Is this Commercial Deal Good?

Question

One tenant commercial building for sale, about 4000 sq ft. It is currently a salon spa. The initial 10 year lease still has 5 years left. Rents are about $30,000/year and tenant pays all utilities. Owner pays taxes and insurance and outside maintenance like walls, roof, parking lot. Rents increase each year at 3%.

Building was listed for $280K two years ago and since then has dropped in price two times. It is now listed at $210K.

Why is this deal still available? It seems like the cash flow is good and long term tenant seems stable. NOI is roughly $24K.

Bradford Arner · Answer

@Manley Peterson

One of the underlying things that both @Joel Owens and @Steve L.  are hinting at is that there are few 'fixed laws' in real estate investing. There are many strategies and principles (i.e. 'Don't Lose Money') but it is very difficult to say without a shadow of a doubt that you should only buy a certain property type and stay away from everything else. Everyone has a different strategy.

For example, it would be foolish for a small investor to buy up abandoned lots in the middle of Detroit at the moment yet there are a number of hedge funds that have bought up huge areas of land in the heart of the hardest hit portions of Detroit. They are making a long play because they bought the land for pennies on the dollar. However, the risk to which they are exposing themselves can make perfect sense for their model, in which such an investment is a tiny portion of a larger portfolio and there is a low downside risk but high upside.

Another example, Glimcher is one of the leading performers among REIT's at the moment. They specialize in Class-A Malls with high end retailers in secondary markets. In fact, if you sat down with them, I would bet they can put an incredibly precise definition on what they are interested in buying and what they aren't interested in buying. By comparison, there are number of prominent REIT's who specialize in and making very nice returns on distressed assets and Class-C malls in tiny markets.

As Steve L. pointed out, you can definitely find lenders who would finance that property at 65% LTV. If that fits in your investment strategy, then go for it. I was only throwing out 50% LTV as an example of one strategy.

Unfortunately, there aren't any clear answers on what you absolutely should or shouldn't do. Nearly everything can work depending on the strategy. That's what makes real estate so interesting. If it wasn't difficult, everyone could do it. There is always something learn.

Bradford Arner · Answer

It is likely a tenant rollover risk issue.

Throwing your example real quick in a financial model puts it at a debt yield of ~14% on NCF with a 1.74 debt service ratio based on a 75% LTV and a 5% interest rate on a 5 year fixed term with a 20 year amortization. Those figures even include some reserves written in for tenant improvements and leasing. Those numbers look good. In fact, they look very solid. Thus, the numbers are not likely to be the issue.

What that leaves is a question of market and tenant risk. Without knowing the market, it is hard to say what effect that has, although it is likely a contributing factor. The reality is that a small mom and pop salon is a huge rollover risk. Salons in general can be risky even with a guarantee from a larger franchise. In this case, 100% of your cash flow would be exposed in 5 years. This would make it difficult to finance. A bank is going to look at it and think there is a high probability that you won't be able to refinance at the end of a 5 year fixed term period because you could be looking at refinancing an empty space, which isn't going to happen. Meaning the loan would stand a high chance of defaulting at the end of 5 years.

I would imagine that numerous people have looked at the property, possibly secured an option to buy and weren't able to secure financing. This is the sort of property that you would have to go to 50% LTV to get financed and someone with $100K to put in the property can likely find a more solid property at a higher leverage with that $100K to invest. In reality, a smaller deal such as this is the same amount of work as a bigger deal so, if you have $100K to invest, why not invest the time into something with a more diversified tenant rollover risk?

Manley Peterson · Answer

The building is about 50 years old and is on a city street with about 10,000 cars a day. The whole inside was updated about 5 years ago and looks wonderful. The outside is just a normal block and brick one story building.

Thanks to everyone for your input and advice and opinions. I appreciate it all.

Manley Peterson · Answer

Yeah, I noticed that was strange, too. The owner says the roof was brand new replaced for about $15,000 in 2007/2008. In 2013, there was a small leak and new roofing company fixed the problem and said the roof install from 2008 wasn't correct. As far as I know (and would need to verify, of course), the roof should be good now.

Joel Owens · Answer

If the roof was NEW in 2008 then there shouldn't be any PATCHING in 2013 unless it was done improperly. If it was installed improperly then the whole thing will need redoing.

A seller that claims everything Is new and you get in there and find a bunch of rigging that has to be torn out and redone yet the seller still wants the price on everything being repaired properly.

Manley Peterson · Answer

@Erik K - yeah, the taxes and insurance won't be more than $5,500/year. The roof is new in 2008 and patched in 2013, so it *should* be good. I don't know what should be put away as reserves, so I just added another $500/year.

Eric K. · Answer

Originally posted by @Manley Peterson:
	   Owner pays taxes and insurance and outside maintenance like walls, roof, parking lot.

If you have $30,000 a year in rents and an NOI of $24,000, then all of the above is only $6,000 per year?

Steve L. · Answer

If you have a strong relationship with a bank (track record of successful investments) they get more flexible on stuff like this.

All my commercial stuff is single tenant buildings, with similar leases (non national tenants) and I get financing at around 65% LTV (I don't own very many commercial buildings).

You could also make the purchase contingent on the existing owner getting the tenant to sign a longer lease.  The problem is, if the business struggles they probably would walk from the lease and you have little recourse.

Joel Owens · Answer

Yield will usually go down for more security but financing and LTV requirements (money down) tends to be better. The more money you keep for liquid cash the more deals you can go after.

Is this Commercial Deal Good?

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