Is Commercial Real Estate a Good Investment - Part Deaux

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Last week - in this space - we massaged the merits. Discussed were the reasons why not - a liquidity event, a sale of the business that occupies, a mis-match of risk, a dispute, and finally aging owners.

From last week -

“You’ve achieved a nice portfolio over the years with timely purchases, well-timed trades up, and careful management of the occupancy, income and expenses. But you are tired! Akin to captaining a ketch - tiny tweaks and tightening take time and talent. In order to capture the winds of income - your sails must be trimmed and you must stand watch over the ocean swells of expenses - lest your vessel should capsize. 

Whew! How about we find a nice cozy port - drop anchor - and relax. But, your ports are limited - as we will discuss next week.”

Today - as promised - we continue our voyage with a precise probe of age and its impact on ownership.

Here is the dilemna. Changes occur as we age - aside from a bulging waistline and the need for hearing devices. Our risk tolerance declines plus our patience subsides. No longer are a tenant’s late payments met with a cordial conversation or the request to plunge a toilet tolerated. But there is a problem - most commercial real estate requires management to max the income and someone must fill the vacancies, collect the rents, chase flaky occupants, pay the bills, fix the roof, file the tax returns, etc.

So, if you’re fed up and want to pivot - what are your options?

Exchange into to a less management intense property. Let’s say you own an apartment complex of twenty units. Your income is dependent upon twenty timely rent checks each month. If one loses a job - you wait, or evict and suffer a vacancy. Until the vacancy is vanquished - the top line is in tatters. So, one strategy is to sell the project and move the money into a single tenant investment - a Dollar General or Caliber Collision as examples. Just keep in mind - your management is lessened to nothing but your risk just sky-rocketed - one blip - no more income. Make sure the tenant is solid and the rent sustainable.

Sell and pay the taxes. Uncle Sam and governor Brown will take a nice bite - in some cases half the gain. Great. You’ve now got a chunk of cash you must re-invest and find a decent return - good luck!

Hire a property manager. Keep the buildings but divorce yourself from the day-to-day. You pay a percentage of the gross rents - generally 5-7% - but you pacify the panic El Niño portends for that vintage roof.

Craft a creative transfer of ownership. Charitable remainder trusts, deferred sales trusts and the like may be a good option. You exchange the daily aggravation for a fixed return - all very complicated yet legitimate. Strong encouragement is given to seek professional legal and tax advice if a creative transfer is considered.

Is Commercial Real Estate a Good Investment? Five Reasons it’s NOT!

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Seemingly an easy answer - of course it is! However, the more difficult response - for which I will delve today - is it depends.

As we have covered, commercial real estate exists in many varieties - a suite of offices, a manufacturing plant, a distribution warehouse, a retail storefront or big box, finally a residential project of more than four units. Yes. That small apartment complex is considered commercial real estate.

Your ownership is one of - “my business lives there” or “I simply collect the rent from tenants who occupy the spaces”. Today, we will treat both ownership classes the same - after all both are investors - albeit with different objectives.

An investment in commerical real estate garners the benefits of cash flow, long term appreciation, depreciation, treatment as a long term capital gain and the ability to postpone taxes upon sale through the use of a 1031 tax-deferred exchange. But beware - you must also deal with vacancy, flaky tenants, fixing the roof, collecting the rent and paying the bills, obsolescence, roll-over costs, entity tax returns, and broker fees.

So, to the tough query of commercial real estate as an investment - let’s examine several scenarios under which commercial real estate falls under the category of “it depends”.

A liquidity event. This is a fancy way of saying “you must sell”. Reasons for a sale could consume an entire column. But, if the timing of the disposition runs counter to the market - IE a forced sale in 2009 - lost is all of your gain. During that period, we saw values drop 30-50% in a matter of weeks. Be happy you weren’t a seller!

A sale of the business that occupies the building. Owned is your company’s address. Your business is your tenant. You pay yourself rent each month. What could be better? Frankly, nothing. This is a wonderful arrangement many small businesses enjoy in California. However, if you sell the business - you no longer own the “tenant”. Is there a reason your occupant MUST stay in your building? Or will they flee to cheaper environs once the lease expires?

A mis-match of risk. Single payers - such as a Dollar General store or a Caliber Collision Center offer the owner one rent check each month. There-in lies the benefit and the risk. So long as the tenant’s business is vibrant - money flows in to your bank account. A blip - and you’re installing a “For Rent” sign.

A dispute. Divorce, partnership squabbles, or a change in motivation all can occur during the life of an ownership. Unless specially structured - ownership shares are not easily divided - in other words - you cannot simply take your toys and go home.

Aging owners. Wow! Once again - a column worthy topic on its own. Here is a preface. Those greying temples and aching back - stem - not from age - but from the pains of commercial real estate ownership. Told were you in your thirties - “invest in real estate”, young lady. You have. You’ve achieved a nice portfolio over the years with timely purchases, well-timed trades up, and careful management of the occupancy, income and expenses. But you are tired! Akin to captaining a ketch - tiny tweaks and tightening take time and talent. In order to capture the winds of income - your sails must be trimmed and you must stand watch over the ocean swells of expenses - lest your vessel should capsize. Whew! How about we find a nice cozy port - drop anchor - and relax. But, your ports are limited - as we will discuss next week.

