Top 5 Mistakes in Commercial Real Estate Investments
RPIMLLC Published Articles
1. Adding Asset Value Via Sound Property
Management
Today's tough economic times requires owners of income producing
real estate to focus on sound property management practices to
ensure that their investment remains income producing. With the
continuing tightening of business credit, to increasing costs of
conducting business for the user of commercial real estate space,
owners must insure that their investment is continuing to operate on a
profitable basis month-to-month and returning the desired annual
return for the owner.
It is critical that owners understand property management best
practices to achieve financial and investment asset returns year after
year. The best way to insure success is to implement a comprehensive
property management program. Most owners hire experienced
property management firms to manage all aspects of managing their
assets if they do not have the experience nor the time and knowledge
to do so. It is imperative to fully understand various legal,
administrative, landlord-tenant relations/laws, building codes and a
host of other aspects of owning investment real estate for success, not
to mention to keep the owner out of potential legal trouble.
This article is meant to provide a summary of some of the most
important elements of a comprehensive property management
program that not only provides benefits for ownership, but also
benefits users (tenants) as well. The following represents some key
elements of such a program:
1. Proper tenant screening: credit checks, review of financial
statements, review bank accounts (past 60-90 days), names of current
and previous suppliers for reference checks, business plan (if start-
up), existing client/customer base.
2. Understand tenant's business structure: sole proprietor, LLC, S-
2. corp, C-corp.
3. Fit their space requirement and line of business to your property:
understand how tenant's business (industry, hours of operation, etc.)
fits with you property type and current tenant mix if not standard
office property, retail, etc., will the tenant request/require expansion
space in the near future, for high profile tenants, what kind of tenant
build-out will be required and cost.
4. Operating costs: what, if any, property operating costs can be
passed through to tenants, energy efficiency/rebate programs from
local utility companies, monitoring energy usage, property tax
assessments, proper insurance.
5. Lease negotiations: an experienced management firm is invaluable
here with the many issues and requirements that make-up a well
drafted and comprehensive agreement.
6. Routine vs. emergency maintenance issues: preventative
maintenance program, contractor relationships, and in-house
personnel.
7. Marketing/Leasing: market knowledge, broker, user contacts, and
advertising/promotion programs.
8. Tenant retention: existing tenant/property management reporting
system, lease renewal program, property enhancement program.
9. Landlord-tenant requirements: compliance with federal, state and
local laws.
10. Fire/life safety and building codes: compliance with national, state
and local laws and ordinances.
The foregoing represents some important considerations for managing
any investment property. A properly implemented and maintained
property management program is a critical component for ownership
success for any type of investment real estate. Especially in these
tough economic times, it is smart to fully appreciate how a
3. professionally managed property can add value to your investment as
well as add value to your tenants and will go along way toward tenant
retention, which under any circumstance will result in profitable real
estate returns.
Real Estate Investing Fundamentals In
Tough Economic Times
In these tough economic times it is back to fundamentals when
contemplating real estate investing. Whether investing in commercial
properties, defined as office, retail, hotel and industrial property, or in
mult-family apartment properties, it is a different time than in the
recent past. For the experienced investor, it's time to get back to
fundamental principles and understand not only the property markets,
but just as critical, understanding the capital markets in order to
achieve some level of success. This is even more important for the
beginning real estate investor.
During the heydays of 2002 through 2006, capital was plentiful for all
property types. Real estate was easily financed with friendly terms for
most buyers. With money looking for opportunities, lenders opened
the spigot and investors tapped into a variety of financing sources for
an acquisition. The days of lenders' lending based on a property's
future potential income and appreciation are gone. As a result, most
buyers who sold after the run-up in prices and healthy demand during
this time period wound up paying a premium for their acquisition in
anticipation of continued property values appreciating at a double digit
pace. Their rationale: with a short-term disposition strategy and
cheap and plentiful supply of debt, they could realize a very healthy
return on investment based on a low equity (leveraged) position.
We are in a totally different environment today. Today it is more
important than ever to get back to fundamentals. For investors
4. contemplating an acquisition, there are several property level as well
finance level considerations and calculations one needs to perform to
assist in properly evaluating a purchase. Qualified and experienced
professionals can be invaluable in this area to help insure success.
