May 7, 2022
Joe Fairless

JF2804: Why Invest in (Non-Residential) Commercial Real Estate? | Beyond Multifamily with Ash Patel


Welcome to the first episode of Beyond Multifamily, hosted by non-residential commercial real estate investor and Best Ever Show host, Ash Patel. Ash’s goal for this series is to introduce you to the world of non-residential commercial real estate investing and teach you how to look at and underwrite different commercial asset classes. In today’s episode, he shares the top seven reasons why he invests in non-residential commercial real estate, and why he thinks you should expand your horizons and do the same. 

 

7 Reasons to Invest in Non-Residential Commercial Real Estate

 

1. Less competition. Ash gives two reasons for the lower competition: financing and mindset. While multifamily investors have ample access to brokers, agency debt, and bank loans, non-residential commercial investors often have to go through local lenders. Additionally, residential investors are often stuck in the mindset that non-residential commercial investing is too expensive, difficult, and risky, which Ash explains isn’t necessarily the case.

 

2. Quality of tenants. Because commercial real estate tenants are typically business owners, they use your space minimally compared to apartment or single-family tenants. They are also more likely to fix any wear and tear with their own money. 

 

3. You’re not bound by rent comps. Multifamily apartment investors have to price their units based on comparable properties in the area. Not so with commercial real estate. “It doesn’t matter what anything around you has sold for,” Ash says. “It matters what your NOI is and the quality of your lease and the quality of your tenant.”

 

4. More notice before a tenant leaves. Commercial real estate tenants often give at least a six-month heads-up on whether or not they plan on renewing their lease, which gives you a minimum of six months to find a new tenant.

 

5. Fewer evictions. In the 10 years that he’s been investing in commercial real estate, Ash has never had to evict a commercial tenant — and many other investors have the same experience.

 

6. Easier management. There is little to no management overhead when it comes to commercial real estate compared with apartment complexes that require a leasing specialist and full-time on-site maintenance. Most commercial leases at the very least include a clause where the tenant is responsible for the first $250 for things like plumbing and electrical repairs, so often, you won’t even hear from tenants about smaller issues.

 

7. More variation. “I don’t know that I could sit there and look at 100 different apartment buildings where they all just have small similarities,” Ash says. “How many differences do you see in Class C apartments from one to another? With commercial properties, I can look at 1000 in a day, and it’s just exciting.”

 

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TRANSCRIPT

Ash Patel: Hello Best Ever listeners. Welcome to The Best Real Estate Investing Advice Ever Show. I'm Ash Patel and this is Beyond Multifamily, where we discuss topics other than multifamily investments. Today, I'm going to share with you why I invest in commercial real estate and why many of you should expand your horizons and consider doing the same. Keep in mind, when I say commercial real estate, I'm talking about non-residential commercial real estate. Also, just for reference, I've been a non-residential commercial real estate investor and active investor for over 10 years. I've also invested in single-family homes, multifamily, mixed-use, and I've also been passively investing in multifamily syndications since 2015.

The first reason I think you should explore investing in commercial real estate - there is less competition. Today, multifamily has become extremely competitive, properties are going under multiple offers, people are putting hard, earnest money on day one, there are institutional buyers competing for deals, and cap rates are in the threes. It seems like everybody wants to become a multifamily syndicator. So why is there less competition in commercial real estate?

Number one, it's more difficult to obtain lending for commercial properties. Multifamily lending has almost become commoditized. There are brokers, there's agency debt, and a lot of banks would love to do multifamily loans; it just isn't the case with commercial. We don't have a Fannie and Freddie or a secondary market as big as multifamily. Often when we do loans, we have to find local lenders. Lenders that are local to the property that we're buying, or a local lender local to ourselves, that we've built a long track record with and that will allow us to invest in out of state deals with them.

This isn't the case all the time. If we buy a Home Depot, a Starbucks with a 10-year lease that was just inked, you can pretty much go to any bank and get the loan terms that you want. Anything beyond that - value-adds deals - it's usually a local lender. We'll do another podcast on that. It's a whole different ballgame with commercial real estate and getting local lenders.

Why else is there less competition in commercial real estate? Mindset. What does that mean? For years, I've tried to convince residential investors, multifamily investors, wholesalers even, to look at commercial real estate. One of the biggest objections that I get is, "It's too much money, it's too difficult, it's too hard, it's too risky." Let's start by addressing some of these... It's too riskY - Yes, there are different levels of risk. With multifamily, you have class A, B, C properties, and the risk is varied with each level. With commercial real estate, it's the same thing. You can buy a Starbucks that's a class A property; they just signed a 10-year lease, and there is very little risk if any of that location going dark. That corporate guarantee on that lease means Starbucks is going to continue to pay you for 10 years, whether they operate there or not. The only way they're typically allowed to get out of that is if the corporation declares bankruptcy.

