[Book Summary Notes] Commercial Real Estate for Beginners - Peter Harris
As per my previous blog article, I’ve been trying to read more this year. Moreover, I’ve decided to take notes on some of the books I’m reading and share them with you guys. I hope you guys find this helpful and perhaps, if interesting enough, you guys would want to read it on your own.
The first of many, is a free book by Peter Harris called Commercial Real Estate for Beginners. Harris was a student of the greatly respected Robert Kiyosaki (author of Rich Dad, Poor Dad), and now he frequently writes and advises people on commercial real estate investment. Below are my notes for what I believe are the most important takeaways from each chapter.
Commercial Real Estate for Beginners by Peter Harris
Chapter 1: Definition of Commercial Real Estate
If real estate makes money, is rented out, is for investments, or falls into a number of other categories other than being a private residence, it can be considered commercial real estate.
“Commercial property (also called investment or income property)” = buildings or land intended to generate a profit, either from rental income or capital gain.
Chapter 2: Reasons to Invest in Commercial Real Estate
Commercial real estate investment has the same recipe of success as Warren Buffet’s investment rules/objectives: (1) Predictability, (2) 6 types of Control
6 types of control - income, expense, asset, debt, management, insurance
You now have options outside of someone else’s control (eg. you can’t be fired)
Can force appreciation (eg. raise rents = value goes up since net income increases)
Good hedge against economic volatility - can raise or lower rents
Tax shelter - “depreciation”
Leverage & velocity
Can hire external management
Summary: Investing in commercial real estate is the greatest method to build cash flow to supplement your income and to build true wealth over time. The cash flows that are generated are considered “passive” income, while other income (from your job or stock investments) is considered “earned” income which is highly taxed
Chapter 3: The 7 Habits of Highly Successful Commercial Investors
Invest in One Asset Type at a Time (Power of Focus)
Don’t over-leverage debt
Figure out break-even/occupancy percentage
Higher the debt load, the higher the break-even point in occupancy needed
Having 50-60% debt (or 50-60% LTV) is ideal
Properties are Managed Effectively & Professionally
Mgmt’s ultimate goal is to maximize potential rental income, reduce operating costs, strengthen tenant retention and relations, enhance visual appeal of the property, and increase property value.
accountability of the 4Ms - money, marketing, maintenance, managing staff
Patiently Acquire & Have Tolerance for Mistakes
Avg real estate cycle is 10 years
Mistakes = highest form of learning
Effectively Partner
Do what you do best and hire out the rest of the best
Success = relationships
All Business Systems are Accountable
Excellent internal communications and accurate financial and operational reporting.
Business systems: accounting, revenue, internal controls, property staff, marketing system, maintenance, and marketplace.
Well-Insured & Entities are Set for Max Protection, Privacy & Tax Strategy
“Plan for the worst and be happy if it doesn’t happen”
legal fortress with strategic insurance coverage with well-thought entities eg LLC, LLPs, Corps, TICs, Trusts, etc.
Poor protection may lead to lawsuit and loss of personal property
Chapter 4: 10 Opportunities to Invest in Commercial Real Estate
Apartment Complexes (5+ units)
Bank’s favorite to lend money on
Best asset to invest when economy is most volatile
Sweet spot for individual investors: $500K-$5M
Office Buildings
One of the most enticing methods of investing in office buildings is by way of triple net leases (all 3 categories of expenses are paid for by the tenants in your office building). , — where the tenants in the property pay you the rent + any kind of property maintenance, upkeep, and repairs, the property’s taxes and insurance. However, the downside is that it’s typical for triple net leases to be 5-20 years in duration. Cannot increase rent if market value increases.
Retail and Shopping Centers
Many rental properties are also long-term tripe net leases
Anchor tenant - Usually the first, and the leading, tenant in a shopping center whose prestige and name recognition attracts other tenants and hopefully, shoppers.
Power center - an unenclosed shopping center with leasable area that usually contains 3 or more big box retailers and various smaller retailers (usually located in strip malls) with a common parking area shared among the retailers
Big box retailer - physically large retail establishment, usually part of a chain. Eg. Wal-Mart, Target.
