Most people in Northern CA started investing in real estate by buying their own homes. And most have made money as Northern CA real estate has continued to rise in value. So when they move, they decide to rent their first houses. And then they buy a few more houses. They know they have negative cash flow but are making a profit because of the appreciation. This is the typical story of how most real estate investors invest in residential properties. So far luck has been on his side.
With interest rates gradually increasing over the past 12-24 months, while rents in the Bay Area remain very stable, the negative cash flow gap is widening. The risk of investing in residential property is increasing. The same old investment formula may no longer work. At best, investors can still make money, but not as much in percentage terms, since the value of real estate is already quite high. In the worst case, investors may lose money, as residential real estate may remain flat or even lose value. Is there a solution for real estate investors in Northern CA? Of course, these investors can use the same old formula in a new area that has appreciation potential. So the key is to find this new area. They just have to talk to someone who knows this new area. It could be Bakersfield or Sacramento or Fresno. Alternatively, investors can put money into commercial property: strip malls, malls, medical office buildings. Let’s explore this paradigm shift to see if it makes sense to invest.
1. Income: commercial properties generate 50-200% more rental income compared to residential properties in the Bay Area. Also, there is no rent control for commercial properties. Therefore, landlords can charge their tenants as much as the market allows.
2. Leases: In general, commercial real estate leases are more favorable to the landlord compared to residential leases. In addition to the base rent, tenants also have to pay property taxes, insurance, and all maintenance costs to the landlord. These leases are called Triple Net or NNN leases. Due to this type of lease, commercial properties are better maintained than residential properties. In addition, NNN leases also eliminate a lot of risk for the owner, since maintenance costs are unpredictable. On the other hand, homeowners tend to defer maintenance on residential properties to reduce cost. consequently, deferred maintenance will have a negative impact on property values.
3. Best Tenants: commercial property tenants are financially stronger. They may be Walmart or Home Depot with billions of dollars in the bank. They are less likely to nickel and dime you. In addition, they also guarantee the lease with their assets. If for some unforeseen reason they have to vacate the property, continue to pay rent or find another tenant to sublet it. They are also motivated to keep their property in good condition to attract their customers to their stores. While most residential tenants are good, some think that once they pay rent they have a license to vandalize their properties and then disappear into thin air with no forwarding address.
4. Long-term lease: commercial tenants are less likely to move. They often sign 5-10 year leases. Tenants like Walgreens and Walmart sometimes sign 20- to 50-year leases. By contrast, residential leases are short-term. They could move to a new place a mile away for $25 rent relief! It is a fact that the turnover rate for residential tenants is very high compared to commercial tenants. As a landlord, this creates more unnecessary stress and migraines for you.
5.Management: It’s much easier to run a 10-tenant mall than 10 individual houses in 10 different locations. In fact, if you own 10 rental units, chances are your tenants have worn you down and we’re exhausted. They often move in the summer, just when you want to go on vacation. Yes, it is a fact that residential properties are very management intensive due to the high turnover rate. If you have to hire a property manager, it also costs more in terms of percentage of rent to manage residential properties. Also, it’s probably a full time job just managing these 10 property managers!
6. Income Statements: it is much easier to track records for income tax purposes for a 10-unit shopping center than it is for 10 separate residential rentals in multiple states. You only need to have one file for the mall, while you will need 10 folders for 10 residential rentals. The task becomes more challenging since the IRS requires you to keep records for several years. Your out-of-state tax return is also less for a 10-unit shopping center than it is for 10 residential rentals.
7. Tax cancellations: Commercial properties offer the same tax breaks, 1031 exchange as residential rentals.
8. Impact on credit score: Most people don’t know that once they have about 10 home mortgages, their credit scores will start to decline. The credit bureau reasons that credit risk is higher the more money is borrowed and 9-10 mortgages seems to be the threshold. On the other hand, commercial mortgages do not have a negative impact on your credit score since these mortgages are not reported to all 3 credit bureaus.
9. Pride of Ownership: most commercial properties are listed by name rather than addresses, eg Lion Plaza or Valley Fair Shopping Center. They could be trophy properties that offer tremendous pride of ownership. You get a lot of respect when you tell people that you own a certain mall that they know about.
10. Size of the investment: commercial properties often require a substantial amount of money, so it is not intended for someone with a modest amount of money.
So if you want to work hard for your money or bet on appreciation, invest in residential. If you want to work smart, look into commercial properties. Investing in commercial real estate is a more prudent way to invest in real estate if you have more capital for a down payment. Each month has a strong positive cash flow, so you don’t need to rely on appreciation alone to make money. So if you haven’t invested in commercial real estate, now you know why you’re not among the elite group of real estate investors. You’re probably wondering where you should go from here if you want to explore this possibility further. These issues will be covered in future issues.
o What commercial property should you invest in?
o Where should you invest in commercial real estate?
o How to pick and choose a good commercial property
o What you should know before hiring a property management company
If you can’t wait for those articles, you can sign up for a free Commercial Real Estate Investing seminar at Transmercial. The San Jose Real Estate Investors Club (phone number 408-264-3198) occasionally offers a similar seminar for a small fee.
