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Greetings from the metropolis of Cedar Crest, NM!

As I write this post, the Weather Channel is predicting a  HUGE snow storm for the area.  The Weather Channel is such a tease!

Anyway….”Sign of the times”…?  Early last year…and for the past few years…hotels have been a hot asset.  Well…now….hotels are the “black sheep” of the already ugly commercial real estate family.  So bad that project are being abandoned right in the middle of construction.  Check out this article (click HERE) and brace yourself for a warm reality check.  Now…when everyone is running….should you be buying?

Today’s post is awesome and is loaded.  Unlike the Weather Channel (being a tease), This post is an education all by itself.  We have another question from Paul in Lubbock, TX and it is deep!  So deep, that the answers below are from “The Real Wealth Expert Panel”  regarding Commercial Real Estate Investing Strategies for the beginner investor………

Rob, how can I get engaged to learn more about successful strategies pertaining to commercial real estate portfolio building and more opportunities in commercial real estate investing?  I really believe that is where I want to build more wealth; versus residential real estate investing.  In the next 5 years (I’ll be 55), my goal is to create as much passive income as I possibly can.  What would be a realistic “annual passive income goal” for 2009; for 3 years; for 5 years?  Is it possible to build a $1M commercial real estate portfolio that yields an average of 10% ($100,000) / year cash flow in 5 years?  That’s an average of $20,000/ year.  I don’t know if that’s possible, but I sure would like to give it a try if it is.

Can you get me started down a RIGHT path?  I’ve heard of others doing it; just can’t quite figure it out on my own.

Thanks and I look forward to hearing from you ……. Paul

Steve Maxwell’s take:

I also prefer commercial RE over residential … although both have their benefits.  2 of the biggest reasons for my preference are:

1. Leverage – I’ve found that acquire a multi-unit property such as a 200-unit complex is no where near 200 times as much effort as acquiring 200 single family homes for rentals.  In fact my first “multi-unit” was a 6-unit condo complex that I did everything on (and it was in a rougher area of town).  Then my first larger multi-unit was a 206-unit in another state.  I spend well under 1/10^th of the time on the larger 206-unit … than the small 6-units (where I did everything).  Part of the reason for this is LEVERAGE … I can choose to self-manage 6 units … but even working full time I can’t handle a 206-unit property by myself .. thus in a good way I’m forced to use  professional management – which makes all the difference.

2. Cash Flow – While it is possible to generate cash flow with single family homes (i.e. my brother Rob negotiated buying 4 homes free and clear with seller financing where we FOCUSED on how COULD we set the deal up to CF … and we negotiated a 4% interest rate over 45 years … and thus cash flowed $200/mth for each of the houses) … still this took a lot of effort.  While it’s not a given it is EXPECTED that larger commercial properties should cash flow.  Part of this is the economies of scale … for example a larger property can “afford” to have professional management and still cash flow … but again you have to focus on this to make it happen.  How CAN you structure the deal to cash flow?

My experience with generating cash flow from commercial real estate is this happens mostly with the following …

1. When I sell the real estate for a profit.  This is “typical” way to generate “cash” … but this really isn’t “cash FLOW” … unless you’re continually selling properties.  IF you use this route the key

is to buy well and/or “force” the appreciation.  Don’t make the mistake of just “counting” on the property to appreciate.  It may do this over time especially if you include paying down the loan … but this is the slowest and riskiest approach.

2.  Getting a return on cash I invest in commercial real estate.  You ask below is it possible to generate $100,000 a year on a “million dollar” RE portfolio.  IF you’re talking about investing a million dollars it IS (with careful planning and either experience or advisors) to generate a 10% (or possibly better) return on this million dollars … PLUS you’ll possibly have lots of tax advantages especially if you or your spouse are a real estate professional.  The first 206-unit I mention above has consistently provided a 13.5% return on the money we invested (which is pretty darn good for a performing property).  Some of our deals have done even better … while some haven’t done as well.  Although it may be much more work, an ideal candidate might be a property that is a little positive CF initially BUT with opportunity to significantly improve the cash flow.  Note that GREAT property management is key!

3. Cash flow generated as a “founder” or “manager” of the deal where I raise outside funds with investors.  This may include an acquisition fee for pulling the deal together (although we didn’t include this on our first deals but now that we have more experience and are able to negotiate better terms this is more common).  There are lots of ways to structure deals with investor money but one typical way is to offer money investors class A ownership where they receive the principle back before anyone shares any profits on a sale, and then you split the profits with the founders/managers.  You could set this up for investors and founders to evenly share this 50/50 both for the on-going cash flow and back end profits … but it doesn’t need to be this way.  What are your goals AND what are your investors looking for?  If they’re using retirements funds via a self directed IRA they may not care as much about cash flow and want more of the backend profits.

