Seeing the Drift Before It Becomes Bad Debt

Why I'm finally paying attention to "Days to Pay"

Over the past ten years of owning and managing small commercial properties, I’ve had four tenants go bad.

In each case, the ending looked different — some moved out quietly, others required eviction — but the financial result was nearly identical. I lost roughly $2,000–$3,000 each time. Painful, yes, but not catastrophic. And that’s exactly why I missed the warning signs.

Those losses never felt large enough to demand a process change. What I failed to see was that each one followed the same slow, predictable pattern, but I never knew what that pattern was or how to identify it: payment drift.

What is "Payment Drift"?

Payment drift is the gradual, almost imperceptible change in a tenant’s payment behavior over time. Rent doesn’t suddenly stop; instead, it arrives a little later each month — five days late becomes ten, ten becomes fifteen — until “late” quietly becomes “normal.” Because payments are still eventually made, the risk feels manageable and easy to rationalize. But like a car sliding just a few degrees off its racing line, drift compounds: the longer it goes uncorrected, the harder it is to recover, and by the time the loss is obvious, the damage is already done.

Payment drift is identified by analyzing an individual tenant's Days To Pay trend over time. Most of my tenants pay early, particularly if they schedule payments with their bank on a recurring basis.  Those that pay manually, typically pay within 1-2 days.

This chart shows Average Days to Pay for all tenants (anonymized) who consistently pay on time. 

Problem tenants on the other hand will show a distinctive pattern of late payments often exceeding the 1-2 day standard.  In the below example, there are 3 stages a tenant goes through as they drift into delinquency:

• Phase 1 - Stable Payer: payments made on time or early (-2 to +2 days)
• Phase 2 - Drift: persistent but small lateness (5 - 30 days)
• Phase 3 - Acceleration: payments creep into >30 days delinquency

This chart shows Days to Pay for a single tenant (Tenant 1) over time, anonymized and indexed by invoice date.

At no point did this tenant “suddenly” fail. There is no cliff. No dramatic spike. Instead, the line slowly slopes upward over several months.

Five days late becomes eight.
Eight becomes twelve.
Twelve becomes twenty.

At the time, I treated each late payment as a one-off event. Seeing it plotted out like this makes the reality unavoidable: the failure was already underway long before it was visible operationally.

Why I Didn’t See This in Real Time

When rent eventually arrived, I mentally reset the clock. My tracking stopped at paid vs. unpaid, not how long payment behavior was changing.

Because I wasn’t aggregating or visualizing Days to Pay, I had no way to distinguish:

• noise from signal

• exception from trend

• patience from denial

In isolation, each late payment was explainable. In sequence, they were predictive.

Rolling Average Days to Pay (Early Warning Signal)

This chart applies a rolling average to Days to Pay, smoothing out individual fluctuations.

Days to Pay and these charts changed how I think about tenant performance and how I will operate my business moving forward. The rolling average begins rising months before the tenant ultimately defaulted or vacated. That rise represents a behavioral shift, not a single incident.

Had I been monitoring this at the time, it would have triggered a clear question:

“Why is this tenant taking longer to pay every month?”

That question alone could have led to earlier action — tighter terms, firmer conversations, or earlier exit — when losses were still minimal.

The difference isn’t the occasional late payment. Good tenants have those too.

The difference is variance and direction:

• Stable tenants fluctuate but revert to a baseline

• Failing tenants drift upward and never recover

Once you see this pattern, it’s hard to unsee.

Drift vs Cliff Events 

It's important to note that not every tenant will follow this gradual accelerated pattern of drift. Some tenants might exhibit a sudden and dramatic increase in Days to Pay which are unavoidable. You can see in this second example.

This type of default is shock-driven default — something external happened:

• loss of income

• health issue

• business disruption

• legal / personal event

There was no long runway of gradual deterioration.

The tenant remained stable paying within 10 days every month before experiencing a sudden disruption that led to immediate and severe lateness. Both patterns result in bad debt, but only the gradual accelerated drift is meaningfully predictable.

Why Predictable Drift Matters for Small Landlords

Large property managers have automated aging reports, dashboards, and teams dedicated to credit monitoring. Small landlords rely on memory, inboxes, and intuition.

