How can you get started in Commercial Real Estate Investment? Re-Position Retail Properties (Part 3/3)

Continuing the discussion about the three primary models of real estate entrepreneurship with strategic retail repositioning.

Of the three strategies we explore in our series on real estate entrepreneurship, re-positioning commercial real estate may be the most lucrative today. My thinking is driven by the disruption to the brick & mortar retail from eCommerce and the likes of Amazon. The strategy is also driven by the amount of outdated retail real estate that needs to be refreshed with spaces in need of updated tenant rosters. Let’s walk through the model, how it works, and what are some of the potential pitfalls to be aware of.

To get started re-positioning retail properties you have to find one with the following characteristics:

1. A strong location,

2. A building that is not functionally obsolescent,

3. A lot with the requisite parking or the ability to add enough for the proposed use,

4. Nearby other similar properties (retail/restaurants like to be near other retail and restaurants).

Once you have a property that fits these requirements, you need to figure out the rent you can charge a tenant for this location. If it is a local tenant you will probably use an all inclusive gross rent. Gross rent includes the costs for property insurance, property taxes, and Common Area Maintenance (CAM).

Before you get started, you need to know rents for this product in this area (submarket). You can get started with that if you research rents for this location and type of building by using CoStar, Crexi, LoopNet, etc. Once you have an idea what base rent you can charge, then add in the insurance/taxes/CAM, typically ~$5-6/SF. If you don’t know these numbers ask a broker or owner in your area.

An important question to ask yourself at this point is, “Who are your potential tenants?” If you don’t know, ask around, do some research, figure out who is expanding their footprint now in your area. If it is a positive economic environment, there are typically at least a few tenants looking to grow their number of locations. Call them, read business periodicals, and/or call their Tenant Representative to figure out what their location and space requirements are to see if it is a fit.

Once you know your potential tenants, and the approximate rent they can pay, you. need a comprehensive understanding for the existing and potential expenses for the building. This comes from property owners, property managers, brokers, etc. These numbers are important, you will need relationships with commercial insurance brokers, property managers, cleaners, maintenance people, etc. So reach out and let them know what you are doing, this could be the start of a new and long lasting relationship!

Finally once you have all the potential rents and expenses, put them in a financial model. You can then use that to calculate your potential future property value based on using cap rate valuation method. Cap rates can be found by speaking with brokers in the area, doing internet research, and reviewing reports from brokerages and research firms like IRR, JLL, etc.

Let’s calculate the potential Net Operating Income for the property. Start with the Potential Gross Rental Income (PGI), otherwise known as the rent the property tenants can pay, less vacancy and charge-backs, that gets you to your Effective Gross Rental Income (EGI). Then subtract out the property expenses…this gives you an NOI you can apply, divide by a cap rate to get your potential property value.

Now you need to figure out your project budget, how much do you need to spend to get your property up to the standards for your potential, highest paying, tenants. That starts with knowing their requirements, getting a full understanding of the property condition with an inspection, and meeting with a contractor to with some basic scope outline to get a general handle on the total project costs. These can vary widely based on the size of the property and the scope of the project. If you are looking at a small 3,000 sf building your process will be far simpler than re-tenanting a 40,000 sf strip mall. Larger projects require more teammates, like architects, engineers, and attorneys. This can be the most challenging part of any project, so plan accordingly, find someone you trust who has done it before to partner with or to learn from.

Once you have a project budget, and the projected Net Operating Income, you can determine if your potential future value is great than the cost to build your project. This is what developer’s refer to as the value-creation process. It simply means the development activities you do to create value for the developer, their investors, and potential future owner’s of the property.

Different types of projects can require different returns. For this type of value-add re-positioning project investors typically look for a low double-digit return on their money, a 12-15% IRR. It is important to note given today’s environment with quickly moving interest rates, return requirements are extremely dynamic and could shift higher or lower based on investment alternatives such as bond yields, etc. To mitigate this risk it is a requirement to keep abreast of the movements in capital markets and to keep a dialogue with your investors to ensure you have a complete understanding of their return requirements.

Once you have find a potential project works given all of these elements, you should move forward with making an offer.

Potential pitfalls to avoid when attempting the retail repositioning model:

1. Tenant In-Tow Approach - Make sure you have a tenant in-tow prior to finalizing your due diligence (DD) period. This requires you to set a DD period of at least 90 days. This strategy minimizes your risk and potential vacancy that impacts project returns.

2. Contractor Relationships - Prior to putting out an offer, make sure you have a relationship with an experienced general contractor that has done re-tenanting projects. This will save you time and money.

3. Legal Power - Ensure you have the right attorney to help you navigate the approvals and leasing process. This can be one or two attorneys. They need to have the requisite amount of experience in what they are being asked to do. If not, find another one.

4. Offer Price & Leverage - Do not be overly aggressive with the offer price or with leverage. If your NOI is barely covering your debt service, find more equity and lower your Loan-To-Cost ratio and/or lower your offer price to help with this challenge.

5. Partner - If you don’t know this space, but want to be in it, find a business partner that has done it before. Work with them, help them with what you know or have as resources.

That’s it for this approach to real estate entrepreneurship! Still have questions? Feel free to reach out to me on LinkedIn! I’m always happy to strike up a conversation.

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This week’s notes from half-court…

After watching the Celtics over the weekend, I believe they might just have the best team in the NBA. The line up features Jayson Tatum, Kristaps Porzingis, and Jaylen Brown. That’s enough firepower to make them contenders, let’s see if they can deliver. Cooper Flagg committed to Duke this past week. I’m hopeful he has a long and prosperous 1-year term there…I hope he does well and continues on to an awesome NBA career!