Thoughts on this deal?

Question

I’m making the switch from multi families to commercial. I’d appreciate thoughts on this deal:

Medical building priced at $1.9M. Tenant just signed a 7 year lease at $14,667/month with two 5 year options and 2.5% increase per year. The seller is putting $425k towards remodeling and tenant is putting $200k. Mostly paint and flooring, plus some IT and office stuff that will benefit the tenant. The lease states that my taxes will be capped at $8900/year and insurance at $1900/year. I pay anything HVAC over $2000/year. 3 of the 8 HVAC units were recently replaced. They are $6000 each and the others range from one really old one to some middle aged. The roof is steel but some areas need repair. To replace the whole thing (not necessary right now) would cost $60,000. The parking lot would cost $40,000 total but only needs about $10,000 worth of work in the back right now.

Financing would be 15% down and 4.0% for 5 years, 20 year amortization. Other expenses would be about $1000/year landscaping.

Thoughts?

Joel Owens · Answer

"The lease states that my taxes will be capped at $8900/year and insurance at $1900/year."

What does this mean? Does it mean you will only be responsible up to that amount annually or does it mean the tenant is only responsible to reimburse annually up to that amount  and you pay the rest?

Taxes and insurance are really what we call in the business (non-controllable expenses). The insurance policy the seller could have a master insurance policy covering many properties whereas a single insurance policy you might get could cost a lot more than 1,900 a year.  You do not want to CAP non-controllable expenses for tenant reimbursement. That can really, really eat into your expected returns. Also how do you know the extent of the roof replacement needed, parking lot, and A/C's? Did you have a full building inspection by a certified engineer or going off what the seller is saying?

What is the size of the building? Usually about 6 a foot right now to replace. Down to decking could rise further. Parking lot one price to coat and seal but if it has some alligator cracking and has already been coated a few times might need to be milled down and redone which can get very expensive.

Who is the credit for the tenant? Small mom and pop, regional, national investment grade?

"Financing would be 15% down and 4.0% for 5 years, 20 year amortization."

This must be owner financing. For STNL these terms do not exist with regular lenders. If investment grade credit tenant then typically 30% down and if weaker tenant 35% or more down. 4.0 interest rate usually reserved for investment grade tenants. 20 year amortization can usually get better with 25 to 30 year amortization. Have to watch out on 5 year loans as mid-process to fund the loan some lenders will stress test the property as part of an appraisal and then require a larger down payment. By then you are tens of thousands of costs into the deal. If a lender is telling you they can get this done for a loan I would be asking how many loans have closed under those terms and want to speak with other clients for testimonials.

Additionally WHO is quoting you these terms? Is it a mortgage broker, a direct lender? If direct lender who took your information and package submittal? Is it a grunt and then it gets to committee and they turn it down or is it the VP or president of the bank that sits on the committee?

The details matter tremendously on these types of deals. Is this a NNN, NN, or a gross lease?

Is there an elevator? Those can be  few hundred k alone to replace.

Ronald Rohde · Answer

I mean during the lease. I didn't think you had reviewed financials or corporate structures. I've had plenty of clients suing tenants despite thinking that "they are national, this lease is basically a sure thing"

E. Miller · Answer

@Ronald Rohde

I’m not sure what you mean by walk away? After the 7 years?

If they walk away during the lease I’d have legal recourse, they are a multi-state healthcare provider with 150 locations that has been in business over 70 years, so I’m confident the funds are there.

If they leave after the lease obviously I’d need to deal with locating a new tenant but minus a crystal ball I can’t predict that.

Ronald Rohde · Answer

Well, without knowing your market, and the assets in the tenant name, they could walk away because 200k is pretty light in investment.

E. Miller · Answer

@Ronald Rohde

No, there is not.

E. Miller · Answer

@Laura George

Haha I WISH I was a real estate attorney! It’d be way more handy than my specialty!

E. Miller · Answer

@Joel Owens

I can’t thank you enough for your insight. It’s really good info for me to think about before everything is signed. I’m going to approach the lender with the rate cap after 5 years. He might go for it and it would be great to limit my exposure to market rates after 5 years. I’m going to check on the other things you mentioned too. Thanks Joel!

Ronald Rohde · Answer

Looks good to me without knowing your personal investment goals. Any PG on the lease?

Laura George · Answer

@E. Miller

I would ask an attorney.  Lol

Joel Owens · Answer

Multifamily lending and commercial asset lending are different departments within a bank. Multifamily is typically Fannie and Freddie money.

The bank in this case because you are local and have (relationship banking) with deposits might give you loan terms not typical in this space. I have seen it a few times before with a doctor buying retail centers at 20% down instead of 25 to 35% down but he had all his deposits there and personal guarantees across all assets. I am not saying it is not possible I just do not want others reading this thread to think financing like that is readily available in the space for these types of assets.

Multifamily I do not know what type of building you have. Typically those are shingle pitched roofs which is much different than the flat roofs on most commercial buildings for cost and labor totals. I would look at more the building inspection report from a certified engineer. I would also look at how they are reimbursed for the mental health services aspect. Some types of medical over others that are more heavily relied on for government programs can be at greater risk than private payer customers.

When was the building originally built? Did you have the sewer lines scoped to the street? Some older buildings the trees were planted to close to the buildings for the height size and can cause roots in utility lines, sidewalks popping up, animals access to the roof, cracking the foundation, etc.

Since the building Is being updated make sure they are making ADA compliant for required parking outside and upgrades inside.

Checking with building department for city or county and look for any new development projects slated for the area and site plans that might be medical. Check with DOT for any road widening that might take some of your land and reduce down the amount of parking spaces available.

Make sure newly signed rent for that box building size is not inflated for the area where the seller in exchange for TI's is getting inflated rents to sell off to a buyer. There is customary TI's and other costs and average rent per ft for certain box sizes in an area.  The amount of TI's the seller is paying they should have tried for more than 7 years on primary lease term before options. 6.5 cap I like to see at least 10 years left on the lease minimum. I do not like 5 year debt unless I am doing a value add to blend the cap way up. That way if I do not want to sell then and interest rates rise I still have a healthy spread for return putting new debt in place.

If you can try to negotiate a 5/5 with a ceiling. Lenders will usually fight against it. So for instance if interest rate is 4 percent fixed for 5 years then the next 5 years instead of MARKET RATES which lender like to do the language says prevailing market rates up to a cap of 6 percent.

This way you can model out worst case scenario putting the debt at 6 percent and seeing what it looks like for years 6 to 10. I do not like open to market. I want low rates if they are low then but then capped on what the lender can charge me. Open can put you in a bad spot if interest rates go way up with fixed rental increases in a lease. When you go to refi the 7 years lease will only have 2 years lease left on primary and very hard to finance and underwrite. If you had 12 years today then in 5 years you have 7 left on primary and can still do something decent with that for most lenders.

Thoughts on this deal?

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