Investing in commercial real estate, whether for the first time or the hundredth, can be nerve-wracking. The barriers to entry are high, requiring a significant up-front capital investment. Most lenders require the sponsor and their equity partners to put at least 25% into the deal before issuing a loan. To put that in perspective, someone investing in a $20 million property would need to come up with at least $5 million right off the bat.
When making such a big up-front capital outlay, it’s important for investors to “get it right”. One way to cover your bases is by utilizing a thorough due diligence process. Each investor will have their own due diligence process, and that process often depends on the asset type and size of deal. This due diligence process is typically refined as additional investments are made. And still, even investors who have made dozens of purchases struggle to “get it right” at times. That’s because no commercial real estate investment is foolproof, and sometimes deals are influenced by factors outside of our control – such as an unexpected downturn in the economy.
That said, there are certainly steps investors can take to increase the likelihood that a deal is profitable. This article provides a sample investment property checklist for anyone considering adding commercial real estate to their investment portfolios.
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Look for the Right Price
It goes without saying that every investor should start with some “guardrails” or investment parameters to guide their search for commercial real estate. That typically includes setting a realistic budget. Can you invest $10,000 in a property? $200,000? Or are you looking to invest $1 million or more? This will influence the size and types of assets you look for, condition of the property (turn-key vs. value-add), and geography in which to invest.
That said, price is only one variable. Another critical factor, one that’s related to price, is whether you plan to invest in commercial real estate on your own or in conjunction with other equity investors. For example, an individual who only has $500,000 to invest may be limited to investing in a $2 million property. Now, if that person were willing to partner with others, they could contribute their $500,000 and pair it with other equity to invest is larger-sized deals.
There are several ways to do this. One way is to serve as the sponsor, meaning that this person will oversee the deal from start to finish: from acquisition, to arranging debt, to property renovations, all the way through stabilization. In this scenario, the investor will put their money into the deal but their equity as a percentage of the overall ownership of the property will be diluted by any other equity that is invested, but this also opens the investor to larger deal sizes that they wouldn’t be able to invest in on their own. For instance, they could pair their $500,000 in equity with $4.5 million in equity from other investors who would be considered limited partners, taking a backseat to the sponsor in a more passive role. This scenario would allow the investor with $500,000 to purchase a property for up to $20 million, which opens more opportunities when taking on investment partners.
Conversely, that same investor could stretch their dollars by investing as a limited partner in a deal. This has become more common with the advent of crowdfunding for commercial real estate deals. Now, someone can take as little as $10,000 and invest in multi-million projects by investing alongside others in a larger commercial real estate project. This is a route that many investors take when they want to be a passive real estate investor.
Establish ROI Goals
First, whether you have $10,000 or $10 million to invest, it’s important to establish your targeted return on investment (ROI) goals. This is a fundamental cost-benefit analysis. For example, say you have $1 million to invest. You’d start by looking at a range of investment vehicles, including commercial real estate, but also more traditional investments like stocks, bonds, and other equities.
Second, consider your investment horizon: how soon are you looking for a return on your investment? Let’s say you think you can earn a steady 5% on your money by investing in the stock market. You can cash out your stocks at any time, so this is a great option for an investor needing liquidity. Conversely, someone who has a longer-term view may be willing to tie up their capital in a commercial real estate deal that will take 3-5 years’ or longer before generating a return on their investment. But in this case, time may result in greater returns – say, a 15% annualized return on your investment.
Each investor has different ROI goals. It’s important to outline these goals in the context of your overall investment portfolio. This will inform the types of commercial real estate you ultimately decide to invest in.
Let’s assume that you’ve decided to invest in commercial real estate and now you’re out there evaluating multiple opportunities. You’re presented with an opportunity to invest in an off-market multifamily apartment building worth $15 million. How do you decide whether this is a good investment?
One of the key steps in the due diligence processes is creating a realistic pro forma.The pro forma is essentially a spreadsheet that tracks how much cash a property generates based on income and accounting for all expenses, including insurance, taxes, utilities, and standard repairs and maintenance. The seller will typically provide a profit-and-loss (P&L) statement that details the income and expenses for at least the past two years. You can use these numbers as inputs into your pro forma.
Now, this is a good starting point, but it’s just that – a starting point. It’s important to forecast any potential increase in expenses. For instance, one of the main ones often overlooked by novice investors is that if the property has not sold in several years, it may be subject to a tax re-assessment upon closing. When the property is reassessed, if the value has significantly increased (and value is at least partially influenced by sale price), the assessed value will also go up, thereby resulting in a higher tax bill for the new owner.
Calculate Necessary Repairs
Depending on the condition of the property, you may be facing significant repairs upon purchasing the property. Perhaps the roof needs to be repaired, or maybe you’re buying a value-add apartment building that needs a more substantial overhaul.
Let’s take the example of a value-add apartment investment. Say the property is a 50-unit, garden style apartment building located in a secondary market. There have been a few new apartment buildings constructed in this area over the past decade, but there is not enough product on the market to meet current demand. You decide to purchase this property with a value-add strategy in mind – but what will that cost?
You first need to determine the extent of necessary repairs and renovations to maximize rental income. Will new paint, carpet, and fixtures be sufficient or are more extensive renovations needed? What will 50 new kitchens cost? 50 new bathrooms? Determine whether all renovations will be made at once, or as units turn over, which will influence how much capital you need to have on hand for any necessary repairs and improvements. Factor this into your pro forma to see what impact these costs will have on your cap rate and cash-on-cash returns.
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Project Future Repairs
Projecting future repairs is another key step in any investor’s due diligence process. Yet projecting future repairs is no easy task. Many factors can influence the extent to which repairs will be needed: the age of the property, whether the property has been renovated previously (and if so, how long ago), the market in which the property is located, and more.
