Looking at purchasing commercial real estate

Hi everyone, this is obviously a burner account and I have another account that I use on WSO but I wanted to keep this post a little more anonymous. I'm looking for advice on purchasing CRE.

I live in a capital city in the Southeast part of the country that is currently undergoing a rapid revitilization of the downtown area. Demand for housing currently far outpaces the supply in the downtown as more and more people are moving to the area and are looking to be able to walk to work and be at the center of nightlife.

Two coworkers and I are are looking at buying a two-story building downtown (that is listed at 1,050,000) that is ~6500 sq feet, the ground level currently has a lunch restaurant as a tenant that is paying what I believe to be below market rate for the area. The restaurant is also co-owned by the owner of the building, one of the reasons the rent is below market.

The upstairs is currently unoccupied but can be converted in to 3-4 apartments or office space. I believe that apartments are the way to go because like I said housing supply doesn't meet demand and office space outsupplies demand.

We all work in consulting but have finance backgrounds from college and no experience in RE.

What are some red flags that we should look out for, advice on how to approach the landlord/tenat situation in regards to the current owner/restuarant, what costs would like in building out apartments upstairs, and finally how to finance all of this.

Obviously I see the benefits of doing an LBO type scenario where we can be in and out in a short horizon but is that actually feasible in a smaller market on a 'cheaper' building?

I also assume that we would to have a pretty good down payment because of our limited experience in RE and with significant models and a business plan.

I know this is a lot so don't feel the need to answer all of these questions but I'm looking for all the advice that you're willing to offer.

Thanks!

 
Best Response

I think you should wrap your head around the concept of RE purchasing to begin with - ignore all of this if you already know it but you mentioned LBO so I figured I would give some explanation on how these deals normally go.

  1. In a smaller case like yours you can probably find a loan for 70% LTC (Loan-to-cost). Maybe more if you're doing affordable housing or something of that sort. That means you'll be funding $735,000 through a bank loan (I would go this route because you're not going to get a LIFE or a conduit loan w/o any big transactions in RE and conduits aren't really loaning right now anyway). So you're going to need $315k in equity from somewhere. Personally, I don't have that $$ sitting around in a bank. This is an easy fix though - on to step 2.

  2. You'll find someone to contribute the equity for the deal. You get a recourse loan w/ you and your partners guaranteeing the loan. Give the equity somewhere from 12-15% annualized IRR. You can do something like 8% preferred return annualized and 4% deferred until sale at Year X if you'd like.

  3. Now you've figured out how you're going to finance this shit. Now you need to make an offer on the place. Say you win the bid. You'll need to negotiate the Due Diligence period (DD). Give yourself 45 days to figure this shit out. Go through all the environmental, permitting, lease language, loan agreements, equity term sheets, and any renovation requirements you'll need at this point. Model all of this out to get yourself your return and your hold period as well as an offering price you're comfortable with.

  4. After your 45 day DD period you'll need to close on the loan and the contract. Then you'll be able to dig into the shit storm a find out what's really wrong with the place. At this point I would take a hard look at that lease of yours. Make sure you get sales numbers and sales PSF from the lease in the bottom of the place. Look at that and compare it to market rates. Here's the important part. If you're guy is close to his lease expiring then wait it out, release it for a higher rate (using his sales numbers as leverage assuming they're good) and make yourself some cash flow. If his lease isn't coming due anything soon you can negotiate a lease buyout. You'll have to factor this in and make sure that in your model it comes out to an amount that supports the type of return you're looking for long-term.

  5. At this point you can renovate the upstairs, put some apartments in and lease them up. Make some cash off of that. Essentially what you're doing here is called a "value-add" in the RE world. You're adding value in the property with the goal to sell it and make a nice return on it. Doing that again and again is what a lot of developers will do.

I realize this is a lot of information and trust me it's just a baseline understanding of it. I could talk to you for hours on end about all of this and all the nitty gritty details regarding all of this. I'd be happy to talk to you a little more. I'm actually in the southeast (South Carolina to be exact) so I have a really good understanding of the scene. Feel free to PM me if you have any questions.

I hope this can shed some light not only to you, but to anyone else who really doesn't have an understanding of how the value-add process works. I realize I probably skipped 10-20 massive details but I'm trying not to get lost in the weeds.

Good luck with the property. Hope it turns out well.

 

Great Job, 'nana for you, now I would to expand upon some points, or one of your 10-20 details which I think are the most important

CRE SC:

you can probably find a loan for 70% LTC (Loan-to-cost). Maybe more if you're doing affordable housing or something of that sort. That means you'll be funding $735,000 through a bank loan (I would go this route because you're not going to get a LIFE or a conduit loan w/o any big transactions in RE and conduits aren't really loaning right now anyway). So you're going to need $315k in equity from somewhere. Personally, I don't have that $$ sitting around in a bank. This is an easy fix though - on to step 2.

