Is now the time to invest in commercial real estate?

2013 02 26 14 10 22 822 Tuan Leon 70

Can you own the building your practice is in for the same amount you're spending on rent? Current low interest rates and tax advantages make real estate a good investment for dentists right now, according to Leon Tuan, a San Francisco real estate attorney who specializes in these kinds of transactions.

Attorney Leon Tuan.Attorney Leon Tuan.
Attorney Leon Tuan.

Buying a medical office building for a dentist's own use can be very attractive because of good financing, such as U.S. Small Business Administration (SBA) loans that require as little as a 10% down payment, versus the 20% to 40% down payments that lenders usually require for buildings that the owners don't use themselves, said Tuan, a partner at law firm Stein & Lubin who specializes in commercial real estate.

"When you factor in depreciation and other things, quite often the amount you spend on rent can be the same as the mortgage if you bought your own building," he told

The current historically low interest rates ranging from 8% to 9% are another reason to consider investing in real estate. Tax benefits that shelter taxable income through depreciation deductions are another incentive, Tuan explained.

The main advantages of owning commercial real estate include the following:

  • Regular cash flow from the property: Tenants help build equity in the property by paying rent to cover mortgage and interest payments.
  • Tax benefits: Using depreciation deductions to reduce taxable income; these deductions can be spread over 35 years.
  • Most commercial real estate appreciates in value, enabling you to sell it at a profit.

In many regions, commercial real estate, like housing prices, is still less expensive than when prices peaked in 2006.

"Coming out of this great recession, prices are still low on an historical level in the $1 million to $5 million range of commercial properties," Tuan said. "But prices are heating up."

Location, location, location

Class A high-rise office buildings in San Francisco were commanding $700 to $800 per square foot a few years ago, but prices plunged to $350 to $400 per square foot in the depths of the recession, Tuan noted.

He advises clients to buy in locations that are attractive to tenants.

"Knowing the local market and what's going on in the community really helps," he said.

In addition to San Francisco, other gateway cities such as New York; Washington, DC; and Seattle always remain strong, Tuan noted. A number of other cities also are strong, he added, such as Houston, which is driven by the energy business; the Dallas/Fort Worth area, which has a fairly diversified economy; and Chicago, which is always pretty stable and prices don't go up and down as dramatically as the coasts. The Boston market usually remains strong because it has so many colleges and is a financial center of the Northeast.

“Quite often the amount you spend on rent can be the same as the mortgage if you bought your own building.”
— Leon Tuan, Stein & Lubin

And while Los Angeles' huge population means there's always a decent level of interest, it hasn't exploded the same way as the San Francisco area.

Areas that saw the biggest declines in residential values -- such as Las Vegas, Phoenix, and Florida -- have bottomed out and are recovering, but they're still way off historic highs, Tuan said.

Commercial real estate price fluctuations always lag residential values, he noted. "Just because people are starting to move back in doesn't mean I want to buy a strip mall or small office building there," he said. "Some of those areas are still recovering. But if you have deep enough pockets and can ride it long enough, there are good deals."

Commercial real estate tends to run in six- to nine-year cycles. "The question is, are you buying at the right time and selling at the right time?" he said. "It can be tough and risky to time those things exactly."

Pitfalls to avoid

Before buying, Tuan recommends having an architect check the physical condition of the building and its systems, including the roof, foundation, plumbing, and electrical and telecom systems. Also, zoning restrictions often limit the height, bulk, and parking associated with commercial buildings and will limit what can be done with them.

Also, many buildings don't comply with current codes, such as the Americans with Disabilities Act's access requirements, according to Tuan. To bring buildings up to current codes, owners may have to foot the bill for renovations. But once the renovations go past a certain dollar threshold, the owner can start losing protections that were grandfathered in.

"That's something people don't always think about, but it can be an expensive surprise down the road," Tuan noted.

Buyers should make sure there's a due diligence time period in the contract, usually 30 to 60 days, to thoroughly evaluate a property before they commit to buying it.

Before buying, Tuan suggests considering the following:

  • Buyers should look at the physical aspects of the property and determine want they want to do with it.

  • Are the tenants creditworthy, and do they pay on time? What are the terms of leases and are they expiring soon?

  • In addition to a minimum 20% down payment, a minimum debt service coverage ratio also is usually required. Does the property have enough cash flow after expenses so the buyer will have enough to pay off the loan?

  • Is the loan recourse or nonrecourse? If the property becomes vacant and the buyer cannot repay the loan, does the lender simply take back the building (nonrecourse) or can they go after the owner's other assets? Some banks have nonrecourse carve-outs for owners who don't pay property taxes, enabling them to go after other assets.

  • Is the loan assumable? Assumable loans allow the buyer to take over the old loan at the original rate instead of current loan rates.

Plan for expenses

Apartment buildings are considered to be among the most stable and safest investments, according to Tuan. Retail businesses and small shopping centers are generally more risky, and hospitality buildings such as hotels are very, very risky, he said.

Investing $1 million to $5 million can buy a small medical office building, a small apartment building, or a small retail strip, Tuan noted. However, commercial loans can require 20% to 50% down payments. Buyers should also anticipate having enough money for repairs and maintenance of the property. In addition, the property may require deferred maintenance or significant upgrades to get it into good condition, Tuan said.

If leases are involved, owners may have to pay leasing commissions to brokers. Owners also pay for improvements and renovations, or they can give tenants an allowance to do the work themselves.

For owners who don't have the time or inclination to manage their buildings, property managers are another expense; they usually charge 4% to 6% of the gross rent, according to Tuan.

"Physicians and dentists are pretty busy folks," he said. "You have to factor in these costs so you're not distracted."

Finally, Tuan recalled some sage advice he got long ago from an experienced real estate investor: "You'll never make more money than the day you buy real estate." Real estate is still one of the best investments you can make, Tuan noted. "If you get a good price, you're creating much more value for yourself than almost anything else you can do," he said.

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