Commercial Real Estate in the Heartland

Hair salon, pet supply, bakery, and florist are a just a handful of businesses that can be found across typical small town USA. Unlike the challenges with filling office spaces in cities, commercial real estate in rural communities is thriving. In this edition of Rural Rich, I'll breakdown the most important term in commercial real estate and share my real world example of achieving a consistent rate of return by investing in rural commercial real estate.

Cap Rate

Arguably the most important evaluation metric in commercial real estate is 'Cap Rate'. Short for capitalization rate, it is a financial metric used in commercial real estate to evaluate the potential return on investment of a property. It is calculated by dividing the property's net operating income (NOI) by its purchase price or current market value.

Cap Rate Example

Let's say you're considering purchasing a small office building that generates $10,000 in annual rental income. The property's expenses, such as taxes, insurance, and maintenance total $2,000 per year. The property's net operating incoming (NOI) is therefore $8,000 ($10K in rental income minus $2K in expenses).

If the purchase price of the property was $100,000, the cap rate would be calculated as follows:

Cap rate = NOI / Purchase price = $8,000/$100,000 = 0.08

So, the cap rate for this property would be 8%. This means that for every dollar invested in the property, the investor can expect to earn an 8% return on their investment. While cap rates depend greatly on the location and the goals of the investor, generally the market defines a 'good' cap rate between 7-10%.

My Real World Example

You may be thinking that the 8% cap rate example, with the round numbers of a $100k purchase price and $10K in rental income, was easy to understand. However, where can you actually find a commercial property to buy for $100k? The answer is rural America.

In 2022, I noticed a commercial duplex on main street in a tiny Texas town with a population of about 3,000 people. One of the sides was available for rent with a sign on the window. I called the number listed on the sign and asked the owner if he would be interested in selling the property. He was, and I bought it for $120K. Soon, a hair salon decided to rent the vacant side for $550/month. Now, between both units I was making $1100/month or $13,200 annually. The tenants pay all utilities keeping my annual expenses of insurance, property taxes, and maintenance at approximately $3,500. That means my NOI is $9,700. This NOI ($9.7k) divided by my purchase price of $120K yields a cap rate of 8%.

Where to Find Rural Commercial Properties

Like many small towns, the information to access great deals resides in the residents of the community. I recommend calling the local realtors to ask if they know anyone with property that is currently for sale or folks who may be willing to sell. Additionally, stop in the local shops and find out more about an individual's business. I've politely asked business owners who they lease the space from and if they know of any other spaces available in town. These business owners will have a great pulse on opportunities in the community. Finally, the internet site 'Loopnet' can be another resource for commercial listings. However, I've found this website to be more applicable to the 'big cities' than the rural communities with commercial real estate.

In Closing

While I'm not going to be able to retire on an 8% cap rate from a $120k property, the fact remains it is a solid rate of return. Additionally, I'm bullish on the Central Texas region the property is located in, and I'm confident the property will appreciate at a much faster rate than 8%. Throw in tax incentives of the property being located in a qualified opportunity zone (more to unpack in a future newsletter), and it's really a great producing asset. Perhaps investing in small-town commercial real estate might be just the thing you need to diversity your financial portfolio.