One of the biggest mistakes first-time real estate investors make is failing to do their requisite due diligence. The due diligence process for commercial real estate is extremely detailed. One of the key items is market research. However, market research may not be as critical if you are a knowledgeable expert in your local market.
Even those who have studied their local market for years will still need to conduct additional due diligence once they actually find a property that they’d like to purchase. This includes doing a detailed underwriting of the property to see how it performs financially and includes lining up the financing needed to purchase the property.
In this article, we take a look at several steps investors should take when looking to buy commercial real estate property.
Learn the Vocabulary
The commercial real estate industry is loaded with acronyms and jargon that can be especially confusing to first-time investors. For instance, if you want to buy an office building, someone might ask you to sign an LOI before negotiating the terms of the PSA.
Terms like these are common in commercial real estate. LOI stands for “Letter of Intent” and in most cases is nonbinding. The purpose of a letter of intent is to spell out the general terms and conditions that the transaction including such items as the purchase price, the due diligence time frames, contract deposits, closing dates etc. the letter of intent becomes formalized with the signing of the PSA, or the “Purchase and Sale Agreement,” which is a legally binding agreement.
Any prospective commercial real estate investor should spend some time reading up on the industry before making any purchases. There are also several great educational commercial real estate resources for someone looking to understand the nuances of the industry.
Research the Market
Understanding your local market is critically important prior to investing in commercial real estate. Consider subscribing to local real estate publications, such as your local Business Journal or real estate industry data resources like Costar. Similarly, there are online resources such as ULI that track local deals and market trends. These informative materials will highlight investment trends in your local marketplace. It will also give investors a sense for who is buying property, in which locations, the type of asset classes they’re buying and at what purchase price. This will serve as context (and a good baseline) for those considering buying commercial real estate property.
Read Success Stories
Before taking the plunge into commercial real estate, read case studies and talk with other investors to learn more about their experiences. For example, it may seem like buying a hotel is a great investment, but have you considered the seasonality of these properties? That’s how some investors get burned. They don’t think through the full implications of buying a certain asset class or individual property.
Many investors will also be happy to share their experiences buying the asset class you’re considering. For example, what are the benefits of leasing to one or two large tenants vs. several smaller tenants? What are the drawbacks of that approach? How can you stay ahead of your competition and are there new office buildings under construction in the local market? What are the best ways to attract interest from institutional investors that may want to invest with you – and why does that matter? There are many lessons that can be learned from others who have been successful in the industry. Learn what worked for them (and didn’t) as a way of reducing your risk and increasing the likelihood of success.
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Building History and Class Type
The term “commercial real estate” is really a catch-all term for many kinds of investment property. The simple definition for commercial real estate is real estate that is least to one or more tenants that operate a business of some kind within the building. This can include office properties, retail centers, industrial buildings and warehouses, flex space, R&D or lab buildings, land for development and more. The commercial real estate industry also includes the apartment industry and the hotel industry. It’s important to understand the pros and cons of these different types of asset classes so you can decide which is most appropriate to add to your portfolio.
Then there’s a distinction to be made between class type. Class A properties tend to be the newest, most well-located of the bunch. Class B properties are typically a bit older, may have less credit-worthy tenants and may be in need of a refresh. Class C properties are usually in secondary or tertiary markets, don’t lease up as well, and are generally of older construction and feature fewer amenities. At first glance, it may seem like the smarted investment strategy is to invest in Class A properties – but these are also the most expensive, and offer the lowest returns. Conversely, Class B and C properties can prove to be highly lucrative investments for those willing to invest in the upgrades needed to make them appreciate in value.
Contact Feldman Equities to find out more about our commercial properties.
Location, Macro-Economics and Market Trends
Lately almost everyone is focused on the question of where we are in the current market cycle. The conventional wisdom is that cycles tend to last +/- 10 years, so if the market has been on an 10-year upswing, it’s possible that you’d be investing at the height of the market. At Feldman equities we do not necessarily subscribe to this conventional wisdom. For example, Australia has enjoyed a 25-year economic expansion without recession. Nobody can pinpoint the end of a market cycle with any real accuracy, and hindsight is always 20/20!).
That said, aside from the broader market conditions, there are also more hyper-local location trends to consider. You can look at things like whether businesses are growing and expanding in an area vs. contracting or relocating elsewhere. If you’re trying to understand where there could be “up and coming” markets with lots of potential, you might look at something like where a transit line is being extended – having better access to public transit is a draw for many renters and employees.
You’ll want to look at demographic trends as well, such as population growth, new household formation, and employment trends. For example, a recent statistic is hinting at a possible new trend that shows population shrinkage in New York City. This trend is being largely attributed to an exodus into states like Florida where the deductibility of state and local taxes (SALT) provides a powerful incentive for wealthier Americans to relocate.