That works — until it doesn’t.

The irony is that small landlords feel losses more acutely, yet tolerate warning signs longer, because each loss feels isolated rather than systemic.

Days to Pay gives small operators a lightweight early-warning system without adding complexity or overhead.

What I’ll Do Differently Going Forward

Going forward, Days to Pay won’t be a retrospective metric. It will be a trigger.

Specifically:

• I will track rolling averages per tenant

• I will flag sustained upward drift, not single late payments

• I will intervene earlier — when conversations are easier and options are broader

The goal isn’t to eliminate risk. That’s impossible.

The goal is to recognize drift early enough that losses stay small — or never materialize at all.

Practical Policy You Can Implement Tomorrow

I've established tighter internal policies around handling delinquencies and late notices:

Internal Rule Set (Simple & Defensible)

• 3 months >5 days late → written notice

• Any payment >10 days late → tighten terms

• Any payment >30 days late → pre-collections

• Any payment >45 days late → assume default risk

This is not aggressive — it’s data-driven.

After ten years, four bad debts, and a few expensive lessons that never felt quite expensive enough at the time, this feels like a necessary evolution.

A Lucid Landlord Update...

It's been a minute (or 3,250,634 minutes) since I've published a post. After sharing my blog space with a few friends, I became encouraged to start posting again, so I thought I would check in with everyone and give you an update of where I am with my real estate investments and my learnings.

Since my last post, I've learned a lot about negotiating with tenants and operations of both the retail and office/warehouse market spaces. I went through a series of experiences, including a new purchase, so I am anxious to share these with you in this and other posts.

Property Mix and Finding My Niche

When we last met, I had purchased a commercial duplex around August of 2016. The previous owner had renovated it from a former KFC restaurant to retail and office space.  At that time, we had not gone through a pandemic together, which has had a significant affect on the commercial market and large office space in particular. We are also currently in a period of 40-year highs in inflation which brings additional trepidation to real estate investing.

In July of 2021, I purchased my third property, my largest investment to date. I took the time between purchases to really refine my niche and start thinking longer term towards building a strategy.  Similar to my first property, this new one is a multi-tenant office warehouse space. There are 4 buildings with nearly 17,000 sf of rentable space and 17 tenants. Each unit is around 1,100 sf which is larger than the 750 sf units in my first property.  The property is also just a few blocks from my first property.  Strategically, what I like about this property is it allows me to move tenants between properties as their needs change. It also gives me a bit more price control as I control more of the total leasable square footage in the area.

Macroeconomic Affects of the Pandemic

In the early part of 2020, the United States, and many other countries, implemented madatory lockdown measures for their citizens. These mandatory lockdowns only lasted a few months, but continued voluntarily by businesses, individuals, and local governments.  We continue to experience the affects of this today. Retail and hospitality were impacted the hardest initially, causing many tenants to seek concessions and rental forgiveness. 

The biggest long-term impact of the pandemic on the commercial real estate market was the work from home policies that many companies implemented and continue today.  Many industries realized that employees can work from anywhere and the media is ripe with stories about companies shuttering their offices. My own employer, in fact, previously leased close to 300,000 sf of office space across 2 three-story office buildings.  They have since downsized to a single floor of 1 building. 

Depending on what source you reference, office vacancy rates range from an average of 12.9% to 18.6% as more companies adopt work from home and hybrid work arrangements. What's interesting is that, so far, I haven’t seen this move down market to smaller businesses, which is the heart of my office warehouse space. Part of this may be attributed to the fact that there is a shortage of units less than 1,500 sf. resulting in high demand. Another factor may be that smaller businesses are operated by the owners directly and their office may be an extension of their home so they feel safer continuing to come in to the office.

The second macro-economic factor affecting commercial real estate is our 40-year high infltion.  In 2022 we saw inflation hit a high of 9.1%. My office warehouse properties are severly underpriced in the market which allows me to maintain a 100% occupancy rate. With the high inflation, I am now able to increase rental rates for both new leases and renewals alike yet keep the rates below market to maintain high occupancies. 

