Blue Dirt
Blue Dirt: Commercial Property Investing delivers expert insights and strategies for building and managing a successful commercial real estate portfolio. Whether you're a seasoned investor or just starting out, this podcast uncovers market trends, financing tips, and key investment principles to help you thrive in the industry.
Blue Dirt
Digging Into the Dirt: How Smart Investors Evaluate Property Risk
What's your risk tolerance as a commercial real estate investor? This foundational question drives every successful investment strategy, yet many investors fail to honestly assess where they fall on the risk-reward spectrum.
In this deeply practical episode, we unpack the direct relationship between risk and return in commercial real estate, using concrete examples every investor can relate to. Starting with the gold standard of investment security—a McDonald's with a 20-year absolute triple net lease—we demonstrate why these properties command premium prices despite lower cash returns. When comparing identical properties with different tenant profiles, the stark contrast becomes clear: national credit tenants might yield 4-4.5% returns, while local businesses in the same buildings require 9-12% returns to offset increased risk.
Beyond tenant quality, we explore how lease length, rent escalations, vacancy factors, and location quality create a complex risk matrix that savvy investors must navigate. Drawing from our extensive experience with distressed properties, we reveal our methodical inspection approach using specialized trade experts to uncover hidden issues before purchase. This transparency-focused strategy prevents costly surprises while allowing for strategic renovation planning.
The episode builds toward our "trinity of monetization" framework—how commercial properties generate wealth through cash flow, appreciation, and principal pay down—plus the often-overlooked tax advantages that enhance overall returns. We conclude with a compelling comparison between purchasing existing properties versus ground-up development, highlighting why development carries substantially higher risk despite its potential rewards.
Whether you're a seasoned investor seeking to refine your strategy or a newcomer trying to understand where to begin, this episode provides the risk assessment tools needed to make informed, profitable decisions. Subscribe now and join us as we continue exploring the foundations of commercial real estate success.
Learn more about Blue Commercial Properties on our website.
Welcome to Blue Dirt, the podcast that digs deep into the foundation of commercial real estate investing. Unlike most real estate shows that focus on dealmaking and market trends. Blue Dirt gets into the nuts and bolts of what truly builds long-term value the building itself. We break down how to spot deferred maintenance before it costs you, why a solid preventative maintenance program is a game changer and how triple net leases can maximize your investment returns. We'll also explore the importance of strong landlord-tenant relationships and how they drive stability and growth in your portfolio. Whether you're a seasoned investor or just getting started, blue Dirt gives you the practical knowledge to make smarter, more profitable decisions in commercial real estate. It's time to get your hands dirty and build value from the ground up. Let's dig in. Welcome to Blue Dirt, where even idiots can make a killing in commercial real estate. Today is our day and we're going to be talking about the different types of investment strategies and I'm Michael, this is Don and we're going to kind of get into the heart of the matter today.
Donnie Redhead:Yeah, what do you?
Michael Carro:think Don Not much, not much of anything. That's beautiful. That's a great way to start with very few thoughts. So when we think about investing, you know there's so many different areas to invest in. But before you decide, to what invest to, to what you're going to want to and my goodness, I will talk without a fat tongue in just a minute so everything is going to be related to risk, no matter what you buy, whether you like a single tenant property, a shopping center, an office building, it doesn't really matter, everything is related to risk. So as we discuss investment strategies, you have to look at yourself and say what is your most comfortable play. Because think of it this way the lower the risk, the higher the cost. Okay. Also, the lower the risk, probably the better the asset, but again, the lower the cashflow or the return on investment. Does that make sense?
Donnie Redhead:Yeah, okay, and just naturally, right, you just I'm going to invest in stocks. Right, you go to Walmart or whatever it is. It's like they're probably going to be be pretty stable there, but they're not going to provide really huge returns. There's not a lot of risk there, so right.
Michael Carro:More stable blue chip, yeah, and I like, whereas maybe an emerging company that is on the on the verge of a breakthrough technology, if they hit it's gonna do this. Yeah, and if they don't, if they hit it's gonna do this yeah, and if they don't, which one would I press?
