Building value Featured

8:00pm EDT July 29, 2006
Income-producing real estate is a stable investment, especially in the Midwest, where low capitalization rates hike up the perceived value of commercial properties.

“Capitalization rates in the Midwest are significantly below those in other regions, so it’s a good opportunity if you want to invest in real estate,” says Craig Johnson, president and CEO of Franklin Bank, Southfield, Mich.

Investors from the East and West Coasts are buying up buildings in places like Michigan, as are business owners from sun states like Florida, where cap rates are much higher. What’s more, property purchased at low cap rates are more likely return more than a comparable investment in common stocks over a 10-year holding period.

Smart Business talked to Johnson about breaking into the commercial real estate market.

What do low capitalization rates mean for investors, and how are they figured?
Capitalization rates, or cap rates, are the standard for measuring the value of income-producing real estate. To figure the value of a commercial property, divide the net operating income by the cap rate. For example, if the net operating income is $10,000 and the cap rate is 9 percent, the value is $111,111. The lower the cap rate, the greater the value. That’s why the lower average cap rates in the Midwest are drawing interest from investors in other areas of the country.

What sort of risk is associated with commercial real estate investments?
With any commercial investment, you have tenant risk. As tenants come and go, you risk having to co-tenant the building. Also, you must manage the ongoing maintenance and repairs of the building -- general upkeep. Evaluate those considerations against your risk tolerance and knowledge of the real estate market.

Someone with less of a risk tolerance is more likely to buy a retail credit tenant facility such as Walgreens. Credit tenants are Fortune 500 companies or strong regional businesses. On the other hand, someone who knows more about real estate and is willing to take a greater measure of risk might buy an office or industrial building, or a retail strip center with several tenants, none of them credit. Obviously, property that carries a larger degree of risk also carries a larger opportunity.

What about single-tenant properties?
If you are going to buy a single-tenant building, you need to make sure the term of the lease and the current tenant are agreeable. If the tenant has three years left in the lease, are you comfortable with that? Keep in mind, because there is a risk factor when a lease will mature in a short period of time, the cap rate at the time of purchase ought to reflect that risk.

Is tenant turnover necessarily a bad thing?
It depends. If turnover allows you to re-tenant the property at a higher rate, the answer is no, turnover is not bad. In that case, it can present an opportunity to increase your net operating income and the value of your property. However, if there is tenant turnover and you can’t fill the space with a new lessee, you risk losing money on your investment until another tenant signs the lease.

What advice can you offer to those without previous real estate investment experience?
If you do not have knowledge of real estate and this is your first investment, you need to partner with a good broker or management company -- someone who can assist you during the process. And start small; don’t jump at the first opportunity. Make sure you investigate the market with the assistance of your banker and professional broker, and look at a number of opportunities before making a decision.

First-time investors may consider buying within their region before seeking out opportunities in other areas. As you become a more seasoned investor, location won’t matter as much, especially if you are buying a credit tenant, where you really are investing in the credit of the tenant in the building, not necessarily the building.

Regardless of where you choose to invest, you’ll want to bring on board a management company to handle day-to-day grounds issues with the building. You want to invest in the building, not devote valuable time to maintenance and tenant issues that a building management company could address more efficiently.

Whether your impetus for investing in real estate is to produce cash flow or to secure a retirement fund, the Midwest market is a promising region to get your feet wet. With advice from a professional broker and assistance from a management firm, you will ensure that your investment is stable and your property cared for.

CRAIG JOHNSON is president and CEO of Franklin Bank, Southfield, Mich. Reach him at (248) 386-9860 or clj@franklinbank.com.