Why do we focus on Commercial Real Estate instead of Residential?
Our focus here at Sukoon Halal REIT is on commercial real estate properties. Our case studies (Office Building, Retail Building, Medical Building) are from my personal investments and are indicative of the types of properties I’ve chosen to pursue on behalf of Sukoon Halal REIT.
I’m often asked why I’ve limited our fund focus to commercial properties when there are residential properties that also offer stable rent flows and a potential for capital appreciation. There are, after all, opportunities in residential real estate across the United States, and residential real estate is typically significantly cheaper than commercial. It is also true that there are opportunities to build and flip homes, and there are a number of funds and syndicates (not necessarily shariah focused) that focus on this.
While we recognize the opportunity in residential real estate, we’ve chosen to limit our focus to commercial properties for a number of reasons, some reflect the unique advantages commercial real estate offers, while the last one touches on the societal considerations of being a residential lessor.
Enhanced Income Potential
Commercial real estate offers a higher income potential compared to residential properties. Healthcare buildings, retail outlets, and industrial warehouses often yield greater rental returns. Commercial tenants typically sign long-term leases, providing stability and predictable cash flow for property owners. Furthermore, commercial leases commonly include annual rent escalations or revenue-sharing provisions, further enhancing income potential. In contrast, residential leases don't typically last longer than a year, and if there are any escalations, they cause a considerable amount of angst and friction between landlords and tenants.
Triple Net (NNN) Leases = Passive Income without Headaches
In a triple net (NNN) commercial real estate lease like the ones we exclusively pursue, the tenant is typically responsible for paying not only the base rent but also all additional costs such as property taxes, insurance and maintenance expenses. This arrangement shifts a significant portion of the property's operational and financial burdens onto the tenant. The landlord is relieved of the day-to-day management responsibilities associated with these expenses, resulting in reduced administrative workload and a potential for cost savings. Additionally, since tenants under NNN leases are typically responsible for the property's maintenance expenses, they have a financial stake in ensuring that the property remains in good shape. This financial responsibility typically leads to a greater level of care and attention to property maintenance by the tenant. Our most recent property has almost $800,000 of tenant improvements that were undertaken by the current as they modified the property to suit their needs. Not only does this help them make the property more beneficial to them, depending on the improvements made, this increases the landlord's property value as the building is typically updated and more attractive down the line.
My personal experience with corporate tenants is signifcantly more favorable than with residential tenants. Friends and family who own residential properties are either inundated with calls from tenants about every small problem in the property (broken pipes, leaky faucets, running toilets etc.) or they have to employ property managers who handle this, and eat into their returns. We have no such headaches.
Favorable Lease Terms
Commercial leases offer more favorable terms for lessors compared to the tenancy laws governing residential properties. Commercial leases tend to be longer, spanning several years, which ensures stability and minimizes the risk of frequent vacancies and turnover. This reduces the burden on lessors and provides a reliable income stream. Additionally, commercial tenants have a vested interest in maintaining their business location, reducing the likelihood of abrupt relocations.
Resiliance Amongst Crisis
Commercial real estate has demonstrated resilience during challenging times, such as the Covid-19 pandemic. While lessors of residential properties faced difficulties due to eviction restrictions, commercial property owners had more flexibility. Many commercial leases include clauses that allow lessors to negotiate lease modifications or seek remedies in cases of non-payment. Additionally, businesses often prioritize maintaining their commercial space, ensuring more consistent rent payment during economic downturns.
Our focus is exclusively on mission critical properties - these are properties that cannot be shut down during a black swan event like that experienced during Covid-19. While other retail locations such as restaurants, bars and small businesses were all shut down, our property was a mission critical thrift store that serves a large community. It never shut down during the pandemic, and as a result the tenant never stopped making lease payments.
Capital Appreciation Potential
Commercial real estate offers substantial capital appreciation potential. The value of commercial properties is closely tied to their income-generating capability. Capitalization rates (Cap Rates as commonly known) are often used as a basis for property valuation. As rental rates increase through annual escalations or demand increases, the value of the property tends to rise, offering investors significant capital gains. Moreover, commercial properties in prime locations or regions experiencing economic growth often appreciate rapidly, further enhancing investment returns.
Diversification and Lower Risk
Investing in commercial real estate allows for diversification and reduces risk. By investing in various sectors like retail, office, industrial, or healthcare, investors can spread risk across different industries. Economic fluctuations that affect one sector may not necessarily impact others, providing a buffer against market volatility. This diversification minimizes the impact of tenant turnover or market downturns on overall investment performance.
The Human Element
When dealing with large corporate tenants, we prioritize reviewing their financial statements before property purchase. We also receive updated statements annually to ensure their ability to meet lease obligations. Residential lessors rely on credit checks, considering factors like income, credit history, debt-to-income ratio, and employment history. Sudden income loss can greatly impact individuals' creditworthiness. Corporate tenants offer more income stability and can withstand short-term cash-flow changes. In a recent office building investment in Upland, California, the tenant decided to close a managed school, rendering our leased space unnecessary. With several years left on the lease, we negotiated early termination, receiving a year's rent upfront and their forfeited security deposit. We were able to quickly find a buyer for the vacant property and exit with a significant upside gain. Commercial real estate issues are typically formal and contractual, while residential issues can be more personal and may involve legal intervention for non-payment or eviction.
It is important to acknowledge the human aspect when dealing with potential evictions and the impact on individuals who may be at risk of losing their homes. Residential real estate issues, such as eviction situations, can have significant personal and emotional implications. It is often a distressing experience for both the tenant and the landlord.
Unlike commercial real estate, where lease agreements are typically between businesses, residential real estate involves people's homes and living situations. Evictions can lead to individuals being displaced, facing financial hardships, or even homelessness. Many jurisdictions (rightfully so) have laws and resources in place to offer support and help mitigate the impact of evictions, aiming to strike a balance between the rights of landlords and the protection of vulnerable tenants. Understanding the human aspect and the potential consequences of eviction underscores the importance of seeking resolutions that consider both the financial and emotional well-being of all parties involved. For these reasons above all, we've sought to avoid any situations where these human factors come into play by focusing on commercial investments.
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