Flipping commercial real estate has its risks, but with a good grasp of the fundamentals you can generate high returns while minimizing risk.
Imagine a world where you can turn vacant lots into bustling enterprises, abandoned warehouses into lucrative logistics hubs, and neglected office spaces into thriving innovation centers.
Welcome to the exhilarating universe of flipping commercial real estate (CRE) – a high-stakes, high-reward adventure that can unlock untold riches for those daring enough to seize the opportunity.
With an average annual return of 9.5% in the commercial real estate market between 2014 and 2023, this industry promises high returns to investors who can navigate it.
However, as every investor knows, high returns often come with high risk. Uninformed investors can fall into traps by overpaying for bad locations.
Learning how to flip commercial real estate will help you get the high returns that the industry offers, all while managing its risk.
In this article, we will take you through a journey into the world of CRE flipping, showing you how to do it profitably, irrespective of where you invest in the United States. We’ll cover:
[Don’t let the demand for earnest money prevent you from getting a deal in quickly for your desired properties. Sign up for Duckfund to get the earnest money funding you need to close your deals without submitting any credit report.]
“Every person who invests in well-selected real estate in a growing section of a prosperous community adopts the surest and safest method of becoming independent, for real estate is the basis of wealth,” said Theodore Roosevelt.
Said differently, location and the quality of real estate matters (whether we’re talking residential real estate or CRE).
Players in the real estate industry have traditionally categorized properties based on their desirability into at least three classes: Class A, Class B, and Class C.
Class A properties are high-end and high-quality properties that are also situated in desirable locations. At the other end are Class C properties which are typically situated in less desirable locations and/or considered low quality.
In between these two extremes are Class B properties. These properties do not yet have the quality of the Class A properties but they have the potential. They are also located in good markets and some of them might even be in the same location as Class A properties.
“Class B properties tend to be in good condition with fully functioning mechanical and HVAC systems, but may need light repairs or modernization,” according to First National Realty Partners, a private equity firm.
Since your investment strategy as a flipper is finding an investment property you can improve and sell for a profit, Class B properties, by definition, best fit the bill. Class A properties are often new, fitted with the latest technology, and situated in the most expensive locations. Class C properties are often in less desirable markets and in need of significant repairs, which makes them very risky.
Consequently, as a commercial real estate flipper, you should aim for Class B properties (whether office buildings, retail stores, hospitality buildings, industrial units, or multifamily properties) in your preferred states.
You can do this by talking to a real estate agent (who is more familiar with the local market) or by carrying out independent research (if you have the time) or both.
Before we get to the calculations, it is important to note that you (or your agent) must do the necessary due diligence to ensure that there are no legal troubles. Due diligence will also involve checking out the property thoroughly and identifying all issues that need fixing (to avoid underestimating the repair cost).
Even when you find a Class B property, you will still need to determine if it’s worth flipping. To that we now turn.
“Real estate investors should pay no more than 70% of a property's after-repair value (ARV) minus the cost of the repairs necessary to renovate the home,” according to Rocket Mortgage, a mortgage company in Michigan.
This rule is popularly known as the 70% rule of house (or property) flipping.
There are two main variables that go into this calculation: after-repair value and cost of repairs.
The after-repair value of a commercial property is the worth of the property after all necessary repairs and renovations have been completed.
You can obtain this value by considering the market value of comparable properties that currently have the same quality as what this property will be after the renovation. That is, you are considering properties that already look like the future prospects of this property in view.
Since this value is so important, it might be advisable to work with appraisers, realtors, or other market experts to get an accurate figure.
If you choose to do this on your own, you can check online for properties on sale in your state (or that particular area) that are truly comparable (most likely Class A properties). When deciding on the after-repair value, it is better to be conservative than over-optimistic.
Even better, you can come up with a base case, best case, and worst case scenarios to reflect the uncertainty of your valuation.
Given that the objective is to make the property more valuable, repairs and renovations must focus on improvements that can truly increase the property’s value.
Since the property will end up in the hands of an investor who will buy and hold it for its cash flow (passive income), think of repairs that can improve the rental or lease income of the property as well as reduce its operating costs rather than mere short-term cosmetic changes.
In real estate parlance, consider repairs that will improve its net operating income.
Remember that the cap rate (net operating income divided by the purchasing price) is the return of investment (ROI) that summarizes the value of a property for a buy-and-hold investor. Consequently, the higher the net operating income, the greater the value of the property.
So, list all the repairs and renovations needed to increase the property’s value and find out what they will cost. You can get multiple bids for the whole repair project and choose the one that will provide the best value for money. For a general guideline, Invoice Owl, an online invoicing company, says that “commercial renovation costs per square foot range from $30 to $450 depending on the building type and location.”
If you don’t know where to start, you can check this checklist provided by Unissu, a property technology firm. A better approach is to compare the property with the other properties you have used to calculate the after-repair value and identify the repairs and renovations needed to bring the property in view to that level.
Again, it is necessary to be conservative. Many flippers will introduce a 20% contingency buffer or margin of safety just in case the repairs and renovations exceed expectations. That is, if the quoted price is $100,000, they will use $120,000 instead.
We can now go back to the 70% formula.
By this rule, your offer price must be capped at 70% of the property’s ARV minus the cost of repairs.
Let’s take an example.
