Commercial Real Estate Investments (xpost post to r/realestate)
I am looking at commercial real estate investment opportunities and I'm wondering if anyone else is involved in investments such as these and, if so, what your experience has been? Also, from anyone that looks at commercial real estate, what are your thoughts on the potential upside/downside on an investment such as this? Am I missing anything?

Free-standing building with tenants such as:

AT&amp;T
Mattress Warehouse
Chipotle
Kroger

The locations are great; always high traffic, good frontage, good ingress/egress. All lessees are on 10year triple net leases with multiple 5 year options. For the most part, these investments are always anchored with a billion dollar market cap tenant and several smaller or even local tenants.

The investment entity is set-up as LLCs (S Corp). Investors can buy in for typically 1% up to around 30%, depending on the deals. Investors are purchasing equity in the company that owns the property. Investors have to cover their percentage of the down payment and closing costs. They are then on the hook for their portion of all mortgages (guarantors on loans, proportionate recourse). Typical investment is as follows (I'm using round numbers and rough estimates as all deals are unique):

    Purchase Price: $5,000,000
    Down payment: $875,000 (17.5%)
    Mortgages: $4,125,000 (82.5%)

    1st Mortgage $4,000,000 @4.5%, fixed for 7 years on 20 year amortization
    2nd Mortgage $125,000 @5.5%, fixed interest only

    Closing Costs: $60,000

The 2nd mortgage is essentially the "finder's fee" for the company that brings in the investors and gets this set-up.
Closing costs cover attorney's fees, survey, environmental, title insurance, etc.

Cash Flow:

    $400,000 /yr. (Lease payments after management fee)
    $315,000 /yr (Mortgages)
    $85,000 /yr cash flow

Depreciation:

    Assuming 1,000,000 for land &amp; component method, $4,000,000/21 years=($190K/yr)

The entity purports the annual rate of return to be around 25% and calculates it as such:

    (10 Yr. Avg. Principal Paydown+ Annual Cash Flow)/ Down payment
    ($140,000+$85,000)/$875,000=25.7%

I add in the closing costs, which brings the return down a bit. Also, cash flow does not begin immediately. With these triple net leases, the companies typically reimburse for taxes, CAM, etc. so cash flow does not being in earnest for 12 months.

The properties always cash flow nicely, with typical payback of investment within 5-7 years. At that point in time, the properties are refinanced into 1 mortgage. Cash flow stops once the initial investment is paid back and the properties are then typically paid off in 20-22 years from the initial investment date.

Potential downsides:

    Vacancy
    Interest rates spike when refinance is needed
    Commercial real estate prices tank, leaving us upside down

Upsides:

    Depreciation or lease increases past the initial 10 years are not factored into the equation. This adds a bit more cushion should something happen with a single tenant.
    Other than the initial credit check hit on my credit, the loans do not appear on my credit report or personal financial statement as they are contingent liabilities.
    These investments are for my retirement and then for my children. The money that I am investing for the down payment and closing costs is forgotten from my point of view. So the monthly checks (just paying me my investment back right now) are pleasant surprises.

I keep a fair amount invested in mutual funds and plan to use this should there ever be an issue with these real estate investments. I understand that some of these investments could tank, so for every dollar I put into commercial real estate, I put a quarter into mutual funds. I know this is much less than /r/investing[1] would suggest but I am somewhat comfortable with the risk. I have established a few other layers of protection between my salary and other investments.

