Do you ever think something sounds like a great investment deal? Is it possible it’s really not? Aside from more complicated factors like market fundamentals or rent sustainability, is it ever possible the numbers themselves can trick you?
I’ve recently been exploring commercial investment deals. For anyone who knows me, you know I’m not usually into commercial. But I’ve been consulting with someone to find something in the $1.5M-$2M range, and the journey has been very eye-opening. We first met with a commercial agent to explore the options. We discussed restaurant buildings, retail buildings, multifamily residences (5+ units), and we even threw out high-dollar residential buildings.
It was very quickly obvious that a $2M residential property in Venice Beach would not cash flow. There was no question there, as the cap rate wouldn’t even pretend to be positive. So we started ruling out the entire notion of the residential property idea.
The most exciting option seemed to be a NNN commercial building. This would be buying a building that a commercial tenant would rent out. For example, a McDonald’s. McDonald’s themselves don’t own the buildings they are in, as most businesses don’t, and that building by itself would be something we could buy. Then the NNN (called “triple net”) part is that unlike owning a residential rental property where you (the owner) has to pay for the repairs on the building, the tenant pays for everything. So you buy the building and never have to pay expenses for the building—McDonald’s would pay it all.
There are different versions of NNN options—some mean the owner pays absolutely nothing, some mean the owner has to pay for the roof and structure but nothing else, and whatever other variant there might be.
The other factor we were encouraged to consider was buying a NNN in another state outside of California. The reason for is that the land in California is more expensive than other places, so there would be a higher return if we were paying a lower price for the property initially. Make sense?
The KFC Deal
So we began exploring NNN options. We looked at a KFC (Kentucky Fried Chicken), a Starbucks (yum!), a Verizon Wireless store, and there was even a three-tenant building that had a Chase Bank, a T-Mobile store, and a Mexican restaurant called Filberto’s. I personally liked the latter the best, but it had just sold to another investor. All of these properties were outside of California.
I’m going to give you the best deal of them all to explore in more detail—the KFC.
This KFC is in Nebraska and priced at $1,477,000. It was the best of all of the options presented with because the cap rate was higher than the rest (6.5%), the lease term of the tenant (KFC) was the longest (a new 20-year lease), and the tenant was responsible for everything including the roof and structure. It is also sandwiched between some major high-dollar companies like a new Walmart and many others.
The other properties all had lower cap rates, maximum 10-year leases with the option to get out early, and the owner (us) would be responsible for the roof and structure.
No contest, the KFC was the front-runner.
Very simply, here are the numbers associated with this property. And remember, this is literally the most hands-off real property you can buy. The most you could do with this property if you own it would be to walk in and order a bucket of chicken. So that alone is pretty enticing—no work! Not even if you wanted to work on it!
Purchase Price: $1,477,000
Annual Rent Collected: $96,000
Cap Rate: [(96,000/1,477,000)*100] = 6.5%
Wow, what’s not to love about this investment! Sure, 6.5% isn’t an insanely high cap rate, but it’s very solid, totally decent, and you’re literally hands-off and stress-free with this property. Some markets like Atlanta and Houston offer 6.5% cap rates on their residential rental properties, but you still have mangy tenants and/or property managers to deal with and headaches with repairs and such. Additionally, there are many commercial deals out there at a standard 7.5% cap rate, but they all require more of your participation and offer more headaches. So 6.5% with no effort? How could you beat that?
Is it REALLY a Good Deal?
Sounds like a killer deal, right? Actually sit back and think about it and decide whether it’s a good deal or not.
Initially, we thought this may be the perfect investment for what my client was looking for. Granted, he was semi-morally opposed to KFC just because he loathes fast food, but who cares who the tenant in a property like this is if they are solid and going to be paying? It’s not like he’d have to go in there and eat the chicken.
OK, so you’ve thought about this deal. Are you on board with it? Do you think it’s solid? Is there anything we’re missing that would be important to consider?
Obviously, there is probably something missing since I’m asking. What is it?
What if you are financing rather than paying cash?
Plenty of people do have $1.5M to drop on an investment, but a lot don’t. The particular client I’m working with doesn’t and plans to finance an investment property.
Does this matter?
It’s very tempting when you see a deal that is presented to you and everything looks good about it to just go with that and not do further investigation. The agent says it’s a killer deal, it looks and feels like a killer deal, and why wouldn’t it be? It all seems legit.
There is one piece of information that is not included in the marketing packet for this KFC building—the financing.
A Note About Cap Rates and Cash-on-Cash Returns
Before we go any further, you absolutely need to be up on the difference between cap rates and cash-on-cash (CoC) returns. If you are even remotely questioning your knowledge of these two terms, pause with this article for a second and go read “Cap Rate and Cash-on-Cash Return: A Definitive Guide.”
Be sure you are up on the details of what goes into each, but here’s a very short blip about the two. Cap rate only measures the purchase price of a property as compared to how much income it brings in. The CoC is the actual return that you are getting on the money you put into that investment.
If you pay all cash for an investment property, then the CoC will be the same as the Cap Rate. If you are financing, however, it will be different. If you are financing, the more accurate number you need to know when evaluating a potential investment property is the CoC because that tells you exactly how much bang you are getting for your buck.
When you calculate the CoC, the number will be different because instead of comparing the net income with no financing cost included with the purchase price, you will be comparing the net income with the financing cost included to how much money you actually put into the deal. So you end up with an actual percentage return on exactly how much return you are getting on the amount of money you put into the deal.
Cap rates are only helpful for buying and selling purposes—and only if you pay cash for the property. The reason it works to use it if you pay cash is because the numbers will be exactly the same for the CoC equation as they were for the cap rate equation (i.e. no financing differences).
If you are lost as to what I’m saying, go back and read the article. Or if it’s starting to make sense but you aren’t quite there yet, go to the article and refresh.
What Financing Does to the Deal
So now! Back to KFC.
We already said the cap rate on this property is 6.5%. Honestly, that’s not too bad for a NNN property! It’s pretty good actually.
But what happens if we finance it?
Here are my assumptions:
Purchase Price: $1,477,000
Down Payment (35%): $516,950
Loan Amount: $960,050
Annual Mortgage Payment (4.5%, 30-yr): $58,373.19
Net Income After Financing: [96,000-58,373.19] = $37,626.81
So now we know to expect $37,626.81 annually from the property after financing. Is that a good return on your half a million down? Let’s calculate it and find out. We already know the cap rate, so now we want the CoC with our new numbers.
CoC: [(37,626.81/516,950)*100] = 7.3%
Well, I may be tempted to call this one a winner! A 7.3% Coc is higher than the 6.5% cap rate, so that’s encouraging, and a 7.3% return on my money seems decent. It may not be as high as some investment options, but for something I literally don’t have to stress over, it seems pretty good.
Were you thinking the CoC would turn out to be bad because of how I led you into it? I did that on purpose. I did it so that you would realize it is possible for a CoC to be lower than a cap rate! It all depends on the financing terms.
My client hasn’t purchased a property yet to know for sure, but the rumor is the interest rate to expect will be about 4.5%. That seems low to me, but I trust my agent for now. But what if the interest rate was actually 8% (like I assumed it would be)? What does that do to the CoC return? Without spelling out the details of the numbers, but using a loan calculator to determine the loan payment, I come up with a 2.2% CoC. Eek! Just a change in interest rates makes a huge difference! A 2.2% CoC is horrible.
Now, here’s something else to consider and a good lesson in life—never trust anyone else’s numbers for any investment opportunity!