Strip center - A shopping area made up of a row of retail stores traditionally anchored by a supermarket.
Credit tenant - tenants that are usually publicly traded or large private entities with a strong S&P credit rating.
Mom and Pop tenant - small businesses in small square footage
Pad site - A single freestanding retail site, often adjacent to a mall or larger shopping center. Eg. photo kiosk, a burger stand, or a drive-thru gourmet coffee shop.
Self-storage facilities
According to the Self Storage Association (SSA), self storage has grown into a $220 billion industry.
No tenants to deal with on a daily basis and no toilets to fix
Minimum income collection issues – tenant payments are automated and non-paying tenants are locked out.
Multiple profit centers under one roof – sale of boxes, moving supplies, locks, billboard leases, etc
Low risk – no single tenant move-out will greatly affect your cash flow
Industrial Properties
3 categories: manufacturing, light manufacturing and assembly, distribution
Eg. Warehouses, commercial condos, distribution centers, assembly plants, office/workspaces, art studio, workshops, showroom
Hotels, Motels
24/7/365 business
Hard work and marketing. Rooms are worthless if vacant
Mobile Home Parks
Most mobile home parks are owned and operated by “mom and pop” investors and these investments are usually a combination of the land and the mobile homes themselves.
Although banks will readily lend on the land, rarely do they want anything to do with lending on the mobile homes.
Range from 10 to 20 acres. The land becomes so valuable that eventually those homes are replaced by retail or residential real estate. But in the meantime, the mobile home park is creating an incredible cash flow because in essence you are renting the dirt that the mobile homes sit on - so you are leasing the land to people - which makes it a very attractive investment.
Min. maintenance required.
Possibility for many profit centers. Eg. bring in homes to provide tenants with a lease option. So you are not only leasing the land, but you are selling the mobile home on terms as well.
Special Purpose Properties
Commercial real estate designed for a specific purpose
Eg. Restaurants, gas stations
Gas Stations
You buy both the property and the gas station business.
Most have convenience stores + sometimes several car repair bays. Profit margin for gas is fixed at 10-20 cents/gallon.
Considered an owner-occupied property ,ie. qualifies you to a SBA loan with as little as 10% down payment is required.
Once a gas leakage occurs and contaminates the environment, it takes years and $$$ to clean up. May even be liable to damages from owners of adjacent properties…
Commercial REOs (“real estate owned”)
Commercial properties that banks have foreclosed upon, now own, are available for you to purchase, and at times can be acquired at large discounts.
Ideal way (to get the best deal) to purchase commercial REOs from banks is to come prepared to pay all cash.
Commercial Short Sales
Occurs when the amount owed on the property (loan) > the current value of the property. The bank that holds the loan has to agree to let the current owner of the property sell the property for a steep discount to a new buyer thereby "shorting" the loan. This is done to keep the property from going into foreclosure.
REITs (Real Estate Investment Trust) - “Real Estate Stock”
Corporations that own and manage a portfolio of real estate properties and mortgages.
Advantages of liquidity and diversity
~200 publicly traded REITs registered with the SEC
3 REIT categories: equity, mortgage and hybrid
Equity REITs (EREITs) purchase, own and manage income- producing real estate properties such as apartments, shopping malls and office buildings. Equity REITs are different from typical real estate developers because they purchase or develop real estate to operate it as part of their portfolios instead of developing it for resale. Equity REITs are considered superior for the long-term investing because they earn dividends from rental income as well as capital gains from the sale of properties.
Mortgage REITs (MREITs) loan money for mortgages to real estate owners or purchase existing mortgages or mortgage-backed securities. Their revenue is generated primarily by the interest that they earn on the mortgage loans. Mortgage REITs are considered a good speculative investment if interest rates are expected to drop.
Hybrid REITs are a combination of equity and mortgage REITs.
