Commercial real estate is becoming increasingly popular with fix-and-flip investors due to the potential for bigger profits and higher returns per deal. Compared to residential properties, commercial also has less competition because of a smaller pool of potential purchasers. Commercial buyers have more negotiating power, which may translate into enhanced flipping profits. At present, while home inventories remain tight, many markets still have large pools of distressed and commercial REOs. This is in contrast to most US cities, where the most desirable houses have already been flipped and single-family home investors have few remaining choices.
If less competition and the potential for greater profits sound appealing, here is our advice for flipping commercial properties:
1. Network with commercial brokers, bankers, leasing agents, realtors and attorneys.
The easiest way to find bargains is to seek out commercial property owners struggling to pay their bills. There are real estate attorneys who specialize in helping owners of distressed commercial properties and networking with these lawyers can be a great source for new business leads.
Another source for leads is banks that own distressed commercial properties. Banks are usually eager to sell and thus avoid the high costs of a foreclosure (i.e. legal, commercial brokerage and property maintenance fees). Other deal sources include commercial realtors, brokers and leasing agents. These individuals know their local commercial property markets and can help you secure tenants and buyers.
2. Know the property types.
A general rule of thumb is that local supply and demand determines commercial property values and rental rates. Areas that have few commercial properties available and high demand for space support rising values and high rental rates. The ideal commercial property is located in an area where vacancy is low and space available for new development is limited.
Different commercial properties types must be analyzed separately, however. Commercial real estate is an umbrella term for office, industrial, retail, multi-unit apartment and mixed-use properties. Attractive office properties are centrally located with plenty of parking. Industrial buildings should be sited near major roads and/or rail terminals and have large, well-maintained loading docks. Retail properties should have good visibility and, in the case of strip centers or regional malls, plenty of foot traffic.
3. Commercial properties are valued differently.
Unlike single-family homes, commercial properties are rarely valued using the comps method. Instead, commercial properties are usually valued based on 1) cap rates, 2) gross rent multipliers and 3) cash-on-cash returns.
Cap rates are calculated by dividing the property’s price by its net operating income. For example, the cap rate on a $1 million property generating $100,000 of annual income is 10%. Cap rates measure investor returns on a debt-free purchase and tend to be higher for riskier properties. Cap rates are affected by the type of tenant and its credit rating, lease terms, property condition and the strength of the local market.
Gross rent multiplier is measured by dividing the property’s sale price by its gross rental income. This metric is sometimes used to screen for properties that are bargain-priced relative to their earnings power.
Cash-on-cash returns are figured by dividing the property’s pre-tax cash flows by invested cash. For example, a property generating $50,000 in cash flow and purchased for $1.0 million ($800,000 debt plus $200,000 equity) has a 25% cash-on-cash return ((50,000/200,000 = 25%). The advantage of this formula is that it takes into account debt financing; a drawback is that only one year of cash flow is considered.
4. Lease-and-hold may be better than flip.
For investors purchasing a commercial property in a recovering market, leasing may be a better strategy than flipping since property values could increase substantially as the business climate improves. Commercial real estate typically provides more cash flow and higher yields per square foot than residential properties.
In addition, upgrades to commercial properties are handled differently than residential properties and may reduce upfront costs. Commercial tenants usually want properties remodeled to fit their specific business needs. For example, a baker will need a different layout than an apparel retailer. Commercial property owners should avoid making long-term alterations to the property that may reduce the chances of finding new tenants. After a tenant is secured, the landlord should set lease terms that incorporate tenant remodeling costs.
Even if you prefer flipping to leasing, it’s still advisable to get the property under contract and secure a suitable commercial tenant willing to sign a lease before making major changes to the property. Remodeling costs should be built into leases, not taken upfront.
5. Loan terms are different.
The good news for borrowers is that financing a commercial property is often easier than financing a home. Lenders have more flexibility due to fewer regulatory constraints. On the flip side, commercial property loans often have shorter terms (5 to 20 years) and balloon payments due at the five or ten-year mark. Most investors refinance the loan when balloon payments come due, but that strategy can backfire if lending markets tighten.
6. Expect a longer sales cycle.
Another major difference between commercial and residential is that commercial property sales usually take longer. A rule of thumb is 6 months or more to flip an industrial space, 8 months for office space and 12 months for retail space.
All Things Considered For Commercial Real Estate Fix & Flips
Generating profits from commercial property flips requires the ability to spot bargains and/or improve cap rates. Reducing cap rates can be as easy as securing good tenants under long-term leases. The main drawbacks to commercial flips are a bigger time commitment and greater deal complexity. Commercial properties often involve multiple tenants and leases and more property maintenance. Purchases are more complex due to high capital costs, permits and contractual agreements that must be dealt with upfront. There is also risk of tenants moving or going out of business, but these can be minimized by carefully screening tenants for stable incomes and writing long-term leases. To learn more about financing commercial property flips, contact a lender at Socotra Capital.