Seeking Opinions on a $1M CRE Renovation Investment for AAA Tenant
Hi CRE People,

Since I'm new to the CRE world, I'd like your opinion on the following investment -- please be as harsh as you see fit:

I obtained possession of a profitable \~24,000sqft. plaza two years ago with 10 units. Only one unit was vacant (4,725sqft) and in rough shape and not up to code. I signed a top tier tenant on a 5+5 term at $19.68/sqft (about $3/sqft above market rate) or $93,000/yr profit (TMI already accounted for; tenant pays utilities).

Part of the deal was that I paid for the entire renovation costing \~$1M which included getting the unit to a rentable state (\~$750,000 of the cost) as well as paying for their tenant improvements (\~$250,000 of the cost).

I borrowed $450,000 of the money at 2.94% amortized over 20 years which I'll pay off after the first 5-year term ($360,000 remaining) using the 5 year profits of the unit (i.e., $465,000), for a total borrowing cost of $60,000.

By my calculations, it will take 11 years to see a return on this investment, which I understand is odd given the 10 year lease (or rather 5+5 anyway), but it will likely be a lot longer given the nature of the tenant and I will also likely have the next tenant pay 100% of their tenant improvements.

I think I might have been able to get them to pay for all or at least a portion of their own tenant improvements (i.e., the $250,000) but they were a very sought after tenant and were actively looking elsewhere (of course).

