Commercial Real Estate Course - Part 1
In 2005 I wrote an introductory course on commercial real estate investment. This 5-part course was received via email in daily installments. On re-reading this course, I can see that my thinking has shifted slightly over the last few years. For example, in this course I explain that I like to hold both residential and commercial real estate, whereas today I prefer to hold a pure commercial portfolio. Having said that, I still stand by the contents of this course. Many readers have written to me that they found this course to be a useful starting point with commercial real estate investment. Let’s begin! Here is Part 1.
Commercial Real Estate: How To Invest Like The Rich
Part 1: Why Commercial Property?
There’s a lot of money to be made when you invest in commercial real estate. I believe it is the key to creating streams of cash which automatically flow into your bank account, month after month.
Yet, if you’re like most real estate investors I know (including those of you who are not investing right now, but plan to in the future), you’re looking exclusively at residential housing, and are not considering commercial real estate for yourself.
Later, I will show you just how much money you can make with commercial real estate. But for now, let’s look at:
- why most people don’t invest in commercial real estate
- why YOU should!
1.1 Why don’t people invest in commercial real estate?
I strongly believe that we learn from people around us - our family, our friends, our colleagues, and so on. Truth is, not very many people invest in commercial real estate. This means that the rest of us just don’t get exposed to it.
1.1.1 Pre-conceived Notions
Because we’re not exposed to it, we are stuck with pre-conceived notions about commercial real estate, which prevent us from ever considering the possibility of owning it. Some of these notions (or superstitions) are:
- commercial real estate is only for rich people
- commercial real estate is risky
- commercial real estate is boring (who wants to own a shed, when you can own an apartment with a water view?)
- commercial real estate is complicated
Well, this course will clear up any misconceptions you might have.
1.1.2 Lack of Familiarity
Like I say, we’re just not familiar with commercial real estate. Most of us grew up in a house or an apartment. We know what they are, we are comfortable with them. But we don’t feel the same familiarity with a commercial property.
But in fact, you’re already way more familiar with commercial real estate than you think. Every time you walk into a shop, a mall, an office, or a warehouse, you’re walking into a commercial property.
I promise you, you are going to start noticing commercial property more and more after you finish this 5-part course. You’ll notice when they’re for sale, you’ll notice when they’re for lease, and you’ll find yourself driving past shops and industrial buildings, and wondering who owns them.
1.1.3 Lack of Information
When I go into my local bookshop and go to the investment section, I see a mountain of good, bad, and indifferent books dealing with residential real estate. But there is almost nothing available out there on commercial real estate.
The last time I actually found a book about commercial real estate, I immediately bought it, without even looking inside. But when I took it home, I was very disappointed. It was written by a man who had NEVER purchased or owned a commercial property. His ‘research’ consisted of talking to a few people who had done it. In his conclusion, he said that he was now ‘planning to buy something’.
In one section, he listed a whole lot of ‘rules’ for buying commercial real estate. If I had read his book first, I never would have bought anything! I think I broke all his major rules with the first property I bought. Yet I’m still alive, and making money!
Some expert, huh? The same man had written a book about the stock market. I found myself wondering if he had ever bought any stocks!
So, you have to be careful who you listen to. There aren’t many knowledgeable people talking about commercial real estate. A lot of the people who really know about it are too busy to write about it!
1.1.4 Expensive
A second reason that we’re not familiar with it is that commercial real estate can get expensive very quickly. Now I want to clear up any concern you might have about this straight away.
There’s a big belief out there that commercial real estate is only for the rich. Well, it’s just not true. If I look in my local paper, I find a lot of commercial properties under $100,000. I find some storage sheds for less than $15,000! Given that you should be able to borrow 70% of the purchase price, and there are some creative ways to come up with the other 30%, the entry cost into commercial real estate may be much lower than you think!
I started, and still operate near this lower end of the market. The average value of my commercial properties is around $500,000.
There are people, companies, groups, trusts who regularly purchase properties for $5 million, $10 million, $50 million, and higher. I am not in that category yet. I love Donald Trump - I always find him really interesting to listen to, and also I think he’s a funny guy, whether he means to be or not. I really admire him. But I’m not sure that when he talks about real estate, the average investor can listen without tuning out, and having their eyes glaze over. He talks about deals which are so big that the average investor just shuts down their brain.
So there are not many people at the lower end who are taking the time to talk about what they’re learning, and what they’re doing.
1.1.5 Requires Mental Leap
That’s where I come in. Like most property investors, I started off investing purely in residential real estate, because it was all I knew about. After educating myself some more, I switched (and I believe it took a mental leap) to commercial real estate. Now I invest in both. I find it really useful to hold a mixed portfolio. I talk more about how why I hold both residential and commercial in part 4 (hint: it’s to maximize how quickly I can buy my next property).
1.2 Why should YOU invest in commercial real estate?
There are a number of reasons I think it’s worth considering commercial real estate.