My Experiences From the Lockdown

During the lockdowns, both of my national retail tenants requested small concessions which I happily obliged to avoid a prolonged vacancy during a pandemic when businesses were shutting down. This strategy worked in the short term as I was able to maintain occupancies.  The concessions were a foreshadowing of events and eventually one of my national tenants requested to generously buy out the remainder of their lease. 

Given I had negotiated lease renewals with this tenant in the past, I knew they were agreeable to negotiations.  I countered the first offer and we continued to negotiate from there. We landed at a number that compensated me for rent and expenses of at least a year, which was still cheaper for them than having to fulfill three more years on their lease. The unit sat vacant for 12-13 months until recently

I filled the vacancy with a local credit tenant - a public school administrator who is looking to grow their food truck business with a physical location. With this new tenant came additional concessions during their build-out phase and of course the costs of marketing the space through a commercial realtor. 

Returns

Overall, my retail property has been the best performing of my two initial properties with an average annual ROE of 38.9% compared with 21.1% for my office/warehouse space and average annual COC returns of 13% vs. 6% for my office warehouse property. The lower COC for the office warehouse property I attribute to the below market rents, low annual increases and 2-year lease cycles for the tenants.  Note: if there are other metrics you are interested in me sharing, please leave a comment.

Return on Equity (ROE) Comparison - Warehouse vs. Retail

Cash on Cash (COC) Return Comparison - Warehouse vs. Retail

Over the last 3 years, I have also been able to distribute money from the retail LLC and still operate with cash reserves.  I've built enough reserves now that I can loan to my other LLCs for needed repairs such as a roof replacement. Such is the case with my most recent acquisition, which had significantly more deferred maintenance than I had anticipated.

What's next?

For now, I'm sitting on the sidelines again as I try to stablize my new property. My experience from my first purchase was this takes roughly 3 years as you work through tenant attrition and discovery of deferred maintenance. My next post will share considerably more learnings with you. Until then.

Pitfalls of the due diligence period.

For new real estate investors, your first investment is sort of like being a Chicago Cubs fan.  You're committing to something that you think is a winner but if you're not careful there will be alot of disappointments in your future and it may take 108 years before you come out on top...

So you've found that ideal investment property, ran the numbers and decided to make an offer. Not so fast - there are some things you need to take into consideration based on the properties unique attributes that you might want to include as constraints of the offer.

Inspections:

When you are analyizing a financial investment such as a mutual fund, you're given a prospectus that describes the risks involved so that you can make an informed decision on whether to proceed with the investment and/or how much to invest.  Just like a prospectus, an inspection report describes the risks involved with the physical property you are about to acquire.  Having an inspection performed by a qualified commercial inspector is critical to assessing the state of your prospective investment. The inspection report will list any defects or deferred maintenance on the property such as outdated HVAC units, crumbling flatwork or an impaired roof. The older your property, the greater the need for an inspection.  A 40+ year old property, for example, may require electrical upgrades.  The results of these inspections and how you handle them are the critical path during your due diligence phase. You might choose to renegotiate part of the contract or expand on your financial projecttions to consider additional maintenance costs not originally considered before. You may need to call in additional inspectors for roof, plumbing or environmental.

My first commercial property was an 8-unit office/warehouse space with separate HVAC units for each suite.  The property was an older property (over 30-years old) and the HVAC condensers were still original quality.  I was able to go back to the seller and renogotiate the purchase price to include an allowance for condensers that should have been replaced at least twice in their lifetimes.  This enabled me to set aside additional funds for the first few years to cover replacement if any of the units malfunctioned.

My second property was also an older building that had been remodeled.  It originated as a Kentucky Fried Chicken restaurant and had been remodeled as a retail duplex. As I indicated earlier, Electrical and plumbing can easily be areas of concern on a property of this age.  In fact, my insurance carrier for this property required evidence that these components of the building had been updated and brought up to code.  A standard real estate inspector will cover a broad cross-section of a buildings components but typically will not go into detail in any one area.  Working with my inspector, we brought in a Master grade plumber and electrician who were able to validate the systems as per my carrier's requirements.  Knowing this now, I recommend that you check with your regular inspectors to find out whether they have a team of sub-specialty inspectors available should the need arise.

