The Risks, Rewards of Being a Landlord
Looking back over the past four years, Faiez Ennabe figures he might have made more money if he’d sold the small shops he owns and dumped the proceeds into the stock market.
But Ennabe says he’d still stick with real estate, even though it means hard work and a lot more hours than it takes to read a stock table, because owning retail properties gives him more direct control over his investments.
The landlord of about 25,000 square feet of small shops in the Mid-Wilshire district is among the legion of individual investors who own and operate retail properties too small to interest the big real estate investment trusts (REITs) and other large investment pools.
Individual owners of retail property typically buy buildings of 6,000 to 10,000 square feet--large enough for just a few shops or one large tenant--and rely on mom-and-pop businesses to rent the spaces.
Making money as a landlord can be difficult because it depends upon the success of other businesses as well as what West Hollywood investor Monte Overstreet calls “a certain kind of stamina.”
But retail properties remain popular investments for individual owners because such properties represent entrepreneurial opportunities. A well-managed property can return 10% to 12% per year on the owner’s investment, and today’s rising prices mean owners can once again look forward to selling their buildings in the future at a profit, experts say.
“This is an excellent time for small investors who are looking for retail properties,” said Mike Zugsmith, a partner at Encino-based Capital Commercial Real Estate. “There is a significant inventory of small buildings available that are not attractive to REITs or major investors.”
Sales of retail properties represent a big part of the commercial real estate market in terms of number of transactions, according to John Kerin, managing director of Marcus & Millichap in Los Angeles, who said sales of retail properties by his brokerage firm rank second only to sales of apartment buildings in both Southern California and the country as a whole. About 52% of all deals are apartment buildings, Kerin said, compared with about 30% for retail properties.
There is no simple rule of thumb for how much retail space costs. Location, the condition of the property and whether it has tenants are among the factors that affect value, Kerin said.
“We have sold properties for as little as $30 per square foot and as much as $200 per square foot,” he said. Properties are sometimes available for as little as $100,000, he added, but, “Those are usually places where commerce has departed.”
Despite their likely cash flow and potential for appreciation in value, retail properties are not for the faint of heart. Owners and brokers point out that prospective investors need to be savvy about how to buy and operate such properties to avoid pitfalls.
Ennabe recommends first of all that only investors who are willing to personally manage retail buildings should consider buying them.
“If you’re going to be an active investor, you most likely will do well, but this still isn’t the ‘80s,” he said. “You’re not just going to buy something, sit on it and then sell it next year at a big profit.”
West Hollywood investor Overstreet, who has owned retail property since the early 1980s, said individual investors require “a certain kind of stamina” because most small properties don’t justify the expense of a professional management company like those hired by big real estate investors. Although Overstreet now owns a few properties valued “in the millions,” he still considers himself a mom-and-pop operator. His properties include the building that houses the nightclub Rage, plus other West Hollywood locations.
Overstreet said stamina is called for because tenants won’t hesitate to call about any problem and they typically want immediate results.
Problems are one reason that experienced owners and brokers say buying a building is just the first step for an investor. From there, it’s a constant challenge to find and keep good tenants.
Chris Bonbright, president and CEO of Los Angeles-based commercial brokerage Ramsey-Shilling Co., said owners must make sure they sign tenants who can afford to pay the rent, because losing one tenant, or keeping one nonpaying tenant, can mean the difference between positive and negative cash flow.
“Ultimately, tenants can only afford to pay a rental rate that is a certain percentage of their gross sales,” Bonbright said. He explained that this percentage varies widely, based upon generally accepted industry standards. Grocery stores can typically afford to pay only 1% to 3% of their gross sales in rent, while restaurants generally can’t afford more than 10%.
With the Southern California economy continuing to improve, the experts believe retail property owners should be able to find tenants who can pay the rent. Said Bonbright, “If you’re in an environment where the economy in general is rising, then generally you see increased retail spending, which means greater value for retail real estate. I think that’s the trend we’re in right now. I think now is an excellent time to buy retail, provided it’s well located.”
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Wannabes, Beware
Owning retail properties can be lucrative for small investors, but the business has pitfalls. Here are some tips for choosing a building:
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1) Decide whether you are willing to be a hands-on manager. Small properties are not for the passive investor who wants to sit and wait for a return.
2) Make sure you have enough money in reserve to keep paying the mortgage if you lose some tenants or face such unexpected expenses as plumbing problems or emergency roof repair.
3) Look for a property within convenient driving distance of your home. You’re going to need to keep an eye on the place.
4) Don’t rely on pictures or recommendations. Walk through the building yourself and inspect it carefully.
5) Look at as many properties as you can to get a sense of the market.
6) Review existing leases to discover how much rent tenants are paying, lease terms, expiration dates and what portion of common area maintenance charges the tenants are expected to pay. “You’re buying an income stream when you buy a retail property, so you want to make sure the income stream will be there when the deal closes,” said John Kerin, managing director of Marcus & Millichap in Los Angeles.
7) Be conservative in your estimate of rents and other financial factors. “If current market rents are $1 a square foot, you’re better off projecting your estimates at 90 or 95 cents per square foot, just to allow a cushion,” said Mike Zugsmith, a partner at Encino-based Capital Commercial Real Estate.
8) Shop hard for the lowest-rate loan you can get. This can make a big difference in whether your property generates cash flow.
9) Buy the property on the basis of current market conditions, not what you hope will happen.
10) Once you are an owner, make sure prospective tenants can afford the rent before you lease space to them. You will have to pay the rent if they can’t.
Los Angeles Times