1.2.1 Higher Cashflow
In general, commercial real estate provides higher cashflow.
For example, based on their current valuations, across my portfolio:
- my residential properties yield an average of 6.1%.
- my commercial properties yield an average of 11.5%.
Clearly, my commercial properties return more cash, for the given capital value. Now, the actual returns I’m getting are much higher than that, because I purchased them at lower prices, plus I’m using mortgages to give me more leverage. But I talk about that later in the course.
This is true in general. While actual amounts will vary, commercial real estate generally provides a greater rental for the same purchase price than residential.
That’s more money in your pocket!
1.2.2 Longer Leases
Usually, my residential tenants can leave within a week or two of giving notice, leaving me with an empty property, and the task of finding a new tenant.
Not so with commercial real estate - I’ve locked those guys in for years!
1.2.3 Tenant Pays Costs
For my residential properties, I have to pay a lot of additional costs:
- water
- insurance
- rates & taxes
- maintenance
One of my houses even has a poorly constructed pool. I just got a bill for $7,000! That wiped out most of the income I was due to receive from rent for the entire year. I am regularly paying plumbers, electricians, handymen, to fix all sorts of problems.
With my commercial properties, the leases specify that the tenant pays all outgoings.
Every time I get a bill, I just put it on the fax, straight to the tenant. The only bill I personally pay is the insurance (I don’t want to risk the tenant forgetting to pay it). But I make sure I pass the expense directly onto the tenant.
Also, the tenant has a much greater incentive to keep the property in good shape. If the painting looks poor, a door falls off its hinge, usually the tenant rushes out and fixes it without even telling me. Why? Because:
- the lease specifies that it is the tenant’s job
- the tenant is trying to run a successful business, which often includes attracting clients and customers. Having attractive premises is more important to the tenant than to me!
1.2.4 Stronger Legal Position For Landlord
Residential tenants are usually covered by government laws, which cover how long they can avoid paying rent before you can take action. Often, these laws have been written to prevent nasty, greedy landlords from taking advantage of poor battling tenants. After all, you’re dealing with people’s lives.
With commercial properties, your tenant is more often a company, although you may have personal guarantees from individuals involved. Commercial Leases are usually drafted in a way that protects landlords. With my shops, for example, if my tenant falls two weeks behind in rent, I can lock them out of the building, and start selling the contents of the shop! Try doing that with a residential tenant! That would be called stealing.
I can charge penalty interest if rent is otherwise late. If I have to take legal action (eg writing a letter) to recover money, then tenant has to pay my costs. The leases are structured so that the tenant has a huge incentive to stay up-to-date with all his obligations. I recently had a tenant who had to re-mortgage his house so he could continue to pay what he was contracted to pay me.
This might sound nasty, but it’s not. The tenant has entered into a legal contract with me. It is their job to pay what they owe me. It’s nothing personal.
I sleep better at night having a thick lease in my filing cabinet which protects me from tenants who would avoid paying rent.
1.2.5 Easier To Purchase Significantly Undervalue
I give a great example of this in part 3 of this course, where I bought a property for $100,000 less than market value. And the seller was completely happy!
My personal approach is that I always want the seller to be happy with the price I pay. I don’t want to leave them feeling ripped off, or like I’ve stolen from them. I’ve found with residential properties, the seller likes to haggle over every single dollar. On the other hand, with commercial real estate, often the seller has very different concerns. They might not even bother to haggle about tens of thousands of dollars. This may sound unbelievable, but it’s true.
1.2.6 Play A Bigger Game
I found that looking at commercial real estate has changed my relationship to money.
When I used to invest exclusively in residential real estate, at the back of my mind I used to consider whether I, personally, could pay the mortgage.
Now, with commercial real estate, I owe bigger amounts. Each year, my interest bill to the bank is much higher than my personal salary! That means that there is absolutely no way I could pay the interest on these properties myself. I absolutely depend on the rental income each property generates.
When I first had more debt than my salary could pay, something ‘clicked’ in my head. I suddenly realized that there were no more limits to the size of property I could own. I began to realize that I could hold any size property, so long as it reliably generated more income than it cost to hold it.
My game changed from ‘how much property can I afford’ to ‘how much can I get the bank to lend me?’ If you’re not used to debt, and are not comfortable with this idea, don’t start worrying yet. As this course continues, I will keep speaking about it, and you might find yourself getting used to the idea. In fact, you’ll see how the more properties you own, the safer your position becomes.
1.3 Stick a fork in me, I’m done
That’s the end of part 1 of my 5-part mini-course. I have just shown you why I think commercial real estate is worth considering, even if nobody you know is talking about it.
When you start investing in commercial property, it is certainly a different game. But if you’re reading this, you’re up to it.
Next I will talk about a magic little thing called capitalization rate. This little number is the key to finding telling good deals from mediocre deals.