Your last comment about “how to get started and its been tough on your own” … I can relate to.  My partners and I paid a fair bit to learn how to do this, and after our first deal we had an interesting conversation with our lender.  He shared that he was now a believer, but when we started he didn’t think we’d be able to pull it off because we didn’t fit the typical “mold” for many commercial real estate investors – typically older, lots of money & experience … i.e. been playing the game awhile.  The difference was we took the time to learn from others who had done it.

Emily Cressey’s take:

Dear Paul,

Thanks so much for your question.  First of all, let’s put one thing to rest – it’s not that you’re “not smart enough” to do commercial real estate investing successfully.  There are a lot of people who have made money investing in commercial real estate and built up big streams of residual income without being that smart.

Some of them had a lot of guts and made daring bets that paid off, some were in the right place at the right time, some had a lot of time, others, a lot of money.  And some had a good education.

Second, I want to put to rest the idea that investing in real estate is a ‘get rich quick’ scheme.  It’s not.

The trouble is that a lot of promoters out there are suggesting that it is, and it can lead to a lot of disappointments when you think you “should” be able to reach a goal that is very difficult (if not impossible) for ordinary people to reach consistently.

That being said, you can create a lot of wealth in real estate investing if you are able to invest for the long term, and/or add value to the properties you buy, and/or collect enough information about the marketplace (including identifying motivated sellers) so that you can scoop up good deals at below market price.

Although it is possible to invest in real estate with no cash, credit, etc. it is very difficult to do that ALONE.  If you don’t have money to put into your investments, you’ll have to find people that do.  We just got an inquiry from a potential client who is a real estate SYNDICATOR.  He pulls together folks with money but no time (doctors in his case) and invests his TIME in order to put together deals that are profitable for everyone.

Financially, here’s what you can expect:

We look at properties that yield a 15% rate of cash-on-cash return.  That means for every $100,000 of our own money (or investors’ funds) that we put into the deal, we expect to make

$15,000 each year.

If you put $1 Million dollars into a property, you could reasonably get a $150,000 cash flow.  Paul, if you have $1 Million to invest in real estate, you are ready to go.  Buy one big property or a number of smaller ones, hire professional management, and you are set.  You have met your passive income goal in 1 year.

However, a lot of us don’t have a million bucks when we’re starting out.  We may only have $100,000 or even less.

What are some other alternatives to help us reach our lifestyle goals?

One way we have chosen to get into bigger deals is by inviting private investors to buy a property with us.

Let’s say we can find a $5 Million property that requires 20% down payment and will be 80% financed by the bank.  It meets our other criteria for being a good deal, including having a strong cash flow.  We know that if we put $1,000,000 into the property and reach the 15% cash-on-cash return goal, we’ll make $150,000/year.

We structure the deal so it is very attractive to investors.  Personally, Grassland Investments has put together deals like this where we offer a 12% rate of return to investors (so they get 120,000/year.  Grasslands gets the cash flow above this level (assuming the property performs well) and so our income would be $30,000/year.

You can see, Paul, that with a few deals like this, you could also reach your income goals pretty quickly.

However, I would advise you against entering the commercial real estate investment arena with no experience and putting your investors’ money into a $5 Million deal.  Things can and do go wrong in real estate, and it’s nice to have some money to fall back on in case you need to bail your investors out and cover some unexpected expenses.

We started small – on a $600,000 property that we got 100% financed.

If you have $100,000 to invest, I would say start with a $500,000 property… you’ll need at least 20% down in today’s lending market, which is $100,000 down payment.

Instead of putting all your money into this one deal, see if you can find a couple of other partners to put in $75,000 and bring $25,000 of your own money to the deal.

Using the assumptions and rate of return figures I mentioned above, this deal should produce $3750/year from the income you invested, plus $2250/year after you’ve paid your investors.

You could buy four more deals just like this, but I would suggest only putting $75,000 of your own money into the deals, and keeping at least $25,000 liquid so you have some cash to cover emergencies.

Year 1: Find One Deal, Have $25,000 Invested –> 15% Rate of Return, Earn 3% rate of return on partners $75,000.  Total Income: $6,000

Year 2: Find a Second Deal.  Income $6,000 From Deal 1 and $6,000 from Deal 2 – $12,000 Total

Year 3: Find a Third Deal.  Total Income: $18,000.

