Five Steps to a Successful Commercial Property Selection

Of course, commercial property selection is a broad topic due to the varied nature of “commercial” properties.  However, the majority of investors are considering retail space or office space for investment.  Let’s look at an overview of five factors that apply to both retail and office space commercial property selection for long term ROI.

#1 Your Investment Goals

Of course, Return On Investment is always the primary goal.  However, there are other considerations before a substantial investment involving commercial property selection.  Are you seeking a passive role, active management participation, or something in between?  Commercial properties require a great deal more management and sales/marketing activity.  If you do not wish to be involved, you’ll take a different approach to commercial property selection and your role.

Perhaps you’ll join others in a partnership, with some partners only involved monetarily and others also taking a management and marketing role.  If you want to be hands-on, your commercial property selection could be a smaller office complex that will not require as much of your time.  Before setting out to research properties, have your target price range, investment objectives, and involvement level figured out.

#2 The Local Economy – Business and Consumer

This is an interesting factor in commercial property selection because you may not want to rely solely on your business clients’ economic research and outlook.  Suppose they’re haphazard about tracking their customer base and demand.  Or maybe they’re not very diligent in other areas of market research that could create stress in their business in the near future.

You want to do two levels of research, business and consumer.  Let’s use a small retail strip center as an example.  It’s been a good investment for the current owner, but they’re retiring and want to leave the area.  It has five units, currently a nail salon, barber shop, small organic grocery, to-go barbecue place, and a payday loan business.  They have been fairly stable tenants and rents are mostly at market rates.

However, what’s going on in the local economy?  They’re in place and likely just struggling to maintain sales, not necessarily checking the economy to see if leaving is the right alternative.  Either way, you lose a tenant to bankruptcy or they move to go where the customers are.  Your job in commercial property selection in this case is to not only check their current business health, but also the consumers in the area.  Are they moving away, or is the area growing?  Are major employers relocating?  Will the current demand for these services remain viable for your ownership period?  Are wages dropping such that nail salons and gourmet organic products will be priced out of range for the new consumers?

#3 Physical Location

This is really important, as traffic for retail is crucial, and even office complexes must be relatively easy to access and not too far out of the areas where the customers live.  Just travel the old Route 66 to see what happens to businesses when a new freeway moves the traffic away.  It’s usually not that dramatic, but our example retail strip center could be in big trouble if the previously busy street is modified such that it’s harder to access.  Or perhaps a nearby parallel street is widened so traffic moves to the faster route.

#4 Age & Condition

This is more than just how old the building is and if it is in need of work.  That grocery store could have a walk-in cooler and other equipment that’s reached the end of its useful life.  Keeping it repaired or buying new are both expensive projects to be considered.  How about the roof, heating and cooling, and parking lot conditions?  Even if acceptable condition-wise, a lower offering price may be the best approach.  Are there conditions that may be the target of code enforcement, such as handicap access, etc. that could be expensive to remedy?

#5 Are the Numbers Real Numbers?

You’re going to be checking out leases very carefully.  Sometimes landlords allow tenants to work off lease payments, and the cash flow isn’t really as the lease sets out.  Don’t just check the leases, check the deposits against them.  Are some of the units under-leased or the opposite?  Sometimes a poor negotiator as a tenant will overpay for their space, but when they figure it out they leave and the next one isn’t so gullible.

These are broad considerations, but if you take these steps in Raleigh area commercial property selection you’ll probably be happy with the result for years to come.

Pros and Cons of Commercial Real Estate Investment

Commercial real estate investment isn’t the choice of the majority of new investors.  If you surveyed all “real estate investors,” probably the vast majority are engaged in residential single family or multi-family residential property investment.  It’s natural, as many investors have bought and sold homes before as personal residences.  They’ve also probably rented at some time in their lives.  This familiarity with the product gives them a greater comfort level, and that pushes them in the residential direction.

For those with the assets for commercial real estate investment, there is definitely some great ROI potential out there.  There are also other considerations and factors that can make commercial investment the right choice for many who have avoided it so far.  That avoidance isn’t necessarily because they have a negative attitude about it.  They simply don’t know enough, and consider the money amounts involved to be significant.  So, they feel that more knowledge is required before taking the risk.

