Simply stated: Commercial real estate is a bad investment when risk outweighs the returns.
Our neighbor has a tidy portfolio of single and multi-tenant properties. The good news? Single-tenant buildings are easy to manage – one tenant, one rent check. Multi-tenant setups – such as an apartment building or retail strip center – don’t crush your cash flow if someone bolts, but you have several rent checks to chase.
For our neighbor to eliminate her management and convert to single-tenant, a risk greater than her tolerance ensues. Thus her balanced portfolio. Think of single-tenant assets as a share of stock and multi-tenant as a share of a mutual fund.
When is commercial real estate good for business?
We recently represented a family-owned construction company. The company found its origins in the 1950s in a part of town that was booming. Owning the location for the business was a solid plan. Flash forward to today: A decision was made by the next generation to shutter the enterprise. The boom in the 1950s was replaced by blight in this decade.
Consequently, with no occupant to pay rent to the family, the construction company was closed. The mission was to sell and redeploy the sale proceeds. Therefore, an investment once good for the business evolved into one less favorable years later.
Sometimes the metrics are skewed.
Replacement costs, rent, capitalization rate and return, sustainability of the income stream and an exit plan are all considered by most investors of commercial real estate.
Should one of these measures of an income property’s value require realignment, a future problem may arise.
Here’s an example. If you buy a Starbucks location and pay $1,000 per square foot for a building that can be replaced for half that amount, your basis is artificially inflated. So long as Starbucks stays current, no harm. But if folks start brewing coffee at home and store sales wane, you see where I’m going.
Investors mainly focus on a return on their money.
When a check is written to acquire the asset, the return is the cap rate. Easy. Layer in some debt and the answer is a bit more complex. Simply: If the capitalization rate exceeds the interest rate on your mortgage, positive leverage occurs. This is magical as the return on your invested down payment now is greater than the overall cap.
Clearly, the opposite occurs when a borrowing rate eclipses said capitalization.
Don’t forget, tax laws change.
When Ronald Reagan was president (yes, I was around the industry way back then.) at the end of 1986, a tectonic shift happened with our federal tax laws. Lower marginal rates of taxation were swapped by eliminating certain write-offs. I believe our present depreciation rules – 39 years later – were examples. Real estate bought with certain tax shelters in mind was no longer a great investment.
When improvements are too specialized.
We toured a building last week with a client. Our occupant processes food but does so in an ambient environment with no specialized freezers or coolers required. The vacancy we walked was complete with tons of cooler space. Our premise was some of the cooler infrastructure would translate to our use. For those who need these special-purpose goodies, rent is not an object as the cost to create them is often astronomical. But for those who don’t need them – which is a much bigger part of the tenant universe – they won’t pay for the extras.
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at firstname.lastname@example.org or 714.564.7104.
Source: Orange County Register