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Deal of the Week: Our New Mixed-Use Property

Summary: This is a continuation of our series of posts where we do a deep-dive on a property that comes across our desks to show you how we evaluate deals. For this week’s deal, we evaluate a property that we recently purchased as part of a 1031 exchange. This one is looking good so far, but we believe it has the potential to be great. Read on to see why.

 

Earlier this year, we sold a duplex in Seattle and bought two new properties (i.e., replacement properties) using a 1031 exchange. The 1031 exchange is a way for you to take the proceeds of the sale of a property and reinvest it tax deferred. We’ll cover 1031 exchanges in detail in a future post. The property we are featuring in this week’s deal of the week is one of the two replacement properties from our 1031 exchange.

 

Property Description

This property was brought to us by an agent as an off-market deal. It is a mixed-use property in an up and coming area of Spokane. The asking price was $600,000.

Mixed-use means that there are residential units as well as rentable commercial space.

The residential portion of this property is on the second floor and consists of four one bedroom, one bathroom units. Each bedroom is roughly 800 square feet, and they have nearly identical layouts. The residential units come with a basement area that contains a laundry room and storage units for each resident.

The commercial space is on the ground floor and is roughly 4,200 square feet. There is also a large unfinished basement area, which is roughly 1,500 square feet.

 

Initial Screen Using the 1% Rule

When he brought us the deal, our agent told us that the rents for the upstairs units totaled $1,855/month. However, this was with one unit vacant and one significantly under-rented at $485/month. The highest rent unit was at $695, so we figured all of them could immediately rent for this amount because the units were nearly identical. This would bring our total to $2,780 month for the residential space.

We didn’t really have a sense of the rents for the commercial space because we’ve never done commercial leasing, and we didn’t know the going rate for space in the area. However, the seller occupying the commercial space told us that they would lease the space for one year at $3,000. We checked with a commercial leasing agent, who told us that that this was a sub-market rent.

Using the 1% rule (click here to learn about the 1% rule), assuming the residential units would rent for a total of $2,780 and $3,000 for the commercial space, this property is slightly below the 1% rule at 0.96%. However, since we knew we should be able to get more for the commercial space in the future, we felt we were comfortably above the 1% rule from the beginning.

At this point we decided to put in a full price offer in order to “lock it up” and prevent anyone else from putting in an offer (click here to read more about why it’s so important to lock up properties). Remember, just because you lock up an investment property at one price doesn’t mean that you can’t figure out a way to negotiate the price lower or get additional concessions before completing the purchase. As it turns out, we heard from our agent that several people had approached the seller to purchase the property when they heard it was for sale. Lucky for us, the sellers had already accepted our offer, so their hands were tied.

Besides being close to the 1% rule, there were two other reasons we felt comfortable putting in a full price offer at this point (note we didn’t know any of the expenses yet). First, we recognized that there was some hidden value that could potentially be tapped for more income (click here to read more about how to find hidden value). Second, we knew that there was a possibility that we could get a triple net lease (NNN) from the next commercial renter (if not this one), significantly reducing our expenses down the road. We discuss both of these in more detail below:

 

Hidden value

In our initial screen, we identified five potential sources of hidden value:

  • Basement: Our agent told us that there were two large basement areas – one for the commercial space and one for the residential units. After talking to a commercial leasing agent, we learned that we could easily rent the commercial basement to a tenant, like a restaurant or brewery, in the future. We also thought it might be possible to squeeze additional residential units into residential side of the basement.
  • Storage units: The residential basement space has separate storage units for each of the residential units. This is a potential source of additional income if we were to decide to charge for storage.
  • Laundry area: Our agent told us that there was a laundry room in the basement. Currently, these machines are free for the residents, not coin-operated. We had heard that the residential units didn’t have washer/dryers. We knew that if we converted the laundry room into a coin-operated laundry room, it could potentially yield additional income.
  • Detached garages: From the aerial photo, we could see this property clearly had two detached garages. Looking at street view, we could tell that the garages weren’t in great condition, so we knew they probably would need a little work before we would be able to rent them out. Regardless, we recognized this as a source of hidden value that we could potentially tap in the future.
  • Federal Opportunity Zone: The property sits in one of 11 Opportunity Zones in Spokane. An Opportunity Zone is a federally-funded program aimed to “spur job creation and business development throughout the U.S.” This has attracted a lot of investors to the area, who are aggressively buying up properties. In addition, the city recently improved the street and sidewalk, adding greenery and improving the walkability of the area and completely changing the complexion of the neighborhood. As many investors will tell you, you want to be in the “path of progress,” and this property fit that description perfectly.

 

Triple Net (NNN) Lease

For those who aren’t familiar with a NNN lease, it is a lease where the commercial tenant pays not only for rent, but also for property taxes, insurance and operating costs. In this case, we knew that there was a high likelihood that we could get the tenant to cover at least half of the expenses, because the commercial space occupied at least half of the total building square footage (and more if you include the basement area).

 

Calculating the cash-on-cash return

For this week’s deal of the week, we are going to do things a little differently.

Normally, we calculate the cash-on-cash return before putting in the offer. However, in this case, since we already know what happened, we’d rather use real numbers than hypothetical ones.

With that, let’s fast forward to the present. We closed on this deal last month, and now that the dust has settled, let’s look at how the cash-on-cash return turned out in the end (you can download our cash-on-cash calculator by scrolling to the bottom of this post or by joining our Semi-Retired MD Facebook community).

Let’s go through each line item in order:

Purchase price: We initially got this under contract for $600,000. This was also the final purchase price. During the due diligence period, we were able to negotiate a $30,000 discount, but this came in the form of a credit for repairs (see below) not a price reduction at final sale.

