Ever since starting this blog, I haven’t been shy about sharing my views on real estate investing.
On one hand, it is one of the most effective ways to build wealth for retail investors. The first property we bought generated an over a decade.
You simply don’t get to those levels in the stock market.
On the other hand, and very much unlike buying index funds, real estate investing can be a highly frustrating exercise. I would strongly encourage you to read up on some of the challenges you can expect along the way.
That being said, I promised myself not to give up – and we didn’t.
As of yesterday, the Banker on FIRE household added another property to its real estate portfolio. It’s a five-unit, mixed-use commercial and residential property.
In today’s post, I am going to cover both the logic and the journey involved in buying real estate during Covid.
If you are even remotely considering getting into the real estate game, I encourage you to read it carefully. Then, ask yourself: “Is this a process I would find enjoyable?”
If the answer is not, please do yourself a favour and stay out of real estate as an asset class (other than perhaps buying your own place).
You don’t want your investment strategy to make you miserable. Life is too short.
But if you find the process of finding, pricing, and negotiating deals exciting in its own right, then it may well be that real estate is for you.
The Juicy Details
A couple of things to lay out up front.
First of all, the property is not located in the UK. While we have been living here for almost a decade, for a variety of reasons we actually rent our place in London.
Our existing property investments stem from the time we lived stateside. Because there’s a reasonably high chance we may end up moving back at some point, we’ve decided to add to our real estate portfolio across the pond.
Regardless, the fundamentals of real estate investment are universal across the board, so I would expect this post to be helpful to anyone contemplating a commercial property purchase.
Our new property is located in a satellite town about 2 hours away from one of the largest (think one of the top 5) cities in North America. The town itself has a population of roughly 300k residents and it’s one we know well, having visited multiple times over the years.
The local economy is dominated by technology, financial services, healthcare, educational, and government institutions. For obvious reasons, we were very focused on picking a location that isn’t reliant on manufacturing.
The property itself has five units. On the ground floor, there is a restaurant (you read that right – more on this below). Above the restaurant, there are four one-bedroom residential flats.
The existing owners have bought the place four years ago for about $400k. They’ve spent about $300k on renovations and have refreshed the entire tenant base along the way.
We ended up buying the place from them for $855k. Our bank has extended a commercial mortgage at a 31% LTV and a 2.45% interest rate.
All in, the place nets about $60k in rental revenues per year and runs $11k in annual expenses. This implies a cap rate of 5.7% (i.e. $49k in net operating income divided by the $855k purchase price).
I expect the cap rate to go well north of 6% over the next few years given the anticipated growth in commercial and residential rents.
The one thing you’ve got to remember about real estate investing is that sourcing good deals is 80% of the battle.
As it happens, this is a property I was familiar with because I actually made an unsolicited offer on it last year. Back then, the seller wouldn’t sell for anything less than $900k. I wasn’t willing to pay more than $850k, so we parted ways.
At the time, I hadn’t yet seen the place. However, a few months later I happened to be visiting family in the area. My agent and I hopped in a car and drove down to check out the town and look at some properties, including this one.
Having seen it in person, I was impressed with the quality of the renovations (which usually isn’t the case with flipped properties) as well as the location.
The building is located in the very centre of the town, and the local administration has just spent $16m to renovate the entire area and turn the street into a “flex” street, which means it can be closed to traffic and made pedestrian-only.
In addition, there are at least 10 high-rise condo developments nearby, which will further gentrify the area and significantly increase foot traffic for the restaurant.
Having paid my way through college by working in restaurants, I know that location can make or break a restaurant. I also knew that the rate the existing tenant was paying is about 50% under market, on account for all the construction that was happening on the street.
More broadly, the town itself has seen rapid population growth in the past few years given how unaffordable the nearest metropolis has become. As a result, residential vacancy rates are less than 2% and rents are going up 5%+ a year.
Having considered all the above, I reached out to the seller in February and said I was happy to pay $900k for the place. Unsurprisingly, she now wanted $950k.
After some back and forth, we settled on $910k and signed a purchase agreement. Just one week later, the Covid pandemic came to the fore.
Dealmaking In Crisis
From a deal perspective, I wasn’t too fussed about Covid.
I still had a financing condition in the purchase agreement. It allowed me to get my deposit back and walk if I didn’t secure financing on terms that I liked. The ball was in my court.
The challenge, of course, was that I still liked the property. Given the excellent location, I could see owning it for decades. In the meantime, it would cash flow nicely, even at $910k.
Most importantly, I still had a motivated seller who had near-term cash needs.
The real question was pricing in the impact of Covid. This is when the M&A banker in me went to town.
