The Basics of Commercial/ Investment Real Estate

A.Goals of this report

Most people don’t invest in commercial real estate because they don’t understand it. Yet if I told you I had a place you could invest your money, get an 8% return guaranteed for 15 years by a fortune 500 company plus appreciation and you didn’t have to do anything but get a direct deposit each month, you’d want to know where right? That is part of commercial/ investment real estate and why you need to know more.

This report is aimed at people coming into a large amount of money, want to keep their assets and have income for the rest of their life. But I believe anyone new to investing in commercial/ investment real estate will get something from it. This report will give you a basic understanding of commercial/ investment real estate so that you can do a basic evaluation of a property and know what a real estate broker is showing you. You will be empowered and in charge of your assets.

Knowing how to buy right, including your personal home, is key to any purchase. The old saying, you make your money on the buy, still holds true today. You must realize the market you are in and buy with purpose.

B.Introduction

Before we get too far along let’s answer the first burning question? Who is Jim Carmichael? I have been a commercial real estate broker for over 17 years. I am always trying to find new ways to bring value to my clients. I started in the business as a Mobile Home Park Specialist and still am to this day. However, over the years being flexible for my clients, different opportunities have come forward. I now have some level of expertise in these areas:

* Multi-Family *Turn around Management *Land Development *Tenant Rep/ Site selection *1031 Exchange process * Single Tenant NNN

I believe frequent communication and transparency are keys to a successful business relationship. If I don't know the answer to your investment real estate need, I know someone who does. Problem-solving and making the deal is what I am known for.

I created this report because I heard (then confirmed) the staggering statistics of the number of professional athletes that go bankrupt shortly after their career ends. Then I thought there are plenty of other people who could use this information and certainly anyone could pull something useful from it. I spent years trying to get this to athletes but never got past the gatekeeper. Then it dawned on me, reach out to them directly and as early as possible in their career. Thank you, Twitter.

The number of professional athletes that go broke or bankrupt in just a few short years after leaving the game is unacceptable. It is clearly a lack of knowledge. But it also shows you how cut throat it is. Where was their agent? Where was their representative? You can come to your own conclusion, I’m sure. If you don’t know how bad the situation is, google it, there are plenty of articles. The graph below says it all.

Avg annual Inc    Average career length     BK within 5 years

NBA     $6.39M                          4.8 years                         60%

MLB     $4.49M                          5.6 years                  4X that of avg US citizen

NFL      $2.43M (drafted)          3.5 years                         78%

             $973K (undrafted)

I would be remiss if I didn’t mention lottery winners. 70% of them end up bankrupt within 5 years of receiving their windfall.

The common thread in these groups is the same. It is the same thing most people lack when it comes to commercial/investment real estate …. KNOWLEDGE! No one was taught about CAP Rates, Cash on Cash, IRR or what the difference is between McDonald's and Walgreens.

That my friends is why I have written this report. I want you to have enough base knowledge about this industry to make an informed decision and provide you and your family a lifetime passive income. Some of you may even build a generational wealth that you can pass on.

C. The end goals

Unless we know where we're going, we will never get there. From where you are to where you want to be is not a straight line. There will be some very high “high's”. With proper planning, we can minimize the lows.

How much money will you need to live on? First decide at what age do you want to retire, 65, 60, 55? Then how to determine how much money you will need each month/year to live on. Don't forget to consider who you have to support along the way. You keeping a personal assistant? Trainer? Hanger on? They have to be accounted for too.

The big question is how long will you need the cash flow coming in? This goes back to when do you want to retire. Some assets have longer income streams than others. Some have higher rates of return than others depending on several factors, including but not limited to: location/ market, asset class, class of property, quality of tenant, length of the lease, and more.

A professional commercial real estate broker can help you with a risk assessment and make recommendations. Please don’t mistake your realtor relative for a professional COMMERCIAL real estate broker., or whomever else you know that sells houses. Although the state license may be the same their training and education post-licensure are totally different. You may have to meet and work with a few before you find the one or two you trust and believe into work for you.

