Commercial property with about 12% cap, am i missing something?

Question

Hello All,

I am a new investor getting started in REI.

A commercial property is in front of me in texas that offers about 12% cap rate. I live in California. The property is leased for next 5 years. At that cap rate property would pay for itself by the time current lease is over.

The deal seems to be too good true to me. I am ready to jump on it but I have apprehensions. Is it some kind of a trap? Am i missing something?

I would really any advice you have for a newbie investor.

Regards

TK

Don Konipol · Answer

@TK AgrawalYou don’t provide any details by which we could answer your questions. But I can tell you your math is incorrect. Even if the 12 cap is accurate, it would take 8.5 years to receive the purchase price back in net income, not 5. This doesn’t account for time value of money either, or opportunity cost.

Kevin Dougherty · Answer

@TK AgrawalWho are the tenants, what’s their credit rating, what does the lease language look like, is it NNN, modified, gross lease, etc... who can possibly retenant the property if you loose a tenant, will it be better than or at least equal to the current tenants credit?We need more information to really provide our opinions.

Joel Owens · Answer

Developers typically for NNN new builds have a break even for 9 cap rate on cost. 12 caps are value add deals. There is something wrong with the property you just have to figure out if what is wrong you are still okay to own the asset.

Mike Reynolds · Answer

I will just say that I used for work for a large commercial REI. He had a convenience store that was really rocking it. He built it from the ground up 20 years ago and ran it very well. He even had me remodel the bathrooms and other stuff in it. It had a donut shop attached to it that had a 10 year lease and paid ahead of time. Then he sold it. I was bewildered about the whole thing. Then I saw the ground breaking 6 months later for a super large gas station 1/2 a mile down the road. That thing was HUGE. Now the new owners are thinking about selling it 3 years later.

Scott Passman · Answer

@TK Agrawal What specifically makes this a deal good? What type of commercial property is it? First of all, being listed as a 12% cap tells you right away this building and/or area has some serious problems and thus is going to be a higher risk endeavor. Higher reward, higher risk. Do you know much about the area and the building? Have you run financials to break out the numbers? If you haven't already, you should start finding out everything you can about the property, city, and adjacent area if you are seriously considering this building to figure out what makes this property a high risk and is it something you personally are confident you can solve to turn it around?

Gabriel Graumann · Answer

@TK Agrawal Several good points already made. I would add the following:1. Actual vs. proforma financials are important to determine when analysis deals. Remember that most sellers will paint the "best case scenario" in the financials while most buyers/investors will need to know the "most likely scenario" and to a lessor degree, the "worst case scenario." Ask for 5-yrs income and expense financials, 3-5 years tax returns for the selling entity, and other info related to the property.2. Physical features. How much life does the building have if this tenant is removed? Roof, exterior, curb appeal, interiors, electrical, HVAC, parking lot, etc. Effectively, how much will it cost you to either retain a good tenant or attract one?3. Market. How well will this property lease if you lose the tenant or want to replace them at the end of the current lease? What's the vacancy rate in the local commercial market? How about barrier to entry for that type of business? How many other similar businesses within the trade area? Employment leads everything, so who are the major employers in the trade area and what happens if the top 5 all downsize or leave, will your property be okay. What else could you buy in that same market for a similar price? Better or worse opportunity?

Brandon B. · Answer

@TK AgrawalA cap rate often reflects the perceived risk. Being sold at that price means the seller thinks the income may not be sustainable, or they cannot find buyers who think the income is sustainable. If the tenant fulfills the entire lease term, what would it rent at to another tenant? Or what would someone purchase it for to remodel it?If I were you, I would run several sensitivity analysis and make sure I was comfortable with a worst case scenario. Glad to help if you don’t know how to do that - I’m here local in San Diego.

Parker Eberhard · Answer

@TK Agrawal until people stop dying I would think being in the funeral business would be a pretty secure profession

TK Agrawal · Answer

Great feedback!! Thank you who shared their wisdom Your comments helped me get some more info. 1. Annual rent $34 k; NN lease till 2024 some time. No early termination clause. Priced at about $200 k 2. NOI of about $25 k3. Tenant runs a funeral house. 4. Area seems nice, in commercial zone closer to big factories and stuff. C class building. Seems ideal for a warehouse or distribution center 5, corner lot closer to a freeway My worry is : 1. Sustainability of the business of the tenant 2. If the existing tenant moves out before or on expiry of lease, would the next tenants worry about the place being a funeral house?Another thing I want to know is importance of knowing a place well before investing specially for commercial non residential investments. I live in San Diego. It’s hard to find affordable deals with good cap rate. I want to invest outside San Diego. How should I go about it? I have some cash but I lack expertise and time ThanksTK

Greg Dickerson · Answer

@TK Agrawal You need to make sure you are looking at the numbers accurately and calculating net operating income not gross income or proforma income.