  • You'll find someone to contribute the equity for the deal. You get a recourse loan w/ you and your partners guaranteeing the loan. Give the equity somewhere from 12-15% annualized.
  • -You might be able to get as high as 75% LTC -Add in costs for legal(your lawyer & the banks lawyer) should not cost more than $10,000. You will most likely have to pay the banks other 3rd party fees which could run you $5,000.
    -Please take this with a grain of salt, but please find yourself a good mortgage broker. It really sounds like you don't know what you are doing, especially mentioning LBO modeling. Please don't take any offense, it is not your main line of business you shouldn't know all the ins and outs yet. Don'y pay more than 80bps, don't be afraid of an exclusive agreement just redline the heck out of it. -I don't know of any institution which would write you an equity check for less than 1-2 million so if you need additional equity I would suggest friends and family. If you use a mortgage broker don't pay more than 2% for equity. -Also the other metric which banks consider more than Loan To Cost is Debt Service Coverage(DSCR) it is the amount of the buildings income over the debt payment for that period e.g. Net Operating Income/Debt Service, $120/$100= DSCR of 1.20x. This 1.20x is actually the minimum coverage ratio that most banks would consider loaning, and therefor your loan amount could be limited by the Present Value of the $100 Payment. This is for a non bridge loan.

    CRE SC:

    After your 45 day DD period you'll need to close on the loan and the contract.

    Push for a mortgage contingency in the sale contract. It is really market dependent but you wont be on the hook if you can't get a mortgage for whatever reason. Also push for 60 days of DD

    Best of Luck!

     

    No broker is gonna do an equity raise for this, come on dude. Crowdfunding is the only option, but good luck getting signed up for a raise even on those platforms with a big donut for experience. OP and all his friends work in finance, I'm sure they can scrape together equity from friends and family, so it's a moot point but reading that made me cringe.

     

    Another key consideration is you actually going and building 3-4 apartments and what goes into that (you are saying it's unoccupied but can be converted, what's up there right now though?)... All great points above, but you'll need to engage someone to help you come up with a renovation budget and timeline so that you can accurately project whether or not the investment makes sense. Then you'll need to add these costs to the total amount of capital required for the investment on top of the purchase price. Taking into account the purchase price for the asset, the (seemingly) extensive renovations upstairs, and the market rates for apartment units (projected to begin conservatively after renovations are completed) combined with the existing rent from the retail unit (and accounting for any future growth in retail rent as mentioned above), you should be able to figure out if this is a project that is going to give you a favorable return.

    Returns aside, really understanding the nuts and bolts of the condition of the upstairs and the work required to get solid, leaseable units up there is key. It might be a lot of work for a couple of busy consultants to oversee, especially if you're travelling quite a bit.

     

    I would second this. Multifamily is a really competitive sector, and what types of finishes you decide to build will determine what you can reasonably expect to charge for rent. Combine that with local construction costs and local market demand, and it will factor heavily into what type of cash flow/rents you can expect from the apartments. Additionally, there are services you can provide to tenants for extra monthly charges - e.g., package delivery, laundry, parking.

    One other thing you'll have to factor in for the apartments is the management fee. These have a lot higher turnover than office space, and your leases are typically only 1 year. You need to get someone to oversee those leases and renewals every year, as well as respond to daily maintenance, etc.

     

    This... Incorrectly estimating capex is one of the most common and costly mistakes by new investors. Is the upstairs down to the studs? If so, you're looking at probably a minimum of $25K/unit to bring those up. Can the rental market support the ROI on the finishes you want to put in? Do you have any idea what is the wiring or plumbing? If it has aluminum wiring or polybutylene plumbing, be prepared for your lender withhold loan proceeds until you remediate those items.

     

    I love mom and pop investors, especially owner/users like this. As sellers they are generally willing to carry back some paper (a 2nd trust deed). See if you can get the seller to carry back 50% of the required down payment as a second lien.

    Not all banks lending as a senior lien will allow subordinate debt like I propose. But realistically this purchase loan, based on what I see isn't Wells Fargo/Chase material anyway. You're going to need a regional bank to do this deal for you. They are more flexible on terms.

    What market are you in? In CA, converting vacant space to multifamily works out well a lot of times, but you have to project out your interest costs over that time. In CA, getting working drawings, permits and building out this space is an easy 12mo plus. In TX, maybe just a couple months.

    Show the owner user lease comps in the area. If the seller is going to lease back the space, ask him for market rents and go from there. It's real estate...all is negotiable and on the table. You're paying market for the building, shouldn't the seller lease at market?

    Edit:

    Financing structure:

    Purchase price $1,050,000 Seller Carry $157,500 Equity/Down Payment $157,500 Closing Costs $15,000 +/-

    There are other terms on the 2nd you can ask from the seller. For example, if you're not cash flowing for 6mo to a year, I've received 0 interest and 0 payments for 6mo on the sellers note before.

     

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