Please tell me where you think I made mistakes and how you would have done anything differently. All advice/criticism is welcome. Thank you.
[{"id": "hks01b5", "text": "* How on earth did it take $750,000 to get a 4,725sf space \"into a rentable state\"?\n* For a $1M investment, and what sounds like a turn-key buildout, I'd want 10 years of hard term. \n* Are you able to share the nature of use? My guess is medical/dental? \n* Credit of the tenant is very important when I lay out this kind of money...but man, I don't think I'd ever spend that type of money unless I'm getting a ton of term and a higher rent.", "replies": [{"id": "hks4dgm", "text": "* It is a 100+ year old building that required a lot of work; basement below, stories above, in a country where building code regulation is insanely strict. I can't see how I could have gotten it to a rentable state without significant financial input. I sought out a lot of opinions on that, and it's not my area of expertise (building code/construction), so ultimately I had to trust the architects and engineers. Only alternative I could see was doing it illegally, which was not an option for me personally.\n* It is turn-key, and yeah I could have pushed harder but again I wanted the tenant.\n* Satellite unit for an educational institution -- think college/university.\n* Tenant was in their previous unit for 30+ years, that's the kind of timeframe I'm banking on (literally).\n\nDoes my return timeline make sense to you, or do you generally look for returns sooner than that? Thanks for you input.", "replies": [{"id": "hksoi6r", "text": "u/stoweker does a good job covering some metrics that you should keep in mind going forward. I'd be curious to know what your purchase price was for the property and whether you have any debt. When will you be cash flow positive when you include the $1M investment for this tenant?", "replies": [{"id": "hkv4s1a", "text": "Inherited. Only debt is what's stated above ($450k). We've always and continue to be cash flow positive.", "replies": [{"id": "hkvoqa0", "text": "Nice. How does the $19.36/sf rent compare to the other tenants and the market in general? Sounds like this can be a really nice long-term hold for you.", "replies": [{"id": "hl1apai", "text": "It's \\~$3/sqft above comparables both in the plaza and around town, and thanks, I'm sure hoping it is!", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}, {"id": "hks4w1k", "text": "If it took $750k to bring it to a rentable state, and the t/I was $250k, then I\u2019d use that # for payback. Also, if you increase the NOI by $93k, at an 8% cap rate you increase the market value by $1.162M so you basically traded $. If it brought your occupancy up to 100%, the you probably lost $ as everyone would deduct at lease 5% for vacancy.", "replies": [{"id": "hks5h66", "text": "Yea but you shouldn\u2019t consider value for this on a cap rate basis, tenants are transient need to look at it on an NPV basis. \n\nThat said I wouldn\u2019t look at the LL work as part of the lease basis, this dude would\u2019ve had to do the work no matter what to get it into leasable shape. Personally I\u2019d consider the LL work as just basis creep capex and the TI as part of the NPV calculation. Ideally if the new tenant blows at least now the guy has lettable space whereas before it sounds like he didn\u2019t.", "replies": [{"id": "hks8114", "text": "I don't know what NOV, NPV, and \"basis creep capex\" means. Would you mind taking the time to explain?", "replies": [{"id": "hksa2he", "text": "NPV = Net present Value", "replies": [], "depth": 5}, {"id": "hksbe57", "text": "Yea sure - NOV was a fat finger, I meant to say NPV (and just edited my post), and NPV = net present value. Net present value is a calculation of what the lease is worth - take the amount you spent on TI/LC (tenant improvement &amp; leasing commission), use that amount in time period 1, then run a cash flow of the lease over the entire first term. Do it on a monthly basis, and use the XNPV function in excel. It\u2019ll ask you for a discount rate, I typically use the pro forma Discount rate (which is your unlevered IRR) for the deal (which you\u2019ll have to divide by 12 since your calculating this all monthly) and bang, it\u2019ll tell you how much value the individual lease creates. If it\u2019s a positive number, cool, you\u2019re building is worth more. If it\u2019s a negative number, not so cool, but there could be non financial reasons to do the deal (like maybe it adds something holistically to your project). \n\nWith respect to basis creep, the basis (amount of total money invested in the property) \u201ccreeps\u201d (goes up) over time because you need to invest in capex to just keep the property running. In this instance it sounds like you had space that wasn\u2019t leasable before you spent the $750k on it. Whether this tenant came along or not, you\u2019d still have to spend that money to lease it to someone because it was so decrepit you couldn\u2019t lease it. Because of that I\u2019d think of that cost more as general capital (and people typically think of landlord buildout as such - it\u2019s the same thing if you had cold dark shell in a space and needed to get it rent ready) so they\u2019d exclude it from the NPV calculation. That being said, your basis on the deal went up because you put a ton of money into get this guy into the property. Not to confuse you more but both the $750k in landlord improvements and the $250k in tenant improvements would both add to your increased basis. I just personally would calculate the value of the lease using the $250k you gave in TI and not the full million, even though the cost (basis) of your property just went up by a million bucks. \n\nAnyways I hope this was helpful. Good luck!", "replies": [{"id": "hksdj9q", "text": "Thanks for explaining this! So happy to see such a helpful community in this sub. Thanks again!", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}, {"id": "hks7unq", "text": "Can you explain what you mean by \"traded $\" and \"lost $\" further for me please? I think I understood everything else in your comment but not how you came to those conclusions. Am genuinely curious as I'm trying to learn.", "replies": [{"id": "hkugamr", "text": "Traded money meaning you spent money now on improving the space which resulted in an increase in the value of the property (at an 8% cap) that roughly offsets it if you were to hypothetically sell it right now.", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "hks6fn9", "text": "How much has that work (both in rent rolls, and general condition of the property) increased the value of the property?", "replies": [{"id": "hks88vn", "text": "I don't know... how do I figure that out? One of my concerns is that the upgrade \"out-shines\" the rest of the building, but it doesn't look like it if you know what I mean.", "replies": [{"id": "hksa0rn", "text": "If you had an appraisal before and after. The rent part of the equation should be pretty easy to model.", "replies": [{"id": "hksacyh", "text": "I have had the before appraisal, so I'll definitely get a post-appraisal, too. thanks!", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "hks8zti", "text": "Wouldn't the base building improvements be considered a CAPEX for the property able to be charged back to the tenants collectively? Depends on the leases but may be worth seeing if these can be amortized over a period of time.", "replies": [{"id": "hksa14w", "text": "Unfortunately the previous owner had pretty weak leases in place when I came in, but I will be trying to implement your suggestion for the few leases it applies to, for sure. I really appreciate the comment as it reminded me to do this, thanks!", "replies": [{"id": "hkswxy8", "text": "Bummer about the leases being what they are. It may be worth a quick look at some cost segregation. May not apply in this case, but help.", "replies": [{"id": "hktc3pz", "text": "Just start phrasing the new leases that way.", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "hksccb4", "text": "Personally I would rather have $1m today than over 11 years. If you do a NPV calculation you will likely agree.", "replies": [{"id": "hksctmh", "text": "Fair enough. Surely you wouldn't hold onto cash (I assume?). What would you rather do with it? Simple investments?", "replies": [{"id": "hksdhzp", "text": "I have no idea how CRE financing works in your part of the world. Where I am, for $1m cash there are a lot of interesting things you can do. A $5m commercial development which would bring in $300k per year. Or, a small business that generates $1.5m net per year is about $5m, and you can buy two of them for $1m down with SBA financing here.  \n\nAt the very least $1m in index funds turns into ~$3m after 11 years.", "replies": [{"id": "hktcnty", "text": "I totally agree with this, plus that\u2019s 1 million invested on an improvement but realistically there should have been a tenant improvement allowance put into place. Set at a cap no where near that amount especially with no other leases having CAMS it sounds like and the exterior is visibly in disrepair or better phrased unmaintained. That\u2019s what\u2019s visible. \n\nIts possible a lot of things might start popping up on this 100+ year old building by the sound of it but who knows maybe this is in a prime location and the foot traffic makes it worth it.", "replies": [{"id": "hkv5322", "text": "Very good points, thanks. Things will likely keep popping up with this building for sure, but it is in a very desirable location. I'm considering (long-term) demolishing the building and redeveloping it as a $20M condo building (a loan we've already qualified for). But that's a much much larger project I don't think I'm ready for yet.", "replies": [], "depth": 5}], "depth": 4}, {"id": "hkv5qll", "text": "Considering that's not something I know a lot about (those points you made about prices/returns on small business), is there a profession or service I can hire to help me with that?", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "hksnuc9", "text": "Is that the best use of that capital is it profitable still as it sits and what would be that cash on cash return per year", "replies": [], "depth": 1}, {"id": "hksu3cn", "text": "I\u2019d love to see the scope/breakdown on your $750K base building work. That\u2019s $150/ft. Plus another $50/ft on TI costs. \n\nHow are you generating 100% profit on the deal? Is this a gross rent? You said the tenant is paying for utilities, so I assume that means the rest of the Tax/Opex are on you?", "replies": [{"id": "hkv5bxj", "text": "Unfortunately I don't think it would be appropriate for me to share that information, but once again I'll mention that I relied on multiple architects and engineers for their opinions on what was necessary for the building to be leasable.\n\nIt's a NNN lease.", "replies": [], "depth": 2}], "depth": 1}, {"id": "hkt2ocd", "text": "I love any deal that improves an unusable space with a tenant that is coveted paying it back. If you didn\u2019t improve the space then it would sit there.", "replies": [], "depth": 1}, {"id": "hktbyrh", "text": "I am not sure what cap rates are in your area, but if they're below 9.3, then you added more than $1M in value by spending $1M to get a tenant in that space.\n\nIt sounds like you'd have to spend $750k regardless of the tenant, so then the question is whether the TI is reasonable in your market, and $50/sf in TI could be reasonable.\n\n$150/sf to get it to rentable condition is quite rough, but if that's what it costs then that is what it costs.", "replies": [], "depth": 1}]