Evaluating Commercial Real Estate – Part 1

In the Pacific Northwest, where I live, we don’t have a lot of public or hedge fund companies. What we do have is a high number of people who invest in or develop commercial real estate — from the dentist with some rental properties in his retirement plan, to major companies that own huge tracts of land and hundreds of buildings. There are also a lot of people in their 50s and 60s inheriting properties from their parents.

I decided to learn more about commercial properties so I could better evaluate this type of prospect. I talked to experts and did a lot of reading. Like researching stock or an art collection, there were methodologies and jargon to learn, resources to bookmark, and some calculations to understand.

Unlike stock, however, the details are not laid out in nicely footnoted filings. It can take patience, persistence and a big dose of intuition to follow Alice down the rabbit hole of commercial properties and not end up at the Mad Hatter’s tea party. I’ve discovered that what you need is a map that:

  1. Starts with definitions: The vocabulary and property types and understanding an area’s markets and submarkets
  2. Progresses through market factors and profitability: Current local market trends that affect profitability — like what types of properties are desirable, which areas of town are hot and not, and what economic factors affect value
  3. Takes a slight left turn into gift potential: Researching the people, companies and front companies in the market
  4. Ends with the math: Discovering the professionals, the dabblers and the nest egg investors

Part one of this two-part article, which follows, will cover the first two sections of the commercial real estate map: definitions and profitability assessment. Part two will cover the latter two sections: research and math. This trek through commercial real estate will enable you to not only better understand commercial real estate, but also to better partner with gift officers to strategize around donations of property.

Getting Started: The Basics

Commercial real estate is a property used for business and investment purposes. This includes office buildings, any type of retail shopping venue, leisure properties (hotels, restaurants and sports facilities), industrial buildings (warehouses and manufacturing sites), flexible properties that can be configured to tenants’ needs, and farms and land. It also includes mixed-use buildings, like retail with apartments and office-warehouse combinations; multi-family residences with four or more units; and special-purpose units that don’t fit into the other categories, like storage facilities and bowling alleys.

There are three classes of commercial real estate set by BOMA, the Building Owners and Managers Association. However, even BOMA’s website admits the classifications are somewhat subjective.

  • Class A assets are the best buildings in terms of aesthetics, age, quality of infrastructure and location.
  • Class B properties are generally older, not as good looking and often targeted by investors for restoration.
  • Class C units are usually over 20 years of age, in less appealing areas and possibly in need of maintenance.

Class categories are normally noted in “for lease” ads or flyers and on websites like LoopNet and Officespace.com. They are not on deeds or leases, since they are really a marketing tool that is used by lenders, brokers and investors.

There are four types of commercial leases. The type that makes the owner the most money is called triple net (NNN) because the tenant is responsible for rent, property taxes, insurance and maintenance. With a double net lease (NN), the tenant pays rent, taxes and insurance, and the landlord pays for maintenance. Class A and B buildings are generally NNN or NN. Class B and C also may be single net, where the tenant only pays rent and property taxes. Class Cs are most often gross leases and the tenant pays only rent.

A Cyclical Process and Factors to Consider

Commercial real estate is cyclical. The commercial market typically lags about a year behind the residential market, which is a nice indicator for researchers. Developers are hot in an “up” real estate market. There can be a lot of foreclosures in a down market if they are not careful. A good economy also means higher occupancy levels as more businesses are started or expand, which drives lease rates and profits up. A down market means tenants go out of business, downsize or defer expansion.

However, interest rates actually have more impact than the economy, but investors have to be careful — low interest rates encourage investment, but the increase in investment then drives values up and lowers return-on-investment (ROI). Another thing affecting ROI is the down payment required for purchasing properties — many lenders now require a down payment of 30 to 40 percent, up from 20 percent prior to the real estate boom. Other factors that affect commercial real estate include changes to building codes, government tax and fee increases, and tax code and regulation revisions. Additionally, an aging portfolio means increased maintenance costs or big repairs and renovations to remain in the same building class and keep technology current.

How to Make a Profit

There are a number of ways to make money in commercial real estate. Building owners currently earn around 6 to 8 percent on lease revenue. This is better than current bank interest rates and a more stable long-term investment than stocks. More properties mean higher revenues. Owners can sell a building with significantly appreciated value or sell and reinvest the money in a property that generates more revenue and/or has a good possibility of long-term value accrual. They can increase lease rates as the market and vacancies allow — and change lease terms from N to NN or NNN. Some investors buy and flip foreclosures or take the lead in commercial zone urban renewal.