Environmental:

Before the acquision of my second property, I bid on a single tenant automotive facility which fell through in the end.  Having grown up in a family that owned a Body Shop, I knew there could be environmental issues with automotive paint waste. Assuming you have a realtor worth their weight in gold, they can recommend inspectors who will evaluate the environmental conditions on a property. These reports come in two stages:  a Phase I analsyis reviews the historical uses and ownerships of the subject property along with any reported environmental infractions within a certain radius of the subject property.  A site visit is conducted to perform a visual inspection and note any potential concerns.  This report also outlines any recommendations such as the need for a more complex Phase II analysis, or recommended corrective actions.  A Phase II analysis goes into much greater detail focusing on specific conditions and advanced testing.

In my specific case, I paid for a Phase I analysis which confirmed my suspicion that twelve 55-gallon barrels of paint waste were leaking into the open ground.  The inspection report recommended to remove the 12 barrels of waste and conduct a more advanced Phase II report with soil samples. What I've come to really like about commercial deals over residential deals (at least in Texas anyway) are how you can terminate a contract for any reason up to a certain date without much penalty or with a very insignificant amount of earnest money at stake.  My earnest money in this case was an insignificant $100 for example.  In my original offer, I attempted to include a contingency for the seller to pay for the Phase II inspection if the Phase I recommended it, but he wouldn't accept it. Normally, this would have been a red flag for me but the seller was the owner's brother who was terminally ill therefore he wasn't aware of the property conditions.  I attempted to further negotiate with the seller to remove the waste prior to a Phase II inspection and assume responsibility for the results however the seller wouldn't budge stating it was the tenant's responsibility.  This allowed me to back out of the deal with minimal costs incurred (I lost my $100 earnest money).  Had I moved forward with the closing, I might have been stuck with a hefty environmental cleanup on my hands and possibly incur fines.  With a copy of the Phase I in hand now, the seller was required to disclose this information so in a sense I felt justice had been served in the end.

Warranty Deeds and Title Insurance:

As my closing date for my second property was fast approaching, my realtor stayed on me to ensure I had reviewed all the Warranty Deeds and Title Insurance documents accordingly.  During this review, I noticed several items that were concerning.  First, the Warranty Deed carried with it a list of exceptions in a section titled "Reservations from and Exceptions to Conveyance".  If you are just starting out in acquiring real estate, particularly Commercial properties, it would behoove you to understand exactly what all these documents mean that we normally take for granted at closing.  The Warranty Deed is a guarantee that the deed to the property is free and clear.  Sometimes they carry exceptions or restrictions with them, also known as restrictive covenants.  For example the property may be part of a larger development (think homeowner's association restrictive covenenants) and there are limitations on what type of business can occupy the space.  My particular property sits on the corner of what used to be a Safeway grocery store and to protect their image and brand, there are restrictions against liquor stores, bowling alleys, other grocery stores, and drive-in curb service eating establishments.  As the property changed hands later, Kentucky Fried Chicken added in restrictions against any food service establishments serving chicken, pizza or Mexican food for 20-years (Tricon Global, now YUM! Brands owns KFC, Taco Bell, and Pizza Hut chains throughout the US).  All of a sudden, my tenant list begins shrinking smaller and smaller really limiting who I can rent to. Fortunately, some of these Special Warranty Deed restrictions will expire cooinciding with the lease exprirations of my current tenants.  This is a great example though of how you must know and understand all aspects of the property under consideration and how they are interrelated.

Another area of real estate we often take for granted are Mineral Rights.  One would normally expect the property's mineral rights to transfer with the property.  A Special Warranty Deed may accompany the property however in which those mineral rights were transferred to a third party along the way. There may not be much you can do to retain those mineral rights, but it helps to understand and avoid costly disputes later on down the line.  The seller of this particular property owns 80+ rental properties and was obviously very experienced in these matters.  This particular property sits on a popular Shale formation so the owner transferred the mineral rights to himself and retained the property in his LLC.  He was able to subsequently sign a gas lease with a well known natural gas corporation thus creating an additional revenue stream from the property.  He now retains those rights and revenue streams even after our deal has been consumated.  

