The Beyond Multifamily series is 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 this episode, Ash discusses increasing interest rates and other current factors that are impacting commercial real estate investors. He also reflects on several different deals he has recently worked on and the lessons he’s learned from them.
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Ash Patel: Hello, Best Ever listeners. Welcome to the best real estate investing advice ever show. I'm Ash Patel and this is an episode of Beyond Multifamily, where we dive into topics other than multifamily investing. Today, we're just going to dive into some current events. I'm going to share with you some lessons that I've learned from deals that I've worked on. Let's start with the elephant in the room, interest rates going up. The Fed funds rate and the 10-year Treasury are both around 4%. Wall Street Journal Prime in November of 2022 is at 7%, and Redfin just came out with an article that said, "You need 40% more income to afford the same house that you would have purchased one year ago." I understand what that does to the mentality of single family homebuyers, people that are looking for purchasing homes for themselves... But it also affects the fix and flippers, the wholesalers, and then that trickles up to multifamily investors. We have to readjust how we look at cap rates, how we underwrite deals, what our exit cap rates are, and hopefully, Best Ever listeners, you're taking all of that into account.
What I'm hearing a lot of is people not worrying a whole lot about interest rates going up, because the word on the street is rates will be backed down in one year. The other popular consensus is that within three years, rates will be declining. I don't know where this information is coming from, but nobody has a crystal ball, and to underwrite deals or to purchase deals expecting rates to come down in one or three years is not prudent. There was an eight-year period between 1978 and 1986 where interest rates remained above 10%. That's eight years of interest rates being over 10%, and the all-time high that they hit was over 18% interest. I know our central bankers have a lot more tools in their arsenal today. I'm not saying that we're going to go eight years with interest rates above 10%. But I would not expect rates to come down in a year, or even three. Underwrite conservatively.
What is interesting is that the loans that us commercial people do - and again, when I say commercial, I mean non-residential commercial - are actually at a better rate than your typical residential or multifamily loan. The reason for that is there's not a secondary market for the loans that we do. Again, in an earlier Beyond Multifamily podcast I shared how local lenders work, and that the deals that we do are portfolio loans, and they're capped on the balance sheets of the banks that we originate the loan from. What this means is it's not like your typical multifamily loan, where there's agency debt, and there's a secondary market in which these loans are bought and sold. Our banks have more discretion on the rates that they charge, so we are getting a better rate than just about any other asset class out there right now.
Best Ever listeners, there's a lot of headlines, where very profitable, very successful companies are laying off hundreds of people... And this is what typically happens in an economic downturn. They use that as an excuse to lay people off, and it's really just a trim weight. And this happens in every economic downturn. Wall Street typically rewards companies that do that, because they believe they will be leaner for the future. That being said, there's still some great retailers out there. Ross discount stores have added hundreds of stores, and they're going to continue to add hundreds more. Ace Hardware I believe has added 200 stores this year, and even in q4 of 2022 they're planning on adding 40 or 50 more stores. These are the headlines that don't make the front page news when companies are doing better, expanding, adding more employees; but the clickbaity headlines when Twitter's laying off people, JP Morgan's laying off people, those seem to make the headlines.
Talking from experience now, we have a strip mall where one of the tenants is Gopuff. What's crazy about Gopuff is they've been leasing space in our center for almost two years, and they've never done a build-out; they signed a lease, they got possession of the place, they got the keys, and they planned to do this whole big renovation, and it's been crickets. They've not done anything since then; they've not even stepped foot back into the location. And we've looked at a lot of strip malls across the country where this is the case. They've leased out space, and they have a signed lease, but there's been no activity.
For those of you that don't know, Gopuff is a multibillion dollar company that basically delivers goods to your home same day. They have a flat $3 delivery; deliveries can be in as little as 30 minutes, and they've got thousands of items, from food, ice cream, dog food, soft drinks, alcohol that can be delivered to your door, basically anytime.
Roughly five months ago, in July of 2022, we saw the headlines that stated Gopuff is going to shut 76 of its stores, they're going to lay off 1,500 people, and their IPO was going to be postponed until more favorable market conditions. Now, having them as a tenant, we feel okay, because we have a signed lease that has two more years left on it. And Best Ever listeners, when you have a corporate-backed lease on commercial real estate, they have to pay their bill; there's no way that they can get out of that lease unless the parent corporation declares bankruptcy. From a financial perspective, we are not affected. However, from an aesthetic perspective, we have a strip mall with a vacant end cap. We don't love having Gopuff's space still look like a vacant space. There's no signage on the building... So it's not the most ideal thing, but it doesn't affect our financials, because they're still paying rent.
