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.
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.
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