Chapter 14: Taking Investments to Next Level

Personal Investing Journey Video

How did I get started? Find out here.

Click for YouTube Video

Owner User Video

Becoming an Owner-User is the best way to Reduce Risk. Why? Find out here!

Click for YouTube Video

SBA Loan Benefits Video

For people that are looking at making their first purchase for their business, the SBA is a fantastic resource.

Click For YouTube Video

Lease vs Purchase Video

The Age Old Question: To Lease or to Purchase

Click for YouTube Video

This chapter is for the executives who are so fascinated by the industrial property experience that they want to dive in more deeply. You want to take your knowledge and skill sets one step further. You are not content to just lease. Instead, you want to become an investor and buy industrial property. I know this experience firsthand.

My investing career began when my wife and I purchased a three-unit apartment building the month we got married. Few people imagine starting married life in an apartment complex that is constantly under renovation and filled with tenants asking you to fix their toilet at odd hours. However, it turned out to fit us perfectly. We were building our life together, and this was part of the journey.

We decided we loved investing but needed to be more analytical with our next purchase. We were willing to go wherever our analysis took us if we could do so in a safeguarded manner. We looked around the country at demographic shifts, population migration, and job growth. This led us to Austin, Texas. At the time, it seemed like we were gambling, as this was our first experience investing out of state. But Austin has since become a magnet for successful young professionals, and our initial$100,000 investment paid off handsomely—we ended up doubling the amount. The investment was so successful, we invested in Austin again the following year, and the year after that.

When our firm decided to purchase an office building, I invested as a limited partner within the property, while also being a partner in the property’s tenant firm. In essence, I was both landlord and tenant. This gave me a better understanding of how to align interests for everyone’s benefit.

A year later, it was time to combine my skills and expertise into industrial investments and build a platform for future investments. In that spirit, we invested in a multi-tenant industrial property in Dallas, Texas. This property acquisition was in a market with growing demographics and job growth during a period of sustained economic expansion, and it was a type of property I knew like the back of my hand. I looked at every investment as an extension of the program and felt comfortable adding value to properties, working with banks, managing property managers, and building relationships with all of my partners.

Today, clients like the fact that I own industrial property. It shows that I practice what I preach. They understand this helps me gain fundamental insights into both sides of the negotiating table. You, too, now have the skills needed to begin managing such an investment prudently. Depending on the scale of your business and its maturity, you may find it is time to invest in buying your industrial property instead of leasing it. Or you might find it is time to start investing in industrial property for retirement or wealth creation, now that you have the capital available.

Figuring out what to invest in is half the battle. The age-old answer is, invest in whatever works for you. I will walk you through the different types of industrial investments in this chapter. Entire books are devoted to investing, but I want to focus on four of the most common investments for entry-level and high-net-worth investors.

OWNER/USER

The term “owner/user” refers to a business that both owns and uses the building. It is the simplest first step toward ownership for executives. Most small businesses initially lease 1,000 to 10,000 square feet of space until they reach stable size and profitability; then they decide it is time to own instead of lease.

Companies that buy their first building for their business usually get a bank loan. Anecdotally, 75 percent of these buyers utilize Small Business Administration (SBA) loans, and 25 percent use conventional financing. When you buy your building for your business, you typically borrow money with a down payment of 10 to 25 percent, amortized in twenty-five years and paid off in twenty-five years.

Owner/user buildings offer security for a bank for a few reasons. The first is because the owner signs a lease with his own business in the space. This alignment of interests means the owner has skin in the game. Additionally, banks also like SBA loans because of how they are structured. The down payment for most industrial property buyers utilizing an SBA loan is as little as 10 percent of the purchase price. I helped my local veterinarian purchase his building with no down payment, using an SBA property loan from a bank that specialized in banking for veterinarians.

SBA loans are actually a composite of two loans. The first loan is for 30 to 40 percent of the purchase price and is the portion lent by the SBA. The second loan, for the remaining balance, is lent by a conventional bank. The SBA is happy because they are promoting small business growth and ownership, and the conventional bank is happy to limit their loan value to 50 percent of the property purchase price. This gives them a lower risk profile.

