How to Invest in Commercial Real Estate

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Episode #005 - Commercial Real Estate Asset Classes & How to Evaluate Them.

by Criterion, Braden Cheek, Brian Duck
December 18th 2020

In today's episode we have Brian Duck and Braden Cheek from The Criterion Fund, and Joel Thompson from Precision Equity going over the different asset classes in Commercial Real Estate and what to ... More

I remember we looked at this one deal and it had its own sewage plant on it. Yes, in north Carolina, they literally processed their own sewage. Yeah. How's it going guys? And welcome to episode five of how to invest in commercial real estate. My name is Brandon Sheikh from the criterion fund. I'm joined by my partner brian Duck, also co founder and the criterion fund and Joel with precision equity. What's up guys? What's up man? How you guys been pretty good, good, got some snow over the weekend. It's it's cold war at, at the time of recording. But anyway, the episode today is all about how to invest in commercial real estate in the different asset classes that people are investing in. So when somebody's investing in commercial real estate, they typically have um you know, the top four or five asset classes um in mind industrial properties. Um so those can be, you know, single tenant, those can be a lot of things, warehouse space, ideally uh multi family, which is basically apartments. Um you have retail strip centers which businesses lease out like, you know, target Gamestop restaurants, etcetera.

Um Raw land, you have hotels and office hospitality and then office, yep. So we're just gonna hop right in um I think the first one is industrial, so hop on over to the slide we made. Um you can see there's a few different pictures of what an industrial investment could look like. Um So let's just hop right in Joel, what are some pros and cons of industrial and then, you know, comparatively speaking to maybe some other asset classes. Um how do they trade? Well, I'm obviously not an expert on industrial. We've looked at a lot of industrial deals over the years, but we've never purchased those. Uh but I do know that a lot of people like them and buy them. Uh previous employers, employer stan johnson I worked at, they sell a lot of single tenant uh industrial deals like Fedex facilities and warehouse. Um I say distribution center, distribution centers and really fracturing. Industrial has become um a little little bit of a hot area of commercial real estate.

A lot driving in our market and in Colorado and others is is marijuana, indoor grow facilities. They've been sucking up all of the vacant uh industrial space, But just by nature, industrial tends to be more single 10ant because it's a lot harder to divide. Usually it's bigger spaces with high ceilings, uh warehouse specialized for the user to yeah, they may have heavy lifting cranes. So it's but it's manufacturing warehouses, its distribution centers, uh storage facilities. Self storage is kind of under the umbrella. Um You know, comparing it. It typically is a lower price per foot, obviously it's a lower rent per foot uh than retail and office and um and a couple of others, but uh I would say the returns are, you know, the cap rates are a little higher than multi family and retail. I don't know, there's probably some lower if you get a credit tenant for a long time, like we get Fedex on the hook for 10 years, it may be a six cap, but if it's just a local manufacturing shop or warehouse, it's going to be on the higher side.

Can it be riskier Because being single 10ant that uh you know, you buy a manufacturing facility or something and uh you lose that lease or um so does it have more risk factor than maybe some some of the other retail where you've got multiple tenants? I think single tenant always has that inherent risk of losing the one single tenant. But I I think what goes hand in hand with that is they typically have longer lease terms um to make up for that. So you're getting 10, 15, 20 plus year lease if it's a single tenant deal. Um and then a lot of single tenant um deals are full triple net, meaning they ensure the building themselves, they pay the real estate taxes directly. Um they're taking care of any commentary maintenance and that could be a benefit to industrial as well. Um Just because it's super easy to own, You may not even need a management company. Yeah, the risk profile for industrial is Way more focused on the credit of the 10ant versus um multi tenant retail or multi family or an office that has a bunch of uh different users in it.

So really you're if you're going to get into industrial either gonna try to get it at a low price point? Maybe vacant and try to lease it or um you'll want to really analyze the credit. Um If it's a single 10ant industrial. Yeah, I mean there's there's a lot of different types of industrial. I mean I don't think people are buying industrial properties based on location necessarily. It doesn't have to be in a busy thoroughfare with tons of traffic counts. It's not necessarily focused on the consumer. It's maybe not the sexiest building you've ever seen. Typically got high bays, garage doors. Um And I mean it can be anywhere from your leasing 1000 square feet of bulk warehouse space for you know, eight bucks a year. Or you could be amazon released thousands of millions. I mean amazon is leasing millions and millions and millions of square footage that they don't know. So um it can be super specialized for you or it can just be general, you know, warehouse space for, you know, a c service company and they just need 2000 square foot shop and a receptionist that's perfect for them. Yeah, definitely. Location is not the main factor credit or the price point you're getting at is all right, so the next one we have is multi family.

