Finding Your Niche...

It's been about nine months since my first post so I thought now would be a good time to check in. I closed on my first property last October. For the most part, my experience as a new investor, landlord and property manager has been enjoyable.

In my last post, I discussed the various considerations a new investor should weigh before diving in to the dark world of Real Estate Investing (REI for short).

If it wasn't obvious from my post, I placed a large emphasis on Commercial real estate as this was the segment I had become interested in. What I discovered though was that real estate is like any other industry with many segments and sub-segments. The first rule of product marketing is to understand your markets and segments and fortunately I had spent many years in Product Management so I was up to the challenge.

Gross vs. NNN

Before I jump into these segments I should provide a short primer on the various commercial lease options. As I discussed in my last post, one of the huge benefits of commercial investing is that tenants prefer to lock in low rates with a multi-year lease which reduces the risk of vacancies for landlords. Conversely, it also exposes a landlord to the risk of inflation. There are ways to minimize this risk based on your choice of lease structure. A Gross Lease, for example, requires the landlord to assume the maintenance and repair costs for common areas of a property such as the roof, landscaping, flatwork (sidewalks and parking lots), utilities that are not separately metered, and the biggest expense of all - property taxes. A Triple Net lease (NNN for short) however places all maintenance and repair costs in the hands of the tenant. As you can guess, shorter term leases for say two to five years tend to be written as Gross leases since the landlord can raise rental rates to keep up with inflation and market changes. Longer term leases can extend as far in to the future as 20 or 30 year terms. These longer term leases have the greatest exposure to inflation and are usually written as triple net leases with regular price increases laddered into the lease agreement.

Which Markets, Which Segments?

The first question I needed to answer was which part of town I wanted to invest in. I live in a suburb of Dallas called Lewisville. The northern suburbs are growing rapidly due to the investments being made by many large corporations. In general, all of Dallas is benefiting from this though. I wanted to find something close to my home so that if I had to tend to an issue at the property, I wouldn't have to drive 45-minutes away. For the life of me, I can't understand how some investors can purchase a property site unseen in a city 400 miles away. This seems irrational to me but its absolutely normal now due to the growth of the internet and it forces local investors, like myself, to compete with someone in New York or California. In any event, I found a property in a city close to my home that is going through a revitalization. I didn't realize though until after I purchased my property that my tenants and prospective tenants like it just as much which makes me happy! My vacancies are low and I have my prospects asking me if I own any other properties so there's the potential to build a niche around feeder properties as long as I can find the right tenants (and more properties like the one I bought).

As I was searching for my first property I realized that there were many distinct segments within Commercial real estate and I needed to narrow down my market and niche. In the broadest sense, commercial properties can be classified by use and/or by tenancy. Usage types might include Retail, Industrial, Office, and other non-residential (think car washes) while tenancy is viewed as either single tenant or multi-tenant. Since this was my first property and my first adventure into property management, my primary focus was on finding a multi-tenant property to minimize my risk of vacancies.

Retail

Retail properties are usually classified by either single tenant or multi-tenant uses. A good example of single-tenant retail properties might be a restaurant space. There are both pros and cons to a freestanding restaurant. The pro is that leases tend to be very long-term for 20 or 30 years with additional options to extend the lease out even further. These type of properties also tend to sit vacant longer when a tenant moves or closes its doors. One property I was interested in for example was a fast-food restaurant in an affluent and high-growth part of the metroplex. There was 10-years remaining on the lease and it was backed by the security of the parent franchisor. There were also four 5-year lease options in the agreement which potentially extended the lease another 20-years. Sounds great right? Commercial loans are usually only extended for maybe five or seven years. The owner can usually refinance of course, however there is a risk of rising interest rates. Also, the likelihood of a bank refinancing the loan on a property that will go vacant in the future for a year or longer is extremely low. I would have had a large balloon payment due after seven years that I couldn't afford. But what about the four 5-year extensions? There is no guarantee the franchisor would extend. A visit to the restaurant showed that the building layout was an older footprint for this franchise. Since this store was located in an affluent and high-growth suburb, there was a high probability that the parent franchisor would want to abandon that location and build a newer store in a newer section of the suburb to better represent their brand. I obviously passed on this deal.

