When is Commercial Real Estate a BAD Investment?

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When risk outweighs return. Our neighbor has a tidy portfolio of single and multi tenant properties. The good news? Single tenant buildings are easy to manage - one tenant, one rent check. Multi-tenant - such as an apartment building or strip center don’t crush your cash flow if someone bolts - but you have several rent checks to chase. For our neighbor to eliminate her management and convert to single tenant - a risk greater than her tolerance, ensues. Thus her balanced portfolio. Think of single tenant assets as a share of stock and multi-tenant as a share of a mutual fund.
 
Good for business. We recently represented a family owned construction company. The company found its origins in the 1950s in a part of town that was booming. Owning the location from whence the business resided was a solid plan. Flash forward. A decision was made, by the next generation, to shutter the enterprise. Boom in the 1950’s was replaced by blight in this decade. Consequently, with no occupant to pay rent to the family - the construction company was closed - and little upside - selling and redeploying sale proceeds became the direction. Therefore, an investment good for the business evolved into one less favorable years later.
 
Metrics are skewed. Replacement costs, rent, capitalization rate and return, sustainability of the income stream, and exit plan are ALL considered by most investors of commercial real estate. Should one of these measures of an income property’s value need alignment a future problem may arise. As examples. If you buy a Starbuck’s location and pay $1000 per square foot for a building go that can be replaced for half that amount - your basis is artificially inflated. So long as Starbuck’s stays current, no harm. But if folks start brewing coffee at home and store sales wane - you see where I’m going. Finally, investors focus on a return on their money. If a check is written to acquire the asset then the return is the cap rate. Easy. Layer in some debt and the answer is a bit more complex. Simply. If the capitalization rate exceeds the interest rate on your mortgage - positive leverage occurs. This is magical - as the return on your invested down payment now is greater than the overall cap. Clearly the opposite occurs when a borrowing rate eclipses said capitalization.
 
Tax laws change. When Ronald Reagan was President. Yes. I was around the industry then. But I digress. At the end of 1986 - a tectonic shift happened with our Federal tax laws. Lower marginal rates of taxation were swapped by eliminating certain write-offs. I believe our present depreciation rules - 39 years - were examples. Real estate bought with certain tax shelters in mind were no longer great investments.
 
Improvements are specialized. We toured a building last week with a client. Our occupant processes food but does so in an ambient environment - no specialized freezers or coolers are required. The vacancy we walked was complete with tons of cooler space. Our premise was some of the cooler infrastructure would translate to our use. For those who need these special purpose goodies - rent is not an object. As the cost to create them is astronomical. But for those who don’t - which is a much greater universe of tenants - they won’t pay for the extras.
 
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.blogspot.com.