The commercial real estate market in Lancaster County is sizzling hot these days! The historically low interest rate environment is playing an important role. Plus, investors are a bit anxious about the uncertainties associated with capital gains tax rates and are looking to shelter as much as they can prior to a potential hike in tax rate. Investors are also selling their properties at record high prices which results in even larger capital gain and the vicious cycle continues.
Below is some food for thought that we like to present to our investor clients:
Be an investor, not a collector of real estate
It’s plain and simple – investors of commercial real estate need to make a profit, either on an ongoing basis via cash flow or through appreciation, and hopefully through both channels. Commercial real estate properties are also expensive assets to maintain. There are significant costs involved such as real estate taxes, building insurance, common area maintenance, costs involved with leasing and property management, etc. So, unless they generate a profit, commercial real estate properties are not good collectibles!
Be mindful of your investment goals
You may have heard the adage “The money is made at the acquisition”. There is some serious truth to this. Acquisition is strongly dependent on your investment goals. Are you in it for the long haul? Do you have significant “patience capital” or is your investment timeline only a few years long?
Appreciation in real estate values typically takes a significant amount of time and may not be appropriate for an investor proforma with shorter timelines.
Is your investment focus to shield taxes or realize cash flow? If mainly the former, keeping track of changing tax laws especially those related to tax-deferred exchanges can be important.
If you are looking to finance the acquisition, financing terms such as any prepayment penalties, interest rates, etc. will come into play in keeping with your investment goals. For example, if you are planning on selling the property relatively quickly, having pre-payment penalties in place is not a good place to be.
Get your team in place prior to the acquisition
Who will manage the property once you purchase it? Will you hire a property manager? If so, have you taken these costs into account in your evaluation of the proforma? Owners who self-manage their investment properties often don’t take these costs into account.
Will you require any vendors to help maintain the property? This is less of an issue with triple net lease investment properties since it is the tenant’s responsibility to maintain the property. However, multifamily assets are usually more management intensive where having the appropriate team in place is very important.
Many investors like properties that provide value-add opportunities. Some examples include additional land for potential expansion, below-market rents in place that can be easily increased with minor renovations or repurposing the property to suit a specific tenant’s needs. It is not uncommon for developer investors to have a tenant or tenants lined up prior to closing on the property.
Tenant Acquisition and Retention Costs
Investment real estate is typically purchased in one of two ways – 1. with a tenant or tenants in place, 2. vacant or speculative without a tenant in place.
As might be expected, properties with existing, financially strong tenants are more valuable than vacant properties. In Lancaster County, we find that national credit tenant-occupied properties sell for low cap rates. Properties occupied by medical tenants also tend to be desirable.
As an investor, if you are considering a vacant property purchase, please keep in mind the costs involved in finding and leasing to a tenant. Some of these costs include broker commissions, attorney fees to negotiate leases, property management fees to manage the property, etc.
Considering the costs involved with acquiring new tenants, landlords favor retaining good quality existing tenants. It is important to negotiate the lease terms properly upfront to ensure long-term favorable tenancy.
Altering lease terms is difficult
If you are purchasing an investment property with a tenant or tenants in place, you will inherit the lease(s) in place as well. Existing lease terms can be altered by mutual consent with tenant. Hence, it is important to carefully review the leases during the due diligence period prior to purchasing the property. Just like anything else that can be negotiated, a new landlord could renegotiate a new lease with the existing tenants. One could offer tenant improvements for increased rent or rent concessions for an increase in term.
Another situation that provides an opportunity for renegotiating lease terms is a sale-leaseback scenario. The owner of a property sells the property to an investor and leases back the property in a lease arrangement with the new owner. The sales and leaseback terms typically get negotiated simultaneously in this scenario and it is a bit of a see-saw effect. Higher leases can justify higher purchase prices and vice-versa.
Be mindful of lease expiration dates
Depending on the type of property, amount of space to be leased, etc., it is a good idea to have conversations with your tenant 9-18 months prior to lease expiration. This strategy not only allows ample time for any negotiations, etc. but also provides the landlord with sufficient notice to find a new tenant if the existing tenant is not intending to renew their lease term.
It is also a recommended practice to include appropriate notification periods in a lease. We have come across leases where tenants have the right to “hand over the key” to the landlord at the end of the lease term without any prior notification needed. Depending on the term of the lease, it is not unreasonable for a landlord to include a 6-12 month notification period for tenant to renew their lease if they wish to do so.
Also, carefully track other lease milestone dates such as any tenant rights to expand or contract their space, requirement for tenant to provide financials, etc.
When investing in commercial real estate, certain factors are more important than others, depending on the type of asset. It is our pleasure to help you navigate the process.