Michael Carro:that's what they're gonna do. But if they hit, everybody feels good, yes, okay, um, so, really. So today we're just gonna kind of focus on risk. So let's just talk about the different types of risk. So let's assume and I like to use restaurant examples because people all go to restaurants and they know restaurants so if you wanted something super safe, so let's just say McDonald's, right. So you wanted to go out and buy a 20-year McDonald's lease. So McDonald's just built a brand new building and in all likelihood maybe it was a developer that built a brand new McDonald's building, okay. And McDonald's corporation came in and signed a 20-year lease and in that lease it provided so much in rent and it had annual increases, and maybe even this lease was what we call absolute triple net, meaning it's purely mailbox money. For the 20 year lease span, mcdonald's is going to take care of every aspect of the building, the roof, every little detail that breaks. You as a landlord will never get a call. Absolutely everything, absolutely everything. Absolute triple net lease, okay. And so, because it's a low risk scenario, mcdonald's is a multi-billion dollar company. They're, they corporately guaranteed it. We know they're. They're not going bankrupt anytime soon.
Michael Carro:So an investor would buy this and they'd be I I'm going to use the term comfortable. They'd be comfortable at a lower return in exchange for that high security of that investment. Okay, so that return might be really low four, four and a half percent. But let's say the exact same building, the exact same location, nothing's different. The lease rate, the lease term, everything is exactly the same. But it is a burger place. They even have a very similar menu to McDonald's, but it's a one man band. It's Don's Burger Shop. Make great burgers, he makes great burgers. People love it. Fantastic, they're going to go. He's going to put his redhead seasoning on it. It's really yummy. But Don's a one man band. He's not McDonald's and he's not corporately guaranteed.
Michael Carro:So even as an investor, if you're going to buy that same cash flow, the risk is different, don. If he goes out of business, if he goes bankrupt, I mean it's over. So you would demand a higher return on investment. So maybe that same property, you would still buy it. But the way you normalize it is you pay less for the exact same asset and your return might go from four to four and a half percent to maybe nine and a half to 12%. It just depends, right. So so there's a lot of different factors that go into that risk and of course, there's everything in between. Other things that determine risk in that same scenario is the length of term.
Michael Carro:If, even if you were to buy a McDonald's, going back to something that really strong, if McDonald's only had one year left on their lease versus 10 years, you might be willing to pay more for that 10 year lease. Right, you have a longer runway of security. Um, other factors might be. Let's say, mcdonald's has 10 years, 10 years left on their lease, but this lease goes up 3% a year and this lease goes up 2% a year. Well, you're over the life of that ownership. You probably would pay more for a higher increase.
Michael Carro:You know? So when you use a cap rate as an example, that is a one-year measurement of return. So if you were to buy a 10-year McDonald's at a 4.5% cap rate but this McDonald's lease went up 3%, and this one is also a 4.5% cap rate, meaning it's a one-year measurement but it goes up at a lower rate, well then you have to adjust to normalize it for your own comfort. So there's just a million factors and that's just kind of one of it. So now we're talking about a stabilized asset that you're going to evaluate risk. But let's just say you buy a property that's empty. You have to add the new tenant, right, so you're going to pay something different.
Michael Carro:And that's usually where we hit right, more value add investors, Well we're. We go one step below that, maybe two steps. So, yeah, depending on the day, right so, but but. But using the McDonald's example, using this building, mcdonald's just moved out of the building, right, right, it's still a great building, great location, everything, everything is perfect and fixed. All right, we don't buy those typically, right so, but there's a there. Now you shift uh, you're shifting your risk because now you're taking on vacancy risk, okay, but you still have a great asset. So you have to determine, right, you have to predict Now you're basing it on a comp rate, what's comparable in the area, because now you have a vacant building. So the comp now you're going to use, you know, maybe more of a price per square foot for that asset class right, okay, and what?
Donnie Redhead:what is comparable? I mean, what is a comp?
Michael Carro:right, it's a comparable a comp, you're going to look for other things that have sold in the area that are as similar to that property as possible. We call that a comp. Right in houses, you know, it's a little bit easier, right? If you buy, if you're looking, if you get a house under contract in this neighborhood and that neighborhood had six other recent sales, then you can kind of normalize it. Well, that one had a pool, that one didn't, this one had, you know. So you make minor adjustments to get a comparable price per square foot.