First, I used a clause in the purchase agreement to extend the closing date to July. Back in March, the stock market was plummeting, and no one had a clue as to what was going on.
I knew that we might not have full visibility to what is happening come July, but we will surely know more (which is kind of how it played out). Extending the closing date meant the seller still had the obligation to sell to me for $910k.
Secondly, I took another hard look at the numbers and made some severe cuts to my projections to create a “downside case” of sorts:
- Assumed the commercial tenant will go out of business and it will take me a year to find a new one. This reduced both the commercial rent as well as the share of expenses covered by the commercial tenant to zero for an entire year
- Assumed that when I do rent the commercial unit out, I will take a 20% haircut on an already below-market price
- Added a $20k one-off remodeling cost in the event restaurants don’t exist in the post-Covid world and the place needs to be turned into a different retail location
- Increased my operating expenses by 50%
- Doubled the interest rate on the bank loan to 5%. Unlikely to happen, but I wanted to cover all bases
Are these some draconian assumptions to be making? Sure. Equally, the number one rule to making money is not losing money. In other words, take care of the downside and the upside will take care of itself.
Clearly, the numbers didn’t look nearly as good as before. If everything played out in the manner above, I would take a $45k cash hit in year 1.
But the property would start breaking even (on a cash basis) the following year and even at the initial purchase price of $910k, my ten-year returns worked out to 5.4% on account of mortgage paydown and some modest price appreciation.
I’ll spare you the long negotiations over the past three months. In the end, we settled on $855k, which I consider to be a fair price to everyone involved.
Could we have pushed the seller a bit more? Perhaps. That being said, I’m not the only one looking to add to my real estate portfolio.
Towards the end of June, multiple properties came up for sale in the vicinity. Having run the numbers on them, I knew I was getting a solid deal.
The last thing I wanted was for the property go back on the market, in which case it could well sell for a higher price.
Restaurant… Are You Crazy?
Yes, I know. In the post-Covid world, restaurants might not exist! So why would I take the risk?
A few reasons, other than the fact that I don’t subscribe to the apocalyptical view above.
First of all, the restaurant accounts for just a third of the total rents. This is still primarily a residential property in an area with strong population growth, low vacancy rates, and an upward trajectory in rents.
Second, the location. Having spent time in the industry, I know that being in a prime spot can make or break a restaurant. In this case, the location is as good as it gets.
Third, it was the restaurant owner. It takes a special kind of person to succeed in the restaurant industry and the owner of the place has a highly successful track record and multiple other establishments.
That being said, I still fully expect him to request a rent holiday now that I have taken ownership. I’d be surprised if he didn’t. But it’s something I have baked into my numbers.
I always have the option of finding another tenant, but for the time being, I’d rather hold on to this one.
Our Plan For The Property
Just like with any property purchase, the first year tends to be a transitional one. It takes some time to get things up and running, sort out all the operational issues, and file all the paperwork.
Given we are abroad, we’ve hired a property management company to help us with the day-to-day stuff. That being said, leaving your property manager to it is a fast and easy way to lose money. You have to keep tabs on things to make sure you are getting a fair shake.
Our investment horizon here is at least a decade, likely much longer. I expect to refinance the mortgage a few times along the way, which will release capital in addition to the annual cash flows. The money will likely be used to purchase additional real estate.
My “base case” projections imply an annualized return of 10%. Worst case, the return declines to ~5% (see the “downside case” above). Equally, it could go up to about 15% assuming rent growth in line with recent trends.
On a ten-year basis, this distribution of returns works for me. And as much as I like the stock market, I am happy to have allocated a greater portion of my portfolio to real estate.
The Un-Glamourous Life
Today’s post is a detailed one. The blow-by-blow commentary is 100% intentional and I intend to elaborate on a few aspects in future articles.
When it comes to personal finance, I simply don’t believe you can tell others what to do. It just doesn’t make sense.
Everyone has a unique set of preferences and circumstances that dictate their approach to building wealth.
Thus, what I prefer to focus on in this blog is describing what I do to build wealth.
And in that, I try to be as transparent and detailed as possible with the hope that others can learn from my experience and apply it in the context of their own investments.
Somewhat unhelpfully, the mental picture conjured by the words “real estate investing” tends to be along the following lines:
Stroll into a luxury development. Buy a condo (or two). Have a property management company do all the heavy lifting for you. Proceed to cool your heels while collecting cash every month.
Perhaps that’s what it looks like for some people. It certainly hasn’t been my experience. More often than not, it’s messy and complicated.
But for returns that exceed the stock market by a wide margin, I am happy to take complexity over glamour any day of the week.
Happy (real estate) investing!