Let’s face it, there are thousands of articles talking about why you need to invest in commercial real estate; everyone knows that if you want to make real income, this is the route you need to go. But what no one talks about is it’s not just the buying of commercial real estate, but the selling of it as well. When you purchase a commercial property, you need to think about your exit strategy and the triggers for selling the property.
Here are four reasons why you NEED to sell a piece of commercial real estate (or at least consider your long term goals).
1. You’ve Maxed Out The Earning Potential
This seems counterintuitive; you are achieving the highest rents possible in your property, and now I’m suggesting you sell it? Well, if your goal is to make the most wealth you can for yourself as quickly as possible, you need to flip this on its head. When you sell a property at its highest potential income level, you are also selling it for the highest possible price you can achieve. If your goal isn’t to build the greatest amount of wealth for yourself in the shortest amount of time, then you probably fall into the category of buyers for this type of property; those who want to hold onto a property and keep a stable income every month, which while it is comfortable, won’t make you rich as quickly. Donald Trump didn’t sit around just collecting monthly rents; he made his millions off of the purchase and sale of various commercial real estate assets, and he took risks.
None of us have unlimited time, so the more quickly you are able to make a smart purchase profitable through a smart sale, the more time and resources you will have to do whatever you want.
2. You’ve Depleted The Earning Potential
Let’s assume that you purchased a tenanted property, which was at one-time bringing in a lucrative annual income, but now things have changed. There are numerous reasons why this can happen. The neighborhood changed. The economy suffered. The building became obsolete. There are countless different reasons why a commercial property has depleted the earning potential. If the reason that you purchased the property, namely the income, is gone, unless you have different plans for it yourself, such as redevelopment, you need to sell. This can be a scary prospect, especially if there is a threat to sell for less than you paid for it. This, however, isn’t the worst thing that can happen. The alternative might be holding onto the property for years on end, paying property taxes every year, paying the mortgage, and most importantly, not making proper use of your equity.
The smart owner is always maximizing their equity and generating income for themselves. For example, if you have $100,000 in equity tied up in a property and it isn’t making any money for you, and you could take the equity and generate an income of $10,000 in profits after financing and all other expenses, wouldn’t you do that? The same general theory applies to property not generating income, and actually has a greater disparity than just the possible $10,000 in earned income. There are significant costs for holding property not generating income: taxes, mortgages, insurance, and maintenance. These costs do not discriminate between properties vacant or full.
3. The Property Is Fully Depreciated
This is getting into more complicated tax benefits, but many commercial real estate investors purchase and hold onto property for the tax depreciation benefits that it brings. If your sole goal is to have a portfolio of income producing properties and hold onto them for the long-term, then one consideration you need to take into account is the entire financial benefit it brings to your portfolio. If you can trade the property for another where all else is equal, like the return on investment, perceived appreciation, etc., and you can take advantage of the full depreciation schedule; you are able to keep more of the income you are generating. As through depreciation you are reducing your tax obligation.
4. The Property Is Under Leveraged
Most owners have the goal of paying their mortgage off as quickly as possible, which is an admirable goal. As your debt on an income producing property goes down, your equity goes up, but your Return On Equity is also going down.
Your return on equity is the amount of annual net income returned as a percentage of your equity in a property. Essentially, ROE = Net Income/Equity. So, for example, if you were earning $10,000 per year on a property worth $100,000, but only had $5,000 in equity for the property, your ROE would be $10,000/$5,000 = 200% Return On Equity. If the property was fully paid off, your ROE would be $10,000/$100,000 = 10% Return On Equity.
The smart investor would look at the opportunity in this and see that if they could replicate the first scenario another 19 times, by only having a 5% equity in additional properties, they could be generating a net income of $10,000 x 20 = $200,000 as opposed to a fully paid off property generating a net income of only $10,000. This would be maximizing their equity, getting the most “bang for their buck”.
Where This Leaves Us
Every owner of commercial real estate has different goals at different times, the same as investors in the stock market may have an appetite for more risk at a younger age, but seek stability as they mature. Those who seek to fully leverage their properties to continue to expand their portfolio may not be a fit with the sale of a fully optimized property, as they can leverage the property for more capital. There are no two owners who act and think exactly the same as another, which is a good thing. The most important consideration that an owner of commercial real estate needs to keep in mind is their exit strategy. Know what triggers will lead you to either sell a property or buy a property. As Benjamin Franklin famously said, “By failing to prepare, you are preparing to fail.”