D. Buying Power

As an individual or group, you have more buying power than most small businesses and any individual I have worked with starting out as a new investor. So many people start with little to no cash. They go to seminars to learn how to flip contracts. Then work their way up to purchasing a wholesale property and flipping it. Eventually, they have a big enough portfolio to sell so they can move into larger multi-family properties. Hopefully, they work through the process, so they own high-quality NNN leased properties that put money in their account each month with no owner responsibilities. We will talk more about that later.

Simple math in the real estate world has to do with financing Leverage in these terms means you can put down an amount of money and borrow the rest. Each bank has its own qualifications but in general, a simple rule is the bank will do a 75% LTV (loan to value) loan. In this situation you can leverage your $500,000 into $2,000,000.

Just like anything else, you make your money when you buy it (not when you sell it). That may not make sense at first, but you can only control so many things in the marketplace. The one thing you cannot control is the future. If you could predict the unknown, you would be in such high demand on Wall Street you would never have to worry about putting your body through the rigors of professional sports.

For your investment property, you want to have buying criteria. This is different for each market and each asset class but as a general rule of thumb, you want as close as possible to a double-digit CAP Rate and as close as you can get to a 15% cash-on-cash return. We will talk CAP Rate and Cash on cash in the next section.

Let’s not forget your personal home. Did you get my white papers on The Myth of Buying a Home and How to Buy Right? This is an area where almost everyone gets it wrong. Unless you plan to live in the city where you play after you are out of the game, you should absolutely rent. I would recommend you wait until you sign that first big contract before you buy anything at all for yourself. If you want to buy a home in your hometown for yourself and your parents, you still want to buy right. Given the amount of money, you will have to sit down with your advisors (at least your CPA, financial adviser, and your commercial real estate broker) And figure out what makes sense. For example, is there an advantage of paying cash? You can get a better rate of return on a rental home that will pay for a loan on your parent’s place (and use another for yours). Finance the purchase of those homes for no more than 12 years (7 years is ideal).

E. The numbers

I’ll be the first to tell you I do not fully understand the stock market and all the different play available. I am sure if you watch the market all day long and watch the stocks or mutual funds you have you can day trade or play the options market. But that is for a different licensed professionals altogether. I can look at the average rate of return of a given fund or stack and try to make an informed decision but that’s about it.

Real estate, on the other hand, has fewer variables. And I have direct control over the property as an owner.

Let’s look at two key indicators when purchasing an investment property, (Capitalization) CAP Rate and Cash on Cash (COC) return. Time to look at the math.

CAP Rate = Net Operating Income            COC = cash flow

                          Sales Price                                   down payment

Like any formula you must know 2 out of the 3 to figure it out. Here is the definition of each term:

CAP Rate = The math formula is above, but if all you have is the NOI and need to come up with a sale price, how do you do that? When you are trying to figure out the value of your property you have to know the CAP Rate for that asset in that market, taking all factors into consideration. It really is a finesse thing and knowing the market.

Actual Income = Gross rent - vacancy (or current actual income)

Net Operating Income (NOI) = Actual Income - expenses (except debt service)

Cash flow = Actual Income - all expenses including debt service.

Down Payment = the amount of cash you put down on the loan to purchase the property.

Now when I say you need to set buying criteria with a CAP Rate of 7% or better with a cash on cash return of 12% or better, you know what you need to figure that out.

Not all books and record are the same. When analyzing a deal, you have to look at rent rolls, P&L’s (profit & Loss statements) and tax returns. Recorded income is something landlords are good about showing. You just need to verify it is accurate. Expenses, you have to review thoroughly. Sometimes there are extra expenses put on a tax return in order to pay fewer taxes. Often, especially when dealing with smaller properties, owners will forget things like management and maintenance reserves. Almost every deal has the wrong figure for taxes. They use what it is currently assessed at, not what the number will be once you purchase it.

Deferred maintenance needs to come off the offer price as well. If you are looking at value add properties those costs have to be accounted for likewise.

F.McDonald's versus Walgreens.

This is a concept that people don’t usually know or understand. But I find it easier to explain this first before asset classes, so it all makes sense. Knowing a company’s business makes a great deal of sense when you are looking to invest with that company, correct? Whether you are buying stock or purchasing property with a lease guarantee from that company.