TICs (Tenancy in common investments)
An investment by the taxpayer in real estate which is co-owned with other investors
Qualifies under the like-kind rules of a 1031 exchange
Limits the number of investors to 35
Appeal to taxpayers who are tired of managing real estate. TICs can provide a secure investment with a predictable rate of return on their investment.
Mgmt responsibilities are provided by management professionals. Cash returns on these types of investments are typically in the 6-7% range. Syndicators of TICs are called "sponsors."
TIC investments are commonly structured in one of the following ways –
A single-tenant property with an established credit rating,
Multiple tenants subject to a single master lease with the TIC sponsor who subleases to the tenants,
Multiple tenants each with separate leases managed by professional management.
Real Estate Crowd Funding
Buying shares of an investment property
Must be an accredited investor to participate and depending on what the exit strategy of the crowd funding manager is, your funds could remain tied to that investment for a significant period of time.
Chapter 5: Getting Started in Commercial Real Estate
Identify city’s future land use master plan or map that shows future zoning and use for all land use within city limits
Look at economic forecast of areas (population growth rates, past and future per capita income, housing costs, etc) via local Chamber of Commerce
Large, influential, infrastructural changes can greatly increase the land values of properties that surround them.
A large part of commercial real estate is dealing with the officials and decision makers of the city or county because they are the ones who decide zoning and use for every piece of property within the city's or county's boundaries. Attend zoning and planning meetings at your local Chamber of Commerce or courthouse. It is there that you can meet face to face the people who will influence your future as a commercial real estate insider. Introduce yourself as a real estate investor, and give them your card. Ask intelligent questions regarding real estate in your community.
Chapter 6: A Simple Way to Analyze Commercial Real Estate
3 Steps to Cashflow
Income per year - Expenses per year - Debt service per year = Income/year
Chapter 7: Key Investment Terms to Master
Gross Income ($): Rents, laundry, or vending machine income (could be monthly or annual).
Vacancy ($): A unit that is left unoccupied and is not producing income is a vacancy. A unit that is vacated and re-rented in the same month is not considered a vacancy. It is considered a turnover.
Vacancy Rate (%): Number of vacancies/number of total units
Effective Gross Income ($): Gross Income - Vacancy Income – (Vacancy Rate (%) x Income) = Effective Gross Income
Operating Expenses ($): Taxes, insurance, utilities, management fees, landscaping, maintenance, repairs, and advertising. This does not include mortgage payments or interest expense.
Net Operating Income (NOI) ($) = Effective Gross Income - Operating Expenses
Debt Service ($) = Monthly Mortgage Amount x 12 months
Annual Cash Flow ($) = NOI – Debt Service
Cash-on-Cash Return (%) = Annual Cash Flow / Down Payment Amount
Capitalization Rate (%) = Net Operating Income /Sales Price. Aka The measure of profitability of an investment. Cap Rates tell you how much you will make on an investment if you paid all cash for it, therefore financing and taxation are not included.
4 Guiding Principles of Investment Terms
POSITIVE Cash Flow: creates and maintains momentum
DOUBLE DIGIT Cash-On-Cash Return% (10% or GREATER): Cash-on-Cash Return % is the the velocity of your money. Eg. how long does it take for your money (down payment) to come back to you? If your down payment was $20,000, how soon does your cash flow add up to $20,000? If your cash flow added up to $20,000 in one year, then your cash-on-cash return is 100%. If it takes two years, then your cash-on-cash is 50%. We need to put an emphasis on cash-on-cash return when we invest simply because you need to know how fast you can get your down payment back so you can invest it again...and again.
Cap Rate of 8% or HIGHER: A high cap rate usually typifies a higher risk investment and a low sales price. High cap rate investments are typically found in poor, low income regions. A low cap rate usually typifies a lower risk investment and a high sales price.
Gross Rent Multiplier OF 9 OR LOWER: Gross rent multipliers are used as a measure to compare income properties in one area or neighborhood. Also a good indicator of the investments’ ability to cash flow. As the gross rent multiplier lowers, your cash flow increases in most cases. And the opposite is true. As the gross rent multiplier increases, your cash flow typically decreases.
Other Notes
Here are three types of leases you’ll most likely come across in retail investments.
