Posted by john on June 29, 2010 at 15:29:58:
My thoughts are to buy an existing business with excellent cash flow, low rent/minimal space, and minimal management. Looking for 20% cap rate or at least a diamond in the rough that can improve the margins to 20%. For example an ice cream business or sandwich shop on a high foot traffic main street. Your thoughts?
Your first commercial purchase experience? - Posted by Vic in Ohio
Posted by Vic in Ohio on May 10, 2010 at 21:16:18:
Hi all,
I’m trying to determine my next course of action as far as my first
commercial RE purchase. I’ve been doing lonnie deals with MH’s for
several years, and purchased Ray’s Dealmaker’s Guide for MHP’s.
I’ve read several books on commercial RE, and will be ordering Ray’s
commercial guide shortly.
My goal is to replace the income from my job in the next 7-8 years, so
I would assume my primary objective is to invest for cash flow
(probably in multi family properties, or a MHP). However, given the
right deal/market, would it possibly be better to invest for some
shorter term appreciation with appropriate exit strategies to reinvest
into larger properties with better cash flow?
While I know a book could be written on this, just curious to see what
type of properties your first investments were, and were any of your
purchases outside of your area where you had to hire management
companies to run them?
As a newbie, I normally wouldn’t consider long distance ownership,
except that the extra management challenges might be offset by
greater opportunities in markets other than the Cleveland area where
much of the area has experienced negative population growth.
Hearing a few of your first time experiences would be appreciated!
Vic
Re: Your first commercial purchase experience? - Posted by ray@lcorn
Posted by ray@lcorn on May 11, 2010 at 14:56:42:
Vic,
Good questions. Your intuition is spot on, and your time horizon fits this market well. This is a cash-flow environment for which the number one priority is structuring the deal for a worst-case breakeven. That’s not to say there won’t be opportunities for appreciation/flip type transactions, but most will have some “hair” on them, meaning a problem to be solved, before any exit is feasible.
As I wrote in the MHP book-- and further elaborated on in the Commercial book-- my preference is for doing the first few deals close to home. Whether you realize it or not, you know more about the local sub-markets and their political/economic idiosyncrasies just from living there, watching local news, reading the paper, etc., than an outsider would. In learning a new market you become the outsider. There is a home-field advantage, and I advise all investors to be sure they’ve used it before abandoning it.
My first commercial deals were all in my home market even though at the time my dad had business operations in several states. Two things drove the decision for me: money, and money. I needed to invest where I could get money and had no connections with banks other than the locals I’d dealt with as a builder, and second, I didn’t have the money to fund traveling and setting up shop in distant markets. (This was in the 1980’s, i.e. no internet, no cell phones, long distance calls were expensive and fax machines did a page a minute).
One of my first commercial deals was a foreclosure on a former restaurant building that had been converted to a tanning salon. I converted it to a Laundromat because I wanted a cash producing business. I sold it about five years later at a small profit and a large lesson about cash businesses. As you might guess there is a lot more to the story, but that’s another post. 
Opportunities exist even in challenged markets. A reflection of this can be seen in the pricing for deals in the NNN sector with credit tenant leases (CTL) selling at significantly higher caps in markets like Cleveland precisely because they’re challenged by population loss, high unemployment, etc. Walgreens deals, the gold standard of NNN CTL deals, are currently priced at average 7.5% caps nationwide, but I’ve seen stores in northeast metros at 8%-8.5%. Granted, that’s not a smoking return, but the point is that you can benefit from the pricing inefficiency resulting from actual versus perceived risk.
The trick is to identify the sub-markets within the larger market that have the right factors (e.g. income, positive population demographics, employment, institutions, etc.) for long-term viability, and then identify the property type(s) that thrives in that demographic. You’ll get a better price on higher quality deals because of the perceived risk of the larger market factors to outsiders. So don’t count your hometown out.
Side story? Ground zero for low valuations seems to be Detroit. I got an email this morning for a bank REO strip center in Farmington Hills at less than $12 psf. I don’t know what the submarket dynamics are but if I lived there I would have known by noon. However, as noted in my 2010 Commercial Real Estate Forecast (included free with the book), the outlook for the retail sector is significantly challenged and in my opinion will remain so for some time. A lot of deals like this should come with a bulldozer and a demolition permit.