About a month ago, we got the letter that I was expecting, a letter from Gopuff stating they're having a lot of hardships and they would like a buyout of their lease. What does this mean? This means that they're going to pay some portion of the remaining payments, hoping that they can get a discount, and they can get a release from their lease obligations. All of this was done through a local broker; we negotiated, and I think basically what it came down to is they're going to pay a little over one year of lease payments, and we're going to let them out of their lease.
Why would we do that? Well, the answer is, we're going to get one year's worth of rent, and in our lease, we had a provision where we were supposed to give them $70,000 to build out their space. Now, granted, that $70,000 would have went towards building improvements. At the end of the day, we took their buyout; I think it came out to $55,000 or so, and we let them out of the lease. We can now re-tenant that space, and already we have a daycare that's looking to rent out that space. So it's essentially double-dipping.
Imagine, for the Best Ever multifamily investors, where you have a tenant that signed a two-year lease, and six months into it or a year into it they're like "We don't want to stay here anymore. We're just going to pay the remainder of what we owe you, and we're going to leave." That's essentially what's happening here. You can now re-rent that space and double-dip. So hopefully in this situation for us, this ends up being a win. Gopuff left, they paid their penalty, and we have a new tenant that hopefully will sign very soon, and they're going to put a daycare in this space, and hopefully they do very well.
Best Ever listeners, moving on... While we're talking about multifamily, I have a student in my mastermind that was having trouble evaluating office space. So I had him come over to my house and we just searched for office and retail space for about an hour and a half... And we came across this one deal. And this was a great epiphany, because it allowed him to relate this to multifamily. This was basically an office building where we were looking at the numbers, and I tried to get him to figure out if this was a good deal or not... And I used some multifamily terms to get this individual to really understand how this office building works. So I asked him, "If you were to buy an office building in this neighborhood, this town, what would you pay per door?" And he said, "$60,000 a door." I said, "Okay, what would you expect the rents to be if you're buying something at $60,000 a door?" and he said, "Ideally, probably around $750 per month." I said, "Okay, in this office building, you're buying at $20,000 a door, and the current rents, which are under market value, are $500 per month." So now let's correlate the two together. $20,000 a door versus $60,000 a door, and for $20,000, you're getting $500 a month in rent, versus $60,000, you're getting $750 per month in rent.
Another way to look at this is the difference between the office building and the apartment is you're paying three times more per door for the apartment, but you're only getting 50% more in rent. And now the kicker here is your apartment has kids living in it, it's got bathrooms and kitchens... The office is basically a square; they're gonna have a common area bathroom down the hall. A lot less wear and tear, and somebody's going to use the office for eight hours a day; they're not going to sleep in it. The wear and tear is just absolute minimal. And typical office leases, when they leave, everything has to be rental-ready. And again, this is rarely an issue, because office tenants just really don't wear out their space.
Best Ever listeners, I hope you're able to understand the correlation here, and I hope you start looking at some of these smaller neighborhood office buildings. And for those of you that are interested in the larger class A and B offices, there are a ton of them coming to market, going to auction, and for the first time ever that I can recall, they're being sold at very attractive prices. Class A office space I've seen go for $40, $50, $60 per square foot, where we know build cost is well over $200 per square foot. And you know, my opinion is office space will come back as soon as the supply and demand for jobs goes back in favor of the employers. I believe employers will demand people work from an office; already tech companies, Wall Street banks are demanding people come back to the office.
Break: [00:12:33.06] to [00:13:40.24]
Ash Patel: Speaking of office, we have a co-working deal that we are purchasing; this is in one of the suburbs of Atlanta, and this is just a suburban office building that somebody had turned into a co-working space. They are selling the business and the real estate together, and the cash on cash returns for this deal are 36%, which includes keeping all of the current staff on board and really not changing anything. Best ever listeners, if you've ever heard me talk about car washes, laundromats, you know that I'm typically against those, because it's a job. So why am I doing this? This is a co-working place... This is a job; you have to manage people, you have to make sure the place is clean, it's attractive. All the amenities are there and working, the copiers, the beverage machines... It's a job. However, there's multiple exit strategies here. You can turn around and flip the property, you can have the business that you own sign a lease with your LLC that holds the real estate, and then you can sell the business. There's some favorable tax write-offs where we're buying a lot of furniture; we're buying goodwill, we're buying a business, so there's a lot of first-year write offs.
