Most people in Northern California started investing in real estate by buying their own homes. And most have made money as Northern California real estate has continued to appreciate in value. So when they move upstairs, they decide to rent out their first apartments. And then they buy a few more houses. They know they have negative cash flow but are making a profit due to the increase in value. This is the typical story of how most real estate investors invest in residential real estate. Luck has been on their side so far.
As interest rates have gradually increased over the past 12 to 24 months while rents in the Bay Area remain very flat, the negative cash flow gap is widening. The risk of investing in residential real estate is increasing. The same old formula of investing may not work anymore. At best, investors can still make money, but not that much in percentage terms since the value of real estate is already quite high. At worst, investors can lose money as residential real estate can stagnate or even decline in value. Is there a solution for real estate investors in Northern CA? Of course, these investors can apply the same old formula to a new area of upside potential. So the key is to find this new area. You just have to talk to someone who knows this new area. It could be Bakersfield or Sacramento or Fresno. Alternatively, investors can invest money in commercial real estate: retail strips, shopping malls, doctor’s offices. Let’s just examine this paradigm shift to see if it makes sense to invest.
1. Income: Commercial real estate generates 50% to 200% more rental income than residential real estate in the Bay Area. In addition, there is no rental price brake for commercial real estate. This allows landlords to charge their tenants as much as the market allows.
2. Rent: In general, commercial leases are cheaper for the landlord than residential leases. Tenants must pay property taxes, insurance, and all maintenance costs to the landlord in addition to the base rent. These leases are referred to as triple net or NNN leases. Because of this type of tenancy, commercial properties are better maintained than residential properties. In addition, the NNN leases also relieve the landlord of many risks, since the maintenance costs are unpredictable. On the other hand, landlords tend to defer maintenance on residential properties to reduce costs. Consequently, deferred maintenance has a negative impact on the value of the property.
3. Better Tenants: Commercial tenants are financially stronger. They can be Walmart or Home Depot with billions of dollars in the bank. They’re less likely to make nickels and dimes with you. In addition, they also vouch for the lease with their assets. If they have to vacate the apartment for unforeseen reasons, they continue to pay the rent or find another tenant to sublet. They are also motivated to keep their property in good condition to attract their customers to their stores. While the majority of apartment renters are good, some, once they’ve paid the rent, think they have a license to demolish your properties and then vanish into thin air with no forwarding address!
4. Long-term rental: Commercial tenants move less often. They often sign 5-10 year leases. Tenants like Walgreens and Walmart sometimes sign leases for 20 to 50 years. In contrast, residential leases are short-term. You could move a mile away to get a $25 rent reduction! The fact is that the turnover rate for residential tenants is very high compared to commercial tenants. As a landlord, you have more unnecessary migraines and stress.
5. Management: It’s much easier to manage a mall with 10 tenants than 10 individual homes in 10 different locations. In fact, if you own 10 rental units, your tenants have most likely worn you down and we’re exhausted. You often move out in the summer, exactly when you want to go on vacation. Yes, it is a fact that residential real estate is very administration intensive due to the high turnover rate. If you have to hire a property manager, managing residential properties also costs more as a percentage of the rent. Plus, managing just those 10 property managers is probably a full-time job!
6. Income tax returns: It’s much easier to keep records for income tax purposes for a 10-unit mall than 10 separate multi-state rentals. You only need one file for the mall, while you need 10 folders for 10 rental apartments. The task becomes more difficult as the IRS requires you to keep records spanning several years. Your out-of-state income tax return is also thinner for a 10-unit mall than for 10 rentals.
7. Tax depreciation: Commercial real estate offers the same tax depreciation as residential rentals.
8. Impact on creditworthiness: Most people don’t realize that once they have around 10 home mortgages, their credit rating goes down. The credit bureau reasoned that the more money you borrow, the higher the credit risk, and 9-10 mortgages seems to be the threshold. On the other hand, commercial mortgages do not negatively impact your credit score as these mortgages are not reported to the 3 credit bureaus.
9. Pride of Ownership: Most commercial properties are identified by name rather than address, such as Lion Plaza or Valley Fair Shopping Center. They could be trophy items that offer tremendous pride of ownership. You get a lot of respect when you tell people you own a particular mall that they know.
10. Investment size: Commercial real estate often requires a significant amount of money, so it is not intended for someone with a modest amount of money.
So if you work hard for your money or want to bet on appreciation, then invest in residential real estate. If you want to work smart, look for commercial real estate. Commercial real estate investing is a more prudent way to invest in real estate when you have more equity to pay the down payment. Each month you have a strong positive cash flow, so you don’t have to rely solely on appreciation to make money. So if you haven’t invested in commercial real estate before, now you know why you’re not among the elite of real estate investors. You’re probably wondering where to go from here if you want to investigate this possibility further. These topics will be covered in future issues
o Which commercial property should you invest in?
o Where should you invest in commercial real estate?
o How to choose a good commercial property?
o What you should know before hiring a property management company
If you can’t wait for these articles, you can register for a free seminar on commercial real estate investing at Transmercial. The San Jose Real Estate Investors Club (phone number 408-264-3198) occasionally offers a similar seminar for a small fee.