Typical amortization for these types of loans is twenty-five years. The loan is also due in twenty-five years. Interest rates are fixed for some of that time, before being adjusted every five years at regular intervals.

If you choose to pay off your loan before the first three years, you will be subject to a prepayment penalty. Prepayment penalties provide stability for bank loan portfolios since many banks keep smaller commercial real estate loans on their books.

A conventional loan has many of the same terms, but with a larger deposit that usually represents 25 to 35 percent of the purchase price. Loan fees are generally 1 to 2 percent of the loan amount and are negotiable, depending on the bank.

Loan brokers are a borrower’s best friend. A loan broker’s job is to know all lenders in the market, shop your loan to the most relevant banks, and negotiate favorable loan terms for you. You can do it yourself too, but I have found the best results occur when working with a loan broker, because there are too many banks in this space to keep up with which one is the best fit. The application process is also time-consuming.

Industrial properties do not come with a warranty period, so it is important to hire an inspector to walk the property and provide an inspection report that will detail every nook and cranny. You must take ownership of the inspection process too: verify everything with your own eyes. Or, better yet, have vendors review your inspection report in hand to give you a real assessment of what it will cost to bring deficient items up to snuff.

Inspectors offer packages that differ in their level of detail. More thorough packages estimate the remaining useful life of all the building components. The most detailed packages include budget line-item costs for each building system. The budgets can help you prioritize big-ticket building systems when negotiating seller credits.

Your bank will require you to have a qualified consultant complete a Phase I study for the property. This involves researching environmental regulatory agency public databases to find out if there are any active or past environmental concerns. This report will usually tell you if the property had underground storage tanks, the status of their removal, and in many cases, if there was soil remediation at the time of removal. The report may also tell you if any unsafe chemicals were used at the site and if they were publicly monitored and disclosed. Some chemicals are susceptible to leaking into the slab and contaminating the soil and groundwater. Banks require reports so they have a full picture of the property and the risks associated with it, because if you do not repay your loan and the bank seizes the property, any environmental issue will be their problem.

EXTENDING YOUR INVESTMENT

Purchasing a building that is both an investment and a place of business faces a number of unique considerations.

Most CPAs suggest the building be in a separate LLC. The general purpose is to maximize your company’s tax savings with the company lease, while maximizing the executive’s personal income tax savings by owning the property. This allows the company to write off its lease payments, property tax, insurance, and maintenance expenses. The executive’s building ownership entity can then depreciate the property improvements, write off the interest paid on the loan, and ensure the tenant effectively pays down the mortgage, resulting in cash flow and property appreciation.

In this instance, you are both landlord and tenant. There is always a dichotomy and a healthy tension regarding the rental payment the company makes to its landlord. This moment of stress is where transparency and open discussion between the business owners and the building owners are necessary to determine if there are differing ownership percentages between the two entities.

I usually see the owner/user model as a practice run. Once you invest in your first building and the benefits become clear, you may want to turn these skills into a larger investment strategy.

In a perfect world, the business owner would be able to keep the first building and buy the next, larger building when their business grows to the next size. The older, smaller building would be put on the market for lease and leased out to a new tenant.

There are many different variations of this scenario. Another typical example that works well for business owners is continually trading up to a larger building as the business grows.

Eventually, many business owners decide it is time to sell their business. When they do this, they can sell the company and keep the building. Business owners consider this the perfect retirement: they can move on from the day-to-day management of the company and have passive income from a tenant they are intimately familiar with.

I have seen this play out with business owners in buildings ranging from 5,000 square feet to more than 100,000 square feet. The only limit to the size of the outcome is the scale of the business and the ultimate footprint the business needs to be successful.

I worked with a former owner of an apparel manufacturing business that operated out of several facilities in multiple markets within the United States. Upon selling his business, he found his industrial building investments paid more dividends than the business itself. In true entrepreneurial form, he raised private equity funds to scale his industrial investment business, which he still operates today.

Acquiring and managing industrial real estate requires a specific skillset. Once you have developed this skill set, you can put your craft to work and create value in the marketplace.