Michael Carro:We do the same type of thing in commercial real estate. Some of the other factors we're going to look at in evaluating the value of a property we want to buy is what do we think that we can lease it up for Right? And then, how long do we think it's going to take to lease up? What is the demand in this particular area? So a lot of things that we have to factor in and guesswork. Yeah, then we get into that empty building that needs love. Yes, and this is where Donnie comes in. This is where Donnie is my hero, evaluating the amount of love to give something money do you need to put into it?
Donnie Redhead:you're, you're coming through and and fortunately right now we have kind of a unique one under contract that really doesn't require much love, but we're getting, we're getting lucky with. It seems like a good deal, um, but yeah, that there's. There's so many different ways to evaluate the risk.
Michael Carro:Um, it's kind of interesting so in that particular case, so you know, um, so let's just say it's two tiers down right. Um, don's right, it doesn't need a lot of work. It happens to be in a slightly off area, so we're not a kind of a lesser demand area, so we have location risk. That location risk is going to contribute a little bit to maybe, an increase in vacancy cost.
Donnie Redhead:Yeah, you may carry that one. At least, how I was looking at it when we had talked, it was not in this central business district type area, right Right, it seems like those backfill pretty quick or in an area that's very heavily trafficked, like by a mall, or on a very high traffic count road. This one has decent traffic count, but it's kind of almost an extreme mid-block which is between two good strong roads, but it had a feeling that there was enough residential around it. It is a restaurant like we were talking about, that it at least feels like if we do get someone in there, they'll probably stay there for for quite a while, based on what it looks like the neighborhood restaurants have been very very, but but to that point it's not going to be a large restaurant group, it's not going to be a chain, it's not.
Michael Carro:It's. This is not the type of area. This is going to be a mom and pop for sure. Now, when I say mom and pop, that mom and pop could have four or five restaurants Don's second burger, don's burger number two, and in this case it could be Don's burger number three. But so so we have this location risk, you know. So, while the asset is better than most of the assets that we purchase, you know we have other, we have other risks in this property.
Michael Carro:You know, listen, nothing is easy. So I'm bringing up all the different areas that you need to evaluate, because nothing seems to be created equal and you have to adjust for market conditions, traffic conditions. This happens to be a corner lot. It happens to have some positive attributes, but it's also on a road that's a little fast, you know what I mean. And while the traffic is good, you know, during those peak hours it's kind of tough to get in and out. So that you know again, I'm not bringing up negative things, I'm bringing up things that you need to evaluate. But to my surprise, and I did not know this. I decided to go. It sits on the side corner. It sits on a corner, but the side street doesn't appear to be a big street. Well, I decided to go down it a couple of weeks ago and it goes right into a major street, into a Walmart, and I did not even know that. Oh, really, I didn't know that. Yeah, it curves, it goes up and then it curves right into where that Walmart is.
Michael Carro:Oh really, and it's actually a pretty short distance, so that actually gave me more encouragement. So if I live in the neighborhood, that's a positive, more encouragement. So if I, if I live in the neighborhood, that's a positive. Now, of course, if we don't live in the neighborhood, so so we have to, we have to discover that. But if I live there, I would know that, oh, don't worry, we can, we have a shortcut. That's all I'm saying.
Donnie Redhead:Yeah, and it's. You're always. Anytime I'll say you're talking to any, any new investor or somebody who's they want that perfect unicorn they want. They want to play a really low rate for the McDonald's and get a huge return and have no risk, and that's just. It's just not the reality of the world. Of course you can get lucky with maybe one or two of these different you know columns of risk if that's what we're looking at them, but the reality is is nothing is without risk. You have to just evaluate the best you can and make a decision and move in. But you're not going to get huge returns with no risk.
Michael Carro:It's just you need to be real. So then let's go into the category that we kind of live in, which you know we went. We started off with great classic, strong, strong tenant long-term lease, then kind of strong tenant short-term lease, then we've got vacant, really good property. We have vacant good property, but not so good location, and then kind of this, we we kind of hover in the bottom, the next level, which I'm going to call a distressed asset, a lot of risk, so you better have upside, because if you miss the mark it's going to cost you some money. And that's kind of the area that we love to hang out in. Why do we love it? Well, number one, because we believe we understand our market and our costs well enough to take these risks Right.