What business is McDonald’s in? Burgers? That’s what most people think. But McDonald’s is in fact a real estate holding company (among other things). Read Ray Croc’s book (or watch the movie). The franchise is in the burger business, McDonald’s is the second largest real estate holder in the world, only the Catholic church is bigger. McDonald’s owns the property, the franchisee leases it from them.

Now, look at Walgreens, what is their business? Pharmaceuticals? Yes. They lease all of those properties. If you notice they are in great locations. Should you get to read one of the leases it’s very strong, usually 30 years with built-in increases and it is guaranteed by Walgreens corporation. Are you very concerned whether Walgreen’s will be there in 20or 30 years or not? Drugs will still be given out then. The same conditions exist for companies like Dollar General, Family Dollar, Advanced Auto, W, O’Riley’s, etc. they are corporately guaranteed leases.

G.Classes of real estate

Let’s look at the asset classes and how we classify them. Each property in an asset class gets a grade A, B, C, or D based on the quality of the building and tenant. Then it gets a location grade of A, B, C, or D. Depending on what your strategy is will determine the classes you buy in. Each asset has subsets as well.

Multi-Family: Apartments 5 units and up, high rise, low rise, garden, condo’s, Mobile Home Parks, Hotels & single-family portfolios

Retail: Single tenant NNN, multi-tenant strip center, neighborhood strip center, power center, Malls, freestanding, restaurants

Office: High rise, office park, free-standing, medical

Industrial: Flex space, free span, refrigerated/ freezer, warehouse, dock space

Specialty: Self-storage, gas station/ convenience stores, car wash, church

A good rule of thumb for purchasing multi-family is you want a C class property in an A or at least B location. Why? The property typically needs better management or a capital influx. The return on your money invested will be easy to regain and then some.

You don’t want to buy a job; you already have one. The first thing in developing your strategy is finding an asset class that sparks your interest and start there. You may have some background in a particular type of property. Or at least go with something you can relate to. One thing you must look at is management. As I said before, you don’t want to buy a job.

H.Management v NNN Lease

The right property manager/ management company can make any asset a passive income for you. But you do pay for that. Depending on the size of the property you could pay anywhere from 5% to 10% of the gross income for management. It is worth it for the right one. Make sure you do your due diligence, check references and a nationally recognized name helps. If you hire mom and pop management and funds come up missing, not only will you not see them, they won’t have the money to repay you if you could find them.

A good property manager will have the experience and technology available to make everything transparent. At any given time, you can look in on your account and see where you are.

Should you get a NNN leased property, there are no management concerns. Just a check direct deposited the first of each month. A true NNN is hard to find these days. The fine print of the lease is important to read. There are modified NNN and NN deals out there that require a minimum amount of management, that you can pass along to a management company for a minimum fee.

I. Buying Criteria

Once you have decided what asset class you want to buy in, you have to come up with a buying strategy. Each market is a little different, so I am going to give you some general rules of thumb that should work in any market (except west coast, NY and higher end, major market cities). Always keep in mind, you make your money on the buy. The old saying is buying low, sell high is just a fact of business. Hopefully, you will have a professional real estate broker to work with to guide you in creating your criteria, but here is where I would start;

Multi-family - this depends on risk assessment. A general rule I have previously stated is to buy a C class property in an A or B neighborhood. This comes down to getting a good return on any money you put into a property. 10% CAP with a 15% COC is the goal.

Retail - this is where you can target secure income with little or no management. Your returns will be a little lower, 6% to 8% range, but while you are playing this is fine. It will not distract you and provide steady reliable returns.

Office - Solid B or A property in an A location will provide great tenants with good returns. This is another asset where you can find a secure income with medical office space. Sometimes you can do a sale-leaseback for a ten-year period which is as good as anything you will find on the market.

Industrial: Location is primary. You want it to be near a major interstate, railroad and or waterway. I-75 (that goes through Lexington) is one of the largest transportation routes in the US. The Cincinnati market is a prime area for shipping hubs because you can reach 60% of the U.S. population within a day (10 hours) drive. As an investor in this asset starting off in the flex space arena is a good idea. That being a large building divided into smaller, about 2000sf units with 500sf of office in the front and 1500sf of the warehouse in the back. This space is in high demand no matter what the market is.