Multi-tenant retail properties are probably the most common as they exist on almost every street corner. The quintessential strip mall comes to mind. These properties are home to a variety of mom and pop retailers from doughnut shops and convenience stores to Chinese food, nail salons, and dry cleaners. These are attractive properties for new investors provided there is availability. Even though there is a plethora of strip retail everywhere, owners tend to keep these properties in their portfolios into eternity. Since you as a landlord are most likely dealing with small entrepreneurs who have only just opened their doors, the greatest risks for properties of this type are frequent vacancies, high marketing expenses, aging Accounts Receivables and high uncollectibles. The benefits of this property type of course are that due to a wider coverage of tenants you will typically have enough cash flow to at least breakeven if not exceed expenses in any given month.

Office

Commercial office space is a broad classification that can range from large single and multi-tenant professional office buildings to smaller multi-tenant office condos, medical offices and free-standing office space. Large single and multi-tenant professional office buildings are out of reach for most individual investors so I will skip through this category. Medical office spaces is one segment that interests me due to my background in Healthcare IT and Administration. With the rapid changes occurring in Healthcare, this type of property seems low risk due to the demand for providers. You have professional tenants that require a stable long-term location at frequent renewal periods allowing you to raise rates with each renewal. Physicians are an affluent group so you are likely to have stable cash flow as well. There is a great deal of pressure however to maintain appearance of common areas and modernize. Smaller professional office space (Accountants and Attorneys) is ideal also for the same reasons, however in some cases there may be additional expenses associated with equipment such as elevators and hot water heaters.

Industrial

As I was first evaluating Industrial space, I was very skeptical of this property type as an investment because of my unfamiliarity with it. The first thought that came to mind was manufacturing and distribution warehouses which can go vacant for long periods of time especially during a downturn in our economy. There's a high correlation between our economic cycles with manufacturing and distribution. What's appealing about this type of property though is the stickiness that is created due to the nature of manufacturing operations. Many manufacturers and distributors require heavy equipment which is accompanied by costly moving expenses so these tenants will remain for years, provided they have ample space to expand. Large warehouse spaces usually require large capital investments so just like large professional office space, it is out of reach for average investors.

Enter Flex and/or office-warehouse space. The concept of Flex space is unique in that the property type is not tied to a single use, rather it is a combination of both warehouse space and office space. The space is flexible enough to house both under one roof. The front area might house an air conditioned office while the rear will have garage access to a warehouse. This type of unit can range in size from large 50,000 to 60,000 square foot office/showrooms with loading docks to smaller 800 square foot office/showroom spaces with ground level garage entrances. They can serve either single tenant or multi-tenant dependent on the size of the building and the tenant needs.

Finding my Niche

When my realtor presented the 6,000 square foot multi-tenant flex space to me, I felt disdain for the property. However, the open-minded individual that I am, I evaluated the property objectively since it was a multi-tenant opportunity. I was pleasantly surprised to say the least, when I saw the prospective returns. The building was 30+ years old but very well maintained. The roof had been replaced two years ago and had a 20-year warranty that accompanied it. The property was 88% occupied and tenant leases ran for two-years. The short-term opportunity was in filling the one vacancy and raising rents as leases came due. The longer-term opportunity however has to do with the fact that this building is in a historic part of town that has a large redevelopment effort behind it. The property is only a block away from a new public transit depot and the area is slotted for multi-use pedestrian purposes (retail on bottom with condos and apartments above) which is the new rage in Dallas. It would be highly desirable for a large developer to come in and buy out all the properties around the area to build condos and retail.

After I assumed ownership & management responsibilities, I was able to lease the vacant unit to an existing tenant which fixed my vacancy problem. Things haven't been all roses though. I did encounter some issues over the last seven months such as slow paying tenants with one in particular that moved out in the middle of the night. No damages were sustained and I was fortunate enough to fill that vacancy in less than a week with a better tenant that was willing to pay in advance every 3-months. His business is flourishing as a result because of the area. My product is in low supply for the area. There is not much office/showroom space available in the under 5,000 sf category which is ideal for the startup blue/white collar entrepreneur.

So Now What?

Now the search is underway to find my second property. I'm finding that the search and acquisition process is the most difficult part of finding a new investment property. I found another property in close proximity to my first one however it was a single tenant automotive property. I was under contract and had a Phase 1 environmental analysis performed due to the paint and body operations on site. The Phase 1 came back recommending further analysis since they found about a dozen 55-gallon drums of paint thinner abandoned and exposed to the elements. Neither the seller or tenant were willing to assume liability for the clean up so I broke the contract and started searching again. I was lucky enough to find a small two-tenant retail property in an older part of town with two national tenants occupying the space. I'm under contract now and we will have to wait and see. What I like about this property is the multi-tenant nature of the building and it's small enough to manage for my first entry into retail strips. Stay tuned for more as I update you on the progress!!!