MULTI-TENANT BUSINESS PARK

This type of industrial investment is a great starting point for the early-stage investor. These properties are called incubator parks, business parks, business centers, industrial parks, or multi-tenant industrial parks. Think of these as apartment complexes of the industrial real estate asset class. Projects can vary from one 10,000-square-foot building up to a large project encompassing multiple buildings totaling 300,000 square feet. Typically, these buildings provide multiple small spaces for startups and local service businesses, ranging from 1,000 to 5,000 square feet per unit.

Multi-tenant projects provide for income-stream diversification. Compare this with the earlier example of a single-tenant building where you either have cash flow or you do not. With investment in a multi-tenant project, you have five to fifty tenants producing income, but no single tenant makes up more than 5 to 10 percent of the project. Of course, the tradeoff for this steady stream of income is an increase in management duties. Managing twenty leases means there is more of a need for a property manager, common area maintenance, HVAC maintenance, and enhanced tenant relations.

Smaller tenants are usually less sophisticated and less capitalized, and may not be able to weather a down market, a challenging business environment, or credit crunches. Smaller tenants typically sign shorter leases too, ranging from two to three years in length, as they have less visibility into their future than larger, more mature businesses. That means that you might have 25 to 50 percent of your tenant leases expiring each year. Marketing smaller spaces, cleaning and prepping each space when vacant, and screening new tenants all take time and money.

There is an upside to this, though. With a five-year lease on a larger building, market lease rates might go up at 8 percent each year, but your contract fixes the increase at 3 percent increases. With shorter-term leases, you are better able to keep your lease rate increases consistent with market rate increases.

Buying multi-tenant industrial property means a larger down payment, usually 20 to 40 percent down. It is common to have your interest rate fixed for five years at a time, with periodic adjustments to market rate.

You must be aware of the debt coverage ratio, which is the amount of net income the property produces divided by your estimated debt payment. The purpose of this debt coverage ratio is to make sure the property economics are robust enough to pay the loan back even in the event of unexpected expenses, loss of revenues, deterioration of market demand, or an increase in the supply of competitive properties. It can fluctuate but usually hovers around 1.25. This means that the property has to generate 25 percent more revenue than the debt service due each month.

Amortization rates for these properties are usually twenty years but can sometimes be twenty-five years. A twenty-year amortization differs from the traditional thirty-year fixed-rate residential mortgage in that the principal loan balance decreases more rapidly.

Due to the fact that commercial income property loans have shorter maturity dates, you have to refinance more often or be willing to sell and exchange property more frequently than you would with residential income property. This can lead to financing challenges if a fiveor ten-year loan matures during unfavorable market conditions. You want to make sure you set up your investment strategy to weather down markets and never put yourself in a position where your property is worth less than your loan balance.

Your motivation to scale will determine what you do at these financing junctures:

  1. You can sell the property every time your loan is due, pay the taxes, and keep the cash liquid for future investments.
  2. You can refinance the loan and continue to pad your property’s operating account. You will then decide how much additional principal you want to pay down.
  3. More aggressive investors will refinance back up to the maximum loan value and take out proceeds to reinvest in another property. This is a winning strategy because the money you pull out of the property is tax-free.

SINGLE-TENANT NET

The third type of industrial investment is the single-tenant net leased (STNL) investment. These investments can often be great for conservative investors who prioritize stable, long-term cash flow over maximizing returns. These investors usually look for a safe harbor to park their funds at an attractive rate, with all the tax benefits of ownership. The quintessential example here would be buying a warehouse leased to FedEx for the next ten years.

There are dozens of factors that impact the pricing of an STNL property. The primary factors are length of lease term, credit, the cap rate, and the geographic area where the property is located.

An example of how the length of lease term affects the property can be shown with an industrial property with three years versus fifteen years left on the lease. If you need a loan on a property with a three-year lease, you will likely find you can only get a three-year loan, which may not be consistent with your long-term hold strategy. On the other hand, if you need a loan on a property with a fifteen-year lease, you will be able to obtain a longer loan maturity, which could dramatically affect your cash flow and down payment.

