Commercial Real Estate Investing vs Residential Real Estate Investing – a Video Series

Commercial Vs Residential

Commercial Real Estate Investing vs Residential Real Estate Investing

A Video Series

You know the saying, the grass always looks greener on the other side, right?

As you deal with another tenant turnover, surprise repair request or increasing tax and insurance costs, it’s easy to think that a five year triple net lease* is a better way to invest in real estate.

But, there are some really significant costs and risks associated with doing commercial real estate deals.

As we just closed on the biggest deal we’ve done to date (a multi-million dollar medical services building), we thought we’d put together a video series to help you decide if commercial investing is right for you, and how to handle some of the common pitfalls if you do it.

If you’re staring longingly at that green grass on the other side of residential investing, we hope these videos help you decide what investment vehicle is right for you today.

*a triple net lease is basically where the tenant is responsible for most of the costs of operating and maintaining the property including taxes, insurance, maintenance, and property management


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How to Value Commercial Real Estate

One of the first questions you’ll ask yourself when you are looking at a new property to purchase is: What is this property worth? That is a different question then: How much can I pay? And it’s still different then: What can I get this property for? But all of those questions need answers before you put in an offer to purchase a new property.

If you’ve been following our real estate investing newsletter then you know we recently tried to buy a little mixed use commercial property. We are still hopeful that the deal is going to come back to us, so we won’t yet give away all the details on it, but the main issue we’ve had with the deal is the asking price relative to the income the property generates. The vendors are pricing it on future value, and of course, we can only pay on what it’s worth today. And, banks will only lend on today’s value and today’s income, not the potential of future value or future income.

But how do you value commercial real estateWe thought we’d walk you through the basics.

How an investor chooses to value a property can depend on the size of the property or the sophistication of the purchaser. We rely on the simple methods, both because we are new to commercial investing, and because we’re looking at small properties. But, simple doesn’t mean less reliable or less accurate when it comes to commercial valuation.

Essentially, there are three ways to value a commercial property:

  1. Direct Comparison Approach
  2. Cost Approach
  3. Income Approach (which includes the DCF method and the Capitalization Method).

The direct comparison approach uses the recent sale details of similar properties (similar in size, location and if possible, tenants) as comparables. This method is quite common, and is often used in combination with the Income Approach.

The cost approach, also called the replacement cost approach, is not as common. And it’s just what it sounds like, determining a value for what it would cost to replace the property.

The third, and most common way of valuing commercial real estate is using the income approach. There are two commonly used income approaches to value a property. The simpler way is the capitalization rate methodCapitalization Rate, more commonly called the “Cap Rate”, is a ratio, usually expressed in a percent, that is calculated by dividing the Net Operating Income into the Price of the Property. The cap rate method of valuing a property is where you determine what is a reasonable cap rate for the subject property (by looking at other property sales), then dividing that rate into the NOI for the property (NOI is The Net Operating Income. It’s equal to income minus vacancy minus operating expenses). Or, you could figure out the asking cap rate of the property by dividing the NOI by the asking price.

For example, if a property has leases in place that will bring in, after expenses (but not including financing) an NOI of $10,000 in the next year and comparable properties sell for cap rates of 6% then you can expect your property to be worth approximately $166,666 ($10,000/.06 = $166,666). Or, said another way, if the asking price of a property is $169,000, and it’s NOI is estimated at $10,000 for the next year, the asking cap rate is approximately 6%.

Where this gets tricky is when properties are vacant, or where the leases are set to expire in the upcoming year. This is often when you are forced to make some assumptions. (We’ll save how you deal with this for another day.)

Value a Commercial PropertyThe other income method is the DCF method, or the Discounted Cash Flow method. The DCF method is often used in valuing large properties like downtown office buildings or property portfolios. It’s not simple, and it’s a bit subjective. Multiple year cash flow projections, assumptions about lease rates and property improvements and expense projections are used to calculate what the property is worth today. Basically, you figure out all of the cash that will be paid out and all of the cash that will be brought in on a monthly basis over a specific period of time (usually the time you plan to hold the building for). Then you determine what those future cashflows are worth today. There are computer programs like Argus Software that help in these types of valuations because there are many variables and many calculations involved.

For the small investors, like us, using a combination of comparable property sales and income valuation using cap rates, will provide a reliable valuation. The real issue is convincing the seller that they should sell based on today’s income and today’s comparable properties. In the case of the mixed use commercial building we just tried to buy, the seller was pricing their property based on assumptions that leases will renew in the next 6 months at substantially higher rates and that the area of the property will continue to improve making the property more desirable. Unfortunately, we don’t buy properties hoping for appreciation. We buy properties today because the property will put more money in our pocket each month then it takes out, and the property fits within our investing goals.

Article Published on July 31, 2008

Other Articles You Might Like:

>> Why You Must Create Multiple Streams of Income

>> Simple Model for Buying Rental Properties

>> Two Factors to Consider When Choosing Your Investment Markets



Evaluating Your Real Estate Investment

How many properties can you afford if each one costs you $400/month?

To buy, or not to buy that real estate investment?