This this is a good one for us, Joel has done a lot of multi family deals, done it for a long time. Um Yeah, I mean why do you do multi family, why do you love it, what does everyone else love it? Walk us through it. Yeah. So we started with flipping houses. Um I think we've covered that and we just wanted to get into bigger deals and uh that was something, you know, we we originally looked for, hey we got, we got uh we've done several houses now and look for an eight plex or 10 plaques. That was My thinking. And looking for a 10 plaques. We ended up Finding a 48 unit. That was our first one. So it's just kind of a progression from single family uh to multi family. I didn't really understand or I really wasn't aware of how the other asset classes worked at that time. That was something we learned along the way. So your business plan was to take this value add, you know, house flip strategy and do it on an eight or a 10 plex. And just initially at a time let's let's improve them will get higher rents and then we'll sell it because it makes more money. That's right. That was our planet first like industrial.

Are there different types of multi family? I mean what there's, I guess there's high rise apartments in bigger cities. Um Sure. You know, unfortunately don't have any money or experience when I started, so I was looking at older run down multi family because that's all I felt like I could afford. I like a class C. Or class D. Yeah, they were, they were tough assets that people were wanting to get rid of. Um, you know, I, if I had it to do over again, I may have taken a different path. But yeah, we, we cut our teeth on some of the tougher, tougher area, tougher location may be rough around the outside. We picked it up at a low price point and at the time I, I thought that was the only way I can get into that side of the business. Yeah. So I mean, okay, why, why do investors love multi family? Like what is, what is the most obvious inherent thing about multi family? You know, it's, it's a living space, right? Yeah. I think a part of the attraction for investors is the fact that some people got to live somewhere. Right?

So as opposed to retail or some, a lot of these other asset classes, um, whether people are losing their jobs or uh, whatever may happen, it's the first bill they're, they're going to pay the first bill they're gonna pay, is there usually is their apartment bill because they don't want to have to be, you have to move, um, you know, going back to your question, they do come in all different types. You've got, uh, a class would be brand new, uh, multi family in a really good market. Um, like that. Read and read and glass one up on the presentation. That's a, that's a really good you know custom a class apartment deal that you might see and you know Dallas fort worth or southern California or something like that. And so a class you'll either get brand new stuff is called a class or really well located uh stuff that may not be brand new. That's still a class. It's in downtown Dallas or something that may be a class multi family then your B. Class. Typically it follows age so you get an apartment complex, it's 10 15 20 years old.

So it was in a. Class but it's just you know yeah little age on it. That's right and it's and it's out of date, it's not the fresh new place maybe that people are moving into. So the rents Are a little lower and they typically are not high rise, they're they're cheaper builds their garden style. When someone says garden style is usually 2-3 story suburban type multi family units that you see driving around your neighborhoods. That would be a typical B. Class. Could you have a B. Class? That is fairly new construction but it's in a less desirable location maybe or is that because it's fairly new construction that that automatically makes it a rather than be. Yeah you might uh these are not hard and fast, not hard and fast rules with these. So someone may say hey it's a it's a B plus asset because it's it's fairly new but it's not in a great location. Yeah, sure less masonry or you know cheaper build or something like that. I can understand you. And C. Class is uh is something that we've done a lot of, that's where we've made a bunch of money because you know, you kind of eliminate a lot of competition in that.

