This article has been written by our friends at BuildingBITs.
In the world of commercial real estate investing, it can be all too easy to fall into the “hype trap”: wanting to own the hippest buildings in town with the trendiest tenants. But as with most areas in life, all that glitters is not gold when it comes to real estate investing. It turns out, going after the hottest buildings in town could cut into your long term profits.
If you’re not looking to invest in the sexiest buildings, what should you look for while building your CRE portfolio? We have 2 words for you: quality leases.
An investment strategy looking for stability and long-term returns targets commercial properties with highly reliable leases and quality tenants. Why focus on these seemingly less “sexy” metrics, rather than stocking up on the hottest spots in town? Read on to discover why we think quality leases offer a great chance to boost your real estate profits.
It’s easy to fantasize about impressing friends with a hip office or retail building smack dab in the middle of a major metropolitan city. That’s the natural appeal of “shiny objects” in the world of properties. But this glamor and glitz strategy could end up negatively impacting your long-term investment results. At BuildingBits, one of our core criteria for investment properties is the reliability of the tenant. Here’s a hypothetical scenario to help explain why this is so important.
Let’s say that you and your friend Mary both became interested in commercial properties at the same time, but adopted different strategies. Mary used “glamor and glitz” thinking, and bought that Trendy start-up building in downtown Los Angeles, CA. You, however, thought like a careful investor, and considered your long term results more important than “the cool factor”.
So you decided to opt for the AT&T store in Maplewood, MN instead. A less trendy area and maybe not the first place people think to own. And Mary even poked fun at your choice for a little while. But then something happened that surprised both of you: Los Angeles city taxes increased and the Start-up begins struggling to stay within their profit margins. Before long, the company couldn’t rationalize the area’s high rent rates, and Mary’s tenant ended up closing, meaning no more tenant, no more rent and hard piece of property to sell.
Meanwhile, your AT&T store in Maplewood is bringing in passive income for you month-over-month. With long-term lease commitments and a location for continued growth, your property is set for the long term with AT&T Committed to a long lease.
Mary chose the “cool” investment in the hot part of town, without considering how reliable her tenant’s situation was. But you considered multiple angles, and even though your AT&T is in a slower part of town and not as hot to own, you came out ahead in this example. Why? Because you went for the more reliable tenant with a more sustainable situation, over the “shiny object”.
High Quality Buildings
One of the other key things we look for at BuildingBits is higher quality commercial properties. Why, exactly? Well, there was another layer to Mary’s cool hip start-up closing down that we didn’t mention before.
Yes, trendy business do get slower and her tenant eventually couldn’t afford the property. But on top of all this, the building had a major issue with the pipes in the kitchen around the same time. So the building was vacant (i.e. not generating income for Mary) for an even longer period of time while the necessary repairs were made.
So not only did Mary lose her tenant, but her selection of an older commercial property reduced her ability to quickly find a new tenant, meaning even larger losses to her overall returns. This is one of the major reasons higher quality and newer properties to invest in a recommended for people seeking stability and less capital expenditures over long-term.
Less Long-Term Uncertainty
All of these factors are aimed at producing less long-term uncertainty and also may provide steadier gains in your investment returns. For instance, there’s a chance that Mary might have gotten a big eventual payoff on her building, since it had appreciated on Main Street, in one of the hottest areas, and that was one of the reasons she purchased it.
But for that to work, she would need the time and money to ride out lots of changes in the market. We believe that prioritizing high quality leases and tenants may provide a more reliable approach to commercial real estate investing.
Prioritizing reliable and sustainable tenants, as well as higher quality properties, may also help you avoid another layer of long-term uncertainty: needlessly cycling through tenants when you could have just made a different investment. Remember, any length of time that your commercial properties are vacant may very well mean a period of negative returns for your portfolio.
Prioritizing quality tenants, reliable leases and newer commercial properties may be helpful in maximizing your returns, and smoothing out your long-term investment uncertainty.