"It's too expensive" is often another objection to why people don't explore commercial real estate. Let's talk about that. Just about any city, if you take a higher-end home, I can find you a commercial property for about the same price. The beauty of that is those properties often have less competition. An out-of-state buyer is not going to invest just $200,000, $300,000, $400,000 in a mom-and-pop commercial building. But somebody local that has boots on the ground is more apt to do that. The returns are often much higher because the risk is marginally higher and the competition is significantly less.

Then there's "It's too hard," and that one actually has a bit of merit to it. There are not many good books written on commercial real estate, compared to Joe Fairless wrote the Bible on apartment syndications. I've interviewed a number of people that literally just read that book and they're very, very successful syndicators based on that. I have yet to find a comprehensive book on commercial real estate.

If you look at the number of masterminds, meetups, conferences, and boot camps, all centered around single-family or multifamily, they're everywhere. I know very, very few on the commercial real estate side. I will give them that. Commercial real estate does have a steeper learning curve and because of that, the complexity keeps competitors away. There's less competition because there's a steeper learning curve with commercial real estate.

My goal with creating these beyond multifamily podcasts is to give you that knowledge so that you can actively or passively invest in commercial real estate. Another myth about why you shouldn't invest in commercial real estate is there's the retail apocalypse, or the Amazon effect where Amazon's going to destroy all the retailers. I've got to tell you, during COVID, we saw suburban downtowns just explode with growth. People realize they no longer need to go to city centers to get their nightlife, the entertainment, their meals. Suburban downtowns are the new hotspots where the bars, the breweries, the restaurants, all the nightlife, and the walkable shops are popping up. Those will always be there.

We had a huge shift in population from city centers to suburban locations and even rural locations. Think about your suburban downtown or even some of your rural locations. That mom-and-pop deli, the pizza shop, the pharmacy, the dentists, the hair salon, the barbershop, the dog groomer, the veterinarian, those neighborhood services are always going to be there. They're internet resistant, they're typically recession-resistant, and there's always going to be a need for them.

We will discuss office and addressing vacancies in future podcasts. I want to get back to you about why I think you should invest in commercial real estate, give you more ammunition. One of them is the quality of tenants. Commercial real estate tenants are mostly business owners. They use your space minimally compared to apartment dwellers or single-family tenants. They often don't sleep in the buildings, they don't shower in the buildings, there's no pets, there are no kids, and there's usually no cooking. Any wear and tear is usually remedied by the tenant because they take pride in ownership of their space.

If they have customers coming into their space and something's worn out, they will often address it themselves. The beauty of it is they often do it on their own dime. I can't tell you how many times we've given a tenant just a white box, or not even a white box, but unfinished plywood floors, primed drywall, or just taped drywall. Some of these tenants have transformed these spaces into incredible photography studios, boutique stores, hair salons, and they do it often on their own dime. Can you imagine one of your residential tenants remodeling a bathroom or painting a kitchen just to modernize it? It doesn't happen. With commercial real estate, it happens often.

Break: [00:09:50.29] - [00:11:37.13]

Ash Patel: Another benefit of commercial tenants is there are often multi-year leases with guarantees. Now, let's contrast them with residential. Typically, every apartment or single-family homeowner is going to sign a one-year lease. If they leave early, there's often little recourse or it's just not worth pursuing the lost rent. With commercial real estate, the leases can be anywhere from one to 10 years or more and they're often guaranteed.

What does that mean? If a corporation signs a lease, that corporation often guarantees the length and term of that lease so no matter what, they are responsible for that payment. Now, there are different levels of guarantees. You can have a mom-and-pop tenant, that gives you a personal guarantee on their lease. Now, granted they are on the hook personally for the performance of that lease, the complexity there is are you really going to sue a mom-and-pop tenant who just went out of business. You have to take that into consideration when you're purchasing a property or underwriting a property. Length of the leases and the guarantee of each lease.

There is an important similarity between investing in commercial and residential properties. That NOI and cap rate are largely used to determine the values of the property. However, with commercial real estate, the quality of the tenant plays a huge role in that factor. What do I mean by that? Imagine in your high-rise apartment building, your tenants include Michael Jordan and Taylor Swift, I bet people would consider paying extra to live in the same building and get some bragging rights or whatever it may be.

With commercial real estate, our celebrities are Dollar General, Starbucks, Chipotle, the higher quality tenants will command a much better sale price. If you have all mom-and-pop tenants in either your office building or your industrial building, warehouse, or retail center, your cap rate is going to reflect that. It's not going to be as low as if you had a Starbucks or a Chipotle. The reason for that is those companies will have guaranteed leases. They'll have longer leases and there'll be corporate guarantees on them.