Not everybody plays in the in the C. Class space, especially the big time investors, private equity, you know, international money, they're going for class A stuff in a really good market. So by the time you get to see which may be in 19 sixties, seventies build, they're typically in neighborhoods that are older, run down the operators and owners aren't as good at what they do. Uh And so that puts it in a kind of a C. Class type type deal. C Class doesn't mean it's it's not, you know, you can't make money on it, you can make a lot of money buying it at the right at the right price. I think, I see, I think of C. Classes, workforce, blue collar housing, you can go out and get pretty much any job and go get a C. Class apartment. No problem. That's a C. Class A B. Is um, you know, I've, I think you can probably build a brand new B. Class. Um but I think it be is just a slight step up, you know, it's it's uh you know less age, so it's maybe, you know eighties or nineties and it's not sixties and seventies build. So um you mentioned that a lot of big money goes after class a uh apartment or multi family, does that mean the cap rates are a little more compressed because you've got big money paying maybe uh maybe uh paying a little bit more money for the for that asset.

And so it's a little harder to buy. And and yeah, we haven't done a show on cap rates and I know we need to, the cap rate is just uh basically the yield or return simplified, we'll break it down later. And so yeah, as someone pays more for a property that's making a certain amount of income, the yield goes down on your money. And and so yes, typically uh you get, you know, go ahead and describe primary markets, they are, you know, entry level markets like L. A. And san Francisco and new york. And they're well established, they're they're they're really large and you know, everybody feels comfortable buying there where there's a lot of money around the world chasing those deals. So the cap rates can get driven down. And right now I think you're seeing four and five cap multi family deals, maybe even less than some of those cities. And then as you move to what's called a secondary market um you know that maybe Nashville uh maybe Dallas Salt Lake Atlanta. Uh I would say, well we are Tulsa, Oklahoma city, they're kind of on the cusp of a tertiary market, moving into a servant, a million a million people in a person S.

A. Is typically a cut off for a secondary market. And then you have tertiary markets were just smaller towns, uh not major metropolitan areas. And and so the cap rates are gonna gonna change not only in in L. A. They're gonna change from a class a deal to a class C. Deal or even a D. Class multi family, but uh you know, they're gonna move across primary secondary and tertiary markets. So what we've seen over the last 10 years or so as the multi family market's been super hot is you know, people can't compete in L. A. So you're getting some bigger buyers into Houston and Dallas. And then pretty soon those buyers can't compete in Dallas. And so now they're like well you know, maybe I'll go to Oklahoma City, maybe I'll go to Tulsa because you know, they're they're one of 20 bidders on a six cap deal uh in in Dallas. And now they can be one of maybe seven or eight bidders on a seven cap deal in or 6.5 7 capital in Tulsa. And so that that's what we've seen a lot of. And the last asset class or style of apartments is D.

Class. And that is either uh the location is so bad that you it's rough, it's it's uh maybe as a higher crime down units maybe and then yeah or you've got a large amount of vacancy and and run down units that that that are not livable. And so I've I've purchased a bunch of D. Class units as well and a lot actually yeah most people they don't they don't want the heavy lifting of going in a place like that. And and with rundown units the management isn't good and the area is a little tougher but we found that that those areas Are are really needing better management. And so we just go in and you have a bunch of you know maybe you've heard the term slumlords they're just they're absentee owners. They're not taking care of the their assets, they don't care about the 10ets and they don't they don't fix anything. You know the leaks and everything. So no one really loves living there but they have to live there because they don't have enough money to go to a better place where we go in and and we we just you know make the units ready and we bring a management team in there and were attentive to the to the tenants and we bring a community feel well now it's easy to rent at a premium in that market because all the other C.

And D. Class units that don't have good management they're they're coming over to our place and so even though the perception of the area isn't good if you can be the best in that area. Uh you've got a shot to make money. Yeah, interesting. Yeah, I like that play. I mean what other people were avoiding, you saw dollar signs in, you know, that's, it's typically where you're gonna make your money, you know, some piece of garbage that everyone else passed on and just dig it up enough. I remember we looked at this one deal and it had its own sewage plant on it. Yes, I mean Carolina, they literally processed their own sewage and I still think we should've bought that deal. Yeah, we almost did. But we ultimately didn't wanna didn't think we get our head around would be more money to be made in those because like you said, I can't imagine a big company that's going in and buy and they don't want to do the heavy lifting, they just want to, I want to buy and operate and move on. Yeah, so we spent a lot of time on multi family, but that's a super popular asset class. Um Super popular. The next one is another one of my favorites. It's retail brian walk us through retail a little bit.

