Can You Parking Against The Flow Of Traffic In California Strategy For Shopping Center Investments in California

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Strategy For Shopping Center Investments in California

Investing in shopping centers in California is a real challenge for many investors. Most malls in the country offer very low if not the lowest cap rate in the country e.g. range 4-6%. This makes cash flow weak compared to malls in other countries. Investors will also need more money for a deposit, e.g. 40-70% of the purchase price to be eligible for a loan.

On the plus side, the state’s retail vacancy rate is among the lowest in all 50 states. For example, San Jose’s retail vacancy rate is only about 4%, the second lowest of any major metro area (Oakland has the fewest vacancies). This means that the income must be very stable. Therefore, if you are not achieving strong cash flow as an investor, you should look for a property with high appreciation potential to achieve better investment returns. To achieve this, you could:

1. Sell the property at a lower ceiling rate. If you bought a shopping center at a higher cap rate 5-10 years ago, you will be able to achieve strong appreciation. However, if you recently purchased the property at an already low cap rate, the cap cannot be reduced much lower. So this approach probably won’t work.

2. Increase your rental income. Most NNN leases have a fixed 3% annual rent increase. Assuming the rate of market capitalization remains the same, this will only equate to a non-exceptional 3% annual appreciation, unless you want to achieve appreciation in a variety of ways.

Property analysis

The goal of increasing your rental income starts with analyzing your purchase. While most retail properties in California offer a 4-6% cap rate, many properties charge tenants lower rents due to market

1. Poor property management and/or simply not knowing the market rent. Some property owners choose to manage their own properties to save costs. However, they are among the worst property managers if their performance is measured by the rent collected. They are often unaware of the market rent and therefore often lease the apartment to the first tenant to ensure quick occupancy of the unit.

2. Long-term leases signed when rent was low.

So the key is to identify properties with lower market rents and a low price per square foot. These qualities will provide you with upside potentials. However, market rents often have a wide range. For example, retail space in San Jose is between $2-5/SF per month. It is not easy to determine whether the tenants of the property are paying below market rent. Here are some properties with low growth potential that we may want to eliminate:

1. Big box properties with anchor tenants, e.g. Wal-Mart, Target or Safeway. These large national tenants often sign long-term leases with low rent due to their creditworthiness and large rental space. Once the lease is signed, the rent is locked in for 20-30 years. Thus, it is almost impossible to drastically increase your income in a short period of time. In fact, many wholesale properties in California are listed below replacement cost. This is because they have long-term leases with below-market rent. They have been in the market for a long time, but they are not sold because the limit is low, e.g. 4%. The prospect of higher income is sometimes 15-20 years away when the lease expires.

2. Retail centers with a very high cost per square foot, e.g. over $800/SF. You will need to charge the tenant $4/SF per month plus NNN to reach the 6% cap. This is almost the highest rent in the market, so it is difficult to raise it even higher.

3. Retail centers with long-term options AND a fixed 3-5% rent increase instead of adjusting to market rent. Pay attention to this small detail in your lease as it can have a big impact on the rent you collect. The problem is that appreciation in California is often higher than 3-5% per year. Therefore, if the rent is not adjusted to the new fair market rent at the start of the new lease option, the rent is most likely below market rent and may not sell at the highest market price.

On the other hand, if you see multi-tenant malls available at a 4-5% cap but only priced at $200-$300/SF, it’s very likely that the property is renting below market value. This type of property will offer great potential for appreciation. When you see this property, you should also see if the property is:

1. Near an anchored tenant. Business owners prefer to be near an anchor tenant because that anchor tenant will bring more traffic to the center. Business owners are willing to pay a higher rent for this location.

2. Multipurpose belt with small units. In general, the rent is higher for small units, e.g. 1000 SF as for larger 4-5000 SF because more tenants are looking for 1000 SF units.

3. On a major artery or near a highway. More traffic and convenience is always good for business.

4. In a stable or growing area with higher household income. When local residents have higher disposable income, they will spend more time and money on the goods and services offered by retail centers.

5. Located in an area with low vacancy rates and high rents. Ideally, you want a rental property that will expire in 1-5 years. This way, you will quickly adjust to the higher market rent.

Sometimes it helps to see problems as opportunities. For example:

1. Most investors don’t like gross lease retail strips. However, if you can convert these gross leases to NNN, you will be able to achieve strong appreciation.

2. Most investors do not like a shopping center with a lot of vacancies. However, you may be able to buy at a low price. If you can turn around and improve your occupancy rate quickly, you will be able to score well.

Property management:

When you buy a property, you will need a good property manager to help you maximize the rent. A property manager is a key partner in implementing your investment strategy. For a significant rent increase, e.g. 30-50% more than the rent in the previous lease, the manager must prove to the tenants that the new market rent is a fair market rent. Otherwise, tenants may make the wrong decision and move out. This includes research to determine fair market rent and securing comparable tenants. So as an honest business person, you want to make sure that the property manager has an incentive to do the extra work. One way to achieve this is to pay the property manager a percentage of the increase in value when the property is sold, on top of the usual 4-5% property management fees. This is beneficial to both the property manager and the landlord when the value of the property increases due to higher net operating income. Otherwise, with a typical 4% commission in a property management contract, you’re likely to receive a 3-5% rent increase at lease renewal. When this happens, both you and the property manager lose out.

Of course, some tenants with minimal profits will not be able to afford the higher rent and will move out. The property manager will need to assess the financial and business strength of all tenants and identify potential evictions. Accordingly, it will plan to find replacement tenants to minimize income disruption.

Before a significant rent increase, you may want to make cosmetic changes to the center and give it a new look. You may want to consider the following:

1. Paint the middle again.

2. Resurface and paint the parking lot.

3. Make sure air conditioners and heaters are working.

4. Repair any roof leaks.

When tenants see these improvements, they may be convinced that it is too risky to move the business to another location with lower rent.

Favorable financing:

You can also improve cash flow by obtaining financing on favorable terms from unconventional sources, e.g. insurance companies or lenders, instead of the usual commercial lenders. Although you have to pay higher loan fees and closing costs, the long-term savings in interest payments are significant. This should bring your interest rate down from about 6.75% to 5.8% for multi-tenant malls.

Conclusion:

The commercial real estate market in California is very different because of the very low ceiling. You will need to be a creative business person with this “so-called” passive investment to achieve a strong return on investment. By choosing the right property with below market rent, hiring a highly motivated property manager, and choosing low interest financing, you will achieve strong cash flow and strong appreciation in a relatively short period of time.

Disclaimer: The investment strategy and investment management information presented in this article should not be construed as formal financial planning advice or the creation of a financial manager-client relationship. The authors intend to provide information to the general public based on our investment management recommendations and investment strategies and are not designed to represent your own financial needs. The information in this document also does not constitute financial management advice. The authors make no warranty or representation as to the accuracy or legality of the information in this article and assume no responsibility for the use of this information. Please do not make any decisions on any investment management matter or investment strategy without consulting a qualified professional.

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