How to Invest in Commercial Real Estate

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Episode 132 - Cracking the Code: Modeling Commercial Real Estate Deals in Real Time

by Criterion, Braden Cheek, Brian Duck
December 27th 2023

Today hosts Braden Cheek, Brian Duck and Joel Thompson go through a live-deal analysis, highligting the key components to look at while analyzing commercial real estate properties.

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All right. What is up and welcome back to another super amazing, excited. I can't, I can't even get it right. Welcome back to how to invest in commercial real estate. So today's cool episode, uh We bought this amazing smart board to use on our podcast a couple of years ago. We've never used it. Today's the day. Today's the day. So we're, we're forcing ourselves to use it. So it should be pretty cool. A lot of people don't like we've never done this. We, we kind of conceptually talk about it, but the idea of being able to walk through these deals live, we're, we're gonna look through some offering memorandums. We're gonna model up some deals together. We're gonna just, and we're actually looking at this stuff, which is cool. Like we're, we're actively negotiating, offering, trying to buy these two that we're gonna go over these assets. Exactly. So, um yeah, it'll be interesting. What I would say is, uh this is probably some of the best experience that we can offer uh everyone watching. So if you, if you are a listener of the podcast, check us out on youtube because you'll actually be able to see us walking through these O MS. But you know, part of what we do all the experience that we've gained looking at thousands of deals come into play when we get these O MS and we, we have to quickly analyze, is this a deal?

I wanna look at, why do I wanna look at it? What are my risk points? What are the upsides? And uh how do I quickly put it into a model and see, do, am I gonna get cash on cash and irr returns that my investors want? And so here today we're gonna do it live for you or not live, but uh you'll see the recording next week when the episode comes out on just how we go about doing that. Yeah. So I think the, the common misnomer is you find this property that you love and then you model it. I think I'm here to debunk that today. Right? It's a numbers game. It's like sales. It's like knocking on doors. You have to underwrite and model as many properties as you physically can find, find some basic parameters. I believe we have an episode of like five basic parameters, seven basic parameters of the first litmus test and then the, you know, the ones that meet that basic parameters, those basic parameters, you have to be underwriting 20 deals a day. If you can, if you have the ability to underwrite 20 deals a day, whoever you're pitching it to your investors, your, your partners, you know anyone that's how you hone in your modeling skills and that's also how you find amazing deals.

Yeah, I'll, I'll, uh, compare it to how I go about buying cars in, in Tulsa, Oklahoma. If I want to buy, let's say a BMW. Uh, there's only so many BMW s in Tulsa and I can get a sense. Ok. They're all selling it, you know, 35,000, 36,000, 34,000. But then when I look nationally that same model with the same mileage, I might find one in Florida that's 29,000. I might find one in California, that's 50. And so the only way, you know, if you're getting a really good deal or the deal of the decade as we like to say shopping uh is if you can do, you can look at hundreds and same with homes, you know, when we were first buying houses, driving markets, the first house you look at, you're not sure how good the deal is but after you looked at 500 houses, you're gonna know which ones are the best deals. Uh Alright, so I'm gonna head up to the board and then we're gonna go through. Yeah, get up there. I'm not sure the audio was. I won't. Yeah, that's a great point. Yes, we're gonna have to commentate a little bit man. The back of your head looks great. Ok, so uh this property is called West Ridge Plaza. It is located in Topeka Kansas.

We drove up there a couple of weeks ago when we first come across this one, remember, broker or just got just an email to us. Yeah, I, I think Andy did bring it up. I think Woodmont definitely did use to, to manage this for the special servicer. A special servicer has it now. So it went into some sort of Receivership. Um, which is probably why it's transacting right now. You may have to pinch it to zoom out or just scroll. Yeah, that works. So, again, this property is located in, speaking of Kansas, we went up there a couple of weeks ago because we initially placed a letter of intent that, um, you know, a lot of other people were placing letters of intent and they had a best and final. So one of the things we do in a best and final is make sure to get a property tour going just so they know we're serious about the site. We're willing to invest our time and our money and our resources to go up there and, and, and tour it. You guys on this full parking lot. Yeah. Yeah, it was full, it was the middle of the day on a Tuesday or something. Yeah. It, it does look good.