If you do decide to invest at a distance realize that the management costs will automatically reduce your return, and possibly property performance. All of us with experience can tell you war stories about managing the manager and the brain damage incurred dealing with the bad ones. (That?s why I included ?101 Questions for a Property Manager? with the book.)
After market and sub-market knowledge, property type matters just as much, at home or away. A MHP can be a good candidate for distance ownership because they are relatively simple to operate (assuming no rental homes), provide stable returns, and have a ready prospect pool of buyers. Also, subject to the retail caveat above, some NNN CTL properties have recession-resistant business models (e.g. Dollar Tree, Dollar General, Aaron Rents, etc.), have no management responsibilities and provide a bit higher returns than the marquee names. Owner-occupied single tenant office or office/warehouse buildings are a nice niche.
Types with more challenges at a distance… multi-tenant office and industrial properties are management intensive and highly subject to local market connections. Single tenant medical buildings are hot right now, meaning they?re probably over-priced. Apartments are suffering from higher vacancies and lack of pricing power in most markets due to over-supply of housing in general, and always subject to competent management.
Best of dealmaking,
ray
Re: Your first commercial purchase experience? - Posted by John
Posted by John on June 04, 2010 at 22:24:09:
Ray
you mentioned that you learned alot about the cash business
of a laundry mat? Can you share more?
Re: Your first commercial purchase experience? - Posted by Bob Smith
Posted by Bob Smith on June 01, 2010 at 11:19:34:
“Owner-occupied single tenant office or office/warehouse buildings are a
nice niche.”
Are you referring to sale/leasebacks? I wouldn’t ordinarily classify a
single-tenant building as “owner occupied”.
Re: Your first commercial purchase experience? - Posted by Joe
Posted by Joe on May 16, 2010 at 07:08:45:
Ray,
What do you think about managing storage units from a distance? I would have a property manager but I would think this would not be as difficult as managing an apartment building from a distance? What do you think?
Re: Your first commercial purchase experience? - Posted by Vic in OH
Posted by Vic in OH on May 11, 2010 at 15:12:59:
As always, thanks for the input Ray! I’m looking forward to reading your commercial guide.
Vic
Re: Your first commercial purchase experience? - Posted by ray@lcorn
Posted by ray@lcorn on June 05, 2010 at 18:02:53:
John,
I could write a book on that subject, but it would likely turn into a huge rant. The laundromat I mentioned was my first cash business and I learned some lasting lessons.
In a nutshell, cash businesses require two things: trustworthy people to collect the cash (and manage inventory), and; security of the premises.
In that particular case the former was easier than the latter. I lost three change machines in 9 months.
The first time they just pried it open with a crowbar. It was mounted on a wall in a blind spot from the street, so that was my mistake. We replaced it with a new, stronger machine mounted in a well-lit area visible from the street.
The second time they took a sledgehammer and beat holes in the wall around the machine until they could take a section of the wall out with the machine still attached.
We bolted a new machine on a steel, “theft-proof” stand mounted with round head bolts into the concrete floor. The manufacturer?s security claim evidently hadn’t reckoned with our brand of crook…
They rammed through the door with a 4x4 truck, wrapped a chain around the hitch and jerked the machine–along with a piece of the concrete slab–out the hole where the door used to be.
This was not in a bad neighborhood, on a main street, and as people heard about the problems it significantly hurt the business. A local police detective made it a personal mission to track down the thieves. He caught them by tracking down some rumors about a couple of dopeheads bragging about their ?business?. Even found the last machine they’d tossed off a bridge into a creek. They went to jail. Insurance paid for the machines and the damage. But the aggravation and interruption of business was a royal pain.
The constant small aggravations were actually worse… death by a thousand cuts.
Customers who repeatedly claim machines ate their money to get refunds; calls about equipment break-downs on Sunday afternoons when my maintenance guy was at the lake; ; a cleaning woman who stole supplies. I had a supplier who shorted the inventory in the vending machines and billed for the full load. Didn?t catch that until I started doing the math on how many laundry loads were being paid for compared to the supplies being ?sold?.
