They say good things come to those who wait.
Well, my wife and I certainly had to wait to make our first commercial real estate investment.
We originally started looking for our next property in January 2019.
Having screened tens of properties, we made a handful of offers but just couldn’t get a deal over the line.
The opportunity cost of sitting on a pile of cash in 2019, when the stock market went up 30%, was astounding.
It’s not something that gets a lot of airtime, but real estate investing comes with its own challenges – and this was certainly one of them.
Thankfully, we finally managed to get a deal done at the height of the pandemic.
Last month, it was time to file our first tax return, which also gave us a first look at the performance of the investment so far.
Let’s start off with…
The Juicy Details
The total cash flow (after mortgage payments) came to around $10k.
Given we’ve only owned the property for six months, that works out to about $1,700/month.
Thus, on a calendar year basis, the property spins off $20k of cash, representing a nice 7% cash yield on our original equity investment of $280k.
In addition, there’s about $18k of mortgage principal that gets repaid every single year, bringing the return to $38k or 13.6%.
Most importantly, there’s price appreciation.
Clearly, the real estate market has been on fire over the past year.
We bought the place for $855k and I see comparable properties trading for $1.2m now, so we are also potentially sitting on a $350k price gain.
However, let’s ignore the noise and assume the property appreciates by just 3% a year, in line with long-term inflation.
Assuming it’s worth $1m today, that’s $30k of price gains a year.
All in, that brings total annual returns to $68k – or about 24% of our initial $280k investment.
That makes it hands down our best property investment to date.
Over time, I expect the $68k to grow materially as rents go up, mortgage paydown accelerates, and price growth compounds.
Below, let’s do a little tear-down on what has gone well, what hasn’t – and what’s in store for the future.
What Went Well?
While we priced in about 4% vacancy, we had zero vacancy last year.
Clearly, this will change over time.
However, I’d be quite happy to have some tenant churn given three out of four apartments are currently rented below market price (more on this below).
The commercial unit is occupied by a restaurant.
Now, I fully expected the owner to try and negotiate a rent holiday with me, especially given what was going on last year.
However, being an experienced restaurateur, he kept the place going and made his rent payments on time.
He did renege on about $1.5k of expense reimbursements, which I have banked as a receivable going forward.
More importantly, the commercial unit is rented at $2k a month, which is roughly half the market rate.
The commercial lease is up next year, and I strongly suspect the owner is trying to build some goodwill to try to keep the rent hike at a reasonable level.
This is a big one.
Working with our accountant, we were able to claim a number of allowable deductions, which reduced our tax rate in a meaningful way.
Many of these serve to defer taxes into the future and will be reclaimed by the tax authorities upon sale of the property.
However, I don’t intend to sell the property for a very long time – and thus the time value of money makes tax deferral a very effective strategy.
Learning about taxes is as unexciting as it gets. But you can trust this certified accountant when I say it happens to be a highly effective way to get rich.
Buying At The Bottom
This is by far the biggest factor that played to our advantage.
Not many people were shopping for commercial real estate in April 2020, which is when we were negotiating our deal.
As such, we’ve managed to secure a $55k price reduction – and got to ride the roaring recovery afterwards.
In addition, our property benefited from the flight out of big, unaffordable cities over the past year.
It’s located in a satellite town just 2 hours away from one of the largest cities in North America.
Thus, it is benefitting from a significant population increase, which is reducing vacancies and increasing property prices.
So far, so good. But to say it was all smooth sailing would be a lie.
What Could Have Gone Better?
Property Tax and Insurance
Compared to our projections, property tax came in $3k higher than expected.
Ditto for insurance, which came in $1k above estimates.
This is why it is critical to include a solid contingency buffer in your numbers. Things can and will go wrong.
Thankfully, we had about $5k baked in for any unexpected expenses, which comfortably covered the items above.
Our commercial tenant hasn’t reimbursed us for about $1.5k of TMI (taxes, maintenance, insurance) that related to his unit.
In a different environment, I would have served him with an eviction notice right away.
However, the last thing I’d like to do right now is to have a vacant restaurant unit. Yes, the economy is finally picking up steam.
However, I’d much rather have a proper renegotiation of the lease later this year. I expect the consumer sentiment to be firing on all cylinders by then, giving me a much stronger hand.
In the imaginary world of “passive” real estate investing, you hand off the keys to the property management and just bank the cash, right?
Perhaps, though I am still waiting for that nirvana-like experience!
To be fair, our property managers are pretty good – I’d give them a solid B+.
Still, we’ve had a few bumps in the road that needed to be resolved. Things are much smoother now but I’d say we spend at least a few hours a month checking in on them.
In other words, you’ve got to “manage the manager” – because they certainly aren’t going to manage themselves!
To be honest, this is probably the most exciting piece of property in our entire portfolio right now.
For starters, three of the four residential units are rented at well below market rates. Altogether, there’s about $750 of rent upside per month – or about $9k a year.
Now, I cannot (and would not want to) kick my tenants out under some false pretense. I also cannot unilaterally raise rents by more than inflation.
However, tenants always churn over time. Every single time there’s a vacancy, I will be able to do a few cosmetic renovations to the unit and realize a significant rent upside.
Then there’s the commercial unit, which is rented for $2k a month while the market price is around $4k.
Our lease is up next March, which means we will renegotiate towards the back end of this year.
Will I be able to get him to pay market rents overnight? Most likely not.
I do, however, expect to put in place rent escalators every year to bring the rents in line with the market over the next 24 months or so.
That’s another $24k of annual rent upside.
Thus, by “repricing” the rents, I will essentially increase the net operating income of the property by $33k.
At a 6% cap rate, that’s about $550k of value creation, which should take the price of the property to about $1.65m by 2023.
By that point in time, we will have about $550k left on the mortgage, implying an equity value of about $1.1m.
That’s a 4x increase compared to the $280k we’ve put in last year – and this is before you factor in the ongoing annual cash flows of $20k+ along the way.
Is this as good, easy, and quick as becoming an overnight Dogecoin millionaire? Not by a stretch.
Then again, this is not how people get rich with real estate. Property investing is a long-term game.
And somehow, I’ve got a good feeling about it.
Thank you for reading – and happy (real estate) investing!
P.S: if you are interested in real estate investing, make sure to check out my previous posts on the topic.
About Banker On Fire
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Banker On FIRE is an M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
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