When is commercial real estate a BAD investment? – Orange County Register
Put simply, commercial property is a bad investment if the risk outweighs the return.
Our neighbor has a decent portfolio of single and multi-tenant properties. The good news? Single tenant buildings are easy to manage – one tenant, one rental check. Multi-tenant setups – like an apartment building or a mall – don’t weigh on your cash flow when someone breaks through, but you do have to chase multiple rental checks.
If our neighbor gives up her management and switches to a single tenant, there is a risk that is greater than her tolerance. So your balanced portfolio. Think of single-tenant assets as a share of stocks and multi-tenant assets as a share of a mutual fund.
When are commercial properties good for business?
We recently represented a family-run construction company. The company found its origin in a booming district in the 1950s. Owning the site for the company was a solid plan. Flash forward to today: The next generation has made the decision to close the company. The boom of the 1950s gave way to rot in this decade.
As a result, the construction company was closed as none of the family members had to pay rent. The mission was to sell and reallocate the proceeds from the sale. Hence, what was once a business-friendly investment turned into a less affordable one years later.
Sometimes the metrics are skewed.
Replacement cost, rent, capitalization rate and return, sustainability of the income stream, and an exit plan are all considered by most commercial real estate investors.
Should any of these measures of investment property value require realignment, a future problem may arise.
Here is 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 base is artificially inflated. As long as Starbucks stays up to date, it doesn’t hurt. But when people start making coffee at home and sales drop, you’ll see where I’m going.
Investors mainly focus on the return on their money.
When a check is made to purchase the asset, the rate of return is the cap rate. Simple. Add in debt and the answer is a little more complex. Simple: If the capitalization rate exceeds the interest rate on your mortgage, there is positive leverage. This is magical as the return on your invested deposit is now higher than the total cap.
The opposite clearly occurs when a borrowing rate dwarfs that capitalization.
Don’t forget that tax laws are changing.
When Ronald Reagan was president in late 1986 (yes, I was in the business then) there was a tectonic shift in our federal tax laws. Due to the elimination of certain depreciations, lower marginal tax rates were swapped. I believe our depreciation rules today – 39 years later – were examples. Properties bought with certain tax benefits in mind were no longer a big investment.
When improvements are too specialized.
We visited a building with a customer last week. Our resident processes food but does so in an environment that does not require special freezers or coolers. The vacancy we entered had tons of cooler space. Our premise was that some of the cooler infrastructures would carry over to our use. For those in need of these special goodies, rental is not an issue as the cost of making them is often astronomical. But for those who don’t need them – which is a much larger part of the renting universe – they don’t pay for the extras.
Allen C. Buchanan, SIOR, is a Principal at Lee & Associates Commercial Real Estate Services, Orange. He can be reached at [email protected] or 714.564.7104.