My advice to you and the takeaway that I hope you have is do not be afraid fraid to look at real estate that also comes with a business. In these competitive times, we want to go where we can escape competition... So how many people are looking for real estate? How many people are looking for businesses? How many people have the tolerance or the appetite to take down both? You will eliminate a lot of your competition if you can open your mindset a little bit, take the blinders off, and evaluate different types of deals.
A couple other deals that we're working on, Best Ever listeners... One is a strip mall in Atlanta, Georgia. My partner lives in Atlanta, and she called me and she said, "Ash, I want you to come down here and take a look at the strip mall. It's brand new construction." As a matter of fact, it wasn't even fully built; it was probably 60% of the way through construction... And my response to her is, "Look, this is not what we buy. We buy value-add properties. Why would we buy a brand new shiny strip mall, and pay top dollar for it?" And she said, "I don't know, but let's just look into the numbers. Let's see if we can get in front of the developer and buy it." So we went down there... She could not get the developer to return her phone call, but the guy's on site every day, kind of elusive... So she gets on social media, stalks him and finds a good friend of his that's a realtor... So what better way to get to this person than through a realtor?
We got a sit down lunch through this realtor, and we talked to the developer. He talked about all of the plots that he's developing, and they're all in the same area... So halfway through lunch, I just said, "Look, we just want to buy everything you have." And he kind of pause for a second, he's like, "That's fine. Once I build everything, I plan on selling it." Well, of course; he's a developer, he's going to build it, he's going to get tenants in there, and then sell it at a very low cap rate for top dollar.
And we kept insisting we want to buy it now. He sat back and thought for a second, he's like "I've got a partner that I'm not too fond of. If you buy this now, I can exit this partnership." So he's like, "Yeah, let me come back and give you a number." Long story short, he gave us a number, and just as I suspected, it was a low cap rate, and there was just not a lot of meat left on the bone... I think the cash on cash returns are way below the threshold of any deal that we would typically do... And I told my partner "Hey, great job, but again, there's no deal here." And she said, "Ash, let me look at this thing one more time. I feel like we're missing something." "Have at it. Let me know what you find out."
Several days later, she comes back and says "There are no renewals in any of the leases." And I said, "There's not a chance that's true." And she's like, "No, look, I'll send you all the leases. There's no renewals in there." And I thought "This is one hell of an oversight, if that is in fact the case." Why is that? This developer is going to build out beautiful - and actually, by now he already has built out beautiful salons, restaurants, boutique stores, and signed five-year leases with all of these tenants. Each of the leases has a yearly rent escalator. But in year five, there's no renewal clauses.
Best Ever listeners, if you recall from some of my earlier talks, you know that built-in renewals only help the tenants and not the landlord. Why is that? Let's say we have a five-year lease, and at the end of that five years, the tenant has the option to renew, but when they renew, the rent gets kicked up by 10%. Let's assume the economy is just down the tubes, it's a ton of vacancy all around, including maybe in your own center. The tenant is going to say "Hey, look, I'd love to stay here, but I'm not paying a 10% rent bump. As a matter of fact, I want a 20% discount if you want me to stay, or I'm happy to go somewhere else." At that point, you have to figure out "How difficult is it for this tenant to move?" If it's a restaurant, for example, they've got [unintelligible 00:19:13.10] they've got all the restaurant equipment, they've got a lot of customers used to coming to a particular location. It might be a little bit difficult to move. If it's a boutique store, it's pretty simple. They can take a lot of their shelving, a lot of their tables, their display furniture, and open up shop anywhere else.
Total sidenote, but one of my tenants is a physical therapist that has a giant pool that he built into his space. So for him to leave would be very, very difficult. This is a heated pool, it has a motorized treadmill inside the pool; he uses it for physical therapy. He does not want to deal with moving that, and the construction that went into putting that into this location, it was very difficult. So you almost have a captive audience in that case.
