The Beyond Multifamily series is hosted by non-residential commercial real estate investor and Best Ever Show host, Ash Patel. Ash’s goal for this series is to introduce you to the world of non-residential commercial real estate investing and teach you how to look at and underwrite different commercial asset classes.
In this episode, Ash dives into the topic of flex space buildings. He explains what flex space buildings are, what kind of businesses you’ll typically find in them, the importance of location, and the pros and cons of owning flex space properties.
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TRANSCRIPT
Ash Patel: Hello, Best Ever listeners. Welcome to the Best real estate investing advice ever show. I'm Ash Patel and this is an episode of Beyond Multifamily, where we will dive into topics other than multifamily investing. Today we're going to dive into flex space buildings, also known as industrial flex, or just flex space.
What is a flex space building? It's typically a combination of either office, showroom, retail with some kind of storage or warehouse space in the rear. There are typically bay doors or loading docks on the rear of the building, and the front of it is often just a man door where you walk into either an office, a showroom, or a retail spot. The rear can be used to house vehicles, manufacture goods, or just storage.
The types of businesses you'll typically find in a flex space building can be a machine shop, a woodworking shop, an auto detailing or auto tint place, auto repair. We've had churches in some of our flex space buildings, food manufacturing, we had somebody that made cake sprinkles and sold them out of the front of the flex space building. Healthcare companies often use them. People that need oxygen, they'll store the vans indoors, or durable medical equipment companies will store all of their products in the rear warehouse section. The front can be office support staff, as well as walk-in customers. We've had pest control companies use flex space, HVAC, plumbing companies have used our space... And those are great, because they can park their vans, which often contain very expensive equipment and tools, inside of a locked building, rather than just a fenced in parking lot. Painters, plumbers all are good uses for flex space buildings.
What typically determines the tenant that goes into the flex space is the location. If you have a flex building in an industrial park, that is ideal for non-customer facing businesses... So a machine shop, a woodworking shop, or even a distribution shop for equipment. If you have a flex space in a neighborhood location, something near other strip malls or other businesses, now you can have the customer facing retail component of that business.So again, our lady who made cake sprinkles would be ideal. A pest control company that maybe wants some visibility from the road.
Location is important to keep in mind when you're buying, renovating, or determining whether to buy a flex space building. The reason is if you're in an industrial area, you know that it's not going to have a retail customer presence, so it can be a little bit rougher. It doesn't have to have a nice retail showroom, it may not have to have a nice exterior signage lighting; it can be more of just a solo, again, woodworking shop, machine shop where people just show up to work, do their job and leave, and there's never ever customers that come in there. However, when you are in that neighborhood location, know that your flex space is probably going to have walk-in foot traffic, you may need additional parking, and your showrooms or your entries are going to have to be a little bit nicer, so that the businesses can present to their customers.
Something else to think about for location is if you are near an interstate or intersecting interstates, you may want to find a larger facility that can be used as a distribution warehouse.
Why do I love flex space buildings? The overhead is so minimal. Often these tenants that go in there are not picky. In a retail location everything's got to be right - the signage, the facade, the parking lot's got to be nice and sealed, no potholes... Everything needs to be on the up and up with these industrial flex space buildings, especially the ones that are located off the beaten path in industrial business parks. We've bought them where they've had giant potholes from semis coming in and out, lighting is poor, signage is almost non existent, roofs are leaking, and the tenants somehow put up with it. So when we go in there and make these improvements, we look like rockstars. But the tenants are just easier to deal with and easier to manage.
Another reason I love flex space buildings is because the tenants in my experience often will put their own money into renovating the space. We had a pretty rough-looking industrial flex building in Atlanta, and a church wanted to lease up about 6,000 square feet. They took what should have been just a giant, ugly warehouse space and they put nice flooring, they put drywall, they made it into a really nice church, renovated all the bathrooms, and they did it on their dime. So if this church ever leaves, that space will be easily rented out at a much higher dollar per square foot, or it can be easily gutted and returned to warehouse space.
There's also something about flex space buildings where the business owners take ownership of their space; it's kind of like they've taken control of their own encapsulated space, and if an office needs to be bigger or smaller, or moved, they often do it on their dime. I don't think we've ever paid tenant improvement money on a flex space building. And this is not the case with retail or office.
