Size Does Matter | Why Bigger Commercial Real Estate Deals Are Better
As new real estate investors plot out their paths, many think that the following is a solid trajectory:
● Step 1: Buy a single-family home.
● Step 2: Buy a few more single-family homes.
● Step 3: Move into the commercial real estate realm with a small (6-12 unit) apartment building.
Makes sense, right? Well, turns out if you dig a little deeper, transitioning from residential real estate owned in your name to commercial real estate purchased under an LLC can expose you to some significant risk if not scaled properly.
In the following article, we’ll look at some of the drawbacks to smaller commercial real estate properties and see why it makes sense to look for larger deals. Specifically, we’ll dive into:
● Financing considerations of commercial real estate deals
● Interest-rate risks of shorter loan terms
● The maintenance benefits of commercial real estate scale
● Syndication advantages
Financing Considerations of Commercial Real Estate Deals
As investors transition from residential to commercial real estate deals, they typically believe that an LLC provides them with personal liability protection not afforded residential borrowers.
Unfortunately, most lenders require commercial real estate investors to personally guarantee loans for properties under 100 units. By providing this personal guarantee, you A) assume tremendous personal risk exposure, as you’re now on the hook for a sizable loan, and B) negate the primary benefit of an LLC - establishing a firewall between personal and business assets.
Additionally, due to the increased actuarial risk of commercial real estate loans, lenders typically charge higher rates, to say nothing of the significant commercial insurance expense, both of which further cut into your property’s bottom line.
Drop us a note with any specific questions about financing a commercial real estate deal.
Interest-rate Risks of Shorter Loan Terms
Related to the financing considerations in the above section, borrowers who personally guarantee commercial real estate loans expose themselves to potentially massive interest-rate risks.
A 30-year personal mortgage is one of the most incredible interest-rate hedges available - nearly no other financial products offer the ability to lock into loan terms for that long.
On the other hand, commercial real estate loans typically have 5- or 10-year (maybe 15-year) terms with a 20- to 25-year amortization. This means that, over the life of a commercial property, investors may need to refinance their mortgages multiple times, exposing themselves to the real risks of rising interest rates (especially from today’s historic lows).
For example, assuming a $1,000,000 loan balance at the end of a 5-year term, here are the monthly payments for 3% and 5% refinancing options (assuming 20-year amortization):
● 3% refinance monthly payment: $5,600/month
● 5% refinance monthly payment: $6,700/month
A 200 basis point increase (not unreasonable looking at 50 years of interest rate trends) from the original rate leads to an extra $1,100 of debt service per month, which could seriously cut into a property’s cash flow - and an investor’s pocket if he or she has personally guaranteed the loan!
Fortunately, with larger commercial loans - typically for properties greater than 100 units - banks do not require personal guarantees, so this interest-rate risk at least remains limited to the property LLC.
The Maintenance Benefits of Commercial Real Estate Scale
Maintenance constitutes another major drawback of smaller commercial real estate deals, as these properties lack the scale to justify on-site maintenance.
Smaller commercial properties (basically anything up to 70 units) are all but guaranteed to require an external maintenance team - there’s typically just not enough scale to hire on-site maintenance. With all the common area maintenance requirements - plus the increased tenant turnover - of a commercial property, this external maintenance can seriously cut into a smaller property’s NOI.
On the other hand, properties with 100 to 200 or more units achieve the benefit of economies of scale, that is, there’s enough cash coming in to support on-site maintenance. This not only directly improves the bottom line of these larger commercial properties, it indirectly boosts profits by increasing tenant satisfaction (and thereby reducing turnover).
Need recommendations about setting up effective commercial real estate maintenance operations? Drop us a note!
Syndication Advantages
So what’s the answer? If smaller commercial real estate deals have so much potential downside, should smaller investors just stick with single-family homes?
Syndication is an outstanding solution, as it lets investors access the economies of scale and profitability of large commercial real estate deals, even if they don’t have the capital to underwrite these large projects on their own.
In a real estate syndication deal, the syndicator (or sponsor) acts like a general partner, with the investors more like limited partners.
The sponsor finds and manages the deals, and the investors - as the title suggests - provide the capital for an ownership portion in the deal. This means that, with limited capital, investors can gain equity stakes in large-scale commercial real estate deals, thus avoiding the above risks and drawbacks of smaller commercial deals.
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We recognize that, even after outlining the above options, entering the commercial real estate market can seem daunting to new investors.
That’s why we’re here to help. The Pocket Broker team lives and breathes commercial real estate, so drop us a note to see how we can help you achieve your unique objectives!