Leases, Estoppels and the Closing Statement:

Any discussion on pitfalls wouldn't be complete without a warning on Leases, Estoppels and reviewing the Closing Statement.  During the due diligence phase of this newest property, I naturally reviewed each of the leases and the estoppels.  During the acquisition of my first property, the lease review was straight forward - the tenants were responsible to me for their rent only.  With this newest property however, the leases are Triple Net (NNN) and I had to educate my self quickly on the details of how NNN works.  In my specific case, the tenants have a base rent that remains static for 5-years and a monthly Common Area Maintenance (CAM) charge that varies from year to year. This charge is made up of all utilities covered by the Landlord, maintenance fees such as landscaping, property management fees, Insurance and Property Taxes.  Trying to understand how the previous owner calculated CAM was complicated by the fact that one of my tenants actually pays the electrical for the entire building and I'm responsible for seeking reimbursement from the other tenants.  The CAM charge is really just an estimated amount then there is a reconciliation process that I have to go through at the end of year.  Since I closed on the property in August and the owner had collected Property Taxes from the tenants for 8 months prior, it was important that the closing statement reflected the credit back to me for those 8 months.  Unfortunately I wasn't aware of this arrangement and my realtor missed it.  When the taxes came around a few months later, I was fortunatel enough for the statement to go to the previous owner who forwarded it to me.  This opened up the door for me to ask him for reimbursement of the taxes at that time.  Again - as an experienced investor himself he had been through this before and quickly reimbursed me for the appropriate amount.  This could have turned out disasterous for me however to the tune of $4,500.  Also during the review of the closing statement, I noticed the title company failed to take into consideration the CAM amounts and only prorated the rent amount.  The day of closing I had to go back to the title company for a final adjustment.

Final Thoughts

As I reflect on the above, one thing that stands out as a common theme is the importance of relationships and building your team.  You must ensure you have a solid team of professionals in place from your Realtor, Lendor and Title Company to the Inspector and Insurance broker.  I built the initial relationships during my first closing but by using the same professionals on my second property, they were willing to assist when issues arose. These individuals go through the same exact scenarios every day of their professional life and they are there to help you solve problems and get the information you need to make a decisions.  Those decisions though are ultimately up to you.

   

Finding your niche.

It's been about nine months since my first post so I thought now would be a good time to check in. I closed on my first property last October.  For the most part, my experience as a new investor, landlord and property manager has been enjoyable.

In my last post, I discussed the various considerations a new investor should weigh before diving in to the dark world of Real Estate Investing (REI for short).  

If it wasn't obvious from my post, I placed a large emphasis on Commercial real estate as this was the segment I had become interested in. What I discovered though was that real estate is like any other industry with many segments and sub-segments.  The first rule of product marketing is to understand your markets and segments and fortunately I had spent many years in Product Management so I was up to the challenge.

Gross vs. NNN

Before I jump into these segments I should provide a short primer on the various commercial lease options.  As I discussed in my last post, one of the huge benefits of commercial investing is that tenants prefer to lock in low rates with a multi-year lease which reduces the risk of vacancies for landlords. Conversely, it also exposes a landlord to the risk of inflation.  There are ways to minimize this risk based on your choice of lease structure.  A Gross Lease, for example, requires the landlord to assume the maintenance and repair costs for common areas of a property such as the roof, landscaping, flatwork (sidewalks and parking lots), utilities that are not separately metered, and the biggest expense of all - property taxes.  A Triple Net lease (NNN for short) however places all maintenance and repair costs in the hands of the tenant.  As you can guess, shorter term leases for say two to five years tend to be written as Gross leases since the landlord can raise rental rates to keep up with inflation and market changes.  Longer term leases can extend as far in to the future as 20 or 30 year terms.  These longer term leases have the greatest exposure to inflation and are usually written as triple net leases with regular price increases laddered into the lease agreement.

Which Markets, Which Segments?

