When is commercial real estate a BAD investment?
Simply put: Commercial real estate is a bad investment when risk outweighs return.
Our neighbor has a tidy portfolio of single-tenant and multi-tenant properties. The good news? Single-tenant buildings are easy to manage – one tenant, one rent check. Multi-tenant setups – like an apartment building or retail mall – don’t crush your cash flow if someone runs away, but you have multiple rent checks to run.
For our neighbor to eliminate its management and convert to a single tenant, it follows a risk greater than its tolerance. So his balanced portfolio. Think of single-tenant assets as a share of stocks and multi-tenant assets 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 has its origins in the 1950s in a booming neighborhood. Owning the business location was a solid plan. Flash forward to today: the next generation has made the decision to shut down the business. The boom of the 1950s was replaced by the scourge during this decade.
As a result, without an occupant to pay the rent to the family, the construction company was closed. The mission was to sell and redeploy the proceeds from the sale. As a result, an investment that was once good for the business became a less favorable investment years later.
Sometimes the measurements are wrong.
Replacement costs, rent, cap rate and return, sustainability of the income stream and an exit plan are all considered by most commercial real estate investors.
If any of these measures of income property value require realignment, a future problem may arise.
Here is an example. If you buy a Starbucks store 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, that’s fine. But if people start brewing coffee at home and store sales go down, you know where I’m going.
Investors primarily focus on getting a return on their money.
When a check is issued to acquire the asset, the return is the capitalization rate. Easy. Layer debts and the answer is a bit more complex. Simply put: if the capitalization rate exceeds the interest rate on your mortgage, positive leverage occurs. It’s magic because the return on your investment is now greater than the overall limit.
Clearly, the opposite occurs when a lending rate eclipses said capitalization.
Remember that tax laws change.
When Ronald Reagan was president (yes, I was in the industry at the time.) At the end of 1986, a tectonic shift occurred with our federal tax laws. Lower marginal tax rates were traded by eliminating some depreciation. I believe our current depreciation rules – 39 years later – were examples. Real estate bought with certain tax shelters in mind was no longer a good investment.
When improvements are too specialized.
We visited 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 vacation we walked through was complete with tons of cooler space. Our premise was that some of the cooler infrastructure would result in our use. For those who need these dedicated goodies, rent is not an item as the cost to create them is often astronomical. But for those who don’t need them – which is a much larger part of the renter universe – they won’t pay for the extras.
Allen C. Buchanan, SIOR, is Principal at Lee & Associates Commercial Real Estate Services in Orange. He can be reached at [email protected] or at 714.564.7104.