Gross lease: landlord agrees to pay all operating expenses + charges the tenant a rent that’s over and above and covers the operating expenses. The types of expenses covered include taxes, insurance, management, maintenance, and any other costs associated with operating the property.
Modified gross lease: some of the operating expenses — eg. maintenance, insurance, or utilities — aren’t paid for by the landlord and are passed on to the tenant. These expenses are called pass-through expenses because they’re passed through to the tenant. Many office-type buildings use a modified gross lease.
Net lease: tenants pay the operating expenses of the property and the landlord gets to net a certain amount every month by charging rent over and above the total operating expenses. This lease is favorable in many ways: It’s favorable to the landlord because she isn’t responsible for any operational expenses of the property. It’s favorable to the tenant because he gets to fix up his store as he sees fit and do his own maintenance and cleaning. Net leases are typically customized to fit tenant needs.
This type of lease is used mainly by retailers. The landlord takes care of the common area maintenance, and the expense of that is spread among the tenants and billed back to them.
There are four different levels and types of net leases:
Single net lease (N): Tenant agrees to pay property taxes. Landlord pays for all other expenses in the operation.
Double net lease (NN): Tenant agrees to pay property taxes and insurance. Landlord pays for all other expenses in the operation.
Triple net lease (NNN): Most favorable for landlords and is one of the most popular today. Tenants agree to pay the landlord rent + all other property- related expenses including taxes, insurance, and maintenance. The landlord gets a true net payment. Banks, fast-food restaurants, and anchor tenants typically use triple net leases.
A great income generator for landlords is to have a clause called percentage of sales built in the lease. Here, the landlord gets an additional payment from the tenant if and when the tenant reaches a certain sales volume or profitability.
Commercial Leases
A lease can be for a short term (as little as one month) or long term (up to 15 years!), and it can be written or oral -- although a lease for more than a year must be in writing to be legally enforceable.
Practically and legally, there are many differences b/w commercial leases and residential leases. Commercial leases are NOT subject to most consumer protection laws that govern residential leases -- eg, there are no caps on deposits or rules protecting a tenant's privacy. Also, since a business will often need to modify the existing space (add cubicles, raise a loading dock, rewire, etc.), the terms of commercial leases are usually subject to at least some negotiation.
The following checklist includes many items that are often addressed in commercial leases.
Rent, including allowable increases and method of computation
Security deposit and conditions for return
Length of lease (also called the lease term)
Whether rent covers utilities, taxes, and maintenance (called a gross lease) or whether you will be charged for these items separately (called a net or, if the tenant must cover three additional costs, a triple net lease)
Option to renew the lease
•If and how the lease may be terminated, including notice requirements
What space is being rented, including common areas such as hallways, rest rooms, and elevators
Specifications for signs, including where they may be placed
Whether there will be improvements, modifications, or fixtures (often called buildouts) added to the space, who will pay for them, and who will own them after the lease ends
Who will maintain the premises
Whether the lease may be assigned or sublet to another party
Whether disputes must be mediated or arbitrated as an alternative to court
Should address what improvements or modifications can be made to the property, which party will pay for the
improvements, and whether the tenant is responsible for returning the unit to its original condition at the end of the tenancy.
Many lease agreements will incorporate a use clause to define the activity the tenant can engage in on the premises. These clauses are in place to protect the property from damage and limit the liability of the property owner. If possible, ask for a broad usage clause just in case the business expands into other activities.
Exclusivity clause is an important clause for retail businesses renting space in a commercial complex. An exclusivity clause will prevent a landlord from renting space to a competitor.
Ask the landlord for the right to assign the lease or sublet the space to another tenant. This is an important term because the tenant is still responsible for paying the rent if the business fails or relocates, but with a assignment or sublet clause in place, the business can find someone else to cover the rent.
Compliance with the Americans with Disabilities Act: Under the act, if a business is open to the public and has more than 15 employees, the premises must be accessible to people with disabilities. The lease should determine who is responsible for making any necessary alterations to the property and who must pay for these changes.