Secondary considerations are property characteristics, submarket demographics, and your ability to lease the property in the future. If you have a fifteen-year lease and plan on holding on to the property for five to seven years, you might not delve as heavily into all the factors that would be relevant to future leasing. If you are in the game long enough, like one of my clients who owns nine single-tenant industrial buildings, you realize you will eventually need to have a tenant move out of your property, and at that time, you will need to hire a broker to market your property for lease. At that time, it is imperative for you to have a functional building in a growing area. While vacancy has been at a historical low for the past decade, some buildings have sat vacant on the market for months, even years, at a time. Anyone who has been through that experience has a more discerning eye for property and market analysis.

Single-tenant net leased investments are simple, low-risk, and generate moderate returns. Triple net leases are set up so the tenant is responsible for paying all of the property tax, insurance, and maintenance on the property, as if they owned it. If they have a long-term lease, you will be freed up to use your time as you see fit, rather than managing tenants, property managers, and real estate attorneys.

SALE-LEASEBACK

The last popular industrial real estate investment with high net-worth individuals is the sale-leaseback. The only difference between the single-tenant net leased industrial investment and a sale-leaseback is that the company selling the building is the property’s tenant. Sale-leasebacks are generally pursued by experienced investors, as there is more room for creativity in structuring the transaction to be mutually beneficial.

Companies look at sale-leasebacks as a financing instrument: investors in sale-leasebacks will underwrite the company, much like a banker would. If you are thinking of purchasing a building in this situation, find out why the company is trading their ownership stake for capital and what they intend to do with this newfound capital. Usually, you will find that the company is reorganizing and needs the funds to pay off debt and/or focus on acquisitions.

One sale-leaseback I listed and sold recently in Tustin, California, was for a printing company. This printing company had been in business for twenty years and in the same warehouse for the last ten years. The printing industry, however, has been going through massive consolidation due to the prominence of digital media, so printing companies have had to be nimble and adjust. This is difficult for a business that requires substantial capital investment in the form of large-format machines. Printing companies that once just printed mailers have had to diversify their services to include packaging for cosmetics, craft beer, cannabis, and other new growth industries. My client was trying to become more vertically integrated by adding a digital marketing agency. To fuel this growth, they decided to sell their building and then lease it back from the buyer.

Other considerations in a sale-leaseback are the length of the lease term, capital improvements, and security deposit. Remember, you are not just buying a building: you are also signing a lease with the seller. This means you need to put your landlord hat on and consider a mutually agreeable lease term; the condition of the property, roof, and HVAC units; and how to handle the amount and payment of a security deposit.

Sometimes the seller will want to maximize proceeds, which means they will offer the lowest cap rate possible to maximize the property value. Buyers, on the other hand, usually want to increase their cap rate by offering a lower purchase price.

INVESTOR SKILLSET

Combinations and permutations of investment strategies organically take place in industrial markets. For example, I recently worked with a high-net-worth couple who had long since retired and wanted to spend more time fishing and traveling to Mexico. They had initially purchased a small industrial building to occupy as an owner/user.

Over the next ten-year period, they turned their owner/user investment into a multi-tenant investment by using the extra land on their office property to build an industrial building that consisted of five units. Each unit had an entrance, reception area, private office, restrooms, water, power, and a roll-up door. The couple leased out all of these units and kept them leased for years, which effectively paid their mortgage on the front part of the building. During this time, they managed everything themselves: leasing, bookkeeping, maintenance, contracts, and more.

After a few more years went by, they asked me to do their leasing, and they requested I find a property manager to take care of the day-to-day operations. A few years later, they decided to sell the property. We sold it to an owner/user who needed all of the building units for his own business.

My clients were able to take the money from the property sale and buy a newly constructed, single-tenant net leased building with a fifteen-year lease in Dallas, Texas.

When we met, this couple was generating $27,576 net cash flow every year from an old 1960s industrial building. Following my advice, they ended up with an investment that generated $96,000 net cash flow in year one and is set to compound 3 percent annually for the next fifteen years.

These investors moved up the investment food chain over the years. They started as owner/user investors, became multi tenant industrial investors, and ended up being single-tenant net lease investors. Today, they are hard to reach because they spend their time enjoying retirement, just as they had hoped. All of their accounts are direct deposit because this couple only checks their mail when they are back in the United States once a month.

The moral of this chapter is that leasing, owning, and managing industrial real estate is a valuable skill set. You can use these skills, if you so desire, to create successful investments for yourself, your business, your family, and your retirement.