Commercial vs. Residential Real Estate Investing

Uncategorized Jun 12, 2023

Today I'm making a new pitch deck for a commercial real estate project. Hopefully, in the next week or two we'll have a good financial forecast and start having meetings with investors to raise money to buy a commercial real estate property.

So when I say we're doing the new pitch deck, what does that look like?

It’s a presentation outlining the idea, the feasibility, who the team is, why it's a good opportunity, that type of thing.

Now to give you guys a little bit more insight into what we’re working on and why we're approaching things in the way that we are, we have to talk about the difference between residential real estate which is what I was doing and Commercial Real Estate which is what I'm looking to move into.

Residential Properties

So in residential real estate, you find the value of a residential property by looking at comparable homes.

So if I have a three bedroom, two bathroom, built in 2001 and it's in similar condition as a three bedroom, two bathroom, built in 2001 that's next door to me, then whatever that home sold for is probably going to be pretty comparable to what my home sells for.

And if my home is nicer than that home, then it'll probably sell for a little more. And if it's not as nice as that home, it'll probably sell for a little less.

So the value is all about comps.

Commercial Properties

Commercial properties can also refer to commercial/residential, which is five units or more.

So a 50 unit or a 500 unit apartment building is technically commercial real estate. Or it can also refer to more business-focused properties, like a strip mall that has a CVS and a Starbucks in it. So those are some examples of commercial real estate.

And what we're talking about right now is moving into commercial real estate that is more business-focused than residential-focused.

NOI (Net Operating Income)

But either way, instead of depending on comps to find the value of that building we want to focus on something called NOI or your net operating income.

And your NOI is basically the income that the property makes minus the expenses, but you don't include debt payments.

When we look at how much the property makes in income minus the expenses (what you're spending on maintenance, what you're spending on utilities, what you're spending on employees and all your other business expenses) except your mortgage payment, that's going to make up your NOI.

There are more in-depth reasons as to why you want to ignore your mortgage payments, and if you're interested in this type of thing I definitely recommend you read “The Multi-Family Millionaire Part Two.” That's the one that talks about commercial real estate.

The book “The Multi-Family Millionaire Part One” talks about residential real estate.

Read them both.

One of the reasons that you want to ignore the debt payments is because you want a good look at how well that business is operating outside of how good of a loan the owner was able to get.

So if I went to get a loan and it was shortly after the pandemic and interest rates were three percent, well then my debt payments are going to look a lot different than somebody who's trying to get a loan right now when interest rates are at six or seven percent.

And so we want to ignore the debt and the interest rates so that we're getting a good look at the true expenses of the business and not the expenses of the business that are dependent on the terms of the debt that someone was able to borrow.

But why is NOI important?

Cap Rate

Well when you're looking at Commercial Real Estate, the way that you come to the property value is by taking that NOI and dividing it by something called a cap rate.

In Multi-Family Millionaire Part Two, I listened to it on Audible until I really understood this concept of cap rates.

But basically in every market there's going to be a cap rate that investors are using to determine property value.

So whatever the NOI is, divided by that market's cap rate will give you the property value.

And what's most important is that you understand how changing that NOI impacts the value of the property.

So let's just put super simple numbers to it for you to get an understanding.

Let's imagine we have a commercial property whose NOI, the income minus the expenses outside of the debt payment, equals a hundred thousand dollars per year.

Okay and let's say that in this particular market a five percent cap rate is typical.

Well that would give us a property value of two million dollars.

Now let's say that we're actually really good business people and really good business operators.

And instead of a hundred thousand dollars in NOI, we're able to get the income up and the expenses down so that when we take our income minus expenses we actually have three hundred thousand dollars left over when the year is at its end.

Divided by that same five percent market cap rate, now our property is actually worth six million dollars instead of two million dollars.

And this is why commercial real estate is really appealing.

Because instead of residential real estate, where the value of my property is just dependent on the comps of what everything else around me sold for, with commercial real estate the value of my property is now dependent on how good of a business operator I am.

And if I'm able to get my NOI higher so that the value of my property at the end of the day can be more, that can be beneficial when I'm going to refinance.

And maybe I want to do a cash out refinance and get eighty percent of my property's value out of the deal.

If I'm looking at eighty percent of two million dollars, that would be $1.6 million dollars that I might be able to get from a cash out refinance.

But if I'm looking at eighty percent of my increased $6 million dollars, now I'm looking at a cash out refinance of $4.8 million dollars.

Or if I'm just looking to sell the property, now I can show that with a three hundred thousand dollar NOI and a 5% cap rate I've got a $6 million dollar property value on my hands versus a $2 million dollar property value.

So a lot more of the control in terms of what the property is worth is dependent on my savviness as a business person rather than just the comps of the other residential properties around my property.

You could run your own business out of that commercial property that you own and you'll have even more control over the income and the expenses.

Now that's not to say that every real estate investor is also going to be a really good business operator, but I like business and I view myself as an entrepreneur.

Part of what I do is invest in real estate, but I'm also really interested in running other businesses of my own such as my agency and such as this new endeavor that we might operate out of the commercial spaces.

So in that case, we'd own the commercial space but also the business that operates out of it and that's the business plan that I'm working on putting together and presenting to build out the financial model.

Then, we can see really how feasible we think this is going to be, if we're going to be bringing on investors, and exactly what type of commercial property we're going to need to execute on that business plan.

So I was heading home and I got a text from a commercial realtor that I worked with named Carson. He knows all about this big project that I'm working on and he's got his eyes out for some potential industrial/commercial buildings that might fit our needs and so he sent me one and I went and drove by it.

I don't exactly love the location that it is in, but I do think it's a pretty cool building being that it's an old fire station and so there is some good potential. I'm putting it on my watch list to keep an eye on.

But before I can ever really think about what property is going to fit all our needs, I really need to shore up this business plan and this pitch deck so that we'll know exactly what type of building we're looking for in terms of square footage and cost and then I'll be able to really make some moves on the real estate side.

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