 Pros of Commercial Real Estate Investment

Commercial real estate investment enjoys some advantages that can make it the best choice for an investment strategy:

  • Varied property types:  Commercial real estate covers a wide swath of property types.  Investors can, if they choose, specialize in office space, restaurants, malls, retail space, light industrial, warehouse, strip malls and others.  Some investors develop a comfort level with a certain type of property, or they just know more about the type of business leasing the space.
  • Multiple lease structures:  Commercial leases can be structured in a number of ways to meet the needs of landlord and tenant:
    • Gross lease – The tenant pays a single set amount in rent and the landlord handles all property related costs including janitorial, maintenance and taxes.
    • Net lease – The net lease exists in multiple formats, single, double or triple net.  In this lease structure the costs related to the property ownership and management are split between the landlord and tenant to meet their specific needs.
    • Percentage lease – This lease is popular with retail businesses, especially newer ones or those with seasonal or variable revenue.  The base lease is a smaller amount, and after a certain sales level is reached the tenant pays a percentage of sales in additional rent.
  • Different cycles and risk profile:  The commercial investor can balance a portfolio that may include residential and multi-family with commercial property investment.  This diversification can balance risk and smooth out market cycles.

 Cons of Commercial Real Estate Investment

Investors don’t get a risk free ride with commercial real estate, as it has its own unique characteristics:

  • Higher dollar investments required:  Generally commercial real estate investment will require higher dollar investment to buy into a deal or to carry one individually.  It’s just more expensive property.  This keeps many investors out of commercial real estate investment.
  • Risk is concentrated:  The same amount of money that can buy a great many single family homes may only buy a single strip center or small mall property.  The investment is concentrated in a single property, even when there are multiple tenants.  The loss of an anchor tenant can result in the flight of the smaller businesses and a high sudden vacancy rate.
  • More demanding tenants:  Business people will be tougher negotiators, or hire them.  They also will be quicker to complain about property problems or service that impact their revenue.

Commercial real estate investment can be highly profitable and enjoy great tax advantages.  It’s a great way to expand a successful residential investment business.

How to Market and Sublease Raleigh Commercial Real Estate

Unfortunately, circumstances arise when a company no longer has use for commercial space it has leased. Needs may have changed regarding the size of the business or location, or a company may have experienced financial reversals and must rid itself of the unnecessary expense. Whatever the cause, unwanted commercial space is expensive. Companies holding such leases are hemorrhaging money every month and want relief fast.

“The larger the square footage and longer the lease term, the greater the exposure,” says Robert Chavez, founder and CEO of Guardian Commercial Realty. “Maximizing time and efficiency is vital to properly sublease space and mitigate losses.”

Smart Business spoke to Chavez about the few important steps companies should consider before taking their space to market.

What should tenants consider first when looking to sublease space?

First, read the sublease and default sections of your lease and be aware of any sublease restrictions that may exist. Landlords’ ‘form’ leases often prohibit subleasing to existing tenants in their building, or to companies with whom the landlord is engaged in active negotiations. Likewise, governmental organizations with high traffic count, or the Internal Revenue Service, for example, may be excluded because the landlord deems them an unfit occupant of their building. It would be most unfortunate to spend time and money negotiating and documenting a sublease only to find out in the 11th hour that the proposed subtenant is prohibited.

How can they improve the chances that the space will be sublet?

Have a solid marketing plan. Interview real estate brokers that are active in your market. Understand exactly what measures they will employ to sublease your space and keep you informed. Know their track record and ask for references. Make 1certain that any listing agreements they may have in the area are not actually conflicting interests. Such brokers may be more beholding to their landlord clients, as they are simply the bigger fish. Ask if the broker can show you a ‘sublease recovery analysis.’ If they do not understand this concept, it may be wise to move on.

It is imperative to understand the subtleties in your market and price the space properly. Pricing the space too high will likely cause the space to sit vacant and allow the financial hemorrhage to continue. Price too low and money is left on the table unnecessarily. The balance between price and timing must be carefully addressed early and clearly. Discuss commission incentives and see if they are commonplace in the market and likely to bring better results.

Also, be certain that your broker has the ability to find tenants that are actively seeking space in the market. All too often sublease space is listed on a marketing service website and brokers wait for the phone to ring. The likelihood of success is enhanced if your broker has an active and well-conceived marketing strategy. Subleasing space properly is more work, so be sure to agree upon a reporting process and keep your brokers accountable for weekly activity reports.

