4 things you want to consider when buying commercial income property!

If you own 2 or 3 investment properties and are trying to figure out how to replace the income from your job, you know that it will take a long time and purchasing many properties to earn your financial freedom.  Buying commercial property can dramatically fast track your financial goals!  It certainly did that for me.  One commercial deal can change your life.  The first million dollar commercial investment property allowed me to pay for my daughter's college education.  The second one I did, paid for my wife's early retirement.  In order to achieve those scales buying small residential, you basically have to be a deal junkie running on a hamster wheel!

These are the four things you need to know about what's different from residential when buying commercial investment property.  But before we get into that, what is the difference in terminology from commercial and residential real estate?  Residential real estate is anything that is single family through four family.  Anything 5 units residential and above is considered commercial.  Anything that has a use, even a partial use of anything besides residential is considered commercial real estate.  For example, a property with a retail store front and two residential apartments on top (a typical mixed use building), would be considered commercial, even though there are less than 5 residential units.  Ok, now for the four biggest things to consider between the two real estate classes:

1. Environmental.  Whenever you are buying commercial property, you will always want to have professional third party environmental due diligence done.  So always ask if the owner of the property is in possession of a Phase I Environmental assessment.  This will save you money on having to pay for one yourself.  The importance of Environmental due diligence cannot be understated.  If the property you are considering has even implied negative environmental impacts, if could spell trouble for the property.  Now, I'm not talking about lead based paint or asbestos within a structure (which is prevalent in older properties, especially in Rochester, NY).  I am talking about ground water contamination and negative air quality impacts brought about by that contamination.  I could spend hours explaining all of the implications and scenarios of environmental issues but the bottom line is you want to have a Phase I done if there isn't one already and send that Phase I for review to your bank providing the permanent financing.  Even if you are purchasing the property cash, with hard money, or seller financing, you still want to perform this due diligence because if there are negative environmental impacts, if could hinder your ability to sell or refinance that property in the future.  Case Study: I purchased a property one time where the seller held the mortgage.  It was a mixed use property.  Four apartments up top and two commercial storefronts.  I figured, "why do I need a Phase I since the seller is holding the mortgage?"  So I didn't do it, closed on the property, put a ton of money into it and then when I went to refinance with my bank, they found history of there being a dry cleaner there.  So, I had to get a Phase II, where an environmental consultant had to take several ground water samples, and air quality samples to define that risk.  $7000 spent later on the Phase II... the report came back with no recommendations and I was in the clear.  However, I had several unnecessary sleepless nights and stress while I waited for the results.  By the grace of God, I made out OK.  Don't roll the dice on this aspect like I did.
2. Appraisals.  Now this is the fun part.  The reason why I like commercial so much is because of the valuations you can achieve after executing your value add strategy to a property.  Residential appraisals give you value based upon comparable sales.  No matter how nice you make your units, how high you get the rents, and how well you manage the expenses, your valuation will always be hamstrung by recent comparable sales (the value increase will be marginal).  With commercial property appraisals, the appraiser evaluates the property more like a business and they use the property's net operating income (NOI) to determine valuation.  This means, the higher rents you achieve and the better you manage the expenses the higher the NOI, and therefore the higher valuation you can achieve.  This makes commercial income property perfect for the BRRRR strategy.  Which enables you to acquire property, improve the property and it's NOI, refinance it and get all your money back (or your investor's money back) so you can keep recycling that capital over and over again as you grow your real estate empire.  (for more information on this strategy visit Bigger Pockets article on it here)  Some things you want to consider when it comes to commercial appraisals...  The main factor appraisers use when using this valuation approach is the property cap rate (capitalization rate).  The cap rate is essentially how much value an appraiser gives to each dollar of NOI.  It may seem counterintuitive but the higher the cap rate the lower each dollar of NOI is and vice versa.  Cap rates are usually location and property type specific.  To find out what a likely cap rate is for any given property, talk to a commercial appraiser or your local community bank commercial lender and ask them what types of cap rates they see for a given property in a given location.  The calculus for cap rate is: NOI divided by cap rate = property valuation.  Cap rates in primary markets (like NYC) and class A properties are typically lower.  Cap rates in tertiary markets (like Rochester, NY) or class C properties are typically higher.  On a 3% cap rate property type every $10,000 you add to annual NOI will add over $300k to property value.  On an 8% cap rate property, only $125k.  So the value add strategy is much more difficult on higher cap rate properties, however lower cap rate properties typically have lower cash on cash rates of return.  So it's a balance.