Consider the education level and household incomes of people in the areas you’re looking to invest, as this will be a good barometer for the types of commercial real estate that could be in demand (or not) over time. Tech companies typically want to be near concentrations of “intellectual capital”. Locations like Boston, San Francisco, Raleigh-Durham, Austin etc. have been strong magnets for tech companies, which enhances growth in office space.
When looking at office building investments, two factors especially play into prudent underwriting; employment trends and housing supply. For example, the migration of larger, credit companies to a region speaks to a boost in employment and wages, and a supply of housing, particularly high-density housing, like luxury condos in central business districts, can signal growth in both lease and occupancy rates. There has been an old adage in the office building business that leases tend to get signed in an office building that is located within 15 minutes of where the Ceo lives!
Now that you’ve identified the type of property in which you’d like to invest and the location, it’s time to start talking with the pros to help you line up a deal.
Just as you’d work with a real estate agent when buying a home, you’ll want to consult with a commercial real estate broker when you’re ready to start your property search. Talk to brokers about the specific investment type you’re looking to make, as well as the locations you’re interested in and at what price point. Brokers that are specialists in selling commercial real estate are called “Investment Sales Brokers”. These Investment Sales Brokers are a wealth of knowledge and insight into any local market.
Interestingly, quite a few commercial real estate deals happen “off-market”. In these cases, the seller may want to privately negotiate the sale of his real estate without the publicity of a newspaper or web article. Brokers typically have the best inside scoop on these opportunities and can help line them up once they know what you are looking for.
Let’s say you’re interested in investing in an office building. There’s a 100,000 office building in your target area that’s currently running at about 75% occupancy. Initially, you might gloss over this opportunity because a) it’s not on the market, and b) it has historical low occupancy rates. But a knowledgeable broker might bring this opportunity to you in an off-market fashion, explaining that he knows the owner and the owner has such a low cost basis that he’s ready to just cash-out and retire. The broker may also know that a major company has been looking at leasing office space in the area, opening the door for you as an office investor. The broker ultimately lines up the transaction and then connects you with the prospective tenant.
Buying the building and giving it a full makeover, what we call here at Feldman Equities, a Radical Officectomy, you dramatically upgrade the building turning it into a 100,000 square foot Class A office building. Because we have performed this process over and over again, we often able to attract a new tenant to come into our building even before the renovations are complete, or better yet, while we are under contract to purchase the building. As a result, we’ve added tremendous value to a property that we might not otherwise have even considered without the help of a commercial broker.
Real estate attorney
Commercial real estate transactions involve a lot of legal paperwork. Any time you’re looking to acquire or invest in commercial real estate, it’s important to have a real estate attorney review all paperwork with a fine-toothed comb so ensure your interests are protected. Your attorney will also advise you on any issues that may be involved in the property transactions. This includes reviewing zoning ordinances, purchase agreements, mortgage loan documentation as well as closing documents.
In many cases, you will need to bring in legal specialists that have a particular expertise in the aforementioned items. For example, if a building has a use which is not compliant with local zoning, you may want to bring in what we refer to as a “land use” or “zoning” attorney. Zoning matters are a legal specialty that is unique and not widely known by most attorneys.
Another key area in which you might need a legal specialist is with respect to income taxes. If you are purchasing the property as a tax-free “1031 exchange” you’ll definitely want to consult with a real estate income tax expert. Another tax item deals with the potential real estate tax increase as a result of the acquisition. We often consult with real estate tax experts prior to an acquisition.
At the end of the day, the main reason to hire a commercial real estate attorney is to reduce the risk associated with investing in a specific deal. Unlike residential real estate purchases, which can be completed with standard form agreements, commercial real estate agreements are much more nuanced. An attorney will be able to protect you (namely, your equity) by looking into any idiosyncrasies associated with a specific deal. This reduces your overall risk and improves the likelihood of a successful transaction.
When looking to buy commercial real estate property, you’ll want to speak with a property manager (or several). The first property manager to speak with is the one in place already—i.e., the property manager hired by the current owner to manage the property. The property manager typically has the best understanding of the building, property conditions, and improvements that could or should be made over the short-, medium- and long-term. This is important knowledge to supplement your property inspection.
The property manager can also tell you information about the tenants, including those who may be looking to grow and expand (or sublet), those who are paying rent on time, who is due for a rent increase or lease renewal, and more. The PM should also be able to tell you how this property compares to others in the marketplace, assuming they service more than one property in that area (and a good PM typically will).
You’ll also want to speak with other property management companies. This will provide more thorough context as to how your building is positioned in the marketplace relative to its competitors. You can interview several management companies to understand where there are property improvements that could be made at this building to lower operational costs and/or otherwise increase revenue.
One of the most important reasons to interview the existing property manager is to get an understanding of what “deferred maintenance” may exist with respect to the property. This concept of deferred maintenance includes such items as a roof that needs replacement, and elevator system that needs to be completely overhauled, and air conditioning system that needs to be replaced, etc. etc. At Feldman Equities, we send in our own teams of property managers and engineers to inspect building that we are performing due diligence on and we also bring in outside experts to look under the hood.
