Is it Worth Investing in Pre-leased Commercial Properties?
For many prospective investors in commercial properties, the idea seems daunting for several reasons. Typically, the main deterrent to purchasing a piece of commercial space is related to return on investment. Nevertheless, it’s difficult enough to locate a suitable property, finance it and commence operation. In most cases, new owners immediately go about trying to locate tenants who can pass credit checks and who intend to lease for the longest time possible. The dilemma is the age-old challenge for anyone who owns office space.
This is why it is more profitable when an investor purchases pre-leased office spaces because there is no need to go about finding tenants because they are already in place, paying rent and generating income for the property owner. Buying a pre-leased commercial office means saying goodbye to the obligation to find tenants as soon as a deal is inked.
Note: People who are new to the concept of buying or renting office space should pay careful attention to terminology. There happens to be a financial term, “pre-leasing” that has a completely separate meaning. It refers to renters who commit to renting office space in a building that has not yet been constructed. Building owners often give preferential rates and treatment to anyone who commits to rent space in the soon-to-be-constructed building. That is not what we speak about when discussing the topic of investing in pre-leased commercial properties.
How Investing in Pre-leased Property Works
When an owner of commercial space already has tenants but still decides, for whatever reason, to sell a commercial office building, the new buyer gets a huge bonus. Instead of having to wait weeks or months for return on investment (ROI), there is income from day one. The in-place tenants, who are already renting office space in the structure and making regular payments on their leases, provide instant ROI for the new owner.
The Advantages of Pre-leased Office Space for Investors
There are dozens of advantages when it comes to buying a commercial structure that already has tenants. The following eight points are the most important and relevant for prospective investors:
Immediate ROI: The most obvious advantage for new owners is an immediate return on investment. As noted above, there is no “waiting period” or search for new tenants of the property. Buying a commercial location with current tenants is, by far, the most attractive aspect of this form of investing.
The safety of lock-in periods: For many commercial leases, there is a 3-year lock-in period on a 9-year lease cycle. That means the income stream for the new building owner is not only assured but predictable in terms of the amount. It’s important to read the fine print in each tenant’s lease in order to learn the specific lock-in period for each unit in the building.
More lenient financing: For investors who can demonstrate that the building they intend to purchase has in-place tenants, financing terms are much more lenient. Lenders have reason to offer not only larger loan amounts but lower interest rates and more generous payback periods on such loans. Of course, the exact terms of the loan will depend on the number of in-place tenants and the amount of rental income they are already generating.
Predictable monthly income: In addition to ROI from day one, owners can perform their own budgeting much more easily by knowing exactly what their monthly rental income is. In-place tenants offer not just income but the predictability of cash flow for a new owner/investor. It’s actually a matter of simple mathematics for investors. Before buying the property, sum the monthly rent amounts that come from each tenant. That is the baseline return on investment for the initial month, in most cases.
Minimal financial risk: Because the commercial rental market is somewhat shielded from common market forces, there is a high degree of safety in owning and operating a commercial building. Tenants in this type of space tend to stay for long periods, unlike residential renters, many of whom move as soon as their one-year lease is up. It’s quite common for commercial tenants to remain in one location for decades. This aspect of commercial rental protects building owners from the typical ups and downs of the marketplace.
Tax advantages: Depending on the location of a commercial structure, there can be significant tax write-offs in terms of deductions for maintenance and repairs. Of course, the tax situation is more complex than that, but overall, it provides multiple benefits to property owners.
Probable increases in rental income: The fact of the matter is that rental rates typically rise from period to period, especially over the long term. Renters who are in place for many years will usually pay increasingly higher rents, which is a key benefit for building owners. There is no guarantee of the exact amount of rent escalation in any given instance, but in the short-term, owners can look to rental agreements and see what terms are spelled out in the fine print
Some Tips for New Owners of Pre-leased Properties
Anyone who signs an agreement to purchase a commercial office should be aware of several best-practices guidelines. For tenants of all types of commercial space, there are advantages of renting office spaces that sometimes are in direct conflict with the building’s owner. For example, renters can decide to move somewhere else whenever their lease is up, leaving the building owner with a vacancy that generates zero revenue.
It’s up to the owner/investor to know the pitfalls of managing tenants as how to avoid many common problems that comes with being the owner of a commercial office building. The following suggestions will usually be helpful to an investor who purchases a building that comes with in-place tenants:
- Before buying, know the details of each current tenant. Ask questions of the building owner to find out how long each tenant has been in the property, how much money each one put up in the form of a security deposit, and what each tenant’s general credit rating is.
- Keep a detailed list of tenants and their respective lock-in periods in order to know when each renter’s lease is coming up for renewal. Be ready to negotiate with soon-to-renew tenants if the current market has experienced lower general levels of rent charges.
- Prepare a contingent marketing plan for finding new tenants if the need should arise. Keep in mind that a current tenant can leave for several reasons, including but not limited to: their lease coming up for renewal, their default on the payment of rent, their legal eviction for breaking key parts of the lease agreement, and more. It’s important to be prepared to locate new tenants as quickly as possible.
- Research rental rates in the local area and keep an eye on trends. This is the best way to decide whether to raise rent charges when a tenant’s lease comes up. Don’t automatically assume that you’ll be able to raise the rent amount. Likewise, even if local rates are rising, you’ll need to know the amount of any prospective rent increase. There’s no point in over-charging. That’s a fast way to lose tenants to nearby, competing owners.
- Study the demographics of the current renters to find out which units have the lowest and highest turnover. When delving into this data, it’s also wise to write a summary for each unit that includes information about its historic turnover rate, the history of its rent charges, whether it has ever been vacant for more than one month, what its typical tenant demographic profiles are, and more. Armed with detailed data for each unit, you’ll be well prepared in the event of a future vacancy.
There are obvious advantages for investors who plan to purchase property that already has tenants who are actively paying rent and abiding by their lease agreements. However, as is the case with any type of investment, it pays to do some research before making a financial commitment.
By understanding exactly how this kind of investment works, knowing the usual pitfalls, fully comprehending the many benefits of buying a pre-leased structure and learning best-practices of building management, you’ll be well-equipped to reap the significant financial rewards that accompany investment in pre-leased properties.