J. Due Diligence

Now that you know what you want to buy and you have reviewed the materials supplied to you, you must make an offer that includes due diligence. I am not going to go over how to negotiate the price. There are plenty of books about that, but I have given you your buying criteria, so you know not to go out of those parameters. What you need to do is verify what you have been told. Tax returns usually are not turned over until there is a contract. So once there is a contract you want the last two years of P&Ls, rent rolls, tax returns, and any environmental, plats/ surveys, leases, etc. Make sure what you were sold on lines up. Go down your list and check them off one at a time. By the way, this is all information the lender will need as well

K.Building a portfolio through 1031 Exchange

The IRS code 1031 Tax Deferred Exchanges allows you to sell an investment property and exchange it for a like-kind property (any other investment property) without paying capital gains tax. There are timelines and rules to follow. Should you not feel satisfied with the information your professional real estate broker provides on this, let me know. I teach a 3-hour Continuing Education course on it. Here is the idea behind growing your portfolio using this tool;

Assume an investor has a $400,000 capital gain and incurs a tax liability of approximately $140,000 in combined taxes (depreciation recapture, federal capital gain tax, state capital gain tax, and net investment income tax) when the property is sold. Only $260,000 in net equity remains to reinvest in another property.

Assuming a 25% down payment and a 75% loan-to-value ratio, the investor would only be able to purchase a $1,040,000 replacement property.

If the same investor chose to exchange, however, he or she would be able to reinvest the entire gross equity of $400,000 in the purchase of $1,600,000 replacement property, assuming the same down payment and loan-to-value ratios.

As the above example demonstrates, 1031 exchanges allow investors to defer capital gain taxes as well as facilitate significant portfolio growth and increased return on investment.

You can grow a portfolio relatively quickly using this tool. Thinking macro, you can invest a set amount of money when you get that initial payday and grow it to the portfolio you want. It’s just a matter of time and what your goals are.

L. Creative Real Estate Solutions

Exchange meetings are set up all over the US through different groups thatise all related bythe membership. There are local/ regional groups and a couple of national groups. For Example; KREE (KY Real Estate Exchangers), OCREA (OH Commercial Real Estate Exchangers), NCE (National Counselor of Exchangers and SEC (Society of Exchange Counselors). These group are filled with highly knowledgeable investors and brokers on behalf of investors to utilize the 1031 rules and swap properties. This is where deals are made in a day or two, where creative minds gather to solve problems. It’s another place to grow your portfolio with great returns.

You can also find investors and developers to do joint ventures with. One example is a person owns a piece of property and they want to develop it but don’t have the cash and their credit is extended somewhere else and need a partner to come in and either borrow what’s needed or provide cash to be a partner in the deal. You don’t have to be hands on, just the money guy. You will get a preferred return and a large portion of the profit when it is sold.

Another creative way to be in real estate is to be a hard money/ bridge lender. This is a little more advanced than basic commercial real estate knowledge but in essence, you become the lender for a short period of time with the property given as collateral.

M. Picking the right real estate broker

I am putting this section in here because you will need help doing this, at least getting started. First, make sure you are talking to a commercial/ investment real estate broker. Do not try to do this with someone who sells houses and can sell commercial or has done a couple of commercial deals.

I would encourage you to meet with a couple of different ones to see who you are most comfortable with. Not everyone’s personality meshes. Some people don’t communicate in such a way you can understand each other. This is a part of your life where you want to be on the same page. Interview them with a simple question; how would you recommend I start and grow my real estate portfolio so that I have a reliable income from now until I retire?

N. Picking the right lender

Start with the bank you already do business with and have a relationship. They want to keep your business and will help you all they can. However, if you are purchasing out of the market, go with a local bank to the property. Your real estate agent should be able to point you in the right direction.

Depending on the size and type of property and deal structure there are different commercial mortgage brokers out there. Interview them in a similar manner that you do the real estate broker. Explain what your goals are to find out how far they can take you. The bigger your portfolio gets the more options you have for lenders. That is a good thing for you because it creates competition for your business.

In closing, I hope you find this information helpful and I have provided you with enough information to get you started on your real estate investing journey. If you have any questions or ever need my assistance, I will be happy to help.

To contact the author email him at [email protected]

©2019 Steven J Carmichael II (aka Jim) All Rights Reserved