From Houses to Portfolios

A very brief look at the different levels of real estate investment

A friend asked me this past week about what is different between residential and commercial investment properties and I thought there are likely others who have the same question.

At the most basic level there is little difference between residential and commercial investment properties. In both cases the investor is purchasing a property and leasing it to someone who is paying for it. The devil is in the details as they say.

Starting with a single family home rental let’s get into the details.

Residential Income Properties (less than four units):

$2400/mo; wood floors; W/D; first; last; deposit; tenant responsible for all repairs

With residential income properties the investor is purchasing a single family home, duplex, triplex or quad / four unit property. This threshold is seemingly arbitrary and imposed by the lending regulations. More than four units is considered commercial and less is considered residential. Needless to say the largest relevant distinction for investors to understand is that lending terms can be far better in the residential world.

All of these are based on leasing out living space to tenants. Starting with a single family home an investor is buying an entire, stand alone, property that is, typically, leased to a single tenant. One lease, one roof, one foundation, one yard, etc.

Residential is typically provided with a variety of appliances including dishwashers, fridges, and even washers and dryers in some. All of these are for the use of a single tenant and maintenance is typically provided directly by the investor.

Small residential leases can be as rudimentary as a single page covering the basics; they can also be provided as a template from a city or county regulator or you can have a lawyer put something specific together for you. Given that most leases are for a year or less, exposure and risk are usually pretty small and the sums of money are limited.

Investors in residential run the gambit from individuals who may have only one property to major private equity funds that own thousands of homes. It is possible to make a very good living by amassing a handful of rental properties and self managing / maintaining them.

Classic uptown fourplex. Hear your neighbors flush.

The downside to single unit rentals is that when they’re vacant there is no one providing an income. In a multi-unit property any vacancy load is spread evenly between the units. This is a critical difference and one that can sink a small investor if the market turns and they’re caught out.

From a financing perspective these can be quite a good deal as lenders typically offer similar terms to a primary residence. This can provide a very affordable way to get into property investing without substantial capital. Financing is one of the biggest things to change as we get into larger and more complex commercial properties.

Small Commercial Properties (single, under ~10,000sf properties):

Subway or noodle bowl?

These are all over. Once you start looking for them they’re everywhere. Smaller, strip retail centers, small office buildings and of course smaller industrial sites. The size cutoff is more arbitrary here, one I use more as a rule of thumb, and is not a size related lending change like the shift from single family to more than four units was. Instead I consider these properties where it is still quite reasonable to think that a single investor can purchase, manage and handle all the maintenance by themselves. Getting much over this level and it can quickly become clear that help is needed. This depends on the property type and tenant mind you. I know industrial guys that do 100,000sf single tenant properties all by themselves but that’s a unique case. In addition most of these will be owned by smaller local investors and even small groups.

For the majority of active investors this size property may be as far as you ever need go in your investing life. One or two of these properties, well managed, can prove a very nice set up. In residential these would be properties with between four and twenty units; in retail it’s typically four to six tenants; office can be up to ten or even more small users and industrial could be one tenant or broken up like an office into many tenants.

Keep in mind that this is the investment range where having multiple tenants under the same roof and on the same foundation really begins to benefit the ownership. Consider that if you owned six single family homes you’d have six of everything you’re responsible for (roofs; foundations; heating and cooling; laundry; etc.) but in a six unit apartment building you can have one roof; one foundation; a common laundry and possibly even a boiler system for heating the entire building. All of this reduces the number of different systems to be maintained and replaced.

This is the level where, as an investor, you will begin to see the advantages (and disadvantages) between the different product categories. For example: a good portion of retail, office and even industrial tenants will want to have longer lease terms than the standard residential one year term. Longer leases reduce management further and help lock in future value. Sign a lease one year and get paid on it for five years or sign a new lease every year with new tenants. Pretty easy math.

Leases in this category gain a level of complexity and when dealing with retail, office and industrial you will begin to see specific types of leases depending on what costs are paid by the tenants and which are paid by the landlord (NNN; NN; N vs MG). You need a good lawyer to assist in the drafting of these leases and may need them for any issues that arise as well. Commercial real estate brokers will become a part of your life in bringing tenants to your property; negotiating leases; and even canvasing your tenants to move them to another building.

This is also where you see investors begin to specialize in a particular product type. Specialization provides a better understanding and better management which is better for tenants and makes ownership much smoother. The details of owning a sixteen unit apartment building and six unit retail center are completely different and there are limited crossover benefits. Owning a sixteen unit apartment and a six unit apartment have multiple benefits including that you are able to provide an option for tenants moving between the two properties.