Donnie Redhead:Yeah, we understand those and I would lump. You know maybe you're already identifying it, but understand the construction or the building or the maybe what the building can become, cause sometimes what we buy it as isn't ultimately what it ends as Right. So there's that, that that factor in there, maybe replacement cost or you know where, maybe a developer who does a new build or spec build, hoping that that if they build it they'll come. We're already, we're already out of the ground. It may require a lot of other parts, but it's already got a lot of the infrastructure there.
Michael Carro:When you bring the final category, which we'll get into in a moment, ties into that new construction developer who's building a spec property, he's got the greatest risk, but for a different reason. He's got the greatest risk but for a different reason. But where we live, so and and and. So when we go in and evaluate, um, I call them old uglies. You know? Um, that's just what I call these buildings. Most of the buildings that we buy are old uglies and I love them. They have great return on investment.
Michael Carro:Um, we have acquired some additional properties that are just great downtown locations, for different reasons. But for a second, let me just identify the three areas that we really focus on for monetization of our investment. You should be looking at three areas. What we look at are three areas of cash flow, property appreciation and principal pay down. That trinity of monetization on a property is phenomenal. There is a fourth factor that your CPA will take advantage of and that's tax advantages in real estate. But these three, you know, tax advantages in real estate, but, but these three you can calculate really well. The fourth one, I leave it to the professional to calculate for us.
Michael Carro:So, um, I will say all of our properties with the exception of a couple. We have bought a couple of properties that aren't as strong on the cashflow because it just may be a strategic fit. The appreciation is going to be great and the principal pay down is still going to be there, but the cashflow may not achieve our normal desired cashflow. So sometimes we'll buy a property that just is a good strategic fit for us long term. But that's what we look for in our distressed assets. So what Don is really good at is number one when he inspects a property. He doesn't get a single inspector, like a house inspector, to inspect the entire building. I know we've talked about it in another segment but in case somebody is listening to this for the first time, give us a one minute version of what you do from an inspection standpoint.
Donnie Redhead:Usually, we're bringing in the respective trades that understand their world really well. Right, we're bringing in a mechanical contractor who's dealing with the HVAC and can give us a lot of the information as far as age, type, size, the condition of those units and, if they need repairs, what are the costs? Because we need those costs for the budget. It goes into the same thing with the other ones. As far as plumbing, what size lines do we have, and are they galvanized? Are they copper? Are they PEX? You just need to know for planning purposes, right? We also have them come in and camera the drains because, like you said, we buy old uglies and a lot of times, depending on how old uh right, these ugly buildings are, they may have cast iron sewer. We need to know is it? Is it about to crumble? Is it have channel rot? Is it a small section? Is it the whole section? Is there bellies? So we just want to know that, right?
Donnie Redhead:We like to bring in the roofer. What's the condition? Once again, is it? Is there a warranty left? Is it? Does it need a brand new roof? Many times, without looking too deep, we kind of plan on new roof anyways, because we want to hold it for a long time, right. So we're already budgeting that in many times Electrical. What is the condition of the electrical? Is it relatively new? What's the size of the service? Because we know if we have a big enough service it opens up our funnel right For other potential tenants. It just it makes it more potentially desirable to other potential tenants to backfill it faster, right. And then one that we're bringing in more and more now is a moisture consultant. He's coming in looking at the building and he does more beyond moisture. But that's really what he's good at and he can identify if there's any real issues with the building deterioration of brick or block stuff like that.
Michael Carro:So don't hide these from yourself. There's investors out there that want to make a deal so bad that they will create a delusional scenario in order to get to that end goal of acquisition. Don't ever do that. Always be on the conservative side. Be willing to walk away from a deal. Have a model in place for yourself that says listen, if it fits in this box, I'm going to do it, and if it doesn't, I'm not.
