Commercial Real Estate Investment Short Guide

By: Mac Autrey A brief intro into the world of commercial real estate investing.

2010

Investment Short Guide Outline

I. II. Intro Determine the Goal and Use a. Retail b. Office c. Industrial d. Multi-Family e. Mixed-Use III. IV. Importance of Representation Selecting Your Target Market a. Location, Location, Location b. Where are the Future Tenants?

V.

Analyzing Deals a. Return on Investment b. CAP Rates c. Gross Rent Multiplier d. New Development

Investment Short Guide Intro

Commercial Real Estate Investing can be simple if you have the right resources and tools at your disposal. Although the advantages of investing in real estate go far beyond cash flow, typically most purchases in this field are for the cash returns, so for the sake of simplicity we will focus on this aspect alone. The tools and resources that are needed before diving into your next investment will be first and foremost a clear goal to define the type of property you would like to purchase and the returns you would like to make. Secondly, it is very important that you find a professional in the commercial field who can assist you every step of the way. Investing without professional representation would be the equivalent of representing yourself in a courtroom without an attorney not a good idea! Selecting a target market will be your responsibility, and it is important that the target area you choose is in line with your goals. This will be discussed in further detail later, but once the target market has been selected you and your broker can go to work and find properties that fit your criteria. Many investors leave site selection up to their real estate agent, and will have the properties emailed to them with descriptions and pictures. As time is the most valuable asset of all, you can save a lot of time by sorting through the properties in your email and eliminating the ones you know you dont like. Through the process of elimination, you can choose the properties you like the best and arrange for showings at a time that is convenient for you. Investing in commercial real estate doesnt have to be complicated, and using the following short guide you too can enjoy the benefits that commercial real estate investing can create. Please keep in mind that this is a short guide and only scratches the surface of the

aspects and components of commercial real estate. The purpose of this guide is to give you a brief introduction to investing in the world of commercial real estate. Enjoy!

Determine the Goal and Use

The goal is as simple as buying commercial real estate and earning cash flow, right? Well, not exactly its important to further clarify how you would like to accomplish this. There are many types of commercial real estate uses such as retail, office, industrial, multi-family, and Mixed-use, among others. Each one of these types is completely different from the other, and this is why it is important to clarify your goal as to what you would like to achieve. For example; if your goal is to open a restaurant, you could not achieve that if you purchase an industrial building. However, if you purchase or build a building for retail use you could then open a restaurant and achieve your goal! This is why it is important to set a goal for the type of use you would like to purchase. Now, lets breeze through the types of uses you can choose within commercial real estate. To keep this simple only the most common uses will be described, and government uses and other special uses will not be included. Retail Retail properties are typically shopping centers and free standing buildings that allow the sale of merchandise or services. Tenants of these buildings would typically be restaurants, grocery stores, dry cleaners, clothing stores, jewelers, and other tenants that rely on the sales of goods. These tenants typically look for high visibility for their locations, so the best retail sites are on major roads that have good exposure to traffic. These are great investments, but are also the most at risk to market conditions. This is because in good markets people buy more merchandise and in the bad markets people tend to save more and spend less. Since tenants in retail rely on sales, this is a factor you must be prepared for.

Office Office properties are self-explanatory; they are built to suite office professionals. Tenants that perform more service related tasks such as attorneys, accountants, and call centers. Because the tenants use the space for their business operations as opposed to selling merchandise, they do not require the exposure that retail tenants require. Office tenants like to find space that can accommodate the needs of the employees, such as high speed internet, built in technology features, nice lobbies, and maybe a water view for the managers. Office buildings range from high rise buildings downtown to scattered buildings in an office park. Industrial Industrial buildings are sometimes considered the eye-sore of commercial real estate because of the unattractive exterior features. However, they can be one of the most stable investments of the categories discussed here. Industrial properties encompass a wide variety of property uses such as manufacturing, processing, storing, transporting, and research and development. Many large companies like Home Depot, Wal-Mart, and Microsoft, need warehouses to store, ship, and build their products from. There is also a hybrid use among industrial buildings which is often referred to as flex space. Flex space is both office and industrial, built for the tenants who need an office or showroom to work from, but also need the warehouse portion for industrial use. Industrial tenants are most interested in building size, ceiling height, and proximity to major road or railways. Multi-Family This category is a commercial use mostly due to its size. Any building over 5 residential units is considered multi-family commercial, and anything fewer than 5 units (such as a duplex) would be considered residential. Multi-family building examples would be apartment buildings and condo buildings over 5 units. Tenants of a multi-family building are mostly concerned with location, such as proximity to work and schools. Security is also a factor to be considered by the tenants. Is it a gated community in a good neighborhood; are there patrol guards on site? Etc. Mixed-Use Mixed-Use is a category of commercial real estate that allows multiple uses. For example: a high rise building that has residential condos on the top floors, offices on the middle floors, and retailers such as restaurants or gift stores on the bottom floor. Many communities have been developed with this use in mind, and some are commonly referred to as live-work-play communities for obvious reasons.