Loans, mortgage, and credit options
Most people will buy commercial real estate using some sort of leverage. This is most often done through the use of a mortgage. Most lenders will want to see at least 20% down on a commercial property. Some people will buy a commercial property for cash as a way to close a deal quickly (arranging financing can take time) and then, after closing, will put some sort of debt on the property.
There are many different types of loans and mortgages that can be used to buy commercial real estate. It’s important to talk to several banks to ensure you’re getting the most competitive rates and terms.
For example, Bank A might be willing to give you a 4.25% loan on a commercial building that is only 50% occupied. Bank B might be willing to give you a 4.50% loan on that same property but with a three-year interest-only period (note: the term “interest-only” refers to timeframe during the long term during which amortization is not applicable to the loan principal). At first glance, Bank A seems like the better deal. However, in this case, when an investor is buying an underperforming property, having a three-year interest only period might be worth the higher rate. This gives the new owner some time to improve and lease up the building, thereby stabilizing it prior to amortization payments kicking in.
How much risk?
Investors will want to consider how much risk they’re willing to take on with any specific opportunity. As noted above, Class A buildings tend to carry lower risk (and in turn, have lower returns). Class B and C properties tend to carry higher risk, at least until repositioned. Properties that are highly levered (say, with less than 20% equity) are also considered high-risk. The more equity you have in a deal, the better you’ll be able to withstand a market correction when property values and rents come down.
Determining how much risk you want to take on should be done in consultation with your investment advisor—your risk should always be balanced with the risk of other investments in your portfolio. If your retirement account, for example, is loaded with government bonds, maybe you’re OK with investing in a higher-risk commercial property. It’s just important to strike that balance based on your risk tolerance and investment horizon.
Learn more about risk, consulting, and other important CRE due diligence factors at Feldman Equities.
Clear it with your broker/other advisors
Ready to buy a commercial property? Great! The first step is usually submitting an LOI (see above), which your commercial real estate broker will help you to negotiate. Your offer should be very explicit as to the amount of the contract deposit you are putting up in the time frames that you will require for due diligence and closing. The offer should also include such details as to who is paying for title insurance, escrow fees, legal fees etc.
When it’s time to sign a more formal purchase and sale agreement, you’ll want your attorney (including specialists as needed) to review and incorporate any changes to protect your interests. This is also the time you’ll need to line up the property inspection and financing. Most deals are structured so that the buyer only has a set period of time to complete certain tasks. After such set time frames expire, typically the contract deposit is “at risk”, which means if you failed to close you will lose your contract deposit. So you’ll want to get started right away.
Do your due diligence (is the building up to code, etc.)
As soon as you identify a commercial real estate property that you’d like to purchase, you should commission property inspections to evaluate the building and the grounds. The property inspections will usually be compartmentalized into two broad categories: a physical inspection of the building which is usually referred to as a “property condition assessment” (PCA) and an environmental inspection which will determine what risks exist, if any with respect to hazardous materials on the property.
As the buyer you will want your engineering companies to focus on potentially big-ticket items such as underground storage tanks or structural issues that could cost hundreds of thousands of dollars to remedy. The purpose of property inspections is to ensure you go into a deal with eyes-wide-open, allowing you to negotiate off the purchase price accordingly, negotiate certain repairs to be completed prior to purchase – which will reduce the risk of unforeseen problems down the road – and to properly budget your capital expenditures post closing.
Investing in commercial real estate is not for the faint of heart. The acquisition process is much more complicated than purchasing a single-family home. Managing commercial real estate is also a totally different ballgame. The stakes tend to be higher, with more equity on the line.
That said, there are tremendous benefits to investing in commercial real estate when approached thoughtfully. Commercial real estate is a highly tax advantaged industry. Investors can write off depreciation, interest and expenses on an annual basis, thereby lowering their taxable income. Moreover, if an investor decides to sell a property, they can use what’s called a “1031 exchange” to roll the proceeds into another property to defer paying capital gains tax. It’s no wonder, then, that so many people have built their wealth by investing in commercial real estate.
It’s important to do your homework before investing in commercial real estate. There are many great books, blogs and other resources out there to get you started. Once you’re ready to take the plunge, start talking to other professionals in your area to learn the nuances of your local market. And of course, always circle back with your investment advisory and attorney prior to making any purchase. It’s important to ensure your assets are protected over the long-term, and they’ll be able to help you to that end.
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The state of Florida and Tampa has one overriding major industry that is senior to all other industries. I call it the “population growth industry” 😊.
Commercial real estate is on a substantial uptick right now. With interest rates at all-time lows, employment at all-time highs, the economy booming, and occupancies high, it’s hard not to remain confident that for the foreseeable future, commercial real estate is going to remain on an upward trajectory.