Now you have invested your whole “nest egg” of $75,000 – with $25,000 kept in reserve.  In addition, you have collected $6000 + $12,000 + $18,000 in revenue which is an additional $36,000 in cash.

You also have an equity position in each of the properties you bought.  Depending on how you structured your deal, you might have a 50% equity stake or higher.  Let’s use 50% equity for the sake of simplicity.

Also, property values and appreciation rates vary WIDELY around the country.  I’m going to use very conservative figures because the market is flat/falling right now and when you invest in areas with big cash flow, they often don’t appreciate as well.

Let’s assume each property appreciates at 2% each year.

Deal one: Bought for $500,000, after 3 years is worth: $530,000.  If you have to sell with a 6% commission, then you’re just breaking even on this property.  So we will say you have no equity build up for the first 3 years in the property.

You should have tax savings and debt pay down as your other 2 profit centers.  But tax laws are going to be changing thanks to the new president, and there are a lot of interest-only loans out there, now so let’s just keep things simple and avoid complicating an otherwise long article with those two factors…

So, you’ve acquired 3 properties in 3 years.  Let’s say you take 2 years off.  What’s your position after 5 years look like?

1) Cash Flow: You have $18,000/year in passive income.

2) Cash: You have $97,000 in cash reserves

3) Equity: $61,000 (See Explanation Below)

Property one: Worth $551,000

Property two: Worth $530,000

Property three: Worth $541,000

You paid $500,000 for each, and we’re not counting debt pay down, so your total equity in the buildings is $122,000.  If you split half that with your partners, your position is $61,000 in equity.

So, now the numbers look a little better and we can start having some fun.

You can refinance or use a line of credit to get access to your equity.  Let’s say you use $50,000 to be conservative, and let’s say that wipes out $4,000 of your annual cash flow.  Also, you want to keep some money in cash reserves – $47,000 now since you’re working on bigger properties – so you have $50,000 cash to invest.

You buy properties with similar rates of return before.  It could be one big property or smaller properties, and you use investors like you did before.

Let’s say you put $100,000 to work in $2 Million worth of real estate properties.   Let’s say you know what you’re doing now, so you accomplish all this during Year 6.

Here’s what Year 6 looks like.

Cash Flow: $28,000/year ($18,000 – $4,000 for your first 3 properties = $14,000) + (15% cash on cash return for the $100,000 you invested in Property 4 = $15,000) (3% return on the $300,000 your private money partners invested in Property 4 = $9,000 )

Real Estate Owned:

Property 1: Worth $562,000 – $50,000 line of credit

Property 2: Worth $551,000

Property 3: Worth $530,000

Property 4: New Acquisition Worth $2,000,000

Fast forward to Year 10:

Property 1: Worth $608,000 – $50,000 line of credit

Property 2: Worth $596,000

Property 3: Worth $574,000

Property 4: Worth $2,250,000

Let’s say you sell all your properties (paying 6% in realtor fees) and pay your partners 50% of the equity.  You pay off debt equivalent to what you bought the property for.  You get $333,440 for your equity.

Plus you’ve gained $112,000 from the cash flow for the last four years.

Now… if you take this $445,440 and invest it at 15% cash-on-cash return you can get $66,800/year in cash flow.

Now, it’s not going to set you up like a Rockefeller, but it’s not a bad living in retirement. With only 10 years and $100,000 to start with, it stacks up pretty well.

This is a conservative plan, but hopefully that makes it more compelling – since you know it’s realistic and do-able.

According to Lisa Vander’s great book -The Real Guide to Making Millions Through Real Estate – You should be able to make about 20-30% rate of your return on your equity invested in real estate once you factor in all the profit centers:  Cash Flow, Appreciation, Debt Pay Down and Tax Savings.  (Remember, this model leaves out those last 2 entirely, and is very conservative with Appreciation.

Also, remember that the income your real estate produces will be inflation-adjusted, which a lot of retirement income streams are not.  This will be increasingly important as the government seeks to allay its deficit spending by reducing the value of the dollar through printing more money.

I hope this is a helpful scenario to walk you through what is not just *possible* (which is what you asked) but what is actually *realistic* when it comes to building wealth through real estate.

Feel free to change the assumptions and you will see that it is certainly possible to do much better than what I have described here, if you have more time, energy and effort to invest.

To Prosperity!  Emily

Commercial Real Estate News in the Blog-O-Sphere:

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Until Next time…..rob

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