The fads in good shape. Um, I believe they have new roofs in 2020. Um, about 90,000 square feet, it looks like um almost 14 acres. So a big, big property. So uh anchored by Target uh also has Dollar Tree and TJ Maxx and famous footwear, All Nationals. Yeah, a lot of those are, are, are public companies. Um You can get placer data on these tenants. We we have got placer data on these tenants um which is just a, a tool we utilize to um measure performance of some of these stores. It it kind of reverse engineer sales. It's a, it's a pretty cool product. Yeah, so here we're looking at the rent roll, right? And this is the list of tenants, the square feet they occupy and the percentage they are in relation to the rest of the center. One big thing I like to look at here is just um you know, I kind of like having tenants under, you know, 10 15% of the total gross leasable area just so you're not, you know, putting all of your eggs in one basket.

Obviously, this is, you know, some junior anchor larger box space, you've got a TJ Maxx at 25,000 square feet. That's like 27% of the center and it's probably your biggest tenant. Um So yeah, we, we utilize that placer data and uh the feeling of the parking lot, you know how busy the store was inside. I know Joel was freezing that day. So he went in and, and bought a, a little hoodie there. I was flying the new drone after I flew into our office building, I get a new one. But anyway, we also, what we really like about this is, you can see here the retail, all four corners. Uh, we're pretty busy and we're full of retail. Yeah. So those are, those are good points and everyone kind of has those corridors in their city. But, um, in neighborhood and community shopping centers, you can definitely find some that, you know, you're all alone, maybe in just a sea of houses or, or by a bunch of manufacturing or, or jobs or something, but being in a corridor of, of tons of other shopping and places to eat, um, you know, if somebody's close by the probability of them stopping at your shopping center as well and spending additional money is, is really high a couple of things.

Uh Target anchor, also strong gym anchor and it includes one of the Yep. So, um you're not buying the target, but obviously this is kind of what we would call a shadow anchor. So it's not in your center, it's obviously really close by Target is a massive driver. So just being in the proximity of them, again, the probability of somebody coming to Target and going over to one of these other tenants is, is very high, um keeps the parking lot full and then again, you, you have that corporate Hardee's there on the corner. So corporate Hardee's, you have the ability to kind of spin that off for additional upside. Um, you know, I, I think this property is listed at like an 8.5 cap. That Hardee's is maybe worth a, a 6.5 cap, you know. Ish. So you got a couple points to spread there again. Just kind of penciling additional upside. You see that they spent a quarter million dollars on the roof. They improved sidewalks, paint lots of Capex they put into the center. Yeah, I did, I actually didn't see that in the, the first pass of this.

They have invested a ton just that they got that much roofing done for $250,000. You can tell they did it three years ago. Right. Roofing has doubled since then. Yeah. So, um, a lot of location overview here. It's gonna give you demographics of how many people are living in 135 mile radius. Um, how much money they're making, whether or not they have a degree, the percentage of them, at least the average home value, average household income spending power. I like to see the average household income. Uh, if we can get about 75,000, you know, if it's down to 40 50,000, you're looking at more workforce housing, lower income. Yeah. What I would say is that's not always the first deterrent, but you need to match up your tenants to your demographics. Right. When you see an average household income of $77,000 going back to the target TJ Maxx gym. I mean, it fits massage MB. Even though in this economy, I don't know, 75,000 household income, you're getting a massage on the weekend. Probably not. Why not Sally Beauty, great clips, famous footwear. Uh you know, very common tenant lineup.

I would say nothing too out of the ordinary crumble cookies. Those are bomb. So the next thing we do is go to the red roll and we see. Ok. Uh what do our leases look like? Are they expiring Hardee's is out uh to 2029. Uh I can't see them from here. Are there any that are due next year? 2024 September, that's a little close. So we want to dig on how they're doing. Uh Dream Nails out 2031 2028 2031 2029. So that's good. You wanna see four or five years down the road? Yeah, we uh I think some people that in the industry call that the the walt or the weighted average lease term of the gross leasable area, your lender is gonna look at the the average lease term and you really just want to be looking. Ok, do I see any immediate exposure? Do I see any tenants that uh you know, are not doing well and probably not going to renew or the opposite?

