The 13 Golden Rules of Commercial Real Estate Investing

Real Estate Investing

Golden Rule 1: Risk is equal to yield

As with any endeavour in life; the higher the risk, the higher the reward. To express this using our newfound understanding of cap (capitalisation) rates, we would say the lower the risk, the lower the cap rate. In other words, for an investment with low risk, the market would capitalise the rental income at a low cap rate (that is, a high factor); the market would apply a high cap rate (low factor) to rental income from a risky property.

Consequently, the aim with real estate is not necessarily to seek the property with the highest return, but rather, the property with a good compromise between risk and return that is appropriate (and profitable) in your circumstances.

If you can buy a low-risk property (low market cap rates) with a high return, you have found your deal of the decade.

Golden Rule 2: Ensure safety

What is more important: return on capital or return of capital? What good is a ROI (return on investment) of 25% per annum if the investment goes belly up after two and a half years? Make sure your capital is safe, which includes insuring your properties against earthquakes, fire and other natural disasters.

Golden Rule 3: Control your liabilities

While we generally have control over our assets, we have relatively little control over our liabilities. In many parts of the world, it is impossible to fix the interest rate on your mortgage for more than a few years. For commercial property where you can, make sure you fix the interest rate on your bond.

One of the big advantages of the real estate market in the United States, relative to many other countries, is that it is possible to obtain mortgages – even 30-year mortgages where the interest rate is fixed. I am astounded at the number of investors who choose not to fix their interest rate. For the sake of perhaps a 0.5% lower initial interest rate, they are willing to risk interest rates going through the roof in the future. It is a folly, committed not only by a legion of otherwise sane investors, but also aided and abetted by armies of mortgage brokers who, no doubt, receive larger commissions on loans that turn out to be more lucrative for the banks.

Furthermore, you should avoid any requirement for a personal guarantee on real estate loans. The reasons are twofold: First, a real estate investment should stand on its own two feet. The risk of having a personal guarantee is that it may be called up, and you would be forced to pay off the principal debt component (or capital) on a loan taken out by an entity with limited liability. Signing a personal guarantee, of course, breaks this liability firewall.

Second, when you apply for future loans, banks will often ask for a list of your contingent liabilities – liabilities that may end up on your shoulders. The more items on this list, the more reluctant a bank will be to lend you any more money.

Golden Rule 4: Add value to a deal

If you buy a fully leased, commercial property at a fair market price, you are going to have to wait for inflation to increase the value of your rentals – and thus the capital value. Alternatively, if you buy a property with vacant space, with some rentals that are below market, rooftops that are underutilised, storage space that is not leased, and a host of other features that you can do something with, then you can exchange your ideas, thoughts, energy and enthusiasm for huge chunks of capital value very quickly. In other words, you are an extremely important factor in the real estate you acquire.

Another way of expressing this is to say that, when I buy a property, it is a different property from when you bought it. Physically, it is the same property, but with the ideas that I brought to the table, the property itself ends up being different. Whether you like it or not, you end up being part of the equation. That is why the more ideas you have in your head, the more value you add.

The most valuable piece of real estate is the six inches, give or take an inch or two, between your right ear and your left ear. What you create in this space determines your ultimate wealth and happiness.

Golden Rule 5: A broker or agent must bring something to the deal

Just as you become a part of the equation, your broker, or buyer’s agent, must also bring something to the deal. Remember, in most parts of the world, sales commission is paid by the seller. If you choose to enlist the services of a buyer’s agent, make sure they contribute something of value, other than simply an email with present listings. Agents with whom I have worked over time know to bring me not just real estate listings, but also background information, pending zone changes, ideas for alternative uses, and even prospective tenants. Furthermore, they willingly make this extra effort, as they know that doing so will result in more deals being closed, and therefore, more commission for them.

Golden Rule 6: Real estate is a long-term investment

One of the aspects of commercial real estate that I particularly enjoy is that you can buy a property, have some rudimentary management in place, and then all but forget about it. In fact, you could take a six-month cruise and not have to worry on a day-to-day basis whether everything was all right. However, if you need more nail-biting, nerve-racking excitement, then trade stocks, where you generally have to monitor the market by the hour; or trade futures, where you have to monitor the market by the minute; or trade currencies or other derivatives, where you have to monitor the market by the second.

Also, take note that you will not find many stock traders over the age of 50, many options traders over the age of 40, many currency traders over the age of 30, or many futures traders over the age of 25. These nail-biting, glued-to-your-screen professions burn people out. They also require that their practitioners complete another deal to earn another dollar.

Meanwhile, back on your cruise boat, you are reading books or mingling with people, knowing that your tenants will pay rent that month, whether you have worked or not. Never sell. When you sell, you lose your income stream from an asset that is rising steadily in value.

