Buying Larger Real Estate Properties

Although it's generally true that the best place for new investors to begin in real estate is with single-family homes (they are by far the easiest type of property to buy or sell, plus you can hold onto them and realistically expect their value to increase; even if markets are down, they've historically always rebounded), they are certainly not your only options. Many investors decide to move up to other kinds of investment properties. Of course, it's not a requisite; you could, as many real estate investors do, spend your entire career dealing only in single-family residential properties, and you could do very well. But if you want to make larger chunks of money at a faster rate, your calling might lie in the area of larger properties.

Let's assume, for instance, that you own a 20-unit apartment building, or perhaps a strip mall. With one of these properties, you could not only reasonably expect to garner considerable profits over time but also, if you obtained the proper financing when purchased, you might have been able to achieve a significant positive cash flow beginning right at the closing table. In other words, it's possible that you could immediately afford to hire someone to manage the property so that you wouldn't have to trouble yourself with collecting rents or repairing faulty air conditioning units. Furthermore, at the end of the month, you'd still have a sizeable amount of money left over after expenses. And as the icing on the cake, by buying right and improving the property, you would experience substantial and rapid equity growth. It's therefore fairly understandable that many investors choose to jump to larger properties.

On the other hand (doesn't there always seem to be one?), the potential for loss with bigger investment properties is also greater. For example, if you have only one single-family rental house, you only need to find one tenant. Even if the market goes south, you generally only need drop your rent a few dollars a month to keep your property occupied. But with larger properties, you may need to find ten or twenty good tenants. In tough times, you might be able to rent only half or three-quarters of your units, resulting in some very serious negative cash flow problems. Simply put, a bigger property can be lost more quickly and easily than a single-family house. Therefore, "graduating" to larger investment properties not only offers greater rewards but also greater risks – which is not unlike most investments.

In investing, it's important to know where the profits are being generated. For the bold and fearless, there are quicker and more superior profits to be made in larger properties. This is due to the fact that the dynamics of the two fields are quite different. With single-family homes, prices increase only as overall residential market values rise. If you buy a home with a 10 percent down payment, for example, and the value of the property increases by 10 percent, you've actually made 100 percent profit on the money that you invested (not figuring in transaction costs, of course). For example: you buy a $100,000 house by putting down $10,000 and obtaining a $90,000 mortgage for the rest. The house's value then appreciates to $110,000, giving you $20,000 in equity – a 100 percent profit on your actual investment. Additionally, all of the increase in the property's value is counted toward your equity; the lender has no share in it. This is known as leveraging your money, and it's one of the major reasons that real estate is such an attractive investment.

However (you guessed it!), there's a down side. If overall property values don't increase, then you make no profit at all. If the above home stays at $100,000, your profit is zero. And if the value of the home should decline, your profits (equity) would bottom just as quickly.

Now let's consider an apartment building. With this type of investment property, prices are mainly correlated directly to rental income. In other words, by simply increasing rents you can significantly boost your property's value (and your profits) immediately. Also, the rental market doesn't always move at the same rate or even in the same direction as the market for single-family homes. For example, in a given area there may be a shortage of rental units but a large supply of single-family homes. As a result, you could see rental rates going up while single-family home prices remain level (or possibly even decline).

As a matter of fact, the apartment- and single-family-home markets have historically often moved in opposition to one other. When housing prices were increasing, many families moved from apartments and bought houses to take advantage of the profits being generated by rising home values, leaving a surplus of rental units and thereby driving down rental rates. Conversely, when housing prices were level or declining, many people saw no reason to leave their apartment units, which worked to cause increased demand for the units and subsequently increased rental rates.

There are a number of methods that can be used to determine the value of an apartment building. For instance, you can capitalize the property's net income, you can check the values of comparable properties, or you can simply hire an appraiser. But savvy investors often use a simple system known as the gross rent multiplier (or GRM) to calculate a quick and amazingly accurate estimate of value. Keeping the numbers simple, here's how it works: let's say that you own a 10-unit apartment building in which each unit is rented for $500 a month, producing a total monthly rental income of $5,000, or $60,000 annually. The value of the property is then based on that rental rate. Properties in the area that also bring in $60,000 of rent yearly have been selling for $600,000. Therefore, the gross rent multiplier is 10. The GRM is simply a quick and easy way of quantifying the relationship between price and rental income in a particular area. If you were to double the rental rate to $10,000 monthly ($120,000 annually), your building's value would increase to $1,200,000.

As you can see, apartment buildings can be used to generate truly impressive amounts of profit. Of course, as noted earlier, the risks can also be great. If the rental rates were to fall to half of their previous level, so too would the value of the building.

Commercial buildings (and office buildings) operate in a similar manner; their value is also directly determined by the rental income. So, the more income a property generates, the greater the property's value. By purchasing a building at one level of rental income and simply increasing rents, you can sell it at a higher price.

An additional major factor that must be considered in the valuation of commercial buildings (and industrial buildings, as well) is the strength of the tenant leases. Long-term leases with strong tenants (in other words, those who are likely to continue paying their rent year after year, even with escalation clauses) are worth more, and thus translate into a higher property value. Short-term leases and weak tenants connote a lower value. Therefore, by improving the leases, you can improve the investment's value.

And there are other issues that must be taken into account. For example, the rent for commercial buildings is typically determined by a measurement of the front foot. Since access to the public is absolutely critical to businesses, the more exposure a business is afforded, the more valuable the location. Thus, a commercial tenant pays rent according to the number of feet that are directly accessible to the public as well as the desirability of the location. Furthermore, the value of the property generally declines as the height goes up. For example, a commercial tenant on a second-floor mall location will generally pay less rent than a tenant on the street level of that same mall. The reasoning is that there's normally less foot traffic on the second floor, so it's generally considered not to be as desirable a location.

When considering office buildings (or industrial buildings), on the other hand, access to the public is generally not seen as a particularly major factor. Thus, the front foot usually doesn't matter. The primary concern for offices is the total amount of floor space available. Therefore, these properties are rented out on the basis of square footage – a set price; say, $1.50, for example – per square foot per month. This is the reason that office buildings can be built to such great heights, even to the point of being skyscrapers. The tenants usually have little concern for the level that they're on (assuming the elevators continue to work) as long as the rent is affordable. However, views from higher floors do tend to command larger rents. Conversely, as stated previously, the higher you go up the less foot traffic you can expect, which is why commercial buildings such as malls are rarely ever more than three stories in height.

 

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