Do I see tenants that are expiring soon that are under market. Do I see media upside to where we can renew those leases and, and capture additional value immediately. One thing I look for with the largest tenants is I want their rent to be lower than the the smaller shop spaces because if they bail, I wanna make sure I can backfill and here the rents are running 15 to $20 a foot but TJ Maxx is less than $10 and dollar tree is also less than $10 which is good. The lower you can have the rent on the bigger box, the safer you are in case they, they bail. Dollar tree doesn't have a ton of time left. So that's something we'll have to look at uh G Max 2027. Yeah. Dollar tree. TJ Maxx definitely expiring in the next few years. I, I, what's dollar tree at per square foot? 950? I like, I like Dollar tree at 950 TG. Yeah. TJ Maxx. It looks like 975. I honestly, I like both of those where they're at. I'm not super worried. Um I'd like to go back. Ok. So it looks like they're doing a, a potential cash flow for us here. This could be interesting guys.

This is not your model, right? Holy cow. It's like going and buying a brand new BMW and listening to them on how much it's gonna cost to maintain. Oh, nothing. It's brand new. Like no, it's gonna be, it's, it's gonna be different than this. Like this is the best case scenario from the broker trying to sell you the brand new shiny car. Like just don't even, don't even use this. You're looking for day one. No, I use your own assumptions from there. All right, Brian, I got us a little copy over here. So why Joel is moving back over? Um This is just a, a quick and easy model. Obviously, the, the longer or the further you get into the project, you know, the, the more you're gonna hone this down. Um But just quick and dirty, right, we're looking at a net operating income of $1,349,651. And so we're offering uh 14 7, what is that on the cap rate? Uh 9.18. Yeah, which for this center, it's a really nice center. Uh We think getting it above a nine cap uh in today's market is pretty good. Um You know, with the, with the target anchor and the, the traffic counts and everything, we really like it.

So then we have to put in some assumptions on fees, you know, typically, uh let's see, it looks like we put AAA full point on the lender, you could do a half a point to a point depending on how, what lender you're gonna use. Then, uh closing costs at third party and legal. Uh, you know, typically you're looking at 15, 20,000 in closing costs. Our lender legal is not lender legal, but our legal fees are probably about 15,000 a deal. Yeah, probably less than that. Maybe like 57 now. And then, and then you've got your third parties which is appraisals, which is environmental, which is a property condition report, maybe a roofing report. And so we throw in a few $1000 for those, maybe, maybe a total of 5 to 8000. And then we, you can see there, we're charging an acquisition fee and then one point on a mort mortgage guarantee fee and then we've got 300,000 of working uh, capital. So, go ahead. Well, I was just gonna, so what do we do? We did 2%. We just assumed about 2%. Uh, we did have a little bit of a problem with the parking lot. Right. It looked like it might need some repairs. There was actually snow on it. You could see where it had been scraped. So we had a little bit of concern there.

So I don't know if we, if we put a little bit more in for that or is 2% sort of, uh, just sort of a, a starting point for us or does it just happen to be 2%? And you, I, I was just going purely based off of the fact that it has a relatively new roof, we have limited exposure there and, and the usable life of that roof is 20 to 25 years. I would say. So, I, I know we have a little bit of exposure over TJ Maxx. I think that has an older roof. So you've maybe got 25,000 ft that you may have to replace. Yeah, I think it's a starting point. The bigger the deal, the lower the percentage, the smaller the deal, the higher the percentage, obviously you're buying a $2 million deal, maybe 2% isn't quite enough uh working capital. Uh But you know, once we get into the deal, this is just loy stage, we can always go back to the seller and say, hey, the parking lot needs repair and try to get, you know, a credit for some of that to help make up this number. Yeah. And what I would say is, um you know, for those of you listening for modeling tips, I go in a little bit heavier on the cash pending the deferred maintenance. Like how old the roof parking lot, et cetera, how vacant the center is.

