How I Bought My First $1.5M Commercial Building
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THIS POST MAY CONTAIN AFFILIATE LINKS. LEARN MORE BY READING MY DISCLOSURE.
In late 2016, we bought a 10,135 square foot retail building in Deer Park, Washington.
At that point, it was the largest and most expensive building I’d been a part of acquiring. Quite frankly, I was a bit scared that we could pull it off. Up until then, the most expensive building I had purchased with partners was $390,000. The building we were contemplating was almost four times that price. It made my heart race considering it.
However, we believed the building to be well-built, positioned great and priced right. That’s the trifecta when looking at a commercial project.
We made our offer on the building and then conducted our due diligence. My investing partner and I believed in the project, but our partners thought the price needed to be a bit better.
Then we did what we previously thought unthinkable.
Finding the Big Deal
Deer Park, Washington is 34 miles north of Spokane and has a population just shy of 8,900 people.
The retail building had been built and tenanted in 2005. As I mentioned before, it was a little over 10,000 sq. ft. After its completion, it sold in 2006 to an out-of-area investor for $2,526,750.
Unfortunately for this investor, he had no way of knowing that he (and the rest of the world) soon faced the worst economic downturn since the Great Depression.
He lost half of the building’s original tenants and then tried to re-tenant it during a recession. Leasing in a small market is tough enough. It’s doubly tough when the market is in the tank. The property had sustained vacancies for years.
Finally, the investor decided to put the building on the market. He listed it at $1,962,000. He was going to take a $600,000 hit (before paying commissions and closing costs) just to move the property of his books.
When a property is listed, it begins to “season” – think of a marinating meat. Its placed in a certain mixture and sits for a prescribed time. If it doesn’t sit long enough, it won’t get any flavor. If it sits too long, the marinade can actually damage the meat and infuse it with strange flavors. However, if it sits for just the right amount of time, it develops the perfect taste.
In terms of real estate, a commercial property that is listed and snapped up immediately usually means it was priced too low. If it sits for too long it means, it was priced too high.
Unfortunately for this seller, he had overpaid for the property going in (remember, you make your money in the buy) and the market wasn’t interested in his building it even with the steep loss he was going to take at the listed price. No one saw the property as a good value.
The project sat on the market, generating little interest. After an extended period, it was determined between the investor and his brokers to lower the price to $1,739,357. This price was indicative of a 7% cap rate (the return an investor would expect to get on her investment) – at the time a 7% cap rate was indicative of returns seen in larger markets, not tertiary ones like Deer Park.
The property continued to sit on the market.
An interesting phenomenon happens with properties that are over-priced and sit unsold for some time. They become “shelf-worn.”
You’ve probably been to a store and seen a product that you know has been too long on the shelf. It’s dusty. Its box may be dented on the corners from being dropped once or twice. Maybe it is even faded because it has been in the direct sunlight for too long. Even if the product works perfectly, the fact that it is in a sun-faded and dusty box will probably cause you to shy away from it. No one else has bought this item yet so they must know something you don’t, right?
It’s the same thing with investment real estate. After a while, a property will develop a stigma that forces other investors to question, “Why hasn’t someone scooped this up yet?” Investors will question themselves against the unknown market.
Surely, someone who knows more than me would have snagged this property by now. What am I missing?
Shelf-worn properties happen repeatedly, even in hot markets which 2016 wasn’t.
This is what happened when we purchased the property that I detailed in the story You Make Your Money in the Buy.
In mid-2016, my investing partner, Kevin, sent me a marketing flyer for a property in Deer Park and said, “Why haven’t we looked at this one before? I think it could be a good buy.” Even without looking at the numbers, we knew the reason we had passed over it. Everyone else had.
It had become shelf-worn and we were just realizing the opportunity. Now we had to jump on it before anyone else opened their eyes to it.
This is my own belief, but once you start to feel good about a property so will others. I don’t care if that property has been shelf-worn for years. It will happen.
It’s the same thing with the shelf-worn box. If you suddenly feel good about that item and pick up its dusty, dented box from the shelf, some dude is going to walk over and say, “I was looking at that, too. You going to buy that?”
Don't Buy High and Sell Low
The price tag on the building scared the hell out of me. $1.7Million. To that point, the largest building we had purchased together was $390,000. Now, Kevin had similar sized projects with other projects with other partners.
For me, though, $1.7Million was a huge number. Could we raise that much money from partners?