What other challenges must be overcome?

Unless the real estate market is ‘white-hot,’ subleasing space is difficult. Unlike the building owner, a tenant (or sublandlord) only has its specific amount of space, design and floor plan available. Sublandlords are seldom in a position to spend vast sums of money retrofitting their space to suite another occupant. Accordingly, the target audience for subleases is dramatically reduced as compared to what a landlord can offer. Pricing the sublease space below the landlord’s rates is often the only viable way to quickly sublease the space. Timing is extremely critical. It does a company little good if their space works nicely for a particular company but they cannot occupy for 18 months because that is when their lease expires. This would cost a company with 10,000 square feet nearly a half-million dollars in rent just waiting for the subtenant to become viable.

What are the final steps once a subtenant has been identified?

It is important to qualify the company before agreeing to final terms. Be certain to review financial statements and research the company as well as their industry. You want to be as certain as possible that the subtenant will continue to pay their sublease rent. The last thing a sublandlord needs is to spend even more time and money evicting a deadbeat subtenant, and then have to start the process all over again.

Inform your landlord in writing once you decided to sublease space. This may expedite the landlord’s consent process, which will be required to consummate the sublease. Additionally, you may get lucky and the landlord could elect to ‘recapture’ the space if they have another party interested.

In rare instances, a sublandlord may be able to profit from subleasing space due to an upward trend in market conditions. This is more typical in a retail setting, but can happen in office or industrial sectors as well. Once again, look to your lease before celebrating. The landlord may be entitled to all profits if the lease was poorly negotiated. If that is the case, the tenant might as well sublease the space at its below-market rate and a find subtenant much sooner. Again, read your lease, as you may not be permitted to undercut the landlord’s rates. Most commercial leases are ultimately drafted such that the landlord and tenant share any sublease profits on a 50/50 basis, after the tenant has recovered reasonable fees for commissions, improvement allowances and other marketing expenses.

As you can see, subleasing space is no fun. There is little certainty with regard to the outcome and very limited flexibility. The best defense is to plan ahead and exercise extreme caution when entering into a lease in the first place.

Leveraged Appreciation

Values of Raleigh Commercial Real Estate don’t have to go up much to provide a healthy return because of something called ‘leveraged appreciation.’

Leveraged appreciation is the increase in the property value when compared to the amount of cash invested in the property.  The leverage comes from the fact that the property has a mortgage that’s being paid from the rents received from tenants.  This means the owner did not have to invest an amount equal to the entire property value.  Instead of investing 100% of the value, the owner only put down a percentage…say 25-30%, and the lender is supplying the rest.  Rents then go to repay the lender.  But the owner still derives the benefit of the appreciation based on the entire value of the property.  This means the return on investment is much higher than just the rate of appreciation.  Or, as it is termed, the appreciation is ‘leveraged’.

The amount of leverage is obviously impacted not only by the amount of appreciation but also by the ability of the owner to get good financing.  The lower the down payment and purchase costs, the better the return on investment will be when the property goes up in value.  A large part of the potential return on an investment comes from this concept.

Commercial Real Estate Vs. Residential Real Estate

Commercial Real Estate in Raleigh NC, for all but the owner-occupant, is solely an investment and the numbers need to make sense.

Unlike residential real estate markets, which are largely driven by whether or not people like or dislike a home, commercial real estate markets are driven by the profit that can be earned by owning the property.  For this reason, being able to understand the profit potential of commercial property is critical to success.

There are essentially three things that determine the quality of a potential investment:

  • The amount of appreciation expected in the property:  Just like any investment, people who buy commercial property are hoping for the value to increase over time.  Part of what a potential investor will analyze is the amount of appreciation compared to the amount of cash they have to invest to own a property.  This is known as leveraged appreciation.
  • The current, future and/or potential earnings of the property:  Income minus expenses should deliver a net profit.  Investors want to know how much money the property is earning or will earn.  They want to compare this to the value of the property, a comparison that is known as the Capitalization Rate, or Cap Rate.  They also want to compare this to the amount of money they have to invest to own the property.  This is known as the Cash-on-Cash Return.
  • The tax ramifications of owning the property.