So I go in heavy on the cash and I want the first half of my model to be really good, right? Because shit's gonna happen. I'm gonna find something that I don't like, you know, I is gonna come down, parking lot is gonna be shit. There's gonna be something that's gonna eat away at that constantly. It's, it's rare that in modeling, the models get better. Right. They're, they're typically getting worse because you're finding out new factual information, set of assumptions and, and I would say about 50% of the time the seller, you're gonna be able to get some credit out of the seller. If you, you've paid for uh third-party reports and those third-party reports uncover things that you may not have been able to know and just glancing at the property. And so they know that well, ok, I don't like that. They're asking me for 100,000 for parking lot repairs. But if I take it back out to market, I gotta try to get another buyer and then that buyer's gonna do the same inspections and they're gonna come back with the same findings. So I might as well, you know, work a deal with the seller or the buyer that I have now. So the next point, we've got kind of our acquisition cost assumptions. Um Moving over to the income and expense details. There's gonna be a lot of people who hate us on this. I think like there's gonna be so many people who use a models and, and discount, you know, every single tenant to a different cash flow number based on the associated risk.

And I'm just gonna say that's why you don't buy anything because you spend too long on your models. Um That's just the reality of the situation here. Guys, we like to model no I and, and kind of grow that. And then again, as we get into the deal, we're getting way more detailed on the income and expenses, we'll build out a three year cash flow projection. Um And that's really where we get the nitty gritty about what we actually believe free cash flow is gonna be. But right now, we're trying to be optimistic because again, you know, we're looking at a lot of these, we need to effectively work through a bunch of models and a bunch of deals. And from our experience, you know, in a, in a normal good piece of real estate, you can grow noy by, you know, 2 to 3% a year fairly easy. Now, what we would do if we were gonna, if we move to a purchase, like Braden said is we would go into the rent roll that we kind of scroll to earlier and we would actually look at exactly what the increases are for each tenant and then build the no I per year based on that, that takes a lot of time. And so we just don't have that kind of time.

Most of the time tenants are gonna have some types of increases whether it's yearly or whether it's 10% you know, at the end of year five. And so 2% is a, is a great model. And you can see Braden, I think we grew at 2% for the first two years and then backed it down to 1%. It's a large, no, I too, on a, on a smaller deal. I may be a bit more aggressive with that. Like I said, I may go up to 3% on, no, I growth. But again, we're already at 1350 on the, no, I, so you don't have to be too aggressive in my opinion. And again, most of these tenants are probably gonna have those 10% every five year increases anyway. Um So probably not gonna actually realize 2% every single year. It may be, you know, 7% year, three, you know, 3% year four. But anyway, we, we have a debt quote, uh 75% LTV, 6.6 on the interest rate fixed for five years and amortised over 25. Uh You know, I think the Feds came out yesterday and they said they're pausing increases and they expect uh three rate cuts next year uh for a total of about, you know, 0.753 quarters of a point. Um And so if we can get this to model today and rates come down, the deal only gets better over the next two or three years.

If we can refinance at that lower interest as we've talked about in other shows, it gives you a chance to increase your cash flow. Yeah, and I'm not even to the point where I'm doing that yet. Like I'm not, I'm not factoring in that because are, are we going to refinance at the end of next year because it came down to 75 basis points when we believe it's gonna continue to come down, we would, we would wait at least at least two or three years hard to, hard to know exactly what we would do and what the interest rate would be at the time. But again, it's a data point, right? It's additional upside like the Hardee's that we're not modeling a sale on it's additional upside. Should we choose uh to, to look at it? So not being insanely aggressive on the LTV, we're looking at 75% loan costs. Um That was quote from our best bank. They're a decently sized bank in the Oklahoma region. I know this assets in Kansas, they're interested. They've got a branch in Texas. So our VS bank has been and they're out of Arkansas so they're in there. They're in the region. Yeah. Yeah. Yeah. A big bank. We've done several deals with them before. I know you've done some of the uh anyway, best Bank. So uh equity details, distribution, assumptions kind of this top right corridor here, we're looking at a preferred return of 8% and then a 7030 split, 30% going to the GP, 70% going to the LP.