You?d think counting the money would be the fun part, eh? Well, even with automatic coin counters, running a thousand dollars in change to the bank every week gets old. Not to mention what happens when a change bag breaks in the trunk?
There’s more, but you get the idea, and I?m getting close to the rant stage?
ray
Re: Your first commercial purchase experience? - Posted by ray@lcorn
Posted by ray@lcorn on June 02, 2010 at 20:32:26:
Bob,
Sometimes I read what I’ve written and confuse even myself, so I hate to think what I do to others. (smile)
I re-read that paragraph three times trying to figure out what I meant and sale/leaseback makes sense in the context. I also just closed a sale/leaseback deal with a single-tenant business owner so it’s fresh in my mind. I’ll graciously accept your suggestion for the missing words. Call it a pre-senior moment!
Thanks for asking for clarification.
ray
Re: Self-storage - Posted by ray@lcorn
Posted by ray@lcorn on May 16, 2010 at 16:22:37:
Joe,
I?ll qualify my comments as someone who has never owned a self-storage project. That said, I?ve pursued several self-storage deals, and once went far into a development deal to build a new facility. But I never pulled the trigger on either. The existing projects fell out of due diligence for various reasons, often inflated income statements, and I abandoned the development deal because I got an offer for the property I couldn?t turn down.
However I learned enough to know what to look for, and what to look out for. One issue was the requirement for on-site management.
Self-storage is a business, and as such it requires some degree of day-to-day management. It?s not so much the degree of difficulty of running the place, but the volatility of the income stream. Profitability will depend on the quality of the management systems and the dependability and skill-set of the manager.
There are systems available which reduce the management load–e.g. registration kiosks, credit card billing, electronic keypad entry, etc.-- but none will completely eliminate the need for some level of human presence.
Someone has to make sure the place is kept clean and secure, deal with customer service and inevitable equipment malfunctions, oversee maintenance contractors, and inspect and clean vacated units. Finally, there will be past due accounts and someone has to collect them. This issue is more pronounced with this property type than rental properties.
My due diligence on self-storage projects found a consistent trend of high delinquencies. Well-managed properties commonly ran a 20% delinquency rate (i.e. 30 days past due). Less well-managed projects had delinquencies of 30% and higher. In talking with owners and reading trade publications I found this is pretty much a fact of life in the storage business. Seems when money gets tight the storage bill is at best about fifth or sixth in priority, and the tenants know that action typically won?t be initiated until they are a couple of months behind. They can be locked out of the unit and it isn?t a big deal unless they?re storing business inventory.
Key to reducing collection loss is a strong rental agreement. There are numerous resources available for the industry and I would recommend getting several examples of peer reviewed contracts, going over them with an attorney in the town where the project is located, and customized for any state or local laws.
If management isn?t proactive in collecting accounts charge-offs can spiral to 25% or more of revenue. In my state, the law regarding notice of default and a cure period must be followed before access to the unit can be denied. The final remedy available to the landlord is an auction of contents and a deficiency judgment for any remaining balance. Selling or disposing of the property of a delinquent tenant is loaded with liability if you fail to do it according to the law. All property is not created equal. Special procedures are required when dealing with vehicles, boats and other titled items. This varies by state, so check yours.
The second big issue is competitive supply in the market. The facilities are fairly cheap to build, and it seems a lot of entrepreneurs are convinced they are the only ones with the idea. I would advise doing a thorough study of market supply, occupancy and rates. Even then you have to realize that a new complex can be built in a few months? time between your property and the biggest demand generators.
It?s a very competitive sector. I live in a college town and often see storage ads for dollar move-ins, no security deposit and no credit check. As a landlord terms like that make me go yuck. In that scenario the revenue from a new tenant is a fraction of the cost of maintaining the unit, so unless they stay for several months there is no hope of making money. Competition also means marketing and advertising expense, and someone to design and place the ads. An untrained, part-time retiree manager type can get over-extended in a hurry. You won?t know the marketing isn?t working until occupancy falls below break-even.