Any glaring issues with these investments? How common is a structure such as this? Am I getting hosed anywhere?
[{"id": "cc9i3gs", "text": "I think they're overstating the annual rate of return. You don't get the $140,000 in principal paydown every year since it's not cash to you. You only get it all back on reversion the last year of your investment (Year 7). This has a huge impact on your return because you have to discount the principal paydowns for the full 7 years. You'll want to build your own model of the property and calculate your IRR and equity multiple based on actual net cash flow.\n\nWhy do your cash flows stop once you get your basis out after the first refi? Unless if I'm misunderstanding this scenario but you aren't selling the property so you should still be entitled to cash flows going forward even though you had a refi.\n\nYou're right about the downsides. Vacancy is a concern although your lease term does go out longer than your mortgage so it's really just your belief of whether if Chipotle will still be in business 7 years from now. Interest rate risk is also good to be aware of and property values are tied to that. If they're higher, you'll get a smaller mortgage on refinance with worse terms. Be ready to write another check if that happens.", "replies": [{"id": "cc9iq21", "text": "Cash flows stop once investors have been paid back their initial investment. At that point in time, the focus is switched to paying off the mortgages. Once the mortgages are paid off, cash flow will pass straight through to investors. I've also been told that after x years, we can refi and take money out, borrow against the equity for another property, etc. For me, my focus would be to get the properties paid off so that I can enjoy retirement. I don't need the initial cash flow to live on, so I just take any cash and put it into another property or pay down my portion of the second mortgage.  \n\nMy understanding with these commercial properties is that you are essentially buying the lease, the rest does not matter as much. thus far, I've only gone with large market cap tenants in hopes that I am better protected against the downsides.", "replies": [], "depth": 2}], "depth": 1}, {"id": "cc9i9i0", "text": "Let me see if I have this correct. \n\nThis company pools investors to buy property A. The company sets up another LLC in which the investors are all members and receive x% equity based upon their investment size. \n\nThe company does all of the leasing work, closing, etc. takes a finders fee and is now free of obligations? \n\nWho is doing the ongoing work like building managment? What if someone breaks the lease? Who finds a new tenant? What if you want to sell your equity? Are you buying \"x\" amount of shares? How liquid are they? Why is this option better than a dividend paying commercial stock?  \n\n\"I add in the closing costs, which brings the return down a bit. Also, cash flow does not begin immediately. With these triple net leases, the companies typically reimburse for taxes, CAM, etc. so cash flow does not being in earnest for 12 months.\"\n\n*They reimburse for property taxes for the first year and then it is triple net???* \n\nThe properties ~~always~~ *(don't fool yourself there is a vacancy risk if that happens are you on the hook to cashflow negative?)* cash flow nicely, with typical payback of investment within 5-7 years. At that point in time, the properties are refinanced into 1 mortgage. Cash flow stops once the initial investment is paid back and the properties are then typically paid off in 20-22 years from the initial investment date.\n\nWhat happens after the building is paid off? Does that cashflow reinstate? What if the majority equity share decides to sell before then?\n\nI have never done this, but it's interesting. Could be a good deal, but there are some pretty serious questions to answer. Very interested in your response though.\n", "replies": [{"id": "cc9j82s", "text": "&gt; Who is doing the ongoing work like building management?\n\nProperty management firm for the 2%/$10K.\n\n&gt;What if someone breaks the lease? Who finds a new tenant?   \n\nThe property management firm would seek another tenant. Hopefully with tenants as large as these, that isn't an issue for some time.  \n&gt;What if you want to sell your equity?   \n\nBuy-sell agreement. Sell to current owners first, then to outsiders. New owners (substitute members) are subject to current terms, transfer restrictions, etc. I've seen this happen already where an investor needs to sell his stake. Normally one of the other investors will step up and buy it. \n&gt;Are you buying \"x\" amount of shares? \n\nA new LLC is created for each property and I am buying a percentage of that entity. I've seen deals where a firm sells x% (maybe 50%) of the equity in a new LLC, this is not one of those cases. 