With this strip mall, we have a number of tenants that have incredibly beautiful spaces, and at the end of five years we can go back to the tenants and say, "Hey guys, look, we'd love for you to stay, but here's what the new rent number is going to be." And we can get closer to market rates. The space can also be very valuable to a competitor. Imagine if you have a great Mexican restaurant, a great pizza restaurant, and they decide "I'm just going to move to this other strip mall." Well, you can recruit a another pizza place, another Mexican restaurant to come in, because you have that residual audience that is used to coming to that location.
Back to the numbers on this strip. Year one cash on cash returns were 14%, and with the built-in rent escalators, it goes to 16%, 18%, 20%; year four and five are at 20% cash on cash. And again, this is not a deal that would typically appeal to us. However, because there are no renewals, we can charge market rents in year five. And at that point, the exit should be well over $1.5, $2 million in increased value, from increasing the value of these leases, hence increasing NOI.
So the moral of the story here, Best Ever listeners, is a deal that we thought was dead, there was just no upside that we saw, if you dive in, there was considerable upside. But this is something that very few people would see. They're not going to take the time to dive into each of the leases and actually find that there's no renewals. So good for her, she did an outstanding job. We're closing on that property here in a couple of weeks, and it should be a win.
Another example of a deal that may not appear to be all that great on paper, or look at the numbers, even if you look at the leases, it just may not be all that great of a deal, and when you look on Google Maps and dive in, it turned out to be an incredible deal, potentially.
Another student in my mastermind found a family Dollar. He has a fund where a lot of his investors just want to conservatively invest in real estate, so he invests in a lot of Dollar stores, and they get double digit returns, but there's not a tremendous amount of upside. At the same time, there's very little risk associated with this fund. So he found a family Dollar, and he said "Ash, I'd love for you to get your set of eyes on here, and maybe help me evaluate the steel." So I spent a half hour with him on a Zoom call, and we dive in... A lot of this stuff is run of the mill; maybe get a seller to do some CapEx items, fix the parking lot... And then you zoom out a little bit, and I noticed - imagine a city block, just down the middle, divided in half, family Dollar's on one half, and the other half it has a squiggly driveway coming into it. So if you look at top and bottom, halfway through the neighboring lot, there is a driveway that comes in, a curb cut from the road, that comes in towards the family Dollar, and then it does a gentle 45-degree turn down, and then another 45 degree towards the Dollar General. So basically, an S shaped driveway going right through the center of the neighboring lot. I asked the student if we have an easement on this property; if there's an actual recorded easement. He said, "Yes. We looked up the easement", and it didn't just say that you get a curb cut on this property. It basically had that S-shaped driveway drawn out. And this was a recorded, perpetual easement; it is going to be there forever, unless both parties agree to get rid of it.
Why is this beneficial to the individual that's buying the family Dollar? Well, the answer is because you've got this easement going right through the center of this lot, it makes it unbuildable. There's very little you can do with it, because your lot is divided in half; you have a setback from the road, you have a setback from the neighboring property line, so you could build a very small, skinny building. My advice to this individual was you have to go to the property owner and say "Look, it sucks that there's this easement there. This land is completely useless. Happy to buy it off of you." Why would you want to buy it? Well, if you control the entire city block, you can get rid of that easement, and now you can build directly attached to your family Dollar and build a nice-sized strip mall utilizing the second lot. The second lot really just has no value, but it has a tremendous amount of value to the buyer of the family Dollar.
This again, Best Ever listeners, is something that when you're thumbing through offering memorandums - you know, the brokers never put this down as an attribute. You've got to just dive into different deals. A lot of this comes with experience... Once you start looking at a lot of deals, you'll be able to pick things like this out. So this could be a massive homerun if this individual buys that land for pennies on the dollar; he can develop a $3, $4 million strip mall on this land.
Alright, Best Ever listeners, we'll call it a wrap for this episode. I have a favor to ask all of you... If there are things that you want to hear on this Beyond Multifamily episode, we'd love to hear from you. You can email me at ash [at] investbeyondmultifamily.com. Let me know what non-residential topics you would love for me to cover.
Best Ever listeners, thank you so much for joining. If you enjoyed this episode, please leave us a five star review, share this episode with someone you think can benefit from it. Also, follow, subscribe and have a Best Ever day!
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