Do Asking Prices Matter?

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As a seller of commercial real estate - you’ve typically three goals - to dispose of your property for the most possible dollars, in the shortest period of time, with the fewest contingencies. Simple, right? Yes, very. However, the execution - AKA “the devil’s in the details” is not so easy.

Let’s start with the asking price - shall we? Some would advise the price at which you advertise your sale is irrelevant - especially in this robust market. After all, there are many more buyers than available buildings these days. This argument does have merit - as you want to maximize your proceeds - but with a catch. Therefore, I will introduce three different strategies - and the appurtenant pitfalls.

Strategy one. Inflate the ask to an un-achievable number. You can always lower the price - right? Well, right. Sort of. You don’t want to leave dollars on the table and in an upwardly trending market - every sale is at a level greater than the last. Buyers expect this. But, take too great a leap and several potentials say “no thanks!” If too many react this way - you then must lower to achieve activity. 

Anticipated by the market are further drops in the price. Created is a “let’s wait and see if we can make a better deal” mentality. You burn valuable daylight reaching the market. Meanwhile, purchasers have bought elsewhere. That popping sound you hear is your strategy back-firing!

Strategy two. Market the offering un-priced. We see this employed when the pool of potential purchasers is plentiful - and of a certain genre - IE: institutional investors. Generally, an un-priced offering is packaged with the income, expenses, and due diligence material readily available. Prospects are able to review the leases, put their spin on the market rates and determine if the roof leaks - all before making an offer. This approach generates several proposals - which are vetted.

 Typically, a “best and final” follows the initial offering round and a buyer is chosen. Players in this arena are used to un-priced opportunities and therefore will react positively. Just know, if you’re after a less seasoned buyer - your effort will suffer - as this group is accustomed to a traditional “ask - offer - response” scenario.

Strategy three. Establish a starting point lower than expectations. Our residential counterparts perfected this method. It works like this. The market is X. We publish our amount as X - Y. Buyers beat down your doors and bid up the price well past your go amount. An offer war ensues and you - as the seller - are the benefactor. Just remember, you need lots of interest to make this happen. If one lowly buyer comes along - you risk selling your property at far less than otherwise. 

Also, be aware of the other risk - a buyer wins the proposal scrum - but can’t close at the agreed price. Now, you start all over - albeit with several other potentials anxiously waiting for buyer number one to fail.

Why Hire a Broker - Just do it Yourself!

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Selling a commercial real estate asset is akin to planning your daughter’s wedding - sure, you can do it yourself but things go much more smoothly if you have a wedding planner - AKA a commercial real estate professional.

Certainly, you can do a quick Loopnet search, establish a price, purchase a For Sale sign at Home Depot and wait for the phone to ring - set the date, book the church, rent some tuxes and order the cake - this is easy!

Vista Print will create a glossy brochure of your building, mail a few to the neighbors and the inquiries will start to flow - Wow! They do wedding invitations too? Cool! Invite aunt Marjorie and a few dozen friends and let’s do this!

Just got your first hit! They want to see the building next week. Oh wait, you’ve a day job and can only meet the buyers on weekends or evenings. Hmmm, this doesn’t work for the buyers- now what? I guess you could slip out during lunch - but what if the buyer is late or stiffs you? Time wasted - and on an empty stomach.

OK, you get them through. They like it. An offer will be forthcoming. I’ll bet you’re glad you’re saving that 6% you’d have paid the broker. Why don’t more folks do this themselves?

Your prospective buyers call. Do you have a recent appraisal? Does the roof leak? When will the tenant vacate? What will be left when the occupant leaves? I noticed the building doesn’t have central air. Do the cracks in the floor portend something serious? Would you consider seller financing as we have a small credit blip - a bankruptcy? Oh, by the way, my wife has her agent’s license - so we will be deducting 3% from our offer. Next!

Three different agents - who comb the area - call. We have qualified prospects who would like to see your building. Will you pay us a fee if we bring you a buyer? Can you forward to us any marketing collateral you have? Any idea how much electricity feeds the property? - as one of our buyers is a machine shop. One of our guys stacks products high in the warehouse. Will the sprinkler system handle high-piled storage? What is the zoning? Our buyer is a trade school. Will the city allow that occupancy without a conditional use permit? Hmmm. Feeling a bit overwhelmed?

Finally, your perfect buyer appears - dressed as Prince Charming. Let the wedding bells ring! After all, a commercial real estate deal is a union of sorts. You gloat a bit as your email buzzes with a full asking price offer. No financing required, quick close, as-is - alright! Done. But, not so fast. You see, this buyer has made three full price offers to three separate owners. His plan is to tie up all three - and jettison two of the three. Will you be saying I do? Or, I wish I had - hired that broker.