Am I ready to move into commercial real estate?

Many real estate investors spend their entire careers at the single-family home level and do very well at it. But for those who hunger for bigger deals, the answer is usually larger properties. The plusses include positive cash flow (sometimes from the moment of purchase), professional management (which becomes more affordable when dealing with multiple units), and sometimes very large profits when you sell. It’s not hard to imagine why investors want to move up to larger properties. But, along with the plusses are some minuses. You will generally have more of your own money at risk; the lease structures can be complicated, even arcane; and if there’s a recession or a problem with the property, you can have massive vacancies. My suggestion is that you start out Simple, in single-family homes, Once you have a taste for it, you can spread out into other areas of real estate. Some investors, in fact, make the transition very quickly . . . and successfully.

Do I understand the new dynamics?

With single-family homes, profits usually come when you sell. Until then, you typically hang on hoping to achieve positive cash flow, but often having to accept some negative cash flow. Prices are largely determined not by how much you can rent the property for, but by how much similar homes sell for. With larger buildings,it’s a somewhat different story. While negative cash Row can sometimes be a problem, prices are tied directly to income. The higher the rents, the higher the value of the property. Notice the difference. With single-family homes, profits come when a neighborhood of mostly owner/occupant owners goes up in value. In larger buildings, profits go up when you’re able to raise rents. In single-family homes, you’re tied to the sales market. In larger buildings, you’re tied to the rental market.

Do I understand the relationship between rents and price?

The simplest way of evaluating an office or commercial building is to use the GIM (gross income multiplier, which was discussed in detail in Chapter 7). You find out what the gross annual rents are, and then multiply them by this number, which is actually derived from comparisons of similar buildings that have recently sold. What is important to understand is that if you double the rents,
you double the value of the building. (In single-family homes, how much you receive in rent is virtually irrelevant when calculating price.) Thus, everything comes down to how much you can rent the property for. Many savvy investors spend entire days looking at apartment, office, and commercial buildings trying to find those where, for whatever reason, the current landlord/owner has not raised rents to market levels. They then try to buy those buildings based on the current low rents. Once they own the property, they do what’s necessary to raise rents. This may involve fixing up the property, or getting newer and better tenants, or In the end, the higher they are able to raise the rents, the more valuable the property becomes, and the more they are eventually able to sell it for.

Do I understand leases?

Although the dynamics of all commercial property are more or less as described above, leases also play a big role. The strength of the tenant leases also helps determine the property’s value. Long-term leases with strong tenants (those likely to continue to pay their rents year after year with escalation clauses) mean a higher value. Short-term leases and weak tenants mean a lower value.
Improve the leases and you’ll also improve the value. Of course, there are other factors. In commercial buildings, the value of the property generally declines as the height goes up. For example, a commercial tenant on a second-floor mall generally pays less than a tenant on the street level of that same mall. The reason is that there’s normally less foot traffic on the second floor - it’s not as good a location. The reverse is often true for office buildings, where the higher levels are considered more prestigious (until there’s an earthquake or a disaster like 9/11).