There is information everywhere on the internet about building long-term wealth by investing in income-producing property. But is there adequate information that you can access one-on-one in the Denver market over a cup of coffee from an experienced commercial broker and developer? At Canon Property Group at Buell & Company, Rodolfo Canon is available to do just that. In this blog, Rodolfo extracts the learning from the podcast episode, “Do You Have to Be a Millionaire to Invest in Commercial Real Estate,” in which Joe Massey from Castle and Cooke Mortgage discusses the financing options available in this market.
How much money is needed?
If your interest is in commercial real estate you will need 25%-30% down payment of the purchase price to obtain financing for the purchase. Assume that you have $250,000 in savings and you are thinking about risking it in a commercial real estate investment. The first question that needs to be answered is, do you want to risk all of that in your first commercial real estate venture? Probably not. This is the number one reason we find that new investors are reluctant to pull the trigger. They are afraid of losing it all. But you don’t have to risk it. There are other ways.
An alternative source of capital
The primary purpose for a home is a place to live. It may increase in value but if you do not tap into its equity, its primary purpose is still a place to live. It’s second purpose is as an investment. It can generate additional assets and cash flow. You must opt to use it that way.
If you have owned your home for 10 or 15 years you have built up equity that is what we call “trapped equity.” It is trapped because it is not producing income for you. The wealth building you are experiencing is limited by market appreciation which is driven by supply and demand. Today, the residential market is a seller’s market since there is an imbalance in the supply (low) and the demand (high). In Denver, we have been experiencing at least average annual appreciation of 6% and in some segments up to 10%. But that is only part of the wealth building equation. What if you could access that trapped equity, invest in commercial, income-producing property, not put your savings at risk and build wealth at a faster pace than with just residential market appreciation? Borrowing against your home will get you the lowest rate and the longest term. Let’s see how that might work.
Current home purchased 10 years ago for $500,000 with 20% down.
- Current Property Value $800,000
- Original loan amount $400,000
- Interest rate 5%
- Total Monthly payment, excluding escrows $2,147
- Current Loan Amount $325,000
- Equity ($800,000 – $325,000) $475,000
If you were to refinance your home at its current value with a 30-year fixed rate mortgage, two things would happen. One, you would have cash available to purchase an investment property and two, your debt would increase. When this is complete, someone else is paying for your asset. Now you are set up to watch your asset appreciate and the principal go down and it pays for your additional mortgage payment.
Next step. Refinance
Assume the following:
- New loan to 80% of $800,000 value ($160,000 in equity) $640,000
- Less Original Loan Amount $325,000
- Net to invest: $315,000
- Fixed interest rate (P&I payments) 75%
- Total Monthly payment $3,339
- Payment Increase $1,192
- Cash Available to Purchase Investment Property $315,000
You still have your $250,000 in savings plus access to the “cash available” of $315,000 to use to purchase a commercial property. Now you must find the property. Where do you look? What is the asset class? How much “deferred maintenance” is acceptable? What will the renovation costs be? How much can you increase the rents? These are all questions that need to be answered and you will need some expert advice.
Assume you purchase a Commercial Property for $1,000,000. It is a 3,300 square foot building renting for $20 per square foot. This results in the purchase of an income producing asset that covers your mortgage payment on the new property, plus the increased mortgage on your home and leaves you with a positive cash flow of $551 per month.
- Commercial Loan with 30% Down $700,000
- Total Monthly Payment $3,757
- Monthly Rental Income $5,500
- Annual Rental Income (12 x $5500) $66,000
- Monthly Cash Flow $1,743
- Net Cash Flow after paying increased mortgage $551 per month
- Net annual cash flow $6612
Now you own an asset that is producing income and net positive cash flow for you and your family. But how do you generate an increase in the value of this asset in order to accelerate your wealth-building? First of all, your lease will have a rent “kicker,” or an annual rent increase (assume 3% for our example) agreed to by the parties in your 5-10-year lease agreement. This increase in rent will automatically increase the value of your asset. Look at “IRV” below:
- Net Operating Income (I) = Capitalization Rate (R) x Value (V).
- $66,000 = R X $1,000,000.
- $66,000/$1,000,000 = 6.6% cap rate which is your rate of return.
That $5500 in monthly rental income (to make things simple to understand, the assumption is that the $5500 is the net rental without the operating expenses) at the beginning of the term will increase by 3% in the second year of the lease and every year thereafter.
In year 2 the value is calculated as follows: $5500 first year rent x 1.03 (3% increase) = $5665 new monthly rent amount. $5665 x 12 = $67,980 (I). Assume the same cap rate of 6.6%. $67,980/.066 = $1,030,000. In the first year your asset has increased in value by $30,000.
Force or accelerate the wealth building
Assume you have bought this asset with a tenant. The building is a bit shabby and in need of repairs. If you, for example, after the first year of ownership and at the end of the tenant’s lease, were to invest $10 per square foot (psf) in improvements and lease it to a new tenant at a 20% increase in rent the results would look like this:
- Rental income per month of $5665 x 1.20 = $6,798
- $6,798 x 12 = $81,576
- $81,576/0.066 = $1,236,000.
You invested $10 x 3300 square feet = $33,000 and generated additional rental income and increased the value of your asset by $206,000. This is what you do to change the value of the property. Move out old tenants. Invest in renovations. Increase rent.
Commercial real estate assets have classes typically A, B, and C. If you take your C building to a B building you will find a larger tenant pool. These scheduled rent increases that are included in the lease are a great reason to own commercial. These tenants will know exactly what they are signing up for. It’s a win-win for asset owner and tenant.
Risks of refinancing your home mortgage
If you refinance your mortgage to invest in commercial real estate your personal Debt-T0-Income (DTI) ratio goes up. Does that impact your ability to get a commercial loan to buy a million-dollar asset? Not necessarily, if the commercial asset is in good shape.
Commercial lenders have criteria by which they evaluate each loan. They are looking for the sources for the repayment of the loan and they include:
- Debt service coverage ratio. Can the asset’s income stream cover the debt and a little bit more?
- Debt to income Ratio (personal income)
- Liquidation of the asset
They like for the rental income of the building to be the most important factor.
Are there still opportunities out there?
Some new investors have asked if they have “missed the boat.” Why? Their home has appreciated 80%. Other properties have appreciated 80%. Interest rates have gone up 1%. Are there still deals for them?
Yes, because there are different asset classes and different locations. Your best strategy is to have a long-term planning perspective and to optimize the value of the property with an increased revenue stream. You can manipulate that, but you must buy right and location is a critical factor.
You may not have the knowledge of how to renovate, what costs you should expect, how to increase the rents, or how to develop a comprehensive wealth-building plan with commercial real estate investments. I can guide you through the entire process. How and what you buy are important. I can tell you if it needs work, what inspections are needed, the permit processes, cosmetic upgrades, piecemeal upgrades, etc. or an option with step increase in improvements.
An asset with upside potential requires $200-250,000 down payment and that will buy you a $700,000-800,000 property. They are older buildings often located in corridors just outside of Denver. They can be found in locations like Lakewood, Wheat Ridge, Old Arvada, or Westminster
In residential it is a seller’s market, in commercial it is a little bit tough to buy right as well. But you should consider the long-term asset accretive. You might think it is expensive right now. Look for assets that can generate “good” rents. Buy it in the right location. Forcibly add value..
The last thing I would like to say is put a real estate management firm in place. Don’t self-manage commercial real estate. Hire an experienced manager. How much is your time worth?
In my experience in working with investors I have learned that the older investors who have commercial real estate investments are never sorry they made the investment.