Commercial Real Estate investment: Exit Strategies
Commercial Real Estate investment: Exit Strategies
“Begin with the end in mind” is one of Seven habits of highly effective people as mentioned in Stephen Covey’s bestseller. We can apply the same principle to real estate investing. Knowing your “exits” is not only good for a piece of mind and the long-term planning, it prepares you for vast variety of outcomes with a clear pathway on how to prosper in any situation.
We have started to look at the various commercial real estate investment strategies in the previous issue with the introduction to the Triple Net Investment Properties and we cannot overlook one of the main components of the real estate investment – exit strategy. As with any investment – precious metals, stocks or real property, the exit strategy is the most important part of the buying process.
When assessing an investment property, you must consider two types of events: those that are planned and those that aren’t. I will try to summarize some of the most popular exit strategies in the Commercial real estate investing, some of them could be applied to residential properties as well.
1. Profit on purchase:
Ideally, we must always profit on purchase of the investment property right when you buy. As an example, let’s consider a market area with an average 6.5% cap rate for a small plaza (valued $1.538M at $100K NOI). Let’s say that due to a lucky coincidence our buyer was able to buy the property at 7% cap rate($1,428,600). If resold at a market rate immediately, 0.5% difference in cap rate can bring as much as $100K gross profit (less closing cost) on this property. I am in no way encouraging this type of investment, as I believe in long-term planning, however, this is a good option to consider on an advantageous purchase.
2. Adding value:
As vague as “adding value” can be, it can be anything from changing the regular light bulbs to LED, renovating the units and increasing the rents accordingly, getting rid of extra expenses, all the way to adding another story or two to the property. The main idea is to reduce expenses and to increase revenue of the property. Upon successful increase in revenue, the investor usually has two options: sell the property with the new (increased) stream of revenue, thus, increased value, or refinance the property in order to free up the capital involved in the “value-add process” and leave the property in the investment portfolio for many years to come while cash flowing.
Going “out of the box” on a larger scale, could mean building a garden suite (where permitted) for a residential property, adding a couple of 10x10’ pods to your rental cottage property. In larger commercial properties one of the most popular ways a retail plaza would be creating an additional stream of income is by converting a part of the vacant land/parking lot into another drive-through/restaurant pad.
3. Changing the status and selling part of the property:
This strategy works well in residential multi-family properties, as well as in the commercial/industrial multi-unit buildings. One way to implement this idea is to convert an existing property into a condominium corporation with separate titles for every unit. This process will depend on the municipal by-laws and requires legal help and a budget. However, when implemented, it will allow the owner of the property (now, the owner of separate units) to sell off several units to recover the cost of the purchase and, potentially, to pay it off completely and leave enough units rented out for the cash flow. The tenants might have an opportunity to buy the unit that they are occupying or to stay on a lease.
The same general concept can be applied to the parcel of vacant or excess land. It can be subdivided (severed) into several parcels, if the existing zoning allows, or upon rezoning. Later it could be sold off or built upon.
4. Change of Use
Most adventurous, the concept of “Change of Use” allows the owner of the underperforming property to increase the income through converting the whole or a part of the property to another use (i.e. commercial to residential). It’s not a secret that retail malls in North America were hit hard by online shopping and are going through tough times with lots of vacant “dark space”. Some of the mall owners have tackled this problem with creativity and understanding of the market by turning some of the retail and office units into short-term residential rentals.
As an example of this concept, a couple of years ago, I was approached by a person who owned a 16,000 SF commercial building on a main street of a medium-sized town in Ontario. The property was in good shape but had a problem – 2/3 of the building was vacant for 2 years to date and the holding corporation was taking losses. Initially, I have tried to sell the property as is, but seeing the low level of interest, I have done my research and proposed a “change of use” strategy to convert the existing vacant commercial space into the residential suites. After working with the local planners and the municipality, following the minor zoning variance, we were able to receive a building permit for 12 residential units, while keeping the 1/3 of the building commercial. As it sometimes happens in smaller municipalities, we were even offered a small grant and a zero-interest loan for a part of the construction cost. Even after the additional construction costs estimated at $800,000, our financial projection was showing an increase in net operating income from -$52,000 to +$32,540 within a year of residential occupancy. However, we never had a chance to test it, as we were able to sell it before we started any work on the property as buyers' interest to the project grew when they were presented with the new numbers.
To conclude this article, I would like to say that I love Commercial Real Estate because the opportunities are endless if you have an open mind and a bit of creativity. Of course, it is advisable to have your exit strategies in place in case of the worst-case scenario at the moment of the property purchase. Working with a real estate professional might help you save time and money as well as to get a fresh new look at your particular situation and coming up with a plan of action.
Credits to: Kirill Perelyguine is a Broker with Royal LePage Real Estate Services in Toronto, specializing in commercial investment properties and land development. Contact him at email@example.com