Down Payment: The commercial lender we used required a minimum of 30% down on this deal.

Closing costs: Closing costs typically range from 2 to 5% of the purchase price. In this case, our closing costs were close to $9,000 or 1.5% of the final price.

Repairs/Renovation: Our inspections didn’t uncover any major issues. The building had undergone considerable renovations by the sellers, so it was in fairly good condition. The sellers were planning to update the electrical system but they weren’t going to be able to get it done before the closing date. This was estimated to cost around $30,000 so they gave us a $30,000 credit at closing for the electrical repairs. We estimated the cost for these repairs to be a little more, probably around $35,000, so we’ll put in $5,000 to complete the electrical repairs ($35,000-$30,000) in the cash-on-cash calculator.

Interest Rate/Years/Payments: We ended up getting a 10/25 loan at 5.3%. This means that the first 10 years are fixed at 5.3% after which time we will have a balloon payment for the remaining balance. Also, the loan is amortized over 25 years instead of the usual 30 years that we are accustomed to with residential loans.

Number of Units: There are four residential units and a commercial space. As a reminder, we need the number of units because there are leasing costs associated with each unit. This combined with leasing cost per unit (below) and average occupancy (below) will determine your total annual leasing cost. To keep things simple, we will leave the commercial space out for now because the leasing terms are completely different than the residential units (usually commercial leases are signed for 3-7 years, and the agent who negotiates the lease usually collects 4-6% of the value up front as a fee).

Property Taxes/Year: According to the Spokane County website, 2018 taxes are around $3,300. Part of this is paid for by the commercial tenant under the NNN lease. We were able to negotiate to have the commercial tenant pay half of the costs.

Insurance/Year: Our commercial insurance policy will cost us $2,500/year. As above, the commercial tenant will pay for half of this cost. Therefore, we will enter $1,250 for insurance into our calculations.

Monthly Gross Rental Income: We asked the seller to get the vacant unit rented prior to closing, and it immediately rented for $725, which was more than we had initially estimated. Assuming we can get all of the residential units up to $725, the total rents from the residential units should be $2,900. The commercial space is currently being leased at $3,000. Therefore, the total monthly gross rental income for the next year should be close to $5,900.

Vacancy Rate: We used an estimated a vacancy rate of 5%.

Property Management Fee: Our usual property management fee is 7% per month. This is a negotiated rate with our property manager. Typically property management fees in Spokane range from 8-10% per month.

Leasing Cost per Unit: Our property manager charges us a half month’s rent. Therefore, if rent per unit is $725, our leasing cost is $362.50.

Average Occupancy: We conservatively estimate one year when we are looking at a property. Keeping a tenant longer than a year will decrease your leasing cost and increase your cash-on-cash return.

Maintenance Costs: We typically use 5% as our assumption. In this case, even though our commercial tenant would cover half of the maintenance costs, we left it at 5% to be conservative.

Monthly Utilities: Monthly utilities for this property include water/sewer/garbage and electric. The total cost is around $600/month. But again, this would fall under the NNN lease, with our commercial tenants covering half of this cost.

After entering in all of the figures above, we get a 10.7% cash-on-cash return or $20,844 in cashflow per year on a total investment of $194,000.

 

Aftermath and Conclusion

Given the cash-on-cash return of 10.7%, we believe we made a solid purchase.

However, this deal may turn out to be much better than we originally thought.

After the purchase, our leasing agent told us that he already had several parties interested in renting the commercial space. Even better, they were interested in renting the basement as well.

This is where it gets fun.

Market rents for the main space run around $12/sq ft and $8/sq ft for the basement space. Therefore, we may be able to increase our rent for the commercial space from $3,000 to $5,200 next year. If we are able to get $5,200 for the commercial space and maintain our residential rent at $2,900, our cash-on-cash return goes up from 10.7% to 22.1%!

In addition, because the commercial tenant would occupy more square footage when they rented the basement, we would expect that commercial tenant to cover a higher proportion of expenses. We don’t know exactly what that will be, but any decrease in expenses increases our cash-on-cash return even further.

None of this includes any of the other value-add opportunities in the residential side of the basement or the garages, which we have yet to tap.

Overall we are really excited about this purchase. We look forward to updating you on what happens with this property in a future post!

 

Do you have a recent deal to share? Please tell us the details in the comments below! If you liked the article, please share it with your friends using the share buttons below.

 

Do you want to learn how to creatively fund your real estate portfolio and achieve financial freedom? Join the conversation! Follow our Semi-Retired MD  Facebook page and join our Doctors or Professionals  group!

Semi-Retired M.D. and its owners, presenters, and employees are not in the business of providing personal, financial, tax, legal or investment advice and specifically disclaims any liability, loss or risk, which is incurred as a consequence, either directly or indirectly, by the use of any of the information contained in this blog. Semi-Retired M.D., its website, this blog and any online tools, if any, do NOT provide ANY legal, accounting, securities, investment, tax or other professional services advice and are not intended to be a substitute for meeting with professional advisors. If legal advice or other expert assistance is required, the services of competent, licensed and certified professionals should be sought. In addition, Semi-Retired M.D. does not endorse ANY specific investments, investment strategies, advisors, or financial service firms.

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Hi, we’re Kenji and Leti

we provide coaching and mentorship for doctors and high-income earners

Several years ago, we were newlyweds working as full-time hospitalists. On paper, it looked like we had everything: the prestigious careers, the happy marriage, the luxurious rental home, the cars, etc.

But in reality? Despite having worked for several years, we had very little savings. Despite our high income, we had very little freedom in terms of time or money.

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