Last Updated on February 17, 2022 by Mark Ferguson
I bought a commercial property in 2018 for $2,100,000. It was a 68k square foot strip mall that had a grocery store, restaurant, office, and coffee shop as tenants. I bought this property in Northern Colorado and it was the most expensive and biggest property I had ever purchased by far! I thought this was a good deal when I bought it and that is why I bought it! However, it turned out to be an even better deal than I could have dreamed of! I ended up refinancing the property and the appraisal came in almost 2 million dollars more than we paid for the property. Technically, I may not have made quite 2 million dollars based on the appraisal but I think the appraisal came in low and I created more equity than that! How was I able to make so much money on one rental?
Why did I buy a commercial strip mall?
I bought 16 single-family rental properties from 2010 to 2016 in Northern Colorado. I stopped buying rentals in 2016 because prices rose so much that I could no longer cash flow on those properties. I was going to invest in another state but I found my new niche locally with commercial real estate. I could get great deals that cash flowed and many commercial properties had tremendous value add potential.
Even before I started to buy commercial properties in Colorado I had the dream of buying a big commercial warehouse and splitting it up into commercial condo units. I had a 250,000 square foot building under contract for a short period of time but it turned out to be too much work as it had been abandoned for many years. The bids to repair that building were over $6 million dollars! Technically I think that deal could have made millions of dollars as well but it was extremely risky and could take years to make a dime.
When this property came up for sale I knew it was something I was immediately interested in. It had a great price to square foot ratio. I knew that building this property would take at least $10 million if not much more. The property also made money even after getting a loan on it. It was selling at about a 9 CAP rate which is very good for this area in Colorado. I made an offer right away and looking back now, I wish I could have bought ten more like this!
How are commercial properties valued?
To know how we added $2 million in value to this property we first need to know how to value commercial real estate. Commercial real estate is most often valued using CAP rates. A CAP rate is the Net operating income divided by the value or purchase price. For example:
If the value of the property is $700,000 and the net operating income is $49,000, the CAP rate is 7%. $49,000/$700,000 = 7%.
The CAP rate is what determines the value and it varies greatly from area to area and property to property. In my area, a 6 or 7 CAP rate is typical when valuing these types of properties but in other areas that CAP rate could be higher or lower. This property was bought for $2,100,000 at a 9% CAP rate which means it was making $189,000 a year or just over $15,000 a month.
If the property was valued at a 7% CAP rate it could have cost $2,700,000. As you can see the CAP rate makes a huge difference in the value of a property! If a property does not have any income coming in it is often valued base don potential rents or the value to an owner-occupied buyer which is often much less than if it was rented for full market value.
In my area, most properties similar to this are selling for a 7 CAP rate or lower, which means we walked into the deal with a lot of equity!
How much did we pay?
The asking price was $2,250,000 and I offered $2,000,000. They countered back at $2,100,000 and I accepted the offer! I could not buy this property on my own, or at least I did not think I could so I asked one person to partner with me and they agreed! We ended up getting a loan with a local bank that provided 75% of the $2,100,000 and we came up with the rest for the down payment and other costs.
Some of the other costs include:
- Appraisal: $5,000
- Inspection: $3,500
- Closing costs: $15,000
Each of us had to bring in about $275,000. I am a real estate agent and usually represent myself on all my deals, but for this one, I used a commercial agent because I did not want to screw anything up. That agent also helped get me the deal so it was well worth it to use them and have them get the commission for the buyer’s agent than myself.
How we almost lost the deal
We had an inspection done on the property. The inspector found that some of the heating units were older and the roof was not in great shape on part of the building. The estimates to repair these items were more than $100,000 but they would not need to be done for at least a few years, we hoped. My agent convinced me that we should ask the seller for a reduction in price for those items. We asked for the full amount and that was a huge mistake.
I rarely do an inspection on homes or smaller buildings I buy, because it often gets me better deals. When I do an inspection, I almost never ask for work to be done or a price reduction unless there are major problems I did not know about. When I do ask for a price reduction I am very reasonable and do not try to take the seller to the cleaners for everything they have. I made a bad choice trying to do that on this deal and even though the agent suggested it, I should have known better.
After making the inspection request we heard nothing for weeks. We were holding off on paying for the appraisal until we got this figured out since we did not want to pay another $5,000 if the deal was not going to work out. Finally, we hear back the seller wanted out of the deal and wouldn’t do any of the work. We needed to extend the contract a few weeks to get the appraisal done and he did not want to do that either. I was freaking out because I knew this was a good deal and I knew we asked for too much.
I did something I should not have done, but I did it anyway. I contacted the seller directly, I apologized, I told him I made a mistake, and that we would move forward without any credit or repairs, but we needed to extend for the appraisal. He agreed!
The appraisal was completed and came in at $2,400,000! The appraiser said he had to work to get it that low, which showed us how good of a deal it was. Most appraiser wants to come in right at the contract price because coming in too high brings up suspicions of loan fraud which was frequent in the housing crisis ten years ago.
How was this property ripe for value add potential?
Not only was this property for sale base don a 9% CAP rate which already made it a great deal but there was potential to add value. The best way to add value to a commercial property is to add income. There were two vacant units in this property that totaled almost 10,000 square feet.