Suppose the calculated ARV of a Class B CRE in Detroit ranges between $5,000,000 (base case), $4,500,000 (worse case), and $6,000,000 (best case). Let’s also assume that all repairs and renovations will cost $500,000. We will add a 20% buffer to get a total of $600,000.
Given the base case, your maximum offer should be $5,000,000*70% - $600,000, which is $3,500,000 - $600,000 or $2,900,000.
Which of these you choose will depend on your perception of what the market will be once the renovations have been done. For our purposes, let’s choose the base case (assume that the market will be normal).
What this calculation has shown is that you should not pay more than $2.9 million for this particular property.
There is another alternative way to determine what you should offer for a property you are flipping. This is called the maximum allowable offer formula.
The maximum allowable offer for a property is its ARV - fixed costs - rehab cost - desired profit.
Let’s focus for a minute on the two extra inputs in this formula.
First are the fixed costs. These include, according to Real Estate Skills, “real estate agent fees, title fees, holding costs, taxes, insurance, and utilities associated with carrying the property.” They further explain: “Over the span of working on the property, you’ll have to pay for holding costs, real estate taxes, and utilities such as electricity and gas.”
This is understandable since it might sometimes take months before the necessary repairs and renovations are completed. Moreover, selling the property might also take some time.
Second is the desired profit or equity. This formula wants you to input your desired profit as an absolute figure rather than a percentage. But you can also choose a percentage and multiply it by the ARV to get the absolute figure. So, if you want a 20% profit on the ARV (let’s stick to the example above), the desired profit will be $500,000.
Suppose all the fixed (property management) costs add up to $400,000 and the desired profit is $520,000, the MAO of the previous example (given the base case) will be $5,000,000 - $400,000 - $600,000 - $1,000,000, which gives us $3,000,000.
There is no right or wrong formula though MAO seems to be more comprehensive (by considering fixed costs) and flexible (allowing you to input the desired profit). But if setting a desired profit is not ideal, then you might prefer the simplicity of the 70% rule discussed above.
If the property owner accepts your offer, then you can sign the deal and start working on improving the property.
Anything can happen during the repair process. This is why we mentioned the 20% contingency or buffer. Nevertheless, aim to stick to the budget. Most importantly, don’t tell the contractor that there is a buffer; that will only make them be less careful about staying within budget.
Ideally, you would have agreed the expected duration of the repairs with the contractor; ensure they don’t slack off.
Finally, it is important that your contractor keep the comparable property in mind so that the repairs and renovations deliver on its projected after-repair value. It is this repair process that will make or mar the flipping exercise, so you cannot be too careful that everything happens according to plan.
It is true that “flipping houses is like painting a canvas – it allows you to express your creativity and vision for a beautiful outcome,” according to an anonymous author. Yet, it is what potential buyers consider valuable that matters most in the grand scheme of things. If it’s beautiful in your eyes but offers no value to them, then it is worthless.
After the repairs, it is time to put the CRE up for sale. The goal here is simple: ensure the sale price is not below the after-repair value that you have chosen at stage 2 (“buying the properties at the right price”).
If you worked with a real estate agent when projecting the after-repair value, then you can just bring them in to facilitate the sale. Since they already know what you are aiming at (and why), they are already up to speed.
Alternatively, you can select a new real estate agent (if you think they are better equipped to get you the sale) or sell the property yourself.
In commercial real estate, sellers are often torn between selling as soon as possible and holding on for the desired price. However, this is often a false dilemma as it is possible to sell quickly even at your desired price. It all depends on the value of the property and your (or your agent’s) negotiation skills.
This again goes back to the differentiation we made between Class B and C properties. If you are dealing with Class B properties, then you should not have too much difficulty selling except there is a general macroeconomic situation (say recession) impeding economic activities.
Nevertheless, if you did your after-repair valuation well, such factors would have come up and probably affected your decision to buy the property or not. This is why it’s better to be realistic about what a property could sell for; better to end up making excess profit than losses.
By adhering to all these factors, you can build wealth in the CRE market. If it’s true that “Ninety percent of all millionaires become so through owning real estate,” as Andrew Carnegie posited, then there is nothing stopping you from making money from CRE flipping.
In today’s CRE market, buyers are often required to pay a soft deposit (also called earnest money) before sellers will show them the property or start negotiation. In the US, this is often an average of 5-10% of the property’s purchase price. But the figures differ across states (take Texas and Colorado as examples).
Sellers embraced this requirement to filter through the pool of potential buyers and identify the serious ones.
So, commercial real estate investors who want to flip properties must not only know how to flip commercial real estate; they must also have the earnest money to pay for desired properties to close great deals faster.
But getting cash to pay this quickly can be hard, especially if you desire to close many deals at the same time.
Enter Duckfund.
At Duckfund, we provide you with the earnest money you need to quickly close a CRE transaction. Our application process takes just 2 minutes and we provide the needed funds within just 48 hours, without demanding any credit report from borrowers. What is more? We charge only a 2% financing fee, which is far less than what a bank or online lender will offer.
More importantly, we can provide earnest money for multiple deals at the same time. With this, you can build a portfolio of multiple CRE investments without being cash strapped.
[Are you ready to purchase and flip multiple CRE investments? Sign up for Duckfund to access the earnest money you need to get through the door and build a profitable portfolio.]
