Add a Couple of Zeros to Your Profits

“Money frees you from doing things you dislike. Since I dislike doing nearly everything, money is handy.” – Groucho Marx

One of the great things about commercial properties is that you can find under-market value deals just as you can in residential property investing. And you can also use strategies to quickly “add value” to the properties after you acquire them. But when you do it in commercial, the paydays are much bigger and you have more opportunities to jack up your profits. Let me use one of my very first deals as an example to show you what I mean…

I found the property on LoopNet.com. It was a 22,000-square-foot office building in Kissimmee, FL. It looked like a reasonably decent deal, so I sent the seller an e-mail. I didn’t hear back from him, so I chased him again, and again, and again.

This went on for a few weeks until he finally wrote back and said he was going on a trip, but would send me some information when he returned. Now I was really interested. Most people would have given up after the first e-mail went unanswered, so I knew that 99 percent of his potential buyers had probably dropped out by now.

A few more weeks of chasing later, the numbers finally arrived – and I went to see the property the next day. I was the only person who’d seen it…

The seller showed me around. It was a nice property, class B – which generally means over 10 years old, but nicely kept. (Class B properties are often good buys.) It had a dozen or so tenants (I like to see five or more, so you’re not reliant on just one person paying rent), and the price was right. Plus, it had a 9 percent CAP Rate. (The CAP Rate is basically the yield of the property; the higher the better. If it’s comfortably higher than your loan cost, you should get a good, positive cash flow.)

The deal looked good, so I wanted to try to get the right terms.

“Will you hold paper if I give you a good price?” I asked. By that, I meant would he loan me all or most of my down payment and closing costs – that is, would he carry a “second mortgage”?

“Sure,” he said. We signed an agreement within a week.

He ended up carrying a good size second mortgage. Meanwhile, the first mortgage I got from a bank ended up being for five percent more money than I had expected them to lend me. Suddenly, the deal was over-funded. I walked out of the closing with a check for $235,000. Not too bad…

I hired a management company to run the place, and went looking for my next deal.

A couple of months later, I was looking through a local business paper. Medical office condos were selling for $188 per square foot. I had paid $104 per square foot for the Kissimmee property. What’s the difference between an office building, like mine, and an office condo building? Nothing. Just some paperwork. It’s pretty much just splitting the title deed down into smaller lots so they can be sold individually – so the pieces are worth more than the whole.

To turn my office building into office condos, I first had to get approval from my lenders – the bank and the seller. “What’s in it for us?” they asked when I asked them to move their mortgage liens over from the building as a whole to individual units. “The property is worth more that way,” I explained, “which means your lifetime value figures will decrease, making the loan safer for you. I also have the ability to sell off units individually, paying you back faster.”

The lenders agreed that changing the property’s use was a good idea, so the attorney did the paperwork. And I was suddenly the owner of about 20 office condominiums, worth about 80 percent more than I’d paid for a plain old office building a couple of months before. It was an instant equity gain of $1,848,000. Again, not a bad result, and everyone else did the hard work.

Let’s compare this commercial deal to a residential deal…

Price: The office property was offered at a price where it would make money – because if it hadn’t been, no one would have been interested in buying it. But residential deals are sold as places to live, so they often sell for prices much higher than they are actually worth.

Financing: Financing was easy to get for the commercial deal, because I didn’t have some nervous lender worried about underwriting a sub-prime deal.

Sellers: The commercial property seller was willing to hold a second mortgage. Unlike a nervous homeowner, he was a savvy businessman who knew that would close the deal.

Possibilities for more money: Changing the use of the commercial property to increase its value was a snap, but a house is always just a house.

This all goes to show what I’ve been saying for a while: Commercial property is not that difficult to do. In many ways, it’s easier than residential deals. Plus, the market is a lot more stable, because investors are buying income streams (rents) rather than speculating on single-family homes and hoping for an ever-rising market.

Here are a few things you can do to prepare yourself for your first commercial property deal:

• Start educating yourself about key terms and concepts in commercial real estate. That includes Net Operating Income or NOI (what’s left over after expenses and vacancy but before debt service), “CAP Rate” (NOI divided by sales price), and Debt Service Coverage Ratio (how much of the monthly mortgage payment the NOI covers).
• Surf Loopnet and other commercial sites to get an idea of what commercial properties are selling for in your area, and how CAP Rates vary depending on the location and type of property.
• Surf Loopnet to also see what commercial properties are leasing for in your area so you can start to gauge the income you might bring in if you bought one.
• Seek out and talk to other commercial real estate investors. It could be the landlord of the building where you work or members of local investor real estate groups who specialize in commercial property.

Last, but not least, start thinking big. Once you’ve made profits on a single deal that are equal to what you might make on five, 10, or even 20 residential deals… with a lot less hassle… you’ll be very glad you did.

[Ed. Note: Toby Unwin is an active real estate investor who has made millions of dollars investing in income-producing commercial real estate, including office buildings, apartment houses, and shopping malls. Tomorrow, Toby will share his investment secrets on a limited-access, reservations-only teleconference call.]