What to watch out for in commercial/office space ownership?

Question

Hi everyone, first real post here. I'll get around to a proper intro in the appropriate forum and adding some profile info sooner or later.

I have a 2-family rental in Boston that has appreciated considerably since we bought it but rents haven't kept up. I'm currently sitting on about $250-300k in equity but only netting about $11k a year on the rents. I want more cash monthly to get me towards my goal of quitting my day job, and I lived in this property until 2 years ago so I can benefit by pulling out some equity without paying capital gains if I sell now. So I will have about $125k for the 1031 exchange and another $125k in free cash that I can either use to pay down private debt (student loans, HELOC on my personal residence, etc.) to decrease expenses or put into another income property.

Found a 10-unit office building about an hour south from me on the MLS. They're asking $500k. Here's the pertinent listing info:

We have an extremely motivated seller for this fantastic Ocean-view Office Building. Located right on a very busy location with amazing views ... The building has 3 levels and 10 units overall... with 7 of the units currently leased at $7,000/mo total. All units have individually metered electric, individually metered gas furnace, roof-top A/C units, and private half- bathrooms in each. City water and sewer, newer roof (5 yrs approx), and 34 parking spaces. This building would be a great location for a growing business or as a cash-cow investment. The owner has retired from business and no longer needs this amount of office space.... he's willing to consider all reasonable offers.

I figure I can put 25% down ($125k) on a 25-year mortgage at roughly 5%. Property taxes are about $8k. That puts my P&I at at about $2200/month, taxes at about $670/month. Taking a guess at insurance, maybe 1% of the value or about $400/month?  If he's generating $7k now and will have 3 extra units available for rent, these seem like very compelling numbers. He's cash flowing like crazy and it's 30% vacant now. There aren't that many things to spend money on...no lobby, no elevator, no staff, minimal plumbing, minimal common utilities, new roof, pics don't show any obvious repairs needed.

The numbers are almost *too* compelling...am I missing something obvious? Are there some extra costs to commercial real estate that I am not taking into account? What are the ways I could fail miserably here that I'm not seeing?

I contacted the listing agent a couple of days ago asking for full financials and he replied but didn't send them yet. Since I haven't even put my place on the market (I could sell it off-market pretty quickly to some investors I know), I am not quite ready to push him for more info.

Any help you all can give me to decide whether or not to pursue this would be appreciated.

Thanks!

Ann Bellamy · Answer

Several things jump out at me:

• Commercial financing is very different from residential, you are unlikely to get a 25 year fixed rate.  Normal commercial funding will have a 5 year term and a 15-20 year amortization.  
• Commercial appraisals are much more expensive, and appraisers are backed up right now, so allow plenty of time to close
• Lender may required a Phase 1 Environmental, or maybe even more
• Commercial closings in general are most expensive than residential, just the closing attorney can be thousands instead of a few hundred.  Just because it's commercial.
• Flood plain:  The location is likely to be in a flood plain, so look into lender-mandated flood insurance
• Is the heat individually metered?  Does each space have it's own electric meter?
• Make sure that part of Wareham is on town water and sewer, and check with them for average annual bills
• Your insurance estimate (except for flood insurance) is likely high:  Office buildings don't have families in them overnight, so you might find your Business Owner Policy is under $2000/year
• Look for deferred maintenance on major systems, which with 10 spaces will likely be your responsibility, not the tenants'
• And the bigger issue:  Demand for office space in general is on the decrease, with more businesses shrinking their office footprint and allowing workers to work from home.

None of this is necessarily a deal killer, but I'd try to find out why the seller is so motivated.

Charlie MacPherson · Answer

@Jason Turgeon I know the building.  It's a very high traffic area, especially in the summer.  That's a very bad thing for residential and a very good thing for commercial!

It seems like a very good price.  Enough so that I would want to dig very deep.

It was last on the market in 2011, listed in February at $990,000 with price changes as follows:

May 2011 - $575,000

July 2012 - $795,000

The listing expired in August, 2013 and was relisted January 2, 2019.  They all happened well after the crash of 2009, so I don't know what the explanation would be.  Certainly not market fluctuations.  Heck, it's now listed at HALF of what they wanted in 2011.

Those are some pretty wild pricing swings!

It's owned by a corporation.  I can share that name with you privately if you wish.

The public information about that company suggests that they're a small operation with annual sales under $500K.

The company that owns it is a tenant there, so you will possibly have a vacancy if the company is closing down or moving.  I'd be sure to review those rent rolls in minute detail.

Charlie MacPherson · Answer

@Jason Turgeon I have a pretty good idea of where you're looking.  I'd look at the crime heat maps on Trulia.com to get an idea of the neighborhood.

Next, a physical plant inspection.  I'll bet the building dates back to the mid-1800s to mid-1900s.  It could be just fine - or not.  You really want the inspector to dig to find upcoming capital repairs.

The other thing I'd look at is the type of tenants that are there.  I'd want to know how stable they are and whether they're Amazon proof.  I'd look back as far as possible to check for late rent or CAM payments as that's a good indicator of a business in trouble.

Finally, I'd check with the town to see if there are any upcoming projects in the area.

If all that passes the smell test, it sounds like you should pull the trigger.