What what encompasses retail when we say that's in the retail asset class, retail could be a uh a strip center. Strip shopping center. Um It could be a power center where you've got um a really large shopping center with a lot of big huge anchor tenants like uh you know, Home Depot or someone like that. People are our target maybe in that one up there, It's got, you know, a ross a hobby lobby. I would, I would consider those coals best buy lows and then you almost kind of, those centres almost kind of developed around that draw, right? Like you get target on the hook, you develop that and then everyone else says, okay, what I want to be next to a Target or I want to be next to a cold best buyers. There's some of these smaller companies that, you know, that's their business plan is, oh, target went there. So, well, I want to be right next to target or Ulta went their lows went their home depot went there. I want to be there. Yeah, retail can also be um you know, maybe grocery stores could be an anchor tenant, um used to be a lot more back in the day, There's a lot more online shopping now.

So that's evolving retail. Um You know, and that's a good point. Uh kind of transition over to you, Joel is, is the internet, you know, the internet changed the game for retail because uh previous to that, prior to that, you had to go somewhere to spend money, you have to go to a store to spend your money and now people are spending all kinds of money, especially with coronavirus. People are spending, I mean, people don't want to leave their house. We were trending towards online spending and it was impacting mainly big malls, outlet stores like JC Penney's or Sears, you know, that, that kind of stuff was moving online. Coronavirus has really added pressure to all types of uh, of retail. And so, you know, we need to be a little more careful when we're evaluating retail space because the risk, long term risk factor has increased some now. I don't think all retail is going away and I think some retail is still here to stay like, uh, you know, haircuts or gyms, um, nail salons, things like that, even restaurants to some extent, although they're suffering now, people have to go there to get that service.

Uh, and so I think there is still good retail out there. And, and the good news is for, uh, if you know what you're doing, the cap rates on retail because of the perceived risk are increasing in the debt level is staying low. So I, I still think there's a lot of cash on cash, uh, you know, to be made on, on retail, but you do need to really be careful on what you're buying. I think a lot of people are nervous, uh, not just because of coronavirus, but like you said, because of the internet, people just, um, I've found in, in some of our retail deals that people are just generally nervous. They think that, uh, amazon and online online shopping is going to take over. Yeah. So um when we evaluate a retail deal, you look at a few kind of macro economics around the area on a map um you know like how many people live there, the population density, how many cars are driving pie that building every day? Because it's it's focused on consumers. You need people to pull into that parking lot and spend money at those businesses so they succeed. It's much more factor driven than an industrial or even multi family.

We didn't really talk about it, but multi family, the location isn't as critical because uh they don't mind driving a few minutes home. The retail though like you say is you have to have good visibility and location is going to be number one where industrial location is not the number one factor, but in retail it is the number one factor, at least one of the, one of the top factors. Traffic counts are going to be a huge thing. How many people are gonna go by and see your business because part of having an office or mean uh an office in a retail space or a store that you're selling things is you want people to know you're there and so you want that traffic count to be high household income on average. You know what, what do people make in the area that means they have disposable income, you know, you want to be there uh you know who someone may want to open a gym, higher price jim and in a high high fluent area versus you know a 10 jim that wants 10 bucks a month out of people. They want to charge 45. Well you need high incomes for people to want to do that.

Or if you're gonna open a liquor store or whatever it is, you wanna you wanna have people that have money near where you are. So those are some factors that you want to consider when purchasing retail. Yeah. I I think retail is good and I think there's still a lot of value to be juiced out of retail. You know I think people are scared of it. But I think if you focus on the brand of the tenants and how they're taking this new generation of retail and then the location and a lot of people live there. They make good money that live there and it has good traffic counts. Um You can trust those things Were buying a 3-10ant retail deal right now in Memphis. And so it's just three tenants. But the traffic counts are off the chart. The demographics uh and the income are good and it's a it's a planet fitness. So it's 10 15 bucks a month cheap gym. And it was really well built out. We have uh we have a family dollar Which stayed open through the pandemic. So they don't really have that risk of shutdown and their low cost goods that people just want to run and grab and then it had a single 10ant drive through restaurant.