This again is a benefit and a complexity. You can have a mom-and-pop retail center that's bringing in $100,000 in NOI. You can have a class A all-national tenant's retail center that's only bringing in let's say, $65,000 or $70,000 in NOI. That center with national tenants will command a much higher sell price than the mom-and-pop strip center. This again would be the equivalent of doing credit checks on every single multifamily tenant. The beauty of this is that there are no hard and fast rules about this. You just have to underwrite enough commercial deals to where you can determine what the correct value is based on different tenant mixes. This again is a complexity that clears away a lot of the competition.

Another similarity between multifamily and commercial is the improvement of NOI. With multifamily, you can reduce expenses by charging back utilities, you can increase revenue through renovations, adding dog parks, covered parking, new appliances, and better amenities. With commercials, this is very similar but to the extreme. We can add back utility expenses, we can add back snow removal, landscaping, we can even add back maintenance roof repairs, roof replacements, mechanical, HVAC, plumbing, all of it. You can go to a triple net lease, where the tenant is responsible for all the maintenance, the insurance, and even the taxes on the property.

Another benefit of the commercial is you're not bound by rent comps. What I mean by that is if you have a two-bedroom, two-bath house, you have to look at the comps around you to see what you can charge for rent. If you have a three-bedroom, two-bath, newly renovated class A apartment and you have other class A apartments near you, you're bound by those rent comps. With commercial, you can have a run-down, boarded-up building, and right next door to it, you can have a block building where you just signed a 10-year dollar general lease at $10 a square foot. You're now able to sell that at a four or five cap regardless of the neighborhood, regardless of the comps. It doesn't matter what anything around you has sold for, it matters what your NOI is, the quality of your lease, and the quality of your tenant.

An extreme example of this is a small town that I'm pretty familiar with. There was a $20,000 parcel of land that somebody built a block building on, metal roof, just a couple of 1,000 square feet, and they were able to land Dollar General on a 10-year lease. That building sold along with the land for $1.2 million at a 4.5 cap rate, so $1.2 million.

Right down the street, there's a mom-and-pop convenience store gas station that's not selling at the $300,000 asking price. You can add a tremendous amount of value to commercial properties by signing a high-quality tenant for a long-term lease. This just can't be done with residential.

Continuing with extreme examples. If you have an apartment building that is 20% vacant, you know exactly what those rents are going to be once you fill them with or without renovations. If you buy an office building or a strip mall that's 20% vacant, you have no idea what the upside potential is. You can sign a mom-and-pop deli or you can sign an Ace Hardware, a Subway, or a PetSmart. Now, you've added massive NOI and upside to your center.

Another benefit of commercial real estate is you're often given a six-month or more heads up on if your tenant is going to renew or if they're going to leave. If they're going to leave, they will give you typically six months' notice depending on the length of the lease. That now gives you six months to find a new tenant. Another benefit of commercial real estate is evictions. I've never had to evict a commercial tenant in over 10 years and most commercial real estate investors will share the same. They just don't have to evict commercial tenants and commercial tenants are not going to overstay.

Managing commercial tenants is another benefit. For the last 10 years, I've managed all of my holdings by myself. It really doesn't take that much of my time. If you look at apartments, somebody that has a $5 million, $10 million apartment complex, they're going to have those growing pains where they're going to need a full-time leasing specialist, a full-time maintenance person on-site. With commercial tenants, again, whether it's office, industrial, retail, the management overhead just isn't there.

Earlier, I mentioned the extreme example of triple net leases where the tenant is responsible for everything. Even with smaller mom-and-pop leases, there are clauses where the tenant is responsible for their HVAC filter changes, any plumbing or electrical repairs, they're responsible for the first $250. Many times, you won't even hear about some of the smaller issues. The same way a lot of you folks out there that are either passive or active investors and you went from single-family to multifamily. In your mind, you know, you'll never go back to a single-family. Really every commercial real estate investor that I know that has gone from single-family, multifamily, to some commercial asset would never go back to residential.

My last reason for you guys to look at commercial properties is it's just a lot more fun browsing. I don't know that I could sit there and look at 100 different apartment buildings where they all have just small similarities. How many differences do you see in class C apartments from one to another? With commercial properties, I can look at 1000 in a day and it's just exciting. You never know what you're going to see less.

Best Ever listeners, I hope I gave you a small glimpse into my world. There's going to be a lot more knowledge to come and this Beyond Multifamily Series. My goal is to open your horizons and hopefully teach you to look at and underwrite different commercial asset classes. Thank you so much for joining me today. Best Ever listeners, if you enjoy this episode, please share it with somebody you think that can benefit from it. Like, subscribe, and have a Best Ever day.

 

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