The do’s and don’ts of investing in commercial real estate

I’m a HUGE fan of investing in commercial real estate, for various reasons:

  • Predictability of value and cashflows
  • Low beta compared to the stock market
  • Low liquidity is a minor issue for me¬†(money management is something you do BEFORE investing, not after)
  • Perhaps most importantly, smarter people than me have said that real estate is one of the very few industries where mediocre people can succeed ūüôā

However, there are some caveats.¬†Some things to consider and avoid, when contemplating investing in commercial real estate. This applies to investing on a non-instutional scale. Do’s and don’ts, with an emphasis on don’ts:

  • Don’t¬†invest in commoditized real estate. You lack any kind of pricing power and are likely to eventually be outcompeted by bigger and smarter fish. An example of this would be a stock office building in an area of several such buildings. Another would be a B location office building (regardless of building quality) in an area where zoning laws are lax and/or new competition is coming to market. Do try to seek out properties that have some competitive advantage to them. “Location, location, location” is and overused cliche, but it encompasses a lot more than¬†“buy in the city center”. It can be regional road intersections¬†for billboards or wireless towers. It can be¬†the single, grandfathered office building in a fully developed residential area with restrictive zoning laws.
  • Don’t buy small, scattered properties, when you have the option to buy¬†a single property with similar characteristics. There will ALWAYS be management, maintenance, repairs and insurance and these things scale well. Scattered properties incur a huge overhead in terms of property specific issues and time to take care of them. It takes MORE manhours to maintain 5×3000 sq ft than 1X60000 sq ft. Do try to concentrate purchases, if it doesn’t raise the risk profile. Absolutely do it, if it lowers it.
  • Don’t buy a property with a building, when you can buy land with a similar cash flow and risk profile. Ceteris paribus, owning the land is always a better idea than owning the building. Buildings need time, energy, thought and money to maintain their value. You can outsource this¬†for a fee or do a hardcore NNN lease, but this is not a guarantee that you don’t have to worry about a pipe leaking at 4:30 AM and flooding valuable stuff belonging to someone else. On the flipside, they will never call you during the night to notify there’s a slight breeze on your property. Do look for¬†properties with a¬†ground lease with a worthy counterparty. In that situation, you move down the risk ladder with an added cushion for adverse circumstances. The land is basically a senior tranche in the entire property.
  • Don’t take sales presentations for commercial properties at face value. The fact that something is written down doesn’t mean it’s right, or a good idea.¬†Do your homework. What’s the market lease rate vs the property on offer? Always check the background on the tenant’s key people. Try to assess counterparty risk, whether financial, operational or even¬†litigation, if possible.¬† It’s especially important to be sceptical, when offered a property where the owner will remain as a tenant. These types of transactions (sale and leaseback) have a high probability¬†of being a bullshit financing deal instead of a legitimate real estate investment.¬†I’ve written about inflated yields before.
  • Don’t buy stuff that doesn’t have a plan B and preferably plans C and D. For example, if you buy farmland in an area where there is only one possible tenant, you lack options. It MAY be an OK deal, if it’s a long term, unbreakable lease and the counterparty is financially solid, but do consider various “what ifs” that might impact your investment.

The most important thing to remember: investing in real estate is about the land, not the building. From a purely financial and not aesthetic standpoint, a building = zoning + planning + materials + work. Planning is a commodity, materials and work as well. With the extreme exception of some high-density metropolitan areas and related air rights, zoning is almost always a commodity as well. The only thing that is not a commodity, is the uniqueness of the land.

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