I would call this the criterion boilerplate on a deal. Yep. Um You know, So you look down there, you can see uh LP net to invest, that's the amount of money we have to raise to buy the deal and it's $4 million. So it's a pretty hefty equity check based both on the, the, the deal being a pretty large size and also because we're, we're at 75% versus 80% on the loan. Ok? So this next box is the most important box. And I would say if you learn anything on this show, right? You're probably a limited partner, you're probably investing in somebody else's deals. This is how people get irr they have these crazy exit cap assumptions and it's, it's, I don't know, it's the easiest way to manipulate irr in a deal is what you're selling it at. And that's kind of the biggest assumption you have to have is an exit. So, uh you know, in a good economy in normal situations, we don't typically underwrite cap rate compression, which is what you see here. You see our cap rate on our purchase price is 9.18 and our exit cap assumption is 8.25.

So I guess why in your guys' thoughts do we feel comfortable doing that today? I would say this deal two or three years ago uh is selling at an eight and a quarter. Um you know, rates uh went way up over the last year or two and retail cap rates have been moving up. I don't think I ever saw a deal this clean, this nice next to a Target, uh, with this, you know, many cars in the parking lot, the nice facade that it has at over a nine cap that just, that just wasn't a deal we saw two years ago and we've purchased deals like this, uh, for eight and a quarter, 8.5. So I think it's reasonable. Um, you know, I think as rates come down, there's been a lot of money hanging out on the sidelines. I think it's gonna be wanting to get invested. So I think there's a chance we get it. Obviously, we're modeling that at a, you know, five years from now. Um So it's hard to know for sure. I don't think we're gonna be way off either way. Uh Could, could we get an eight maybe? Could we get an 8.5 maybe? So, all we're trying to do here is be reasonable and you just want whoever you're investing with, you want them to be reasonable.

If we had a seven on there, that's not reasonable. Um And so you just don't want to be taken advantage of on that and think that, well, he's promised me 20% of irr, but that 20% of irr is based on a sale price that's never gonna happen. Right. Um The, the next box, there are total cost of sale. This is what we would pay a selling broker for, again, with a deal this size, I feel comfortable with 3%. That's like half a million dollars between a listing broker and a buyer broker. If they're getting a quarter million dollars each, I feel like I could negotiate that deal. I think you could do it for two being 1515 $18 million. I think you could negotiate that deal. Yeah, I think, I think so. On a smaller deal, it may be more guys, it may be four, it may be five. you know, again that, that's, that's something you have to keep in mind. If you have a $1 million commercial property, that's gonna, the fee is gonna be 65 or 6%. If you have a $20 million retail property or apartment deal, you could be 1.5, 2, maybe even one. I mean, it depends if you're a repeat customer, how much, a lot of things, a lot of variables. But, um, this is right.

If at any point, I love this, if at any point you're going through the model and you're just like, man, I have no idea what if it's five, you shouldn't be modeling, you should have an idea. You should just stop right there. Right. Every single one of these boxes. If you don't know, you should call somebody and there's 50 brokers. I know in Tulsa, at least that would, that would be happy to give me their opinion on an exit cap and a cost of sale. You average those together, you're gonna get uh a decent data point to throw on a model. OK? Uh Disposition fee 1% that standard uh Brian. Can you hit that analysis button for us? OK. So this is the juice, right? One page. I probably filled that out in 60 seconds. The first time I did it. I swear to God. I hope you're gonna have to pinch it. Brian, you have to give us a pinch. No, no, it's, it's not. There we go. There we go. That's, that's right there. Don't get too handsy. Ok, so here's what we're looking at here. The first page was our inputs. Now we've got all of our outputs. So we see in the top left, the um year zero equity in is about $4.1 million.