Another reason I love flex is the location really doesn't matter. Let's think about retail or office for a second. Office - you need to be near people's homes or in a central business district. For retail you've got to have a well-trafficked location, and again, a presentable building. With flex, you can find a tenant for wherever your location is, or whatever condition your location is in. These buildings are often constructed of just block foundations, metal siding, flat rubber roofing or metal roofing, they're easy to maintain, and as a new landlord, when you go in there, make those improvements on lighting, paint the facade, you look like a rockstar.
Another reason I love flex buildings is HVAC often is just minimalistic; you don't have to have a lot of ducting. It's just ceiling-mounted units that provide AC and heat. Parking lots, again, depending on location, could be just gravel lots. One of the keys for flex buildings is either the drive-in bay or loading dock. Now, with a loading dock if it's accessible by a semi trailer, that's a huge plus; you just have to make sure it's appropriate, meaning you have the proper size building. You can't have a semi-accessible loading dock for a 2,000 square foot space. A semi trailer has 3,000-4,000 cubic feet of storage, so when you have your flex space, you want to make sure if you have a loading dock that's semi accessible, you don't chop up the space.
And that's also one of the benefits of a flex space building, where it's typically built as a shell. Let's say it's a 10,000 square foot shell. The demarcating walls in between each suite are determined by the entry doors. Now, these can also be moved around. If a tenant is outgrowing their space, you can take down the wall in between their suite and the next one, and they can expand quite easily. If you have a 5,000 square foot flex space that you want to break down into two 2,500 square foot spaces, you just want to make sure that you have enough entry doors, front and rear, for each tenant. And also, there's tenants that may not require the rear door.
So back to the dock doors, the loading doors, the driving bays... Typically, if you could drive into the flex space with a box truck, that is perfect. A bay door that's at least 12 feet tall is ideal. You can get just about any kind of small box truck van in there. Windows are also typically not important in a flex space building. If there is a retail component to this building, sure, have some glass up front; but along the sides and rear of the building you just often don't see windows, which means there's less maintenance, less items to repair and less overall cost of ownership.
Break: [00:11:47.11]
Ash Patel: If you needed to add additional HVAC components for let's say the retail showroom or an office, you can easily add a split system for a few thousand dollars. You just want to make sure that whatever flex space building you buy has adequate power. Three-phase is ideal, not necessary, but just make sure that there's enough power for future upgrades.
Something I've seen a lot of people advertise lately is investing in flex space is COVID-resistant. I guess that could be the case; you typically have your own entrance for your own suite. There's no common hallways, common bathrooms, which another benefit is you get to charge for all of your square footage. If you take an office building, for example, there's a lot of common area where you have lobbies or hallways or elevators where nobody's paying for that square footage, unless they're paying CAM charges, which we'll discuss in a future episode. But all of your square footage in a flex building is accounted for by a tenant, and should be charged appropriately on each lease.
The higher the ceilings, the better for flex space. People can use them for storage. You can have a two-story mezzanine and office storage on two different stories. You can have a first floor retail office, and the second storey could be all storage.
One thing that we've had a lot of luck in adding NOI to our flex buildings is charging CAM. Typically, when you buy the smaller flex buildings, there's no CAM charges; it's just a gross rent that each business owner pays. Well, if you go in there and determine the cost of your dumpster, the cost of maybe the common water, the cost of lighting the parking lot is X number of dollars per year, divide that up by 12, add some additional cushion for maybe redoing the parking lot every four or five years, and you can now let your tenants know that there's going to be a CAM charge.
When their at leases come up for renewal, let's say they're paying $10 a square foot; you may not be able to add five additional dollars in CAM - that's a 50% increase in their rent - but you can reduce their rent to let's say $8 a square foot in add the $5 per foot for CAM. And this way, when you go to sell your property to let's say an out of state tenant, they don't have to worry about variable costs. They know if the parking lot needs to be redone, if lighting in the parking lot needs to be repaired or upgraded, it can all come out of the CAM charges, and whatever the advertised NOI is on the sale is going to be what that new owner landlord receives, because it is now a triple net lease.