3. Leases.  The leases on a commercial property are more important than on residential 1-4 family.  For instance, getting financing on a vacant or substantially vacant property, or a property with month to month tenants is much easier on residential property.  And also higher or lower lease rents have less influence on valuation of residential properties.  Therefore, it may be advantageous to cut a deal on your lease rents if you have a vacant apartment coming up in preservation of cashflow on residential in lieu of a potential vacancy.  If you have an $800 apartment that you have to discount to $750 to get it leased up to avoid vacancy, that can make sense because a $600 annual loss to lease, is better than losing $800 in cash flow.  However on commercial, it's more advantageous to get top dollar for your rents even if it means sustaining a little bit of vacancy loss since an appraiser will take your top line rents in calculating property value.  Also having high vacancy (10% plus) can negatively influence your ability to finance your commercial property.  Also your tenant base on commercial business use tenants (office, retail, industrial) can also have implications on your property valuation.  Longer term leases (5+ years) with national credit tenants (O'Reilly's Auto Parts, McDonalds, Sherwin Williams) will be more accretive to property value than shorter term leases with mom and pop tenants.  For instance, take two properties with a paint store tenant.  One has a 20+ year lease with Sherwin Williams and one property with a 3 year lease with Matt's Painting Supplies (mom and pop) will have drastically different valuations.  Also the fact that you have one national credit tenant in your tenant mix on a given property can have a halo effect on the valuation of your whole property because it shows a bank, an appraiser, or a prospective buyer that if the big corporate girls and boys like this location then it MUST in fact be a GREAT location!
4. Financing.  Financing is also very different for residential vs. commercial properties.  Residential financing is typically lower interest rates and long term (30 year), and fixed interest rate for the entire term of the loan.  This type of financing is made possible because the mortgages are underwritten by the standards of government sponsored enterprises Fannie Mae and Freddie Mac.  Commercial properties, especially smaller ones (less than $1 million), are usually financed by community banks and credit unions.  The interest rates are typically higher than the former, the term is shorter (10 years or shorter), the interest rate is only fixed for a certain amount of time (5-10 years) and they typically have a shorter amortization schedule (20-25 years).  On a positive note, underwriting criteria is usually more liberal, deal specific, relationship specific to the borrower, and subjective with each bank (one deal that one community bank might not like, another bank might have an appetite for)  So it seems like commercial mortgage financing is a raw deal, right?  Well it depends.  With our business model as a developer and investor, we usually refinance our properties every 5 years (to pull cash out and redeploy into buying more deals, so, long term, fixed rate debt is not necessarily that important to us.  However, if your strategy is to buy and hold property for 20+ years and you are just looking to augment your retirement plan, not necessarily replace your income to quit your job this avenue could be ideal for your investment strategy.  Incidentally, since commercial banks are relationship driven, it's important to establish and maintain your relationship with your community bank lender once you've found a great one.  The reason why is if you ever have a deal which does not fit the cookie cutter underwriting box of Fannie and Freddie or most other banks, you are more likely to be able to get financing or even creative financing with a community bank lender that you already have a relationship with than if you did not.  So if you shop your deal around to a few community banks, always take the best term sheet you receive to your preestablished relationship and see if they can meet it or beat it.  If they can't beat it but can get damn near close, go with the deal with the bank that you have a relationship with!  This will pay big dividends later on in your career, even if it means going with slightly less competitive terms.  For example, a few years ago, I had a deal where the numbers were really tight.  The only way I could make the deal work was by getting a 80% loan to value (LTV) and 25 year amortization.  All other banks would only go with a 20 year amortization.  My relationship lender advocated to their loan committee to make a policy exception for this deal because I already had so much business with them.  This one deal ended up paying for my daughter's future college education, thanks to my loan officer Jason (you know who you are!)

We hope this information helps you along your journey!  If you want to invest in assets backed by real estate but do not want to be a landlord, consider joining our OakGrove Capital Distribution List below so you can hear about how you can participate in our next deal!