And our modeled cash flow after debt service that first year is almost 500,000 next year. 448. Why does it immediately dip the first year, Joel? Is it immediately dip? Uh because uh when you first get the loan, your first payment isn't due for 30 days. So that first year you only have 11 debt payments. Uh And so that's why your cash flow is a little bit better uh, in year one than it is in year two where you have a full 12 year, 12 months of debt payments. Yes. So, uh right off the top of our head. We can see here that it meets a normal debt service coverage ratio, you know, 159148151 banks are gonna love that. You know, I would say a minimum in a, in a good or I mean, I I would say reasonable is 12125, I mean, more or less is, is obviously uh acceptable. It looks like the total cash on cash uh for the deal is 12.17% assuming one person bought it by themselves and didn't split it up. Um So these are, are good metrics kind of for us to use and, and people to use. Obviously, there's a waterfall um that we can continue to go through a couple of comments I have is uh you have average uh cash on cash to the investor of about 11% maybe a little less 1010 75.

So anything double digit to the investor. Cash on cash wise is good. Um You have a five year equity, multiple of two, a little over two. You've got a uh irr five year irr of about 18% to the investor, which first of all, you can stop right there. Average cash on cash, which means quarterly dividend of 11%. My my five year irr or my five year yield after this is all said and done is about 17.79% per year for the five years that it's invested and you, you doubled my money over the five years. That's, and that's really what, what our goal is, is to hit, hit that 18 to 20 irr, which is doubling your money in five years. And that's for the LP. Right? Like we're, we're making money in addition to that, that's just for the limited partner. That's their 8% prefer return and 70% of every percent after eight. Right. And so one other comment on the, you'll see there, the investor irr year one, it's 26. So that looks good. What's the deal there? Well, the model has to remember, assume an, an exit or a sale of the property and we're not gonna sell it next year at that eight and a quarter.

Uh Obviously, uh we're gonna have interest rates come back down, which is gonna cause uh cap rates to be able to come back down. And so, you know, really, you, you only want to take that ir number in the year that you plan to sell it. That's when it's applicable and that's what we're using as year five. Yeah, I would say the magic number is 60 months, like everyone kind of underwrites to 60 months if you're planning on buying and holding it like seven years, 10 years, eight years, 9.5, we underwrite to 60 months every single time. So, uh you know, we were, we planned on doing two or three deals for you today. Uh, but we're, we're already over time so we'll have to do another episode with a few of those other ones. But we just wanted, this is an actual deal that we're gonna try to buy that you might have a chance to invest in. And this is our quick down and dirty underwriting that we did before we put in an offer last week or earlier this week. And we drove up there, we spent one full day in the car. Oh my go over four hours to Topeka. Yeah, it's been about an hour. So this, this is about nine hours in the making an hour modeling eight hours in the car on our second drone.

But you know, we may get it. You got to swing for the fences guys. This would be our biggest deal to date and, and we're excited. We're super excited. So hopefully we get this deal awarded to us. Hopefully, everything is great while we're in contract in due diligence and we don't find any, you know, skeletons in the closet. What will be interesting now that we've done this and we buy it is, uh, that we'll be able to go back and see. Ok, which ones of our assumptions were right? Which ones were wrong? Which ones did we miss and which, which ones performed better than we had anticipated. So it could be a little bit tough on us if we end up buying this and some of our assumptions don't go that well, but that's how you live and learn. Uh We're trying to do, we're taking all of our experience when we evaluate these deals and trying to make the best guess uh on how this thing's gonna perform. So this would be a good test case. Anyway, we may do this next week. We may wait a week or two, but we are coming up on Christmas and I know we are doing our Christmas giveaway soon. We'll have to like put this somewhere else in the episode. So it's not at the very end where nobody sees it, but we're gonna release it soon.

So be on the lookout on our social media pages for the Christmas giveaway. It's coming, it's coming up, it's gonna be, it's gonna be awesome, right? We're gonna make it awesome. I feel like we have to make it awesome now that we've announced, it is awesome now that a lot of pressure and it's gonna be simple, right? Like be on the investor, like be on the investor list, which is easy to do. It's free watch the podcast, like, comment, subscribe, share. You don't even have to watch it. They're not getting paid. If they don't watch the podcast, we're not gonna know that. So just don't tell Jill, ok. Alright. Till next time guys. Thanks a lot for watching. See you.

Episode 132 - Cracking the Code: Modeling Commercial Real Estate Deals in Real Time
Episode 132 - Cracking the Code: Modeling Commercial Real Estate Deals in Real Time
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