All that said, you?d think there would at least be a premium in the potential returns as compensation for the management hassles and revenue risk. But storage projects have followed the rest of the RE universe in having what I consider to be pricey valuations. Asking cap rates are running in the 8%-10% range. I would want something around 12% and higher to compensate the risk.
There is an excellent website on the property type at www.insideselfstorage.com Follow the links to the monthly columns and you?ll find a wealth of info, especially in the legal section.
ray
Re: Your first commercial purchase experience? - Posted by john
Posted by john on June 09, 2010 at 09:45:33:
Do you currently own a cash flow business or is Real Estate your cash flow business? I hear you about the hassles. Every time I think I want to be the renter instead of the landlord, I think about the overwhelming responsibility of running a retail business.
There is one tenant here in D.C. that makes 2 million a year selling cupcakes, then I think to myself maybe I should do that?
I’ve got two commercial properties that cash flow, but not enough to live on yet so I keep thinking about ways to increase my cash flow other than working a job.
Re: Self-storage; p.s. - Posted by ray@lcorn
Posted by ray@lcorn on May 16, 2010 at 17:06:41:
For more information, there are 131 posts on self storage in the archives here on the newsgroup. Click the Search Archives button at the top of the page.
Also, on a lark I searched the Inside Self Storage website for “delinquencies”. There are 301 entries, giving credence to the issue as a major factor in operations.
ray
Re: Your first commercial purchase experience? - Posted by ray@lcorn
Posted by ray@lcorn on June 10, 2010 at 13:25:45:
John,
I probably went a little overboard painting a dark picture of that one laundromat… I must have been a bad mood that day and the memories tended toward the negative. There are hassles to anything, but on balance over the years the good must outweigh the bad or I wouldn’t still be doing it, eh?
To answer your question, yes, we have always had operating businesses or ownership interests in businesses in addition to income properties. The business operations vary widely in type and area, and are often connected with our real estate developments.
We’re in the hotel business (franchised and independent) and have been since 1990. Other businesses we’ve been in, out, back in, etc. over the years include restaurants, nightclubs, contracting and service businesses, bowling alleys (now leased out), furniture sales, auto dealerships (franchised and independent), manufactured housing sales, RV sales… and I’m probably forgetting others. At times we develop, buy and sell businesses almost as often as real estate projects. Sometimes we will invest in a going business that locates in one of our buildings. We like that type of synergy.
Personally I’ve always liked the mix of income properties and operating businesses, though at times it gets to be a lot to keep up with. Currently we’re about 70/30 real estate to businesses, but are contemplating two new operations now.
The key to our decision-making about opening a business is people. We will build a business around the right person with the goal of making he or she an owner within a few years. With good people you still need three key ingredients: proven systems for bookkeeping, management and marketing. In my experience, without these failure is inevitable.
ray
Re: Your first commercial purchase experience? - Posted by john
Posted by john on June 14, 2010 at 21:49:59:
What kind of ownership interests in business do you have. meaning are you a silent partner and just receive a cut. How do these arrangments typically work? I’m not sure I’m cut out to actually run the business. What are your thoughts of Pro’s and Con’s of both scenarios?
Re: Your first commercial purchase experience? - Posted by ray@lcorn
Posted by ray@lcorn on June 15, 2010 at 13:02:23:
Yes to both, active and passive ownership. More the former because I’m a control freak.
How do they work? No two are alike. I typically design structures to fit the situation and the players.
If you don’t think you’re cut out to run a business, don’t. It’s not for everyone.
Pro’s and Con’s? Too broad to answer. Different deals have different attributes, some good, some less so, some just plain bad. One universal truth? Pick partners and managers very carefully.
ray.
Re: Your first commercial purchase experience? - Posted by john
Posted by john on July 07, 2010 at 22:01:49:
My thoughts are to buy an existing business with excellent cash flow, low rent/minimal space, and minimal management. Looking for 20% cap rate or at least a diamond in the rough that can improve the margins to 20%. For example an ice cream business or sandwich shop on a high foot traffic main street. Some business where it’s not very management intensive. Your thoughts Ray?