Golden Rule 7: The number of voting partners is directly proportional to the failure of the project

This rule is almost self-explanatory. It is a variation of the cliché ‘too many cooks spoil the broth’. The best way to avoid project failures through disagreements is to undertake all projects alone. However, there are always economies of scale and great synergies of ideas when you team up with others. The trick, as with all things in life, is to find a good balance between a free flow of many ideas and impasses through disagreements.

Golden Rule 8: You are going to be in a lawsuit

Whether you are averse to litigation or not, sooner or later, you will end up being in a lawsuit. Stay in good communication with people and try to think outside the box to come up with a solution that may be beneficial to everyone (and a lot cheaper in the long run).

Golden Rule 9: It only takes one deal to go broke

An accident generally comes about, not because one major thing goes wrong, but rather because a whole series of seemingly unrelated things come together simultaneously to cause the catastrophic event. In the case of real estate, interest rates might increase, tenant demand may go down, your space may become obsolete through new technology, a freeway may bypass your side of town, an airline may drop your local airport as a hub; all of a sudden you are facing a crisis that six months prior you had not envisaged and which any of these changes in isolation would not have caused.

Never become complacent. Always keep your finger on what is happening in the market. Try to deal with all challenges as they arise and not as they come together to cause a big event. Fix your interest rates, keep your buildings modern by incorporating new technology, and find out how to keep your tenants happy with the premises they lease from you.

Golden Rule 10: It only takes one deal to make a million dollars

Just as it takes only one deal to go broke, you can also make a million dollars from a single deal. When it comes to commercial real estate, it is not always a numbers game, where the more properties you buy, the greater the chance you have of becoming financially free. While, in general, two deals are better than one, you would be far better off working on one commercial property and managing it efficiently and properly, rather than taking on five projects and barely being able to keep up with which tenant owes how much rent.

Golden Rule 11: The value of a property is limited by the tenant’s ability to pay rent

This rule is just another way of defining the cap rate. If you cannot find a tenant for a building, then your building will not be worth very much, and no banker will lend you money to buy or refinance it. Your ability to acquire a portfolio – and the subsequent value of that portfolio – depends on your ability to secure stable, long-term tenants.

More particularly, the value of a building is not just dependent on what you manage to get one tenant to pay in rent. What if you lost that one high-rent tenant? The value of a building is dependent on what rent you could get any tenant to pay, within a reasonable time span. Therefore, always work on improving the environment for existing tenants – it will make them reluctant to leave. Then, if or when they do leave, it will be that much easier to find replacement tenants.

Golden Rule 12: Appreciation and inflation are compounded annually

While appreciation increases the value of your portfolio, inflation erodes the value of money. This is supremely beneficial for real estate investors.

Assume you have a portfolio worth R10 million, with a mortgage of
R9 million. Let us also assume that over time – for the sake of this argument it matters not how much time – the portfolio appreciates to R20 million. This does not mean that the R9 million mortgage appreciated to R18 million. The asset may have appreciated, but the loan was expressed in rands and, at worst (interest only), it stayed at R9 million. Furthermore, through inflation, that R9 million will be easier to pay off (as it is effectively worth less than it was before). This is one of the prime reasons to invest in real estate. These factors work, even when you do not. Meanwhile, flippers, traders and speculators have to keep on working to earn their next rand.

Golden Rule 13: You cannot give kindness away – it is always returned

You cannot beat a crook – even if you have a team of great lawyers, real estate agents, accountants, private detectives and other professionals. If you successfully litigate and you get what you think you are owed, the crooks will have taken something else somewhere else along the way, not to mention all the wasted time, effort and energy that you put into dealing with these people in the first place, as well as cleaning up the mess they precipitated.

There is only one solution: Deal with ethical people. You may not make money as fast, but it will last longer and you will feel better about it. One tremendous advantage of dealing with ethical people is that they tend to hang around with other ethical people. Your circle of acquaintances spirals into more and more enlightened levels of fairness, kindness and awareness. Conversely, when you hang with rogues and rascals, your circle of acquaintances tends to spiral into depraved levels of increasingly severe cheating and deception.

Remember, you become the company you keep, so choose your friends and associates very carefully. Be firm about your expectations. Most disagreements come about because of a mismatch of expectations between two parties. Therefore, be aware of your own expectations, and equally important, discuss them with your associates. If you discover a chasm between your way of doing things and that of some associates, turn them into former associates. The world is too full of interesting, kind, knowledgeable and energetic people to be wasting time with takers, no matter how fancy the cars they drive or the homes they live in.

By Dolf de Roos – Source:

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