I have a client considering a commercial real estate investment that he will partially occupy, renting out the balance for income.
So just what should a new investor consider when analyzing a deal? In my opinion, these six factors should be considered.
• Income stream: This is the most important consideration in a commercial real estate purchase. The reason is simple: If there is no income, there is no investment.
Is the building leased and, if so, for how long? How good are the tenants? Is the rent above or below the market? How much income is there after such expenses as taxes, insurance and maintenance?
Sure, an investor can buy an empty building and lease it. But be prepared to invest a significant amount of your future rental income originating a new lease – in some cases up to 25 percent.
• Purchase price: You want to purchase commercial real estate below the latest comparable sales – even if the market is increasing.
The price you pay determines your property tax assessment forever, and your ability to fill a vacancy in the future also depends upon your basis – that is, the price that you pay. Always try to buy below replacement cost if possible.
• Cap rate: The capitalization, or cap, rate is the net operating income of a property (gross rent less expenses) compared to its sales price.
Divide the net operating income by the purchase price and, voila, you have the cap rate.
Notice that cap rate is third on the list. This is not by accident. Too many investors place too much emphasis on this metric.
What can appear as a great return (cap rate) will evaporate if the tenant cannot pay the rent.
A dramatically under-market rent is another pitfall. The cap rate would be measly. But, if you can move those rents to market, a great investment may bloom.
• Financing: I advised my client to pay cash vs. leverage the purchase with new financing. Many would disagree with me, but he’s my client, and I want him to send me a Christmas gift.
If he does decide to get a loan, the term, interest rate, whether it’s a recourse or non-recourse loan, and pre-payment penalty should all be vetted.
• Exit: Is the investor’s plan to pass the property to his heirs or lease the vacancy and sell the building?
I told my client to always have an escape route in case the investment should not unfold the way you planned it. For example, one escape hatch could be selling the building to the occupant.
• Those things you don’t think about: Do you have reserves for when a vacancy occurs? What is the condition of the property and what are the improvement costs?
Are there any environmental or zoning issues or use restrictions? How big is the pool of potential occupants?
Also, you need to look at the structure of the purchase. Does the contract provide sufficient time for due diligence? And be sure to examine the lease documents.
You just never know when one of these snakes will bite you. So be prepared.
courtesy of: OCRegister.com
writtenby: Allen Buchanan