Buying income-producing real estate: the fundamentals

Welcome to the first in a series of columns written for the private real estate investor. Each installment will take a look at some specific aspect of investing, and hopefully shed some light on opportunities for the investor. In this article, let’s review some of the basics.

While investment real estate can be anything from a raw piece of land to the Empire State Building, we’re going to focus on income-producing properties, like retail plazas, office buildings, multi-tenant warehouse and distribution facilities, self-storage centers and apartment complexes. We may also look at single tenant net lease investments, like drug stores or fast-food outlets. Also, we’re going to stay focused on private rather than institutional investment real estate. Although the demarcation line between the two is not always clear, private investment properties run from $1 million to $10 million, and institutional investment properties go up from there.

There are three key reasons for buying income-producing investment real estate. The first is cash flow — the income stream generated from rent paid by tenants, less the expenses of operating the property and servicing the debt used to acquire it. In general, investors want positive cash flow, where the income exceeds the expenses, but there are situations where investors see opportunities even if there is negative cash flow.

The second key reason is appreciation, or the increase in value of the property during the period of ownership. As an owner’s property increases in value, and the debt owed on it decreases, the owner’s equity in the property, as well as his net worth, also increases.

The final key reason is tax benefits. While this is a fairly technical area, and a qualified tax professional should always be consulted, federal tax laws offer two important benefits. One is depreciation (now called cost recovery) and the other is the tax-deferred exchange (also called a Section 1031 exchange). Cost recovery increases an owner’s after-tax cash flow, and Section 1031 allows an owner to continually “trade up” to higher value properties while deferring the taxes due on the owner’s capital gains.

Who invests in real estate?

The private real estate investment community is made up of a wide cross-section of people. I’ve worked with a pizza shop owner who, along with his brother, owns a few shopping centers. I’ve also worked with a high-tech executive who enjoyed investing and uses the tax-deferred exchange method on a regular basis to upgrade his portfolio. Some investors start very young, others wait until the kids are out of college and they have some extra money. All of the investors I have worked with believe strongly in the wisdom of real estate investing, have a good sense of value, and are great with “the numbers.”

So how do you find and acquire income-producing real estate? The next time you drive to and from work, or out on errands, take note of the income-producing properties you see. They’re everywhere. You’ll see small strip plazas, sometimes with a “national” fast-food shop. There are office parks with doctors, lawyers, accountants and other professionals. In industrial zones, there are multi-unit buildings that house contractors, suppliers, light manufacturers and small distributors. Almost every town has a self-storage facility, and larger communities have apartment complexes with 25 units and up. Do you notice those national drug stores? In many cases, they are on long-term leases that call for them to make rental payments and take care of all of the expenses of the building themselves.

You probably won’t see “for sale” signs on many of these properties, but that doesn’t mean that they can’t be bought. As the saying goes, “everything is for sale – at the right price.”

Many private investors like to poke around themselves, but usually it takes a team approach, with an experienced investment property broker as the lead member, to investigate and acquire these properties.

I often work with an investor’s CPA to determine a target price for an acquisition, and then with the investor’s lawyer to generate a “letter of intent” to the owner of the property. Other team members can include a property manager, a commercial insurance broker, a commercial appraiser, and a commercial lender. The lender can play an important role in qualifying the buyer prior to an acquisition, or in pre-qualifying a property for financing before acquisition.

Financing is usually a critical factor to the successful completion of these deals. In some cases, buyers pay all cash. In others, the seller takes back the entire purchase price in the form of a note and mortgage. But these are the extremes. In the vast number of cases, some level of financing, or leverage, is involved.

The private real estate investment world is a fascinating place, and I’m looking forward to sharing some information about it with you. Please feel free to send questions or comments and if space permits, I will respond.

Dan Scanlon is an investment broker with Grubb & Ellis/Coldstream Real Estate Advisors Inc., Bedford. He can be reached at 623-0100, or at dscanlon@ coldstreamre.com.