Potential Downside to Chasing Real Estate Investment Yields
Back in the 2007 time-frame, real estate values started to peak. Many ran to the Central Valley expecting the demand for real estate to continue to push prices up. And, we all know what happened after that. I bring this up again as some investors are continuing to chase investment yields in markets that do not have the fundamentals to support pricing when a downturn occurs again.
There is a reason why investors like investing in the SF Bay Area. We may not get great cash flow or cash on cash returns (but our appreciation has been quite good). However, due to our uniqueness, our downside has been minimized historically. The Central Valley has not had the necessary infrastructure and continual demand that the Bay Area has. Therefore, when investing in commercial real estate, one would expect and demand that the cash on cash returns be higher for the perceived higher risk.
Each property type in commercial has its own opportunities and challenges. As an example, let’s look at buying a NNN dollar-type store somewhere in the mid-west. Typically, these have better returns than investing in a chain restaurant in a growing metropolitan area. The novice investor will be lured by the higher returns. In contrast, the experienced investor will analyze the risk with their Broker; and then they will figure out what will happen if they lose their tenant.
For those familiar with the dollar-type stores, often they are a very basic building that may not have much demand if the tenant does not renew their lease. This implies a lot of future risk. Keeping it simple, it would be much easier to get a new tenant in a busy city than out in a rural area.
My suggestion is to be careful when chasing the higher returns (or the higher cap rates). Always look at what you or your client will have to do if you lose your tenant. This is part of the risk analysis. If you can confidently see that you can easily get a new tenant, then I would keep that property on your potential list of acquisitions. High initial returns are great. However, it is quite difficult to sell a vacant building and get back the value you paid initially. That is the reality of CRE investing. Be smart, think ahead, and work with those Brokers that will have this discussion to protect your best interests.
Articles of Interest:
Reuters reported “A Fed pivot, born of volatility, missteps, and new economic reality.”
Bisnow shared “Bay Area’s Strong Industrial Market Mirrors Strength Of Sector Across U.S.”
Curbed reported “Silicon Valley has the highest housing costs in the U.S.”
The SJ Mercury News shared “Real deal: Silicon Valley housing market healthy, according to Aculist market trends.”
See the table below for approximate interest rates.
|Apartments||4.175% – 4.760%||3 to 10 year (30 yr amortization)|
|Commercial||4.475% – 5.060%||3 to 10 year (25 yr amortization)|
|SBA Lending||Call for Options||Call for Options|