Lending at this level is also, generally, much more flexible and forgiving. Many local banks and credit unions love these properties because most owners are local and hands on. This makes owners directly accountable and lenders able to even drive by and see that a property is still there and in good condition. Terms can be more relaxed as well with less concern on deposit requirements and tenant improvement reserves. It’s still even entirely possible for a new investor to understand all of the terms and obligations of lending for these types of properties.

The Big Time (10,000sf and larger individual properties):

IniTech Headquarters, next to Chotchkie’s Restaurant

Above around 10,000sf things begin to change rather quickly and it becomes obvious that you need to have a pretty solid understanding of the systems and details in order to succeed. In essence it’s still the same fundamental concept: you own a building and tenants lease space in that building from you but the layers and details become very important. Understanding all the details and how little changes can have a big effect if you don’t get them right is imperative.

It also is less likely that a single investor or small group will be able to keep up with everything let alone be proactive. Juggling tenants, maintenance and financing on larger properties can keep a small team of people busy and that isn’t even taking into consideration accounting, legal and tax implications.

As investments get physically larger the layers of complexity grow and the interconnected, intertwined and interdependent issues multiply at a rather amazing rate. Everything from taxes to lease termination dates begin to play on other parts of the property. If a tenant moves out before the end of their lease that has a ripple effect and the cleanup can take weeks before you’re able to release the space and even when you do it will likely cost you money as, generally, no two tenants want their spaces laid out the same way. Nevermind the legal time and cost to pursue the tenant and on and on.

Around this sized property is where you see people begin to shift their view to it being an investment, not necessarily a project. This is the level where a large segment of those putting up money for projects and deals has no interest in managing or in many cases even seeing the property. This is an important underlying pressure that should be well understood. Answering to investors about why their returns were down this month is a whole other animal and one that can ruin an otherwise excellent deal.

As well lending changes, substantially, at this level. While banks still make up a fair portion of the leverage here there are multiple other sources that come into play. Including life insurance companies that have ample funding to place on a regular basis and prefer larger assets for their stability. The details of lending at this level also take on a rather amazing volume and understanding all of the lenders requirements can be critical as everyone wrestles for the best position in the investment. Most lenders don’t necessarily want to find ways to take the property over should you have trouble but they will have reams of requirements to insure that their investment in the property is protected. These can include monthly or quarterly reviews of the books to keep track of the solvency of the operations.

Again this is where you see entire companies dedicated to managing properties with individuals specializing in things like just managing the lenders needs and expectations. Specialization becomes required as it all becomes that much more complex.

Investors in this upper size range will likely have decided to specialize in one particular product type. Given all the detail work required and the nuance of each property type at this level it is unusual for an investor to cross products in their portfolio. Unless, they have a large enough operation to have built the support to manage each type. Typically seen only towards the upper end of this range.

Towards the upper end of this range you will begin to bump into the institutional investors. This highly efficient and well funded group plays by metrics that the average commercial property investor cannot compete with. Many times formed under the acronym REIT, or Real Estate Investment Trust, these are typically large portfolio buyers and owners with hundreds of employees spread around the country. In general these companies do not require leverage to acquire properties, as they’re placing investor capital, and their financial modeling is some of the most sophisticated and intense you will ever see. They generally know where every penny goes and have it’s path mapped since they are beholden to regulators who like to ensure there’s no funny business going on. Unless you have a unique angle or very deep pockets and a penchant for very low cap rates competing for deals with institutional buyers is not something I recommend. They’re generally amortizing returns over an enormous portfolio of properties and thus can stomach some rather absurd cap rate deals that do not look to be worth it.

The Portfolio – Go Big and then Go Bigger:

Just keep adding zeros

Reserved for the institutional and the manically driven the level of owning large numbers of larger properties is a beast unto itself. Investors at this level typically have large companies in support and most will never set foot in the majority of their properties. Typically single product type focused these companies, like REITs, are focused and diligent on the details. Shopping center owners and office park owners live here and when the go looking for a lender they look to the likes of sovereign wealth funds and large state retirement funds. This adds yet another level of complexity to ownership with full teams assigned to lender management.

If you ever get the opportunity to visit and tour an operation like this take it. Even if it’s self storage or industrial and you care little for the product. At this level it’s just a huge company whose product happens to be space. The operations will look familiar but astronomically more complex.

At the root though it’s still just owning a property and leasing out the space.

Wise Acreage

Short Advice on Real Estate and Life

“Don’t wait to buy real estate. Buy real estate and wait.”— Will Rogers

“If you think hiring a professional is expensive, wait until you hire an amateur.” – Red Adair

“Entrepreneurship is living a few years of your life like most people won’t, so that you can spend the rest of your life like most people can’t.”―Anonymous

“Landlords grow rich in their sleep.”―John Stuart Mill

“Buildings don’t move, but neighborhoods change all the time.”―Anonymous