And if you remember from my earlier podcasts, triple net leases are very easy to sell, and they often sell at a lower cap rate. So even if you have somebody at $10 a square foot and you add in CAM charges, but keep them at $10 a square foot, not increase their NOI at all, because you now have a triple net lease, the value of your property is increased because the cap rate may have dropped a point or two.
You can also take smaller steps in adding CAM onto your tenants. So with flex space - and again, the smaller ones are typically one to three-year leases - I would not add in renewals, because renewals only help the tenants; they don't help the landlords at all. I'll illustrate that, because if you look at our time today, we're in a high inflationary period, where apartment rents are going up in some cases 15%, 20%, 30% year over year. Well, imagine those apartment tenants had a five year lease, or a three year lease with two options to renew, and each renewal is only a 5% or 10% rent bump. Now you can't arbitrarily go in and raise rents, regardless of what inflation is doing. So with these flex spaces especially, if you can sign one to three-year leases, with no renewals, you can adjust your next lease at market rates. And if you get on any commercial brokerage site, you'll see that properties that are triple net often trade at a much lower cap rate that properties that have gross leases, where the landlord is still responsible for those common area charges.
So I encourage you to build in CAM into the leases. Now, you can start small. If there is a dumpster or if there's snow removal, you can tell your tenants "Hey, listen, we're going to start charging you an extra $50 a month for the use of the dumpster. Or in the winter months, we're going to charge an extra $100 a month for snow removal." Tenants often don't have a problem with that, because it's a justified cost, it's not arbitrary.
What are some of the cons of flex space buildings? We've mentioned a lot of great things about them... They're often not in a great location, so security has been an issue at times. My advice to you is any building you buy, especially flex, and especially buildings that are off the beaten path where there's not a lot of nighttime traffic, add a ton of lighting. Light your buildings up like a Christmas tree, because if there's other buildings around, your building may not be the ideal candidate for break-ins or vandalism. Make sure if you need to your parking lot is secured, barbed wire, chainlink fences. If you have an HVAC company, a plumbing company, an electrician in your space and the vans are parked outside, people will know that there's a lot of valuable tools and equipment in those vans, so you want to make sure that everything is secured. Have cameras all around your building and make them very prevalent. Make them hard to get to. Have [unintelligible 00:19:38.17] cameras on the corner of your building, high up, that would require a ladder for anybody to mess with them.
When you underwrite flex space buildings, know that they're going to be charged somewhere between retail and warehouse. So if warehouse pricing is typically $4 a square foot in retail is a $8 to $10 a square foot, your flex space building should go for I would say around $6 per square foot.
The amount of retail office versus warehouse will also affect that blended rate. So if it's 90% retail, 10% warehouse, you're going to be closer to retail pricing, especially if the location is retail-friendly. If your flex space is 90% warehouse and just 10% office in, let's say a little corner, you're going to be closer to warehouse pricing. Evaluate the market, figure out what other flex spaces are going for, and I think you'll find in most markets there's no vacancies for flex space. So call up owners and find out what their tenants are currently paying, look on Costar, look on Crexy, and determine the availability, as well as the going market rates.
So Best Ever listeners, I hope I've given you a little bit of insight into flex space buildings. We had a previous episode on mixed-use buildings... I want all of you to open your horizons a little bit. The returns are often much higher in these other asset classes that have less competition, they have less money chasing them, because there's higher barriers to entry, most of which is just knowledge. My goal is to give you that knowledge to get those higher returns.
I implore you to look at flex space buildings, start underwriting them, find them, and do a pro forma, get all the numbers, get the leases, and look at what your cash on cash returns are for these types of properties. Also, keep in mind management overhead is almost non-existent. Again, these are not beautiful retail showrooms. They're more industrial buildings that don't require as much upkeep. There's often not really nice landscaping like you would find in retail or office locations. It's just parking lot, metal building, flat or metal roof, and they're easy to maintain. So go out there and start underwriting some flex space buildings. Compare that to whatever you're investing in today, whether it's single family, multifamily, retail, office, I think you'll find flex is a great asset class.
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