Michael Carro:Establish a level of discipline to look at a lot of deals, but walk away from things that just do not make sense and don't try to force a round peg in a square hole. It either works, depending on what you make your model, or it doesn't. That level of discipline will give you long-term success. But on the flip side, you can also be that overanalyst who overanalyzes everything and makes no decision. So you've got to ultimately land where you're going to land. We are a fire-aim-ready group, but we are Mach, speed, speed and we will buy stuff super, super fast. But we also bring in a team of experts, because I know what I know, donnie knows what he knows, but we bring in a whole group of people that can give us that honest feedback so we can market, not market, but underwrite this asset to a point of go no go, and then, of course, then we bring in the lenders and work that angle as well.
Donnie Redhead:Yeah, and you can bring in these individuals that have. I mean, we've brought in all the professionals right, the mechanical, electrical, plumbing, roof and they've been wrong. I mean we learn stuff all the time that contradicts what somebody else has told us in the past. So you're going to get this information. You can only make a decision based on what information you have. But it does. It walks this fine line between overanalyzing and underanalyzing and sticking your head in the sand and not learning all the issues just is not wise.
Donnie Redhead:And the guy was just talking about the moisture consultant. He'll, he's, you know, he's told us. You must hate calling us, you must hate hearing from me, because all I do is tell you all the bad things, and it's not we want to hear all the bad news. But what I told him is you have to understand, is is I need to understand all the bad things so I can try to budget and I can try to plan for repairs, because you also need to understand I may not listen to you completely. Right, I may fix this and fix that this year, and I understand that I'm just going to buy time and maybe fix this in year three and year four. My goal is to get it back to its, its original state of how it should be Right and will require less higher R&M repairs and maintenance. But the reality is you just need to just say show me all the bad. I need to know it in order to be able to put together a good budget and understand this long-term investment and be able to plan.
Michael Carro:By the way, we obsess over every property we get in a contract. I mean literally obsess. Most of our properties have a 60-day due diligence period and then 30 days to close. I got to tell you. We discuss, discuss, discuss, analyze every aspect of that property over and over and over again, really trying to understand where our costs are, where's the upside, what level of renovation we want to do, you know what color scheme, you know what does the market need.
Michael Carro:It's just and honestly. It's something that I personally absolutely love to do. You know, I just really enjoy it because, for me in my world, because I'm a real estate broker, what the better I understand our own properties. I give that same advice to my clients, you know. And so when I go and look at a property with them, because I have this knowledge about this type of building or that type of building, I can convey hey, here's what I'm seeing, here's where I think the opportunity is, and so I give that same guidance to the people that I work with every day. So it's really this wonderful advantage of working and playing in the same space. So that's the distressed turnaround asset that seems to be our sweet spot.
Michael Carro:And then the last is that development ground up project that Don mentioned. So if you are, if you have a piece of property and you are building a building, you're constructing a building, regardless of whether whether it's industrial, office, retail, it doesn't matter. If it's not already for a specific tenant, you have the greatest risk. Specific tenant you have the greatest risk. Now, even though we take on a lot of risk with our existing buildings that we buy, if you think about it, when we buy something, there's already a building there. We have the potential of leasing it immediately. We don't have the time suck of of going through permitting, going through a site.
Donnie Redhead:Civil right, doing the environmental right of the whole thing, getting all these things prepared, getting it through zoning, maybe having to change the zoning right. Yeah, there's, there's a huge front load of time that exactly get to see yeah and so.
Michael Carro:So, even though we have all of these other ugly parts of it, we could get to market literally in weeks or a month, right, and potentially have cash flow coming in really, really quick. If you're doing a new development, you're probably a year out, but you're spending money today. And, by the way, when we buy a property, we're typically buying it at a fraction of what it costs to build brand new. So so now, if you build something new, in theory you should be able to command a higher price per square foot and then, once you realize an occupancy that is satisfactory whether it's 70, 80, 90, 100% you should be getting a pretty decent return on investment. But you have a lot of upfront risk. You have financial risk, time, and then the pure headache of getting new construction out of the ground is so challenging. So that's why I consider that the greatest level of risk.