The value of the property was based on a 9% CAP rate for the current income the property was generating. It did not take into consideration that we could add value by renting the two vacant units. The tricky part is that it is not always easy to rent commercial units. These two units had been for lease for quite a while and had not been rented.
If I could rent those two units, there was the potential to add a lot more value! One of the great things about commercial real estate is how much value you can add!
- If you add $50,000 a year in income and value the property at a 7 CAP rate, you add $714,000 in value!
- If you add $50,000 a year in income and value the property at a 9 CAP rate, you add $555,000 in value!
To make $50,000 a year you need to add just over $4,000 a month in income, which would be very doable with 10,000 vacant square feet in my area.
How did we add tenants to the building?
One of the toughest parts of investing in commercial real estate is adding tenants to vacant space. I have 17 commercial properties and a couple of times the tenants found me and it was incredibly easy, but other times it took years to find a tenant! The 10,000 vacant square feet in this building had been split into 2 units and they were both about 5,000 square feet each. One unit had recently been a thrift shop and the other had been vacant for at least 7 years. They were not asking a crazy amount for rent in the units, but they were a mess and needed to be cleaned up to get rented.
Renting commercial property is also tricky because many tenants want their space to be custom to them. The landlords are often hesitant to remodel a unit because the new tenant might want something that is completely different from what the landlord thinks a tenant will want. However, I think a space in very poor condition will chase away many tenants because they cannot visualize what the space will look like fixed up. I have tried to keep my vacant units decent, but not go too far remodeling them. The units in this building definitely needed some help just to be decent.
Blue Steel Real Estate
However, I had one tenant already in the bag. Part of my plan to buy this building was starting my own real estate brokerage. I wanted to start a brokerage for a while, but I also wanted to start it in my own building. I remodeled one of the units for my office and moved into the other vacant unit much faster than I had planned! I told my broker at the office I was currently in that I planned to start my own brokerage before I bought this building. He didn’t seem too surprised or to care too much.
When I bought the building in February I told him I planned to move in June to my new office and he seemed blown away that I was leaving. I do not know if he didn’t think I was serious or what. From that point forward he was not very happy with me and a couple of weeks later he came up with a pretty lame reason for why I had to leave in a week! I moved into the old thrift shop while we remodeled the other unit for my permanent office.
We remodeled the space, and I had a new tenant! Blue Steel Real Estate moved in July of 2018 (we didn’t quite hit the June goal). You can see the remodel below:
We had some other inquiries for the other vacant space from an events center, a laundromat, and an office, but the best prospect was a dance studio. We also ended up remodeling that space for the dance studio and they moved in the middle of 2019. We had filled both spaces and added about $7,000 in rent per month to the building!
Not only did we add rent, but the tenants of the building pay NNN, which means they pay for the property taxes, insurance, maintenance, and even property management of the building. Plus the tenants would be paying for the utilities in those spaces. Not only did we add rents but we greatly reduced the expenses. With the new leases and reduced expenses we were making $25,000 a month!
The 2 Million dollar gain, a new appraisal, and a refinance
With the added income, reduced expenses, and other leases increasing in rent, we decided to refinance the property to take some of the equity out to invest in other projects. It was the BRRRR style on a grand scale. If the property made $25,000 a month or $300,000 a year, it should be worth $4,200,000 based on a 7 CAP Rate. We got the appraisal back after some issues at $3,5 million and he was valuing it based on a 5.6 CAP rate. What happened? He counted many of our expenses against us that should not have been like the mortgage payment! It was a mess but we finally got the appraisal increased to $3,950,00 which I thought was too low, but better than $3,500,000. You can see how we got that increased and the issues with that appraisal below:
Before doing the refinance, we had talked to the bank that first financed this property in 2018 and they said they would do the refinance as well. We wanted to do a cash-out refinance that would give us a new loan at 75% of the appraised value and the bank said that was fine. This bank had bothered me some already because they did not help me fight the low appraised value. They kept telling me it was fine and they saw no issues with it.
After getting the new appraisal the bank said they would no longer do a 75% loan to value which would be about $3 million, they would only do the cost of the property to us or what we bought it for plus any repairs we made. We spent maybe $150,000 on the repairs, but actually much less than that since I paid for much of my office remodel myself as Blue Steel Real Estate and not the landlord of the building!
I had to go shopping for a new bank, which took a month or two and we found one who would do the 75% cash out. However, they wanted an environmental report which we never did and the other lender never required. We went through that process as well which took three more months because they found groundwater that was slightly contaminated. It turned out to be okay after $20,000 in inspections!
Almost a year after starting the refinance process we completed the loan and my partner and I split the $1.5 million in cash proceeds after paying off the first loan.
This was an awesome property that still makes almost $10,000 a month after the refinance and we have rents increasing every year. The main tenant is a grocery store and in 2022 their rent will be increasing $5,000 a month adding even more value! We may not have made $2 million based on the appraisal but if the appraisal had been done correctly I think we made more than that by adding value through new tenants and getting an awesome deal. My book: Build a Commercial Real Estate Empire goes over this deal in more detail as well as my other commercial properties and talks about all that goes into investing in commercial deals.