Commercial Cap rate-- I was fooled!

[Jack Martin]

Well, I had been a residential landlord for many years; I understand cap rates and what to look  for, so when I started looking at an office building as an up leg I searched through the U.S. in most major markets and settled on a 14% cap rate newer building in Cordova (Memphis). Visiting Cordova I fell in love with the area; all of the strip centers were full, people were driving nice cars, the demographics were favorable, what could go wrong? 

It was a full building with the owners occupying the whole upstairs (red flag) and signed a 1 year lease. Into my third month as the new owner, I hadn't received any rent from the downstairs tenant ($1700 per month). I was assured by both the former owner and my RE agent that he was a reliable tenant and was just waiting for funding from his parent company in South Africa. So I hung in there for another 3 month, before kicking him out. He cost me $20,000 in lost rent not to mention his utility bill I  was paying for (insult to injury). 

Fast forward, one year is up and the former owners bail! Wow! I now have 75% of the building empty. My RE agents had been unable (or unwilling) to find a tenant for ANY of my space!! Other buildings in the area were feeling the same pinch. 

So, I walked around the office parks and realize that the buildings with executive suites are FULL!! It stands to reason that with more and more small businesses springing up that many don't want to or can't work out of their house! Work Space is killing it nationwide. 

Meanwhile I had been pumping out beautiful flyers, a web site and even a video "walk through" of my building again to no avail. Next, I change my strategy and advertise "executive suites" and the phone rings off the hook!!! 

In the meantime, my RE agent locates a prospective tenant to take 1/2 of the space but it is costly! I took a 15% rent haircut, one month free rent and $2000 in improvements and $2200 for RE commission. 

Here's where my homework failed me: it didn't register that the income for 1/2 the building was from the sellers!! I should have known better, I'm not new to this!!! They inflated their own rent to increase the cap rate and it was impossible to find a replacement tenant for that much space.

My take aways:

• Buy your building from an agent not listing the property.
• Be wary if the owners occupy the  majority of the building
• Understand that agents have little interest in finding you tenants (when they would rather sell a building), so it's up to you!
• Keep your existing tenants happy!
• Kick your non paying tenant out immediately; don't believe their story! It will cost you, not them!
• Offset lower rent by transferring utility costs to the tenant if possible.

[Russell Brazil]

Cap rate is an indication of the underlying risk of the asset or market. It is not a measure of return. A 14% cap rate is extremely high, which means this was a high risk property.  With higher risk means comes a much higher chance that the return will deviate from expected returns.  I would fully expect a property with a 14% cap rate to be a pretty bad experience.