Uh So you have that drive through, so they were able to stay open and people on their way home don't have to go in, they can just roll around and get the food. So we feel like that that's still going uh to be a safe bet for the foreseeable future. And when I got to cooperate premium on it, just given given the market right now. So all right, let's move on to the next one. The next one we have is land raw land. Um I think this is probably one of the most broad available just because there's obviously so much land. Um And it can be anything from shovel ready meaning it's it's um you know, it's got utilities in the ground, it's entitled the right way. You don't have to get a, you know, any sort of special use permit or or any sort of rezoning or anything like that. Um or it could be a pasture, you know, with cows grazing on it, you know, 50 miles north of the path of development. And you just say, Hey, you know, in 20 years, all of this development, all of this housing, all of this stuff that follows housing like jobs and retail and everything like that will move up eventually. So I'm gonna buy this piece of land may be in the way of that and sell it later or whatever.

Um Yeah, I would typically say that for for beginners, land is probably not going to be a great asset class for you. Um mainly because it's it's it's more speculative in nature when you buy land, either you have the expertise uh and the money in the capital to develop something on it and that's going to take a long time, year, 23 years. Um And so you have to have a lot of capital in order to hold that and go through that whole process or you're betting on it increasing in value and just uh and so you typically can't get great leverage on land. Um It's 50 60% generally, so it's very capital intensive. Um it's high on speculation a lot of time uh a lot of times. So I mean land raw land doesn't pay returns typically right. Um We've got uh we're trying to develop our first apartment deal and when we're a year and a half in and and it hasn't paid me a dime and it's just sucked my capital and so obviously I'm in a position where I can handle that, but but I would, I would say most people want to look for strong cash flowing assets, so they get that income that security comes from that income once they're secure and they've got a bunch of money coming in, then you can take some risks on some land deals, or like we're doing cut your teeth on a new development deal and kind of learn the ropes as you go.

Yeah brian and I are working on a few land deals right now. Um and you know, they they're just not fun. I would say they really need um to be a developer or be focused in development, kind of be able to do something with the land. But we bought a site and and columbine and had, you know, probably 68 months and entitlements. Um We're buying a site right now and and DFW and it's a similar thing, we had to get permission from Kroger. Um We're partnering with a group down in Fort Worth. They had to get permission from Kroger. Um We had to get rezoned and all these things take months and months and months and it it just, it's a lot of time and it's um it's just, it's hard. Yeah. Alright, what's next next is hotels and hospitality, which um you know, let's let's try to stay towards your traditional hotels. Obviously, you know, hospitality can include, you know, a resort of Water Park, Disney World, whatever, but let's focus on hotels. So hotels.

Um I almost got, well, I actually did invest in a couple hotel deals just as a small investor online and a crowdfunding site. Uh And don't ask me how those are going uh because the pandemic really hurt those. But uh yeah, hotels, I think you need to time it, right, and you need to allocate for the risk because they move wildly with the market. So they're not only very location driven. Um but you know, if the market suffers, most hotels will suffer in general. And, and so I was looking at hotel deals and they were delivering higher returns, You know, nine cap, even 10 cap deals. And when you can leverage those, a ton of cash on cash, but if I would have purchased those, they would be severely hurting because overnight, uh the traffic just stopped and tourism's, I mean almost gone right now. Yeah, I mean, it's starting to to trickle back, but um if you're not capitalized for this kind of event and it, it's gonna take a lot of people out.

So hotels, I'm sure can be really good investments. I haven't done one yet, but they typically come with higher cap rates and higher returns for the volatility that they have. Yeah, I mean, a couple years ago were amazing economy, you know, 8th, 9th year of a bull market or however long we were in it. You know, people are traveling, people are taking those trips. They have that extra money. The economy is booming. You know, people, that's when tourism is great and that's when you want to be in hospitality. Um but, you know, if I was, if we didn't have the pandemic clouding my future judgment The time to buy hotels would have been in 2009 or 10, right? When they're auctioned off from foreclosure and then you would have been able to ride the way for the last 10 years now. I would say now would be a good time to buy hotels, except I don't know what the game is going to be like. And if every people ever fully recover from a from the pandemic And if they, if they do, what's the risk that we have another one in 5, 10 years. So, and I think with that is when you, when you go in with timing like this, you know, in the hospitality is down and you want to say, hey, I want to find a good deal in a good market on a great hotel because it's empty right now, the leverage you're gonna get on that is a lot less than a good economy too because it's, it's not occupied and you've got more of a pipe dream unless of stabilized assets.

