Commercial Real Estate Investing

buying commercial real estateI’m not a complete newbie when it comes to commercial real estate investing, but I’ve still got a lot to learn. A real estate agent that I know and trust contacted me this morning about buying a commercial building, specifically an office building. He was considering purchasing a the property himself, but said he preferred to take on a partner so he wouldn’t have to put up so much cash. He also was planning on moving his real estate business into the building and would rent several of the vacant spaces and manage the property for a reasonable fee of five percent of the gross rents. We both had some time over lunch and we took a look at the building. It’s a building I had been in on a few occassions, but had never looked at it from a buyer’s perspective. I’ve included a photo of the building.

I knew the building was on a busy street and has great visibility. Visibility is one of the most important things I look for when I consider buying commercial real estate. I looked over the online feature sheet that listed the building’s specifications. There was an aerial photograph showing the parking at the back of the building and I was satisfied that there were an appropriate number of parking spaces for a building of it’s size. So far, so good. The next step was seeing the property in person.

As we pulled up to the building and began working our way around it, we noticed a retaining wall that was beginning to give way and we estimated that’ll it would cost $10,000-$15,000 to repair. We’ll want to get a bid from a qualified contractor to make sure our estimate is in the ballpark before moving forward. For a property built in the mid-1970’s, the exterior was in overall very good condition. We also noticed there weren’t windows other than on the front of the building.

Since the land slopes up from the street, or front to back, tenants and visitors typically use the back door by the parking lot and enter in the top floor. As we entered the top floor, it was clear the property was dated and the interior lighting was poor. Given the lack of windows, we also made a mental note that the lighting throughout the building would need updating. Most of the updating needed in the interior would be a bit of sheetrock repair at a minimal expense, painting, tearing down the current suspended ceiling, installing a modern-looking suspended ceiling and new lights. From there, we’d need to replace the hallway carpet with easy to clean hard-surface flooring and would want to replace the millwork which includes the base, the casing, and the doors.

There is an eight-plex on the opposite side of the back alley that the owner wants to sell as a package with the commercial buidling. The asking price for both properties is $480,000. The commercial real estate broker isn’t interested in the eight-plex and neither am I. The broker has someone else willing to purchase the duplex for around $200,000, leaving the price of the commercial building around $280,000. The commercial broker also said the current owner of the building has offered to sell him sell the building for $250,000. The owner is also willing to sell the commercial building for $295,000 and give the broker or buyer $45,000 to use for interior updates.

The broker provided me with a very helpful spreadsheet showing a purchase price of $295,000 with 20% down and closing costs approximated at $4,000 for a total down stroke of about $63,000. On the spreadsheet, financing is based on a five year loan on a 20 year amortization at 5% interest. I’ve included the actual spreadsheet here for your review. I don’t know about this site’s reliability, but here’s a link to a website that posts current interest rates for commercial property. I’ve decided I want to run the numbers with slightly different assumptions. I prefer to finance the property, any commercial property for that matter, using longer-term financing, preferably at least 10 years. If we’re able to obtain bank financing using 10 year money, I expect we’ll have to pay closer to 6% interest (banker said they’d like to get 3% more than the current 10 Year Treasury rate). After financing the difference between the purchase price of $296,000 and backing off the 20% down plus closing costs equaling $63,000, that leaves $236,000 to finance. The monthly principal and interest, or P & I on $236,000 goes from $1,557.50 at 5% to $1,690.78 per month at 6% or $20,289.33 per year.

The broker was using $51,000 for the annual rent figure if the property is fully leased. Even though he backed off 5% for a vacancy loss, I know the reality is that the building may never be fully leased. Given this, I asked for a more realistic number based on what the current tenants are paying and adding to it what the commercial broker will be paying for the space he wants to occupy. That number is closer to $37,000. Given total operating expenses (which also need to be closely examined and are typically lower than what the actual expenses will be) of $20,675, that leaves $16,325 to service the debt. If we use financing at 5%, the yearly debt service will be around $18,690. If we are able to finance the property for 10 years instead of 5 years and have to pay 6%, the yearly debt service will be around $20,289. Either way, there’s a shortfall from $2,365 to $3,964 just to make the payments.

If I were to take nothing else into consideration, this is probably the point where I’d thank the broker for his time and walk away from the deal. Here’s why I’m still considering this deal. Remember the current owner is willing to give $45,000 to refurbish the place, so we can make it look a lot sharper. The commercial broker feels strongly that once we remodel and he moves into the building and leases two of the offices, he won’t have any problem renting at least several other vacant offices. It’ll only take renting one or two more of the individual offices to make the payments. If he’s able to rent several of the individual offices or an entire floor, the deal begins to look much better. Another thing to consider, and one of the main reasons why buying commercial real estate is so attractive, is the depreciation that we’ll be able to use to offset our taxes.

Lastly, we still have to discuss financing terms with a couple of bankers. It may be possible that we’ll be offered better terms than we’re estimating. The financing in a real estate deal can mean the difference begin a so-so deal and a sweet deal. If we can shave the interest rate down a bit, that only adds to our bottom line and makes this deal more appealing. I’ll try and update this post and let you know if I went ahead with or passed on this deal. I hope this post has given you a bit of insight into buying commercial real estate. As always, before making any investment, make sure to do your own research and discuss the details with your tax and legal advisors. Please share any of your experiences below in the comment section.

Update December 13, 2013:  The real estate broker driving this deal was able to get the last few years of tax records from the current ownership group. Here are the important numbers from the 2012 tax return.

Update December 26, 2013:  We’ve had to modify the contract in order to make it acceptable to banks. We’ve given our last three years of tax statements and our Personal Financial Statements to two different banks. The first bank to respond has agreed to lend us the money for 5 years fixed at 4.5% (which is awesome). Then, the next five years the rate may adjust, but by no more than a total of an additional 2.5% and is capped at 7%. They’ll even stretch the amortization out to 25 years. Once the building is cleaned up and a few spaces leased out, this deal should work out well for at least the next two years while we have most of the upper floor rented to the current owner. While there are no guarantees, I am hopeful this will turn out to a positive experience in commercial real estate investing.

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