100% of the equity is sold to individual investors, with the typical buy-in being 1% to 30% for each investor. Oftentimes the property manager or even the firm's owner will buy in with their own money.\n&gt;How liquid are they? \nThey, being the firm that sets these investments up, are actually a small firm.  \n\nJust a few individuals that set these up, typically buying into a percentage themselves.\n\n&gt;Why is this option better than a dividend paying commercial stock? \n\nThat is the question at hand. I like the idea of owning the actual property, being able to visit the properties that I own, knowing other investors, etc. None of this matters in evaluating the returns, but I do like knowing the person that signs the monthly check and produces the operating report. I am not involved in any other type of commercial real estate investment, so I do not know if the returns are better with REIT, stock, etc.   \n\nIn this investment format, I actually own a percentage of the property and can watch my portion of the mortgage get paid down while my initial investment is reimbursed. My biggest fear is refi and lease renewal time, but several CPAs are investors and from my research, this does not seem any more volatile that what has happened with my stock investments.   \n\nPlease, poke holes in this investment. I would love to hear about any other potential issues or bad experiences with similar entities.\n\n", "replies": [], "depth": 2}], "depth": 1}, {"id": "cc9pn68", "text": "I wish I could give a response worthy of Reddit Gold, but unfortunately I'm extremely tired.  I work for a large special servicer in the US and am currently in Ireland helping them cleanup their mess.  In a nutshell, the deal structure sucks and you need to revisit your returns as they are nowhere close to reality.\n\nDeal structure: The syndicators have no skin in the game and are charging you 2.5% (should be 1%) and getting a preferred return.  Secondly, as debt, they are before you in the capital stack.  It's ludicrous.  Their incentives aren't aligned with the owners on day one.  What makes you think they will have the owners' interest in mind if shit goes south?  I've foreclosed on about a dozen similar type transactions, TIC syndicated deals, that up until the day of foreclosure, the syndicators were milking the property cash flows as the owners lost everything.\n\nWhere are TI, LC, and CAPEX reserves in your cash flow analysis?\n\nNot clearly answered above, who is doing the property management?  Who is doing the asset/ syndicate management ?  Who will handle leasing?  What are they charging?  These deals are generally fee'd to death.\n\nLastly, you scared me at recourse.  Is the debt full recourse?  In not, what are the carveouts?  ", "replies": [{"id": "cc9srwj", "text": "In this deal, 100% or the property is owned by investors. The \"syndicator\" is not keeping any for themselves. If they do own any of the property, they have signed on as a regular investor and paid the same cost per percentage ownership. For this reason, they have as much skin in the game as they have invested (anywhere from 5-30%). The  management firm is a professional property management firm located in the same area as the property. There are different management companies on each deal and, to my knowledge, they are not affiliated with the firm putting the deal together.\n\nI have not experienced trying to re-lease one of these properties. I will ask these questions to find out who handles, fees, etc. Thank you for the insight.\n\nProportionate recourse. If something happens, I am responsible for my percentage of the mortgages. Of course this scare me, but with the lessees involved my hope is that they will keep their leases. If not, the properties are in great locations and should be re-leased. ", "replies": [{"id": "cc9uqxo", "text": "I think the previous poster was asking if you were signing a personal guarantee on the loan or if you're limited to your investment in the LLC. It's an important distinction to make. Also check if you're signing joint and several.\n\nAdditionally, the syndicators are keeping a portion for themselves through the second mortgage. I don't believe this is terribly common so you shouldn't ignore it. It sounds like they're taking a management cut in addition. \n\nYou had said you know some of these other investors, I'd recommend pooling your money together and speaking with a broker yourselves. Maybe you can find a smaller property to invest in. It sounds like these syndicators are overstating the return and skimming a significant amount of cash while shirking all the risk.", "replies": [{"id": "cc9ya2e", "text": "&gt; You had said you know some of these other investors, I'd recommend pooling your money together and speaking with a broker yourselves. Maybe you can find a smaller property to invest in. It sounds like these syndicators are overstating the return and skimming a significant amount of cash while shirking all the risk.