Tim Milazzo · Answer

@Jason Turgeon - yes, planning for the length of the loan commitment and then evaluating opportunities to sell or refinance are pretty much exactly how all of commercial real estate investing works. 5 or 7 year terms are common for smaller local deals. Larger, stabilized properties will often have the option to do a 10 year fixed loan as well, and top of the line product with great tenants may have access to longer term fixed rates from insurance companies. But 5, 7, 10 are considered standard.

A good office leasing broker can talk to you more about the strategy on the revenue side, but typically you build in step-ups, called Escalations, to the lease rates over longer periods. Often you may give the tenant an Option to renew, where they tell you a certain amount of months ahead of time whether they'll stick around, so you have time to plan for a new tenant if they move out. That option may allow them to stay at some pre-negotiated new rate that is higher.

The worst thing you can have is a vacant building when it comes time to refinance. The second worst thing you can have is a building full of tenants of questionable ability to pay, and no commitment to stay anyway, so it can become vacant in a hurry. The third worst thing you can have is a building full of happy, stable tenants who are locked into below market rates and no way to raise them contractually.

Bob Langworthy · Answer

@Jason Turgeon, a lot of good input so far. One other piece to consider is that you would probably have more parking than necessary for the tenants and could lease out parking as an additional income source.

Hope this helps,

Ann Bellamy · Answer

@Jason Turgeon, I wasn't answering to solicit for a loan, it is too far out of my geography.  I will do single family flips as far south as Plymouth and Wareham, but this deal is probably not a good one for hard money.  Unless you get it wicked cheap and have to close very quickly.

Hard money lenders want an exit strategy out of their hard money loan, usually (not always). So you need to be able to demonstrate that you can likely get conventional commercial once you own it and have finished leasing it up.  But it looks like this is probably finance-able with convention commercial as is.  So why use hard money if you can go straight to conventional, unless there is a pressing reason such as a time constraint for a killer deal?  This last is why you would use hard money instead of conventional, or if you lost a couple more tenants before closing day, and it no longer qualifies for conventional.

Talk to the small local banks and credit unions, and go to the commercial lending department, not the mortgage department.

Ronald Rohde · Answer

How will you find new tenants if any leave? Will you continue to self-manage? You won't get 5% interest unless its something like owneroccupied SBA. rates more in the 6%+ range.

Jason Turgeon · Answer

Interesting. That would likely explain part of this guy's motivation to sell. He had it listed from 2011-3 without a buyer (very different market back then), so he may well have picked up another 7 year mortgage which would be expiring in about a year. And since I know he is 74 and ready to retire, I can see him not wanting to go in for another 7 years.

I'd seen escalation clauses in commercial leases, just never knew why they were so common. Really appreciate your insight on happy, stable tenants being a liability. In my residential units, my game plan has been always to get great tenants who are happy and stable, then undercharge them by about 5% so they never leave.

"A good office leasing broker"...I am a licensed agent, but I have only ever done residential deals. This is a good chance for me to step up my game and learn about commercial leasing. I am definitely NOT a good office leasing broker at the moment! I'll work my network a little and see if any friends of friends do office/commercial work down there.

Jason Turgeon · Answer

Thanks, @Tim Milazzo. That's helpful info.

I try to work exclusively with small local banks anyway, so that is not an issue, only problem is my preferred local lender doesn't cover that part of the state so I need to start with someone new.

I will definitely check into the lease expirations, if the selling agent ever gets back to me. Hopefully his delay doesn't mean they are completing a deal with another buyer, but if they do at least I learned something about commercial financing.

He has 10 units and 7 rented. He has his own offices that he is closing down as part of his retirement. I am not sure if he is using all 3 of the remaining offices or if there is some true vacancy. This is a very busy commercial strip with lots of new development, mostly big box stores and national chains, so I am optimistic that there will continue to be people wanting office or similar space here.

I think I can still make this deal work at 30-35% down.

My only real concern from all this is the short 5 or 7 year term of commercial financing. Does this mean I have to refinance or think about selling every 5-7 years? Is that really how the entire industry works? Seems odd. Rates could be dramatically higher in 5 years, but my leases could lock me in to lower rents, cratering my cash flow. Is there some workaround to get stability for longer mortgage terms?

Tim Milazzo · Answer

Solid input from others except... those are not great assumptions given on a commercial mortgage.

No, typical commercial mortgage rates (from banks) are not yet 6%+ as of this writing. Private money or debt funds can be 6-9%, but we're still getting rates from banks in the high 4s to high 5s if the investment is solid. Lender perspective:

1. Small market and small property mean local banks/credit unions are the best candidates.

2. You mention 7/10 units occupied. Next question: when do the leases expire? If all the leases are going to roll within a couple of years, the downside risk is a vacant office property, in an area that may not have high demand. That could be a deal-killer, especially if you don't showcase a solid business plan and some experience with the area/asset class.

3. Assuming the rent roll has staggered leases, and you have solid financials, we're in decent shape. This isn't a 4.X% market, but something in the 5's should be possible.

75% leverage is probably a little bit high, maybe a local bank does 65-70% leverage, 5 or 7 year term with a 20-25 year amortization. 15 year amortization on office property with strong cash flow would be brutal.

What to watch out for in commercial/office space ownership?

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