As usual, Kevin calmed me down. “If the numbers make sense, we can get partners with no sweat.”
An offer was made and after some haggling, a price tag of $1,575,000 was settled on. That was almost a 7.75% cap rate.
We couldn’t believe it. The seller was going to take a hair-cut of more than $1,000,000 to sell the property.
We immediately got busy in our due diligence period. The first step was verifying the numbers. The building had been managed by a property management company for several years so the financials were easy to dissect. Everything appeared to be in order.
The building had three national brands – The Medicine Shoppe, H&R Block and Pizza Hut. There was a short-term local tenant and a little over 2,000 sq. ft. of vacant space.
Now, here’s the thing that got us most excited. The proforma that was built to value the building was done on actuals – no money had been applied to the vacancy. That meant if we added any tenant, no matter the rent we collected we would immediately swing the value above that 7.75% cap rate.
We brought in our various contractors and climbed over the building. Since it was only eleven years old, it was in great shape. There were a couple things that needed to be addressed immediately, however – the parking lot needed some crack filling and the building needed to be painted. Other than that, the physical asset looked to be strong.
Talking with the tenants, everyone seemed mostly happy. A couple of them complained about their rent, but they said they wouldn’t leave as the local market was good for them. When their leases came up in a few years, they would like to discuss rent reduction or flat rents. We factored that into our proforma.
Our bank liked the project and agreed to lend on at an 80/20 Loan to Value (LTV) ration which meant we would have to raise $315,000.
As I’ve mentioned before on the blog, if you have a good deal, money will find you. There are investors out there who are looking for the opportunity to partner with someone. They don’t have time to find the deals. That’s what we need to do. If the numbers of a project make sense, they money will find you.
This was the first time we had a slow response to a project so we knew something was wrong. Both Kevin and I were excited about it. We thought the building was in good shape, the tenant mix was solid, and the potential for upside was great. So what was holding back potential investors?
It was the location. It was the small-town setting and the lower cap rate of 7.75%. Investors wanted a slightly better return for investing in Deer Park.
The Answer If You Never Ask …
We wanted the building, but we needed investors. We were at the deadline of our feasibility period and needed to make a decision going forward. If we removed contingencies and moved forward, we would have a short window to finalize our financing and close. If we hadn’t lined up our partners before closing it would be disastrous for us.
The feedback we’d gotten from enough investors to get the deal done, though, was if the deal was an 8% cap or better, they would jump in. Now, there’s not much of a difference between a 7.75% return and an 8% return on a $1,575,000 deal – especially since we would purchase the building as a partnership. However, it’s a mindset that investors develop. They don’t want to buy below a cap rate floor. It’s not wrong nor right, it’s just their criteria for purchasing a property.
With that in mind, Kevin and I talked about a plan. We decided we would remove feasibility contingencies on the building with a caveat – the seller must lower the price another $75,000, dropping it to $1,500,000. That would get us an 8.1% cap rate.
The answer is always no if you don’t ask. Therefore, we were going to ask.
We wrote a letter removing contingencies along with a new point of negotiation. Realize that we were basically trying to reopen the deal and re-trade the sale price. The seller could have said ‘no’ and we’d have been forced to walk away which we had already agreed to do if we couldn’t get the better price.
Sometimes the best deal you do is the one you don’t do. That’s an old real estate saying and one every real estate investor needs to know. There’s another one that is just as valuable. Sometimes the best deal you do is the one you’re willing to walk away from. I said it before on the blog and I’ll say it again – Who wants it less, wins.
The seller of this property had purchased a massive portfolio of properties at one time. He didn’t know much about retail real estate and bought them all at the height of the 2006 market. When it turned bad, he was burned. He had liquidated almost all his holdings, taking large losses on each. Unfortunately, the Deer Park property was an outlier since the others were in larger cities. No one had expressed interest in the property before now. When we showed up at the bargaining table, it was clear who wanted the deal more.
He agreed to the price drop. Those potential partners who were standing on the sideline immediately jumped in when the cap rate crossed the 8% threshold and we raced toward closing.
At the time, $1,500,000 was a massive number for me to consider. I couldn’t believe we had pulled off that purchase. It truly boggled my mind.
As with any new adventure, though, it’s about pushing your limits, to see how far you can go. Since then we’ve purchase another building for roughly the same cost (that story will appear soon on the blog), but it didn’t have any of the fear attached to it. We knew we could pull it together.
We’d done it before.