The first question I needed to answer was which part of town I wanted to invest in.  I live in a suburb of Dallas called Lewisville.  The northern suburbs are growing rapidly due to the investments being made by many large corporations.  In general, all of Dallas is benefiting from this though.  I wanted to find something close to my home so that if I had to tend to an issue at the property, I wouldn't have to drive 45-minutes away.  For the life of me, I can't understand how some investors can purchase a property site unseen in a city 400 miles away.  This seems irrational to me but its absolutely normal now due to the growth of the internet and it forces local investors, like myself, to compete with someone in New York or California.  In any event, I found a property in a city close to my home that is going through a revitalization.  I didn't realize though until after I purchased my property that my tenants and prospective tenants like it just as much which makes me happy!  My vacancies are low and I have my prospects asking me if I own any other properties so there's the potential to build a niche around feeder properties as long as I can find the right tenants (and more properties like the one I bought).

As I was searching for my first property I realized that there were many distinct segments within Commercial real estate and I needed to narrow down my market and niche.  In the broadest sense, commercial properties can be classified by use and/or by tenancy.  Usage types might include Retail, Industrial, Office, and other non-residential (think car washes) while tenancy is viewed as either single tenant or multi-tenant. Since this was my first property and my first adventure into property management, my primary focus was on finding a multi-tenant property to minimize my risk of vacancies.

Retail

Retail properties are usually classified by either single tenant or multi-tenant uses.  A good example of single-tenant retail properties might be a restaurant space.  There are both pros and cons to a freestanding restaurant.  The pro is that leases tend to be very long-term for 20 or 30 years with additional options to extend the lease out even further.  These type of properties also tend to sit vacant longer when a tenant moves or closes its doors.  One property I was interested in for example was a fast-food restaurant in an affluent and high-growth part of the metroplex. There was 10-years remaining on the lease and it was backed by the security of the parent franchisor. There were also four 5-year lease options in the agreement which potentially extended the lease another 20-years.  Sounds great right?  Commercial loans are usually only extended for maybe five or seven years.  The owner can usually refinance of course, however there is a risk of rising interest rates.  Also, the likelihood of a bank refinancing the loan on a property that will go vacant in the future for a year or longer is extremely low.  I would have had a large balloon payment due after seven years that I couldn't afford.  But what about the four 5-year extensions? There is no guarantee the franchisor would extend.  A visit to the restaurant showed that the building layout was an older footprint for this franchise.  Since this store was located in an affluent and high-growth suburb, there was a high probability that the parent franchisor would want to abandon that location and build a newer store in a newer section of the suburb to better represent their brand.  I obviously passed on this deal.

Multi-tenant retail properties are probably the most common as they exist on almost every street corner.  The quintessential strip mall comes to mind.  These properties are home to a variety of mom and pop retailers from doughnut shops and convenience stores to Chinese food, nail salons, and dry cleaners.  These are attractive properties for new investors provided there is availability. Even though there is a plethora of strip retail everywhere, owners tend to keep these properties in their portfolios into eternity.  Since you as a landlord are most likely dealing with small entrepreneurs who have only just opened their doors, the greatest risks for properties of this type are frequent vacancies, high marketing expenses, aging Accounts Receivables and high uncollectibles.  The benefits of this property type of course are that due to a wider coverage of tenants you will typically have enough cash flow to at least breakeven if not exceed expenses in any given month.

Office 

Commercial office space is a broad classification that can range from large single and multi-tenant professional office buildings to smaller multi-tenant office condos, medical offices and free-standing office space.  Large single and multi-tenant professional office buildings are out of reach for most individual investors so I will skip through this category.  Medical office spaces is one segment that interests me due to my background in Healthcare IT and Administration.  With the rapid changes occurring in Healthcare, this type of property seems low risk due to the demand for providers. You have professional tenants that require a stable long-term location at frequent renewal periods allowing you to raise rates with each renewal.  Physicians are an affluent group so you are likely to have stable cash flow as well.  There is a great deal of pressure however to maintain appearance of common areas and modernize. Smaller professional office space (Accountants and Attorneys) is ideal also for the same reasons, however in some cases there may be additional expenses associated with equipment such as elevators and hot water heaters.

