A passive cash flow source is one of the hardest things in the world to create. That’s because most cash-generating activities require active and highly vigilant hands-on management (e.g., a job, a business, the stock market, etc.). You’re basically trading time and sweat for money.
A commercial real estate investment is different because it allows you to generate cash without 24-7 supervision, unlike your business or your job. And while real estate does require oversight and good management—both of which are minimized if you use a reliable property manager—you can conceivably double or triple your returns by, say, selling a property and then buying a bigger one (thus creating an even more lucrative cash flow source).
A Cash Flow Source
That You Can Control
From a financial standpoint, everyone’s goal in life is to create a passive income stream that allows them to do what they want every day—and for as long as they want to do it—and still generate revenue as a result of something that they did years ago (in this case, purchase commercial real estate). This isn’t an easy mountain to climb, and you’ll need a certain amount of leverage to get started, but in the end the payoff can be pretty significant. Here are some of the key guidelines to create your own commercial real estate income stream.
Examples of Investor
and Owner-User Financing
Roughly 20% of commercial real estate transactions under $2 million are all-cash transactions where the buyers don’t require financing. All the rest are almost exclusively leveraged, meaning that purchasers borrow at least
some of the purchase money from lenders. As an investor, in order to play the game, and depending on where you’re located, you’ll need a down payment of 30%–40% of the purchase price. This is because you’ll need to
cover the bank debt service coverage ratio (DSCR), which is defined as:
A measure of the cash flow available to pay current debt obligations. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, sinking-fund (a means of repaying funds borrowed through a bond issue through periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market), and lease payments.
Now, if you’re going to occupy your property as an owner-user, then you’ll probably have to put down only 10% in cash. In this scenario, your business will be paying for the mortgage and the operating expenses for the building while also creating a future asset to be used for cash flow.
How Much Passive Cash
Flow Will You Generate?
There are several factors that dictate how much cash flow you will generate with your commercial property. The first is fair market rent, or the estimated amount of rent a property of a certain size and type, in a certain area of the country, will command. This number fluctuates, so if you own a building for 20 years, you won’t be getting the same amount of rent year after year. For example, you’ll get annual escalations on your lease to cover inflation. Consider this scenario: The lease on your building expires, and the economy is in the dumps. The market rate is just 80 cents per foot (per month),and you’re forced to lease out the building at this new lower rate. This is just one example of how cash flow really depends on a number of different factors, including the overall state of the economy. On the other hand, when the economy rebounds, you may be able to get an extra 10–20 cents per foot (per month) for the property, so it really does all even out.
The ultimate passive cash flow rewards kick into gear when you pay off your property and move into “cash flow city.” Your debt service is taken care of, and your biggest expenditures are property tax and operating expenses. It’s all gravy at that point because your mortgage has been eliminated and the excess cash is now flowing right into your own pocket.
Always Maintain a Cushion—
It Isn’t Always a Blue Sky
Even if you have a building that’s completely paid off and doing well, just one vacancy can wind up costing you money. This, in turn, can create a negative cash flow situation when there’s no one there to pay the rent that covers that portion of your everyday expenses, including property taxes, property insurance, association fees, landscaping costs, and the investment you’ll make in retaining a broker to help locate a new tenant. The bottom line is that you’d better have enough money in reserves to cover these expenses should your building become partially or completely vacant. Ideally, you want to be able to handle four to eight months of vacancy without feeling any pain.
Negative cash flow can be a setup. Let’s say you are looking for a building and are choosing among 10 different options in the area and that the current owners are all getting $1 per square foot for those properties. Now let’s say the tenant in our target building is paying only 60 cents per foot, but that lease is up in a year. The current seller may try to entice you by saying, “Buy this building now, we’ll cut you a deal, and then in a year you can raise the rent to $1 per foot.” (Please note that it is also very difficult to obtain a loan with only 12 months remaining on the tenant’s lease term; lenders see this as your buying a “vacant” building, which is inherently
riskier than buying one that’s leased.)
This is a dangerous game that you don’t want to get sucked into. Put simply, there are many factors that go into net operating income (NOI), and one of them is time on market. For example, your property may lease for $1 per foot, but that property may take nine months to lease out—you may be better off with the one that leases for 60 cents per foot. This is a common
occurrence in “shallow markets,” where it may take six to eight months to find a new tenant. Be very careful in these situations and know that—more often than not—this will not turn into a profitable cash flow situation. In fact, it’s better to steer completely clear of those situations, unless you’re an experienced, all-cash buyer who has successfully done this many times before.
Don’t Get Sucked into
“Price Per Square Foot”
The primary factors that determine whether a property is (or isn’t) in positive cash flow territory are operating expenses, interest rate, and whether you are still making mortgage payments. It’s important to have four to eight months’ worth of reserves to cover periodic vacancies and other issues that will come up along the way—including the costs of finding new tenants, recarpeting offices, fixing air conditioners, resurfacing parking lots, and paying leasing commissions. These costs are often referred to as “re-tenanting” costs. When you start shopping for your first commercial property, you’ll quickly learn that prices and opportunities will vary greatly according to property type, location, and condition. Because of this, it’s pretty easy to get lured in by lower prices per square foot in an industry where this shouldn’t be your main shopping criteria. You may be able to purchase a building located in one submarket for $130 per square foot—or a different submarket for $280 per square foot—but the latter may actually be the better choice. In most cases, the cheaper-rent areas get hit first (and hardest) by recessions and downturns. Vacancy rates soar, rents retreat, and that $130 per square foot suddenly doesn’t look like such a great deal. The property that was offered at $280 per square foot was most likely in a more desirable submarket with better features and amenities, and it may be worth $380 per square foot within 10 years because rent is escalating at 8% per year (vs. the property that’s priced at $130 per square foot and will be valued at only $160 per square foot in 10 years, with rent escalating at only 2% per year). This is critical because if the building greatly increases in value, and if you’re holding it for cash flow, you profit when the rents go up. In this situation, the motto “Buy high, sell higher” is the right choice for someone who wants to create ongoing passive income over time.
Minimal Cash Flow
Is Normal at the Outset
Commercial real estate that continues to appreciate and remains leased will create higher and higher returns over time. For this reason, it’s important to understand that lower cash flow is OK at the outset. That’s because controlled cash flow is the holy grail of financial independence—not quick or immediate returns. When you can get to the point of having controlled cash
flow, you’re basically on Park Avenue and taking advantage of the wonders of commercial real estate. In a world where we’re constantly reading about the insolvency of the Social Security system and other political issues that could impact our financial futures, commercial real estate is a fantastic way to Get Rich Slow without having to depend on Uncle Sam or your 401(k) program. By using the advice in this book and combining that with your own good sense and experience, you’ll be able to create an ongoing passive income stream that not only supports your current lifestyle but also sets you up for future success.
This article is an excerpt from Rob Johnston’s Book “Get Rich Slow: How You As a Business Owner or an Investor Can Create a Fortune Owning Commercial Real Estate” .