You have found your perfectly located property and are convinced it meets your goals. How do you know whether you should buy it? What if the rent is not enough to cover all of the expenses?

Many of the get rich quick books like Robert Allen’s Multiple Streams of Income or Russ Whitney’s no money down real estate courses are quick to focus on monthly cashflow. They preach that you must buy properties where the rent is high enough to cover mortgage, expenses and profit. We don’t disagree, but just as we have in the last three editions, we want to take you back to your goals before you rule out the ones that don’t have good cash flow.

When we moved to Toronto almost five years ago we bought a small condo in North York. Rents were higher than a mortgage, and we thought we would live there for awhile and rent it out. That is exactly what we did, but it costs us almost $400/month because the rent doesn’t cover the maintenance fees. Why haven’t we sold it? Right now, it still works for our goals.

In an ideal world you would find a real estate investment in a location that is right for you (as discussed last month) that will give you:

  1. Positive cash flow each month (you are taking in more money from rent than you are paying out in mortgage and expenses)
  2. High potential for appreciation over a five to ten year term (or sooner!)
  3. High level of liquidity (in other words, everything about the property is desirable and it wouldn’t be hard to sell in a hot or cold market).

Unfortunately, we don’t live in an ideal world and you will likely have to prioritize which ones you want based on what your short and long term goals are.*

Cash Flow

One of the most common methods of evaluating a purchase in commercial and residential real estate investment is cash flow. In commercial real estate you will often here everyone talk about the cap rates. In residential real estate a common one is the gross rent multiplier (GRM). To calculate GRM:

* Estimated (or known) rent x 12 months = Annual Rent
* Asking price (or what you plan to pay for it)
* GRM = Asking Price / Annual Rent.

For example, if your monthly rent is $1,000, and the asking price is $100,000 your GRM is:

$100,000 / $12,000 = 8.33.

The basic rule of thumb is that you need a GRM of 10 or less to have decent cashflow. This is based on the assumption that your operating expenses are less than 40% of your monthly rent. Operating expenses include your property manager, taxes, insurance, and maintenance and repairs. It also assumes that your financing costs do not exceed 60% of your monthly rental income.

Just to give you an idea of expenses, our properties average about 37% of our rental income each month for operating expenses.

Once you narrow down your list of potential investment properties, contact the listing realtor and obtain an income and expense sheet for the property or ask for actual receipts to determine the true expenses and possible rent of each property. Now, you will be more informed whether to continue looking at this property on a cashflow basis or you should move on.

If your goal is to find properties that will provide you monthly income, then you will need to focus on this method of evaluation. The two other considerations (appreciation and liquidity) should be less of a concern. If you are holding properties for the long term, and looking for ones that are less likely to cause you problems with tenants or repairs, then you are likely also going to be factoring in the other two evaluation criteria.

Potential Appreciation

It is difficult to evaluate appreciation potential as it is based on what happens in the future. There are ways to feel more confident in the potential of your property increasing in value though. For example, consider:

* Are more people moving into the area than out of the area?
* Are there new developments around? What about schools, stores and other services?
* Is there a shortage of land to build new homes?
* Are new roads being constructed? Is the economy in the area diverse and growing?
* Is it a Starbucks area? (from last month’s edition)
* Are people renovating and spending money on nice landscaping?

None of the above guarantees appreciation of a property, but if appreciation is a primary concern, you need to be mindful of these elements.

Liquidity of a Property

Many of the same factors that may help to identify properties that will appreciate are the same ones that will help you evaluate it’s potential liquidity. The objective here is to determine whether you could sell the property in a hot or cold market at a good price.

For us, liquidity is important, but comes in third because we make all our purchases with the intent of holding them for 5 – 10 years or more. In a long term hold situation, liquidity is less of an issue because you do not need to sell it in the short term, and can hold on to it in bad market conditions and wait for the cycle to return to one of strength.

How do you evaluate liquidity? Current market conditions will help you in the short term (how many listings there are on MLS relative to sales is one), but when trying to figure out liquidity in the future, you can consider:

  • Single family, detached homes are always more in demand than any other product, especially ones that are well taken care of,
  • Safe locations near parks, schools and shopping are in demand no matter what the market is doing,
  • Properties that are without extras that people do not need and will not pay for in hard times (pools, 3 car garages, large acreage).

Essentially, you want your property to appeal to the masses in order to ensure liquidity. If it is too unique or too specialized then your market is smaller, and therefore it will be much harder to sell in a market downturn.

Maybe you are tired of hearing it, but it all depends on your real estate investing goals what criteria are most important in your decision. If you only want one investment property and you want the most appreciation potential and least hassles, putting $400/month into it is not a bad thing. Especially if you are in a higher income tax bracket. You can write-off the mortgage interest as well as most of your investment property expenses (speak to your accountant). Furthermore, if your mortgage interest rate is reasonable (less than 6%), your tenant will be paying down a portion of the principal, helping you to build equity (which is our situation with the condo in North York). If you can’t afford to put a dime into the property each month, then you must find one that has good cashflow regardless of the other criteria.

July 16, 2006

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