So you have to go on with a lot more cash. Um And you can really reap the rewards if you do it right? But in the beginning, you're not gonna have that cash flow that you would as a more stable hotel risk here. But I returned possibly right now, All right, switching over to office. Um When we talk about office, these are businesses with um you know, high number of employees that they've got to have working for them, they need a desk, they need a place to sit there answering phones, they're working whatever. Um And these businesses are are leasing anywhere from a few 1000 ft all the way up to hundreds of thousands of feet. It can be, you know, a dentist office, your you know your local neighborhood dentist in his own little, you know, small medical building. Or it can be a skyscraper in new york city. Um But office, generally speaking, walk us through it. Well I haven't invested in office. I've looked at some I would tend to like the smaller uh suburban medical office uh than I would, you know, a high rise office building in these times.

I mean office the virtual, you know, working from home was already gaining steam before the pandemic. And now uh I know offices that still haven't opened back up and some say they aren't going to open back yeah, I'm just gonna let their employees work from home from now on. And so I I just um there could be the right office deal but for me it's it's just seemed a little bit more speculative and I know people that have made a ton of money on office. So it's just maybe I don't understand the risk reward game. But uh you know, you're kind of hoping that you you know your tenant, your big, let's say you get a big office building that your big tenant stays And if they don't um it could be a while before you feel it, it's not as easy as a 1200 square foot retail space on on a really good high traffic corner where a lot of businesses could fit there. It's a very unique size of space. Let's say you have 20,000 square feet of office in the 100,000 uh corporate office building. You need to lease that you may rent that quick and you may, it may take you a few years. I've seen some vacant, we owned an apartment complex in a pretty good area and it was sitting next to a building for uh it was that building was mostly vacant for 56 years and it wasn't even poorly located.

So I just feel like it's a it's a you probably need to go into it like like hotels or any other more speculative with a lot more cash and with knowledge. So like um like multi family or his office space considered class A. B. And C. Yeah. Yeah absolutely. Class A. Um would mainly be uh you know newer or in the central business district where offices and really really high demand be would be more suburban and a little older and classy would be you know trying to think one or two stories uh pretty old, maybe seventies uh type office. So it kind of follows with some of the what we talked about a multi family and the cap rates Are the same. They, they kind of start start lower maybe six caps, seven cap and then they kind of move up from there. Yeah. So I would say a couple things on office. Um, the first one is there probably a lot more management intensive than some of your other asset classes. Um, you may have a lot more tenants. Um, and the way they do the least structure is, is a lot different than most of the other asset classes with modified gross leases.

It's, it's, it can be confusing on what it includes and how often it escalates. Um, and the management just bears the burden of a lot more responsibility because there's so many more common spaces to be up kept and kept track of. Yeah. Any of these, these asset classes that you're going to try to take a look at for yourself. It would be important to go and talk to people that own those properties in your market. I mean, you could start with the brokers, but, uh, but owners to, and understand or maybe the owner has a person that manages their office. Uh, that's the guy or girl you need to talk to because they're going to be able to go over those nuances with you and talk about their experiences. Yeah. And then the next big thing is when you're going in to buy an office building to look at an investment. Um, you're looking at job growth. You know, you're looking at big employers coming in the area or about to come in the area rumored to come in the area. You're looking at, um, you know, corporations that are expanding or growing or might need newer or bigger space, something like that. So, you know, each of these asset classes, you look at different indicators in the market to kind of help you with your underwriting and due diligence.

Um, but yeah, office is a massive scale and um, there's a lot of it. Well, hopefully that gave people a little bit of an intro in just two different asset classes. I know when I started, I didn't even, uh, no, what all you could invest in. So hopefully we gave you just a brief overview. Yeah. And if you have any questions, feel free to comment, send us a DM message. Whatever email or contact information is out there. It's not that hard. Well, I think, uh, I think we wrapped it up and we went over the major asset classes that um, investors invest in when they think of commercial real estate. Thanks for joining us on episode five. How to invest in commercial real estate. Make sure to check out the website. It's probably easiest way to listen, watch, how to invest in All right. We'll see you next time. Yeah, yeah.

Episode #005 - Commercial Real Estate Asset Classes & How to Evaluate Them.
Episode #005 - Commercial Real Estate Asset Classes & How to Evaluate Them.
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