center. The time it takes to lease again will cause unexpected loss in rental income. If the landlord is not financially strong he could face financial problems in making the monthly payment to the lender on time.

An investor could avoid these problems by analyzing the leases at the time of buying the property. The investor should verify if the tenant is personally guaranteeing the lease or it is only the corporation that he incorporated for business purposes that is guaranteeing the lease. If it is only the business entity that is guaranteeing the lease and the business entity files for Bankruptcy protection, the landlord will not have any legal recourse to enforce the lease. The investor should verify the term left on the leases. It is always safer to buy a retail development or shopping center with multi tenants than a single tenant.

Narender Reddy is a 15-year veteran in investment and selling commercial real estate. He has a Bachelors degree in Economics, along with a Law and an MBA Degree.  Narender is an Associate Broker with Metro Brokers/GMAC Real Estate in Atlanta, Georgia).

Read Kavita's September 2005 Community Profile featuring Narender Reddy

Disclaimer: The views and opinions expressed in these columns are solely those of the writers and do not necessarily represent those of the editor/publisher.


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