Michael Carro:Now let's say that that developer finishes the construction, then is able to lease out the space. Now they have the ability to sell that on the investment market and really make a huge return on investment. So let's use. Going back to the McDonald's example, let's say somebody bought the piece of property. Now in this case they would have to have McDonald's. If they're going to build a McDonald's, mcdonald's has already signed the lease. But let's say they bought the property, so they're holding the property. So let's say they hold that property for five years, so they've been paying taxes and liability insurance on it for five years.
Michael Carro:Probably some landscaping, you know. So they it's not wasn't free just because they might've paid it off, but they have carrying costs, so five years. Then let's say they land a deal with McDonald's, so then they build the McDonald's and it's only when they sell the McDonald's on the investment market do they realize the return on investment on that investment lease that they sold. They sold the cashflow. Yes, they're selling the real estate with the land and the building, but they're really selling it to an investor for cashflow. Now they get to realize all of the gain from buying the property the holding costs and then the construction plus a return. So that's why those different categories matter and the different risk levels. So obviously, if you're a new investor going in and doing doing that last category, just do it first.
Donnie Redhead:And the one, that part that always gets me probably the most I don't want to say nervous, but the one that I think about the most when you do talk about brand new development is the time. That time that that is always in the back of my mind, even though we don't do it, it's if you start that process, we know I mean you talk about a year painful, or 18 months or even two years. What can happen to the market?
Donnie Redhead:Shoot me over the course of that, you know what I mean. So that's that's, and hopefully, it is so painful.
Michael Carro:I have a friend going through this right now. He's building a great industrial complex and the amount of back and forth that he has to deal with with municipalities and water companies and all these extra fees and impact, it's just, it's just enormous. And he has been working on this project Now. He worked on the property 10 years ago in in preparation for what we're going through now. But it's just, it's not an easy process. It never is easy. Um, now, if you're a seasoned developer, yeah, you can come to expect some of these circumstances, but there's always unique little curve balls that get thrown at you. So hopefully he's nearing the completion. We already have a couple of signed leases. It's a it's a pretty large amount of square footage and we're probably maybe 20 to 25% there. Um, and a long, long road to go, but, um, but right now it's. It's a struggle, it's an absolute struggle with these municipalities to get these, uh, to get to the certificate of occupancy, so, uh, so, anyways there's.
Donnie Redhead:So that's kind of it's not like it's not a lot of money to be made right With some of these developers that that we know they seem like they're doing very well.
Michael Carro:Yeah Well, a build to suit developer can do very well, because they have de-risked it in the sense that they get a property under contract, they're in their due diligence period, they negotiate a lease with a credit tenant, like a McDonald's or one of these other ones we talked about. So they and so then they get ink on a page, they go and build it and they typically will try to sell it for a one to 200 basis point spread on the cap rate market and so. But it's not without risk, because if the cap rate market or something changes right, um, then they better be prepared to hold it long-term. They're still going to get a return on investment, but they have to be prepared, um. And so you know again, nothing's easy.
Donnie Redhead:Yeah, and the one that always sticks in my mind that was the exact opposite. You know, was was always what Sam Zell would say he he'd always buy stabilized ones. He what Sam Zell would say He'd always buy stabilized ones. He was always the opposite he would take the highest quality stabilized risks, because he always made jokes about how he would try to do these developments and just lose. He just loses his mind.
Michael Carro:Right, sam did some good stuff, so did we answer the questions.
Donnie Redhead:I don't remember what the questions were.
Michael Carro:What are the main strategies commercial real estate investors use? And for me, it's all about risk, risk, risk and then how do risk, return and effort vary across these approaches? And so I think we touched on each of those categories, how they impact each other. At least, I think we answered the question. How about this? You subscribe, like and share this episode, and then you send me a note saying whether or not we succeeded.
Michael Carro:Well, that wraps up another episode of Blue Dirt Podcast, where even idiots like Donnie and me can make a killing in commercial real estate. That's a wrap for this episode of Blue Dirt. We're here to help you build smarter, invest wiser and create long-term value in commercial real estate, one solid foundation at a time. If you found today's insights useful, be sure to subscribe so you never miss an episode, and if you know somebody who could benefit from these discussions, share Blue Dirt with them. Got questions or topics you'd like us to cover? Reach out. We'd love to hear from you. Until next time, keep digging deep, stay sharp and remember real value is built from the ground up. See you on the next episode.
