Recognizing Hidden Value When Buying Commercial Real Estate

One thing I always try and stress to new investors who are considering buying commercial real estate, is to look for the "hidden" value in a property.

One way to increase the value of a commercial property is to improve the tenant mix as well as the quality of the tenants. I will illustrate with a story.

A few years ago I came across a mixed-use commercial property that was for sale by owner. It was located in a particular city that I had been considering buying commercial real estate in, so immediately I was interested. At first blush the numbers looked great. The price was low and the cash flow high, just what I like in a piece of commercial real estate.

An example of buying commercial real estate with hidden value.

The building had commercial space on the main floor with residential apartments above. The owners were not inexperienced real estate investors, but they were out of town owners and had put the management of the building in the wrong hands. Things were spinning out of control for them and instead of rectifying the problems they just wanted to sell the property.

What I saw was a challenge. If I could "upgrade" the quality of the residential tenants and improve the commercial tenant mix I felt I could drastically improve the value of this investment property. And I was right.

Here is an example of what I was looking at. Right next to the main entrance of the residential apartment section of the building was a tattoo parlor. And we're not talking about the kind that would attract an upper class clientèle. Right next to the tattoo parlor was a day care. Nice mix.

The residential tenants weren't much better. The owners had gone through three or four on-site managers in as many years. The building, which at one point had a good reputation in town, now had a bad reputation.

Without going into too much detail I was able to "clean up" and turn around the reputation of the building within about a year. I took an aggressive approach. I immediately got rid of the tattoo parlor (tough decision) and rented the space to the day care so they could expand. The problem residential tenants were strongly encouraged to move along, and eventually the building became an attractive, family oriented building. I saw the day care as a real drawing card for families and immediately had approached them about expanding into the extra commercial space and signing a longer-term lease. Although I could never prove an exact correlation, I am confident that having the day care (which also had a pre-school in it as well) right on the main floor was a major drawing card for tenants, and helped me keep my vacancies to a minimum over the years that I held the property.

In the thirteenth month of my ownership, I had the building reappraised (for refinancing purposes) at $770,000 more than I paid for it. And those weren't just puffed up numbers. I am confident that I could have sold that commercial property for the new appraised value.

Interested in learning more about investing in commercial real estate? Here is a resource written by a 31 year veteran of the industry (called the "Commercial Real Estate Cash Flow System") that is a great starting point.

I guess what you have to ask yourself now is, "When I'm buying commercial real estate, do I want to be the one buying it at the discount or buying it at full price?"

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