Now that you are familiar with some of the uses in commercial real estate, lets cover the importance of finding and using a qualified real estate agent that specializes in commercial real estate transactions.

The Importance of Representation

As previously mentioned in the intro, you wouldnt go into a courtroom without an attorney to represent you, as you shouldnt go into a commercial transaction without a commercial real estate agent. The truth is a qualified commercial agent will not only provide you protection in a transaction but he or she will help locate the properties, analyze them, create comparable reports, and in most cases negotiate a much better price for you as the investor. The agent should be local, since real estate is local in nature, and a reputable commercial agent will know all the other brokers and owners in the area, giving you an advantage when it comes time to obtain more info or make an offer on one of their properties. The best part about a commercial agent representing you as the buyer is the fact that its no cost to you since the agent is typically paid by the seller. A good agent will be able to compile all the properties that match your criteria into email reports giving you descriptions, addresses, pictures, and demographics of each property. This will save you a lot of time from running around city trying to filter through deals. Keep in mind that the demographic reports should be a key tool in helping you determine your investment area, because they will reveal all the ages, incomes, races, and population percentages in that particular area. The real estate agent will know this and typically advise you to read the reports so that you dont end up purchasing a property that cannot be supported due to the demographics. For instance; if you were going to purchase a retail building to put a high price restaurant in place and found that the average income in the area is only $20,000 per year, then

you know that the restaurant would not perform because the people in that area could not afford a high price meal very often. Many common mistakes such as this are avoided when you have a commercial real estate agent representing you, because they will educate you throughout the entire process of finding the property. Agents are great at site selection because they know the current trends, market rates, and future plans of their markets. An agent will also help look over purchase contracts to ensure that any clauses or contingencies written in by the seller are not biased towards the seller in a way that would be disadvantageous to you as the buyer. Statistics show that buyers who use a real estate agent typically save upwards of 20% on a purchase, compared to those who did not use agent representation. In large development deals or projects that would take up more than a considerable amount of time, many agents will require a retainer fee up front for their services so they can dedicate the time needed to that specific project. This is reasonable since the agent will have to temporarily put many of their other clients at bay until the project reaches completion. The value of having professional representation is endless, and having yet another resource to aid in the purchase of commercial real estate will ensure that your investment goals will stay on track. Delegation is the key here, and learning to delegate work to your agent will free you of time that you can use to work on other aspects of your investment goals.

Selecting Your Target Market

As repeated by everyone in the real estate industry, location, location, location. Location is possibly the single most important aspect of real estate, and determines the success of your investment. Invest in a bad area and you can expect bad returns, invest in a growing area and you can expect growing returns. To select a target market you should understand the trends,

