Stay in residential or buy a commercial property

[Tamer Shalaby]

Hello All, 

Please help decide or expose my blind spots. 

I have 3 rental properties in Sothern CA, Orange County area. I have low debt on all of them. I am 45 and have a career, I do not depend on RE for income. I am debating between two ideas, A) cash out from existing properties and buy 1 more residential property or B) sell all and 1031 into a commercial property. My commercial top choices are storage, medical offices, or retail. 

My theory is that rents cannot continue to climb that high in So Cal. Home prices continue to climb but I cannot imagine rents going much higher. Meanwhile if I 1031 into a commercial property I can leverage my equity and hold it for 5-7 years and repeat. 

Plan A Pro and Con

Pro - 

- maintain lower taxes.

- Properties are in affluent neighborhoods, easy to rent. 

Cons

- low cap rates

- lose low interest rates when I refi to cash out, and cannot increase rents.  

Plan B

Pro 

- leverage more 

- commercial rents have 3% increases baked in

Con

- Higher tax and interest

- Recession and high vacancy. 

Summary of Inv

Prop A - 1.5m - 250k loan - 5500 rent - 150 HOA - 3300 mort+tax - cap 3.6%

Prop B - 800k - 293k loan - 3300 rent - 500 HOA - 2600 mort+tax - cap 3.4%

Prop C - 500k - 113k loan - 1900 rent - 500 HOA - 1100 mort+ tax -cap 2.5%

Total Value = 2.8m, Total Debt 660k

Cash left after sale and RE commission = 2m 

Future Property

Fut Prop 3.5m - loan 1.5m - 35k taxes - 2400 ins - 120k mort only - 180k rent - cap 4% 

In 7 years @ 3% appreciation and rent increase and 1% tax increase 

7 Year 4.3m - loan 1.4m - equity = 2.9m 

Which plan would you pick and why?

Thanks

[Evan Polaski]

@Tamer Shalaby

Who is going to manage the properties?

I am biased to residential.  I also don't agree that rent rises are going to be limited going forward.  As you note, home prices continue to appreciate at a time when mortgage rates are much higher than they have been for the last several years.  Therefore, the cost of owning is continuing to grow.  

Combine that with seemingly continued strong demand in the LA market for housing (even though the news says people want out) and you have more room to continue pushing rents, because there is limited supply, strong demand, and an ever shrinking ability for people to buy in the market.

I also think residential is pretty straight forward in terms of managing a property.

Commercial on the other hand I see having a lot of risks.  Not all retail and office leases have 3% annual increases.  They might, but not all do.  When you get into lower end commercial, you will likely have non-credit tenants and will need to finance a lot of their buildout to fill the space.  You will be needing to spend significant dollars to backfill any vacancies, and they will likely sit for a long period of time.  How many people are looking to open a neighborhood restaurant right now?  And if you do find one, do they have the $500k buildout budget, or would they be looking at you to cover that cost and build into lease? How many people are signing new office leases?  

The upside is typically longer term leases (good and bad) depending on the market conditions. You are only likely to get tenant calls during daytime hours. NNN leases on help cover much of your expenses.

To be clear, I work in multi-family now, and started my career with a retail owner/operator.  I do like necessity based retail, but not all retail is the same.  Just like not all office is the same.  And a $3.5mm office or retail center in Orange County doesn't seem like you are buying anything great.