\n\nI agree. In the past, I have been part of financing properties for wealthy investors that have brought in partners into the deal. It is never as good a deal as doing it on your own. I know that the structure here is a bit different, but the same reasoning stands.\n\nAre the assumptions at full occupancy? Are the buildings single tenant? Who is lending the money? Are you personally going to be on the hook as a guarantor?\n\nGet a CoStar or Loopnet subscription and do some research, with luck you might find a deal yourself. \n", "replies": [], "depth": 4}], "depth": 3}, {"id": "ccabc1g", "text": "The syndicator is taking a 2.5% stake ahead of all the investors.  As debt, they could, in a worst case scenario, initiate foreclosure and get paid out before the investors.  That scenario gives me the chills.  I would run from this deal structure and syndicator, but if you do decide to move forward and have more questions, PM me and I'll gladly explain your downside.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ccagy7f", "text": "I have a few questions, and having some experience in the area, I would preface by stating that this structure is not investor friendly and if these are the economic assumptions that they're selling, you should steer clear.  YTuUermana correctly hit on some of these.\n\nFirst, let's talk about the property.  Commercial properties, particularly retail, often have long vacancy periods of 12-18 months, sometimes 24 months even in large strip centers and neighborhood centers.  Where are the cash reserves for retenanting costs?  You should assess the credit of the tenants and underwrite 10% vacancy as a baseline, increasing that assumption with declining credit quality by deducting this amount from the gross rents.  In addition to vacancy loss assumptions, you will need to pay for retenanting, Tenant Improvements ($5-10 psf) and Leasing Commissions (6% new / 3% renewal ballpark).  Free rent may come into play as well.  If any significant tenant is lost, you are defaulting on your mortgages immediately.  Poof, there goes your hard earned money.  To narrow in on market vacancy, TI/LC and overall conditions, contact local commercial brokerage shops for their local submarket reports.  They often provide these for free (Colliers, C&amp;W, CBRE, etc).  \n\nAlso, unless you have an absolute-net leases, you are on the hook for the structure of the building including roof.  You need $0.75/psf or so in reserves per year in your cash flow for this.\nMoving on to the financing structure, who is providing 80%+ LTV financing at 4.5%? Typical LTV ratios for commercial are 50-70% and the higher end of that range typically demands a very high credit tenant with landlord favorable terms.  When that term is up, you may have refinancing risk if the market turns against you.  If you can only get 50% LTV debt after the first mortgage term, will you be able to refinance?\n\nMoving on to the equity section.  How much equity are the sponsors putting in the deals?  It better be AT LEAST 10% of the equity for a group with short track records and I would say it better be above 25% with underwriting assumptions like this.  The acquisition fee should be rolled into equity and ideally be subordinate to your return of capital (you get your money back before they get it).  \n\nBack to expenses quickly.  If you're getting typical net leases, you're going to have an expense reimbursement structure where the expenses for the coming year are estimated and the tenant pays based on the estimate.  Once the year is up you settle up for the difference.  \n\nLastly, why the hell would you want to pay down the mortgage to 0 after you refinance?  Seems inconsistent to use high positive leverage up front then make a shift.  Are the deal sponsors planning on being the financiers?  I would personally prefer to continue cash flows and make other investments rather than effectively making 4.5% (or your refinance interest rate).  I am wary of phrases of \u201calways cash flow nicely\u201d. \n\nIn summary, if you want exposure to commercial real estate, find some local operators with a strong track record of conservative investments at a reasonable yield.  Your #1 priority is to NOT LOSE MONEY.  It is much better to be diligent and accept a lower yield and preserve your capital than to salivate on the \u201c25%+ returns\u201d (which are very aggressive if an annualized return).   Good luck", "replies": [{"id": "ccah118", "text": "Also if you would like to have a second set of eyes on a particular deal, I'd be happy to page through and give some feedback.", "replies": [], "depth": 2}], "depth": 1}, {"id": "cf98tb5", "text": "This sounds like a deal im about to do, except for a hotel property. I find the property, they get investors, Magic, i have a new hotel that i manage.", "replies": [], "depth": 1}]