Making the Move from Residential To Commercial Real Estate

Originally published: Canadian Real Estate Wealth Magazine
March 2014

Differences

1. DEALING WITH TENANTS. In a general sense, with residential real estate, tenants have more power, and with commercial, landlords have more power. This is due to the various residential tenancy acts being used by tenants to protect themselves from landlords, irrespective of where the logical fault lies. In commercial, it is more clear-cut. If a tenant does not pay their rent, then the landlord has the right to lock the tenant out, and even to seize the tenant’s property on the premises in order to obtain payment of rent against the tenant’s goods, equipment and chattels.

2. YOU NEED MORE MONEY. By this, I mean that the property prices are often higher, and your down payment and transactional costs will be greater. While many residential properties can be bought with five to 20 per cent down, most commercial properties will require a down payment of at least 25 per cent, and some as much as 50 per cent. If you don’t have enough capital, you may need to sell one or more of your existing investments. This is not always ideal due to the related transaction costs, but may make sense when a long term investment perspective is considered.

3. AN ADVANCED KNOWLEDGE BASE. The business acumen required to successfully purchase and own commercial properties is greater than that required for residential. You will be negotiating leases representing much larger dollar amounts, discussing clauses and conditions with far-reaching consequences, and shaking hands with more sophisticated businesspeople. A solid understanding of accounting, legal issues and property management will go a long way.

Many investors entering the commercial arena ask me where, and what, they should invest in. The type and location of your commercial real estate purchases will depend on your appetite for risk, and how deep your pockets are. For example, if you are very risk averse, you should buy a property in a densely populated area with triple-A tenants. Keep in mind that you’ll be paying a very low capitalization rate for it, as a low cap rate equals a higher purchase price. However, if you don’t mind some risk, you should buy a property in an up-and-coming area, or where you can add significant value or change the zoning. Lastly, if you hate risk and have a lower budget, you might consider buying into a REIT or syndicate mortgage. Regardless of which strategy you employ, there are three fundamental differences between residential and commercial which you should keep in mind.

Minimizing risk in commercial real estate is similar to minimizing risk with a traditional portfolio, where not only do you want hold different types of assets, but you want each category to be varied. So if you get to the point where you can buy several commercial properties, you may want to consider these suggestions:

? Buy property types which you understand, or which you have the professional support and resources to learn about. To do so, you’ll have to educate yourself about the pros and cons of owning various types of commercial properties.

? Buy properties in various locations so that negative changes in one area will not affect your whole commercial portfolio.

? Buy different types of properties so that fluctuations in demand will be spread across your portfolio.

? If you can afford to, don’t leverage your properties to the max. In commercial real estate, this would mean having a loan-to- value (LTV) ratio of only 40 to 60 per cent, instead of pushing for a possible LTV of 70 or 75 per cent.

? Try to buy properties which have various types of tenants. For example, a plaza with mostly furniture tenants may not be as safe as one with some food, some retail and some service-oriented. Stores with offices or apartments above them are a good way to lower your risk of multiple vacancies.

? Analyze the leases to see if many of them are ending around the same time, or whether they are staggered. You should keep this in mind when signing a new lease or renewing one so that you don’t have the exposure of multiple tenants leaving at the same time.

? Have more tenants in a property rather than fewer. If you have one unit, and it is empty, you have a 100 per cent vacancy. If you have two tenants, and one goes away, your property is only 50 per cent vacant.

Pitfalls to Avoid

? Selling all of your residential properties to get into commercial if you don’t have to. Not only will you avoid the transaction costs associated with selling, but you’ll maintain a portion of your portfolio in a sector you understand.

? Not being prepared for potentially longer vacancies. It is more common to see commercial properties take several months to lease than residential ones, and if you’re not expecting it,then you won’t have budgeted for the necessary carrying costs.

? Asking a residential real estate agent to help you find and buy a commercial property. While many residential Real Estate agents do represent clients buying commercial properties, most of them are unqualified. Analyzing commercial real estate and navigating the negotiations is more difficult than in residential, and require a level of knowledge and experience which the average realtor simply does not possess.

? Not building a strong team of professionals to assist and support you. Your team may include a commercial real estate lawyer, mortgage broker, property inspector, surveyor, environmental engineer and a commercial realtor. Make sure that their strength and experience are in commercial real estate.

? Forgetting to put on your “creativity hat.” Deal-making is much more creative. For example, if you don’t have enough of a down payment to buy a specific property, you can ask the seller for a VTB (Vendor Take-Back) mortgage. Not confident that a tenant is going to survive in the property you’re considering? Suggest that the seller guarantee the rental for that space for a period of time following your purchase.Is your lender loath to loan based on the collateral of just one property? Ask them if they would consider a blanket mortgage on several of your properties.

It seems that the ideal entry into commercial real estate is a multi-residential property, which will be familiar to those already investing in single-family. There are several reasons for this:

1 The value of each unit is small, compared to other income producing properties. This means for that same price, you will have more tenants, thus less risk.

2 For multi-residential properties, you can traditionally borrow the most money (higher LTV ratio). This would be done at a lower interest rate if you opt for a CMHC-insured mortgage, since the risk to the lending bank is lower when the mortgage is insured.

3 These properties are usually easier to sell because the demand is so great for them.

4 Income with multi-residential properties tends to fluctuate less than other income properties. This is because of residential versus commercial tenancies, since in commercial, five-year leases are the norm, and the rental from each tenant represents a significant percentage of the total property income.

Downsides of Multi-Family Properties

? They are difficult to find and buy.

? They frequently suffer from deferred or low-quality maintenance.

? They are management intensive.

? Their tenants are more likely to default on the rental obligations or to damage their units.

? Their cap rates are lower (and so are their returns).