They also can buy low and make upscale improvements (luxury apartments) or reconfigure for a higher-demand building use (warehouse to upscale offices), then increase lease rates and/or sell high. Extra amenities can up the lease rate. A more convenient location or better parking than a comparable building garners a higher rate. The same building in two different areas of the city can have wildly different rates based on location and accessibility.

Return-on-investment and cash flow are low for most commercial real estate, with the big returns coming with property sales. There are several reasons an investor might sell. Properties may be sold because the asset has appreciated significantly over time or it’s an up market. An owner may need funds, be facing bankruptcy, have partnership issues, divorce, or decide to retire. Heirs may have no interest in the investment and sell.

If a building has depreciated (i.e., doesn’t meet current tech infrastructure demands or is dated), but land value has appreciated, that might prompt a sale. If significant deferred maintenance comes due, maintenance costs increase or the building needs a makeover, sometimes a seller will make little or no profit to avoid the cash outlay. When a property has run out of depreciation and the tax benefit is lost also is a good time to sell or gift it.

Alternately, the owner may choose to do a 1031 exchange, which is when appreciated value is cashed out to trade up to a more expensive property that generates more revenue and retains the tax shelter. There are very strict rules governing 1031 exchanges and often the owner employs a firm specializing in managing the details.

Gifting a Property

If a prospect has owned an asset for 15 or more years, the cost of owning and maintaining the building begins to overtake the tax write-offs and ROI decreases, making it an attractive prospect for a 1031 exchange — or a gift. The development officer must have the conversation about gifting prior to the declaration of the 1031 exchange because once it is formalized, there is no legal way to stop the 1031 process.

If the prospect is selling buildings to acquire larger or more upscale properties, there may be some 1031 exchanges going on. This is not the time to ask for a building gift, because the focus is on reinvestment and portfolio growth. Keep an eye on the prospect in this situation to gauge when to step up connection with your organization.

There are other convincing reasons to give a building. Selling a building takes a long time. For instance, buyer due diligence takes a minimum of 30 days, but usually 90 or even 120 days. After due diligence, it can be 30 to 60 days to closing or more because the buyer generally has to line up financing or liquidate assets. 1031 exchanges are complicated, restrictive, time consuming and sometimes risky. And, as with liquidating any asset, capital gains can be a big factor. Gifting has fewer restrictions, is a much faster transaction and offers less complex tax benefits. However, let the gift recipient beware: If the donor is having trouble selling it or is losing money, it’s probably more trouble than it’s worth! Your organization will need to have a professional appraisal done and have an accountant review the profit and loss statement.

When gift officers talk to commercial real estate owners, there are cues that suggest that an asset gift — or a cash gift after a property sale — is a possibility. These are some possible indicators:

  • All my investments are tied up in real estate.
  • I’m selling a building.
  • I’m tired of managing my properties.
  • My building is coming up on a 1031 exchange.
  • I’m getting ready to retire and need to figure out how to manage capital gains when I sell some of my real estate portfolio.
  • We have a few buildings that don’t meet current tech standards.
  • We are moving out of the retail market and into office and industrial properties.
  • My real estate assets aren’t producing enough revenue.
  • I inherited some commercial properties.
  • Capital gains (or estate taxes) are killing me.

Capital gains on sales, as well as estate taxes on inherited portfolios, are good opportunities for an outright gift or the planned gift of a building.

Now you know the basics regarding commercial real estate definitions and profitability. Click here for part two of this two-part article to dive into the research and math.

 


Christine A. Mildner, CFRE, has had a long and rewarding career in healthcare and education fundraising. Currently, she is the senior philanthropy analyst at Legacy Health in Portland, Oregon. She also is a consultant and principal of Strategic Edge Resource Consulting. She was an editor of the Internet Prospector, and has volunteered with Connections throughout her career.

Prospect Research

Want to hear more from Christine on the topic of commercial real estate? Learn about how commercial real estate owners make money, how to evaluate real estate holdings and how to rate prospects in the webinar "Evaluating and Rating Commercial Real Estate Owners."

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