Industrial

As I was first evaluating Industrial space, I was very skeptical of this property type as an investment because of my unfamiliarity with it. The first thought that came to mind was manufacturing and distribution warehouses which can go vacant for long periods of time especially during a downturn in our economy. There's a high correlation between our economic cycles with manufacturing and distribution. What's appealing about this type of property though is the stickiness that is created due to the nature of manufacturing operations.  Many manufacturers and distributors require heavy equipment which is accompanied by costly moving expenses so these tenants will remain for years, provided they have ample space to expand.  Large warehouse spaces usually require large capital investments so just like large professional office space, it is out of reach for average investors.

Enter Flex and/or office-warehouse space.  The concept of Flex space is unique in that the property type is not tied to a single use, rather it is a combination of both warehouse space and office space. The space is flexible enough to house both under one roof.  The front area might house an air conditioned office while the rear will have garage access to a warehouse.  This type of unit can range in size from large 50,000 to 60,000 square foot office/showrooms with loading docks to smaller 800 square foot office/showroom spaces with ground level garage entrances.  They can serve either single tenant or multi-tenant dependent on the size of the building and the tenant needs.

Finding my Niche

When my realtor presented the 6,000 square foot multi-tenant flex space to me, I felt disdain for the property.  However, the open-minded individual that I am, I evaluated the property objectively since it was a multi-tenant opportunity.  I was pleasantly surprised to say the least, when I saw the prospective returns.  The building was 30+ years old but very well maintained.  The roof had been replaced two years ago and had a 20-year warranty that accompanied it. The property was 88% occupied and tenant leases ran for two-years.  The short-term opportunity was in filling the one vacancy and raising rents as leases came due.  The longer-term opportunity however has to do with the fact that this building is in a historic part of town that has a large redevelopment effort behind it.  The property is only a block away from a new public transit depot and the area is slotted for multi-use pedestrian purposes (retail on bottom with condos and apartments above) which is the new rage in Dallas.  It would be highly desirable for a large developer to come in and buy out all the properties around the area to build condos and retail.

After I assumed ownership & management responsibilities, I was able to lease the vacant unit to an existing tenant which fixed my vacancy problem.  Things haven't been all roses though.  I did encounter some issues over the last seven months such as slow paying tenants with one in particular that moved out in the middle of the night.  No damages were sustained and I was fortunate enough to fill that vacancy in less than a week with a better tenant that was willing to pay in advance every 3-months.  His business is flourishing as a result because of the area.  My product is in low supply for the area.  There is not much office/showroom space available in the under 5,000 sf category which is ideal for the startup blue/white collar entrepreneur.

So Now What?

Now the search is underway to find my second property.  I'm finding that the search and acquisition process is the most difficult part of finding a new investment property.  I found another property in close proximity to my first one however it was a single tenant automotive property.  I was under contract and had a Phase 1 environmental analysis performed due to the paint and body operations on site.  The Phase 1 came back recommending further analysis since they found about a dozen 55-gallon drums of paint thinner abandoned and exposed to the elements.  Neither the seller or tenant were willing to assume liability for the clean up so I broke the contract and started searching again. I was lucky enough to find a small two-tenant retail property in an older part of town with two national tenants occupying the space.  I'm under contract now and we will have to wait and see. What I like about this property is the multi-tenant nature of the building and it's small enough to manage for my first entry into retail strips.  Stay tuned for more as I update you on the progress!!!

So you want to become a real estate investor, eh?

As this is my first blog, let me begin this post by qualifying myself.  I am new to real-estate investing as a profession but not new to the idea of investing.  I’ve romanticized endlessly, like many of you, about becoming an overnight real-estate tycoon.  After nearly 20-years of living the dream inside Corporate America, I decided to finally do something about it.  I’ve managed to save a little money to buy my first investment or two and I’ve chosen to chronicle my evolution from Software Product Manager to Entrepreneur. One of my first lessons learned so far is that this will be a rather drawn out evolution so grab your popcorn and enjoy the show.