For example, a property that was built in the 1990s may be structurally sound, but the major building systems (e.g., HVAC) may be approaching the end of their useful life. The systems may be in good working order – for now – but given the age of these systems, the new owner needs to project the likelihood that these systems may need to be replaced in short order. Be sure to budget for future repairs.
Labor costs can be one driver of the cost of repairs, which is why the geographic location of the property matters. It may be more difficult to find skilled labor in an expensive market where the construction industry is booming and you’re competing with others for contractors. In situations like this, tack on a premium for labor as you’re budgeting for future repairs.
Find a Property Manager
In a best-case scenario, a property will be sold with an all-star property manager already on-board. There are efficiencies to working with a pre-existing property manager: that person already knows the ins and outs of the building, has established relationships with tenants and third-party contractors, and can ensure business as usual during the transition to new ownership.
One mistake investors make is to blindly trust the existing property manager. Even if you plan to keep the current property manager, it is useful to interview the property manager and two or three other property managers. Ask them the same questions and see how each responds. At a minimum, as the following questions:
- What is the market rate for the units in this property?
- What value-add strategies do you think could increase rents at this property?
- What is the average vacancy rate in this market, and how does this compare to my property?
- Describe how you’d market this property and to whom.
- What processes do you use to collect rent? How do you handle past-due rent collection?
- What is your screening process for tenants?
- How often have you had to evict tenants, and how do you manage that process?
- How long does it take you to make a unit rent-ready upon vacancy?
- Which other properties in this marketplace do you see as my competitors?
It may be that the existing property manager answers these questions similarly to the others, in which case you’re probably wise to keep with the status quo. However, if this interview process uncovers room for improvement (i.e., property efficiencies, higher market rates, lower vacancy rates, etc.), then consider switching to new management after closing on the property.
Ensure the Building is Up to Code
The average commercial real estate investor does not know the nuances of construction, particularly as it relates to the building code. In residential real estate, most buyers will enlist the support of a property inspector prior to signing a purchase and sale agreement. The commercial industry operates a bit differently. While an investor certainly could bring in an inspector, it’s much less common for them to do so – so how do you know whether a building is up to code?
If a property has already been renovated, you may include a clause that the sale is contingent upon satisfactory review of all building permits to ensure the work has been completed to code. If you notice that permits haven’t been pulled, this is a major red flag. You have no way of knowing whether the renovations were completed by licensed contractors and in line with local, state and federal building codes.
Now, let’s say you’re looking to purchase a property with the intention of making substantial improvements. In this case, whether a building is up to code is less of an issue. You’ll have the obligation to bring the building to code during the renovation process, and then as a condition of obtaining a certificate of occupancy (CofO),but it’s not always so cut and dry.
Sometimes, an investor wants to purchase a property with existing tenants with the intention of redeveloping the property but doesn’t plan to do so right away. Let’s use the example of 100,000 square foot former mill building. The property is currently leased to multiple small-tenants, including some creative offices, a fitness studio, and a furniture store that uses one-third of the building as a warehouse. An investor decides to purchase the property with the intention of converting the mill building to 120 residential lofts, but the investor doesn’t plan to do so until the current leases expire.
During the investor’s due diligence process, they come to find that the property actually needs a new sprinkler system to be code compliant. This will be a condition of obtaining the CofO at closing. The current owner is grandfathered in and hasn’t had to invest in the sprinkler system, but once the building changes hands, this will need to happen. The current owner doesn’t have the capital to do so, nor do they want to given the fact that they’re about to sell. The prospective buyer doesn’t want to pay for it, either. Situations like these often cause a deal to go sideways, unless a mutually-agreeable resolution can be worked out prior to closing (such as the seller giving the buyer a credit at closing to fund the cost of the improvements).
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Set up a Collections Process
Anyone who invests in commercial real estate needs to understand the importance of accounting. Every rent payment, every mortgage payment, every expense – each item needs to be tracked. Setting up a good accounting system is a must.
Start by identifying how you’ll collect rent payments. If you’re working with a property manager, the property manager should take the lead on this for you. Determine to what extent payments can be made online, ideally using your property management software’s payment system. All rent payments should be collected and aggregated into one single account specific to that property. Commercial property owners, depending on the size of the tenant or lease amounts, may prefer rent to be paid with physical checks or by wire. There is no right or wrong collections process, as long as rents are being collected.
Then, establish a process for how late payments will be handled. How soon will a reminder be sent? Will this reminder be sent via email, phone, letter – or some combination thereof? At what point will tenants start to incur fines for late payments? In a worst-case scenario, when will eviction proceedings begin if a tenant has failed to pay rent?
It is important to establish a standardized collection process that is implemented consistently across the board. This will protect a commercial property owner from any claims made by a disgruntled tenant who is behind on rent and argues that he/she has been unfairly targeted by an owner who hasn’t implemented collection policies uniformly.
While it’s true that no commercial real estate investment is foolproof, there are certainly steps that investors can take to minimize the risk associated with any specific deal. This investment property checklist is a good starting point for anyone looking to buy commercial real estate, but again – this is just a starting point.
Every investor will want to craft their own due diligence checklist, a checklist that will likely be refined over time as the investor grows their portfolio, makes mistakes, and learns from those mistakes along the way.
That said, investors must walk a fine line between conducting their due diligence and being stuck in a state of “analysis paralysis,” where they overanalyze a deal to death. This is incredibly common, particularly among more novice commercial real estate investors, and will often result in them missing out on certain deals because other investors are able to move more quickly. Having this checklist in hand will help any investor jumpstart their due diligence process in order to move faster and capitalize on exciting opportunities as they come along.