growth rates of employment, housing starts, zoning changes, and anything else that will help you make a calculated decision. As stated previously, your agent can help tremendously here, but you want to be just as educated on your target market as anyone since you have the most to lose if things go wrong. Speaking with city and county officials will help build your knowledge on your particular area, and they will give tremendous insight as to the growth plans and changes that the government plans on performing. Many times you can ask for something called a comprehensive plan, which shows the different zoned areas in a color map of your particular area. Also known as a comp plan, it will show plans for your target market of up to 5 years. Having a goal in mind will help you to narrow your focus down on a specific target market. It may only be a 3 mile radius that you choose to become an expert in, or perhaps your goals are larger and involve new developments that will require you to expand your reach further than 3 miles. Either way, the importance of knowing your location is in understanding where the tenants and customers are located. If you plan to build a shopping center, you are going to want to locate tenants that would want to be in that center and pay you rent. This can be as easy as driving the area and seeing what tenants are in the current shopping centers. Existing tenants of other centers can be the best candidates as your future tenants, because many of them may either be unhappy with their current location or thinking of expanding and opening new locations. This goes the same for all property types, and you can find your future tenants from existing buildings in your area or target market.

Analyzing Deals
Now the fun part! You know what you want, where youd like it to be located, but need to know how much youre going to make. A few calculations could help you realize what your returns might be, as well as how much you should offer. Again, for the sake of simplicity these calculations and formulas are just a few of the myriad of ways to calculate real estate investments, and we will assume the following deals are cash deals with no financing. Before we begin, lets take a look at some of the most commonly used terms and calculations. Return on Investment (ROI) Referred to as ROI, this calculation is used to achieve a general idea of what the profitability of the investment will be. This is a simple way to calculate returns. The return on investment formula:

Because the formula is so general there is a lot of room for flexibility. Your gains could be a gross figure or a net figure or the cost of investment could include interest or materials. This allows you more flexibility in your calculations, but also leaves room for error, so be careful. Capitalization Rate (CAP Rate) The CAP Rate is a great tool for quickly calculating projected returns based on the income. This will help the investor to compare properties and find the most attractive one in less time. However, it should not be the only calculation used and instead should only be used as a quick analysis. This does not take certain factors into equation, such as growth rates or increase in property value. The CAP Rate formula: Capitalization Rate = Yearly Income/Total Value

Gross Rent Multiplier (GRM) The Gross Rent Multiplier is used to determine the value of an income producing property. Because only to pieces of financial information are used in the calculation it should be considered a rough estimate of value, but can be very helpful in making an investment decision. This formula could be analyzed by month or year, which ever you prefer. The monthly GRM is equal to the Sales Price of a property divided by the potential monthly rental income and the Yearly GRM is the Sales Price divided by the yearly potential rental income. See the examples below taken from Investopedia.com: Example 1: If the sales price for a property is $200,000 and the monthly potential rental income for a property is $2,500, the GRM is equal to 80. Monthly potential rental income is equal to the full occupancy monthly rental amount which assumes all available rental units are occupied. Sales Price GRM (monthly) = -------------------------------------------- = Monthly Potential Gross Income $200,000 --------------- = 80 $2,500

Example 2: We have several similar properties that have sold recently in the same area and their average monthly GRM is 80. We can use this information to estimate the value of comparable properties for sale. If our monthly potential gross income for a property is equal to $3,000, we would estimate its value in the following way. Estimated Market Value = GRM = 80 X X Potential Gross Income $3,000 = $240,000

Based on many of these calculations you can clearly see that commercial real estate investments are made and determined by the income of a property. When an investor buys commercial property they are looking to acquire and grow the income of the property to establish good returns on their investment. What if the investor was purchasing raw land for a development, how would they predict income then? Although real estate developing is a lot more risky, there is amazing returns that can be made like nowhere else! Because more risk is involved you should expect higher returns on your investment. Once you know your target market you will have a better idea of how much rental income you can command for your space. This will also give you more insight as to how much land you can afford. If you have figured that your new development will cost $1,000,000 total after land purchase and construction, and your expected income is $100,000 per year on the building, than you can assume to be making 10% ROI. You can reverse the figures to estimate how much you can afford on land and construction as well.

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Hopefully this short guide has shed some light on the aspects of commercial real estate investing. Now, you should have a brief understanding of the types of uses involved, how to apply each use, create financial goals, select target markets, and of course locate a qualified commercial real estate agent to assist you with all of this. The calculations and explanations were described in a very brief format, so be sure to seek expertise on the final figures of your project before proceeding with a purchase offer.

Written by:

MAC AUTREY Commercial Real Estate Specialist with Dunhill Properties, Inc.