My purpose of recounting this evolution is two-fold.  First, as any Business 101 class will teach, every startup needs to have a business plan.  As part of that plan, entrepreneurs need to understand their markets they will compete in before dropping a bunch of money down the toilet.  As I recently learned in a local investor seminar, the first rule of real-estate investing is to protect your capital (The first rule of fight club....).  So my intention is for these blog posts to serve as the content and market discovery for my business plan so that I can reduce my risk and have a better chance at protecting my initial capital.  Second, since real-estate investing is so romanticized in our society today I hope to dispel the myths and frauds that are so prominent.  This second point is a rather interesting one and will serve as the basis for a future blog.

So let's start at the beginning by deciding on which market to invest in.

Residential or Commercial?

One of the first questions a newbie investor should ask themselves is whether to invest in residential or commercial real estate.  There are pros and cons to each and subsequent strategies that follow depending and this choice.  Too many investors just starting out overlook the commercial market altogether and dive straight into residential investing simply because they have familiarity with the process from buying their own home.  This isn't a bad strategy, afterall Warren Buffet preaches to invest in what you know and understand.  I started down this path fruitlessly and spent several months analyzing deal after deal that I came across in my local MLS.  Unfortunately for me, my timing was off; however I needed to go through this exercise as part of my market discovery to reach my own conclusions.

You see, I live in a suburb of Dallas, TX which is exploding right now due to the import of more than 130,000 people last year and the relocation of and investment by corporations such as Toyota, FedEx, and Nebraska Furniture Mart; the exact reasons I wanted to get into rentals in the first place.  Market data showed inventory was low and buyers were being forced into rentals.  The flip side was I was competing with cash-rich consumers moving here from California that were bidding the prices up with multiple offers and I couldn't justify making an investment at inflated prices.  The returns weren't there and I was convinced this was hopeless until a neighbor introduced me to commercial investing.  My analysis by the way was based on some great insights in Real Estate Investing 101 and 102

"Be fearful...": The case for Commercial

Many argue that commercial investing is more risky due to longer vacancy periods and/or longer sales cycles; a property can go vacant or unsold for a year or more.  I was able to justify commercial investing to myself because of a stronger competitive environment for residential and having headed The Oracle's warning: "Be Fearful When Others Are Greedy and Greedy When Others Are Fearful".

Basic investment principals, such as know your time horizon and diversification, still apply to real-estate investing regardless of property type.  If you can't afford to have your money tied up for 10 or more years, you shouldn't be investing in real-estate to begin with.  As for the vacancy periods, this risk can be reduced by investing in mult-tenant properties where only fractions of the overall square footage are vacant at any given time. Admittedly, some commercial properties are inherently riskier than others and the astute investor should be aware of what makes them risky and how to identify the level of risk. In general though, commercial properties have more levers for an investor to control and manage the risk and overall profitability, especially when it comes to lease terms. Commercial tenants tend to sign longer lease terms than residential tenants which have both positive and negative outcomes. You're trading off the ability to raise rents for the security of a longer lease term however one can stairstep rent increases into a multi-year contract and offer extended lease options to incent a timely and reliable tenant to resign.

There were numerous other reasons commercial investing appealed to me.  First, the market is more rational.  Property valuations are driven by the principals of supply & demand and risk & return not by emotions.  If a multi-tenant property is 100% occupied with reliable tenants holding multi-year leases, you can expect a lower return on your investment than a vacant single-tenant gas station that might have hidden environmental issues requiring costly remediation.

From a landlord perspective, commercial investing brings fewer headaches.  For starters, your hours are your tenant's hours so you can expect not to be bothered in the middle of the night.  Secondly, your tenants actions are aligned with your investment.  Tenants are incented to take better care of the property because they want to present their business and storefront in the best light.  Third, as indicated earlier, commercial tenants tend to be more timely and reliable with rent because their livelihood and investment are on the line.

Don't let me persuade you.  Commercial investing isn't all roses.  There are other risks that don't exist with residential.  For one, there's the risk of the different loan programs available to investors such as loans with balloon payments and the risk of terms and interest rates on commercial lending.  I will go into these in more detail in a future blog post.  Other blog ideas include what I have learned so far about the different ways to invest in real estate and how to navigate the residential investing circus.

So stay tuned as we learn together, this should be about as much fun as having a root canal!