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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   April 2007

Lift Your Cap

Help clients realize their properties’ upside potential — and increase cap rates and returns

Finding properties that have reasonable returns of 5 percent to 6 percent is fairly straightforward for most commercial brokers. Understanding the potential of that same property to make a better return on investment, however, takes a broker with vision. It also takes a sophisticated investor and a flexible lender.

By recognizing the potential upside of the property, you can help clients understand how they can increase their cap rate and their return. Let’s look at an example of how making visionary decisions about a property’s upside can be lucrative and make good business sense for investors.

‘Re-visioning’ the parking lot

The property you’ve identified is a 30,000-square-foot shopping center for sale at $9 million. It currently has a 6-percent cap rate. The center has 20 shops that are each approximately 1,500 square feet. The property currently collects rental income of $1.50 per square foot or $540,000 per year. All leases are triple net (no expenses).

After walking the property, you realize the shopping center, built in the 1960s, was designed with lined parking to accommodate the larger, full-size vehicles of the time, and it has not been re-lined since.

By simply re-lining the parking lot with diagonal parking and shrinking the width of the spaces to accommodate today’s compact-parking zoning requirements, you can create an additional 12 city-compliant parking spaces.

Making the most of the property

After you’ve re-lined the parking lot, you discover you have enough land remaining to carve out an additional 3,000 square feet of rentable retail space. This is essentially free land. You checked with a local coffee shop and sandwich shop, and the business-owners are both interested in the property and willing to pay $2.50 per square foot for their allotted space. This will provide an additional $90,000 per year of additional income.

You’ve created more space and have interested tenants, but is it financially feasible? What is it going to cost to build that extra space? Let’s say the cost is $150 per square foot to build or $450,000 overall.

Let’s sum up at this point. Your clients paid $9 million for the shopping center and $450,000 in construction costs. That’s $9.45 million total investment so far.

The new income generated from the additional square footage is $630,000 per year. To figure out the cap rate, divide $630,000 by $9.45 million. It’s 6.7 percent. This means your clients’ cap rate increased by 0.7 percent. Not bad.

Working the leases

How else can your clients enhance this deal? Before purchasing, you reviewed the current leases and discovered that many of them were below market rates. Half of them will expire within the next two years. At the end of two years, you will have increased the monthly rents from $1.50 to $2 per square foot for those tenants.

Let’s look at the kind of returns that your clients will see at that time:

  • 15,000 square feet x $1.50 = $22,500/month — tenants with nonexpiring leases

  • 15,000 square feet x $2 = $30,000/month — tenants with expiring leases

  • 3,000 square feet x $2.50 = $7,500/month — tenants in the newly built space

The total is $60,000 per month. That’s a $720,000 yearly return for your clients. The new cap rate at the end of two years will be 7.6 percent (dividing the yearly return by the original purchase/construction costs.) Your clients have effectively increased their cap rate by 1.6 percent from the original rate.

Having vision

It can be easy to find a property for sale at a 6-percent return. Smart brokers will go beyond just finding the property. They will take the next step and ask, “How can I look at this to make it provide a better return?”

They will realize there’s more to the shopping center than meets the eye.

Is there even more upside to this? Absolutely — with your permanent financing. Because you’ve increased the net income, the property is now worth almost $12 million ($720,000 divided by the original 6-percent cap rate). Plus, you’ve also created equity of $2.55 million.

It’s also more attractive to lenders. After all, your clients have revitalized the center with new construction, tenants and parking. They’ve also increased and extended the leases. Your clients will now be able to finance the center at a better rate and terms.

Working with a flexible lender

To accomplish all this, you will need to work with a sophisticated lender. The hidden values in a property are directly related to the right financing. To realize the full upside potential of a property, find a lender that will:

  • Work with you through the entire process;
  • Explain how to recognize the upside potential of properties and help investors realize that potential;
  • Help you conduct a financial analysis on the property;
  • Understand current market conditions and how they will affect property in today’s market;
  • Be willing to take the risk to realize upside potential; and
  • Provide flexible and creative lending.

Many lenders require an 80-percent loan to value and likely won’t be flexible because they have so little room to maneuver. So you should seek lenders that are more conservative on the loan to value. The tradeoff is flexibility — they’re willing to work with you to improve value of your clients’ property.


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