A necessary first step is to identify goals for each property as it relates
to ownership, property operations and management, financing and an
eventual exit strategy. The following summary outlines the major
considerations that are important to a successful investing program,
whether at the beginner stage or at the level of the more seasoned
real estate investor.
Property Type: Different property types require different property
management, marketing and operating considerations as well as have
different income and expense profiles. Different property types will
experience different vacancy rates, rental rates and expense ratios and
these factors will be market driven. All these factors are important
when evaluating a purchase. Lenders also rely on historic market
metrics and property operating profiles when evaluating their
underwriting criteria as a bases for how much they will loan, what level
of a property's net operating income is required to meet the annual
debt service on the loan, to many other property operating, market
and management factors. Different property types have different
operating and financing considerations that must be thoroughly
investigated to achieve success.
Property Location: That old adage in real estate: Location, location,
location is even true in commercial real estate. More importantly,
however, cash flow, cash flow, cash flow is more important as it
relates to the right market location of the property. A comprehensive
analysis of the location factors is crucial for a successful investment
program. Due diligence is required and a first step is a geographic
analysis that includes such items as the transportation systems, major
employment centers, and demographic and economic data to a host of
other information useful to assess the broader area where the property
is located. A very useful tool to aid in this analysis is GIS, or
Geographical Informational System. Once the larger market area is
5. analyzed, a narrower focus on the property market location is
necessary to flush-out any particular factor that can add value to the
property such as a major employer locating to the market area or any
factor subtracting value from the property such as a new zoning
ordinance restricting uses and building heights. Once these analyses
are done, it is also important to do your due diligence on the specific
property under consideration. This ranges from the importance of
conducting a structural inspection of the building to environmental/soil
studies to all the related legal and physical lot, zoning and other
local/state regulatory assessments, as well as the tenant mix to insure
no potential problems exist.
Legal and Tax Considerations: There are several different
ownership entities that can be used when investing in real estate with
their own tax and legal consequences. It is important to have a
fundamental understanding of each ownership type and how each type
affects your tax situation. An experienced team of legal and tax
professionals are important to assist in navigating these issues. For
example, setting up an LLC may not be the best entity for tax
implications. LLC's are a popular vehicle for real estate ownership due
to liability reasons, but not necessarily for tax reasons. There are too
many issues and potential risks to go it alone. Having a "Team" of
professionals to handle all aspects of the proper legal entity and tax
considerations is critical.
Financing: Today, more than ever, it is a tough market to access
credit. Lenders are not in the lending mood. With the changes in the
credit and lending environments it is extremely difficult today to obtain
financing for any deal. Gone are the days when lenders would base
their decisions on pro-forma estimates for cash flow and property
appreciation. Understanding the current capital markets and its
impact on the property market is even more important today than it
ever has been. Leverage was the name of the game in the recent
past. It's still important, however, any acquisition will require a higher
equity position than in the past, which will result in lower returns than
with a higher leverage position going into the deal. Some of the
6. questions then are: How will this affect expected returns on the
investment? How will this impact money needed for property
renovations and other capital reserves for expected or unexpected
major repairs? Is the required use of more funds going-in to the deal
(equity) and the resulting return on that money to make it profitable
better-invested elsewhere? There are a host of other questions and
calculations needed to fully assess the feasibility of financing the deal
especially given the environment we are in today. For example, is
there a strong leasing market today to support higher effective rental
rates and rate increases in the future that will more than cover higher
debt service requirements today from lenders?
Exit Strategy: How long do you expect to hold the property? What
will be the market when its time to sell? What governmental
regulations (e.g., zoning and land use) have changed since the
acquisition? What will the credit/lending markets look like? What will
the demographics and employment projections look like?
These questions require a crystal ball to answer. Of course, no one
knows for sure. An exit strategy, preferably formulated before the
acquisition, is as important as the decision to purchase. The exit
strategy should be the basis for any decision to invest or not. A well
thought-out investment program always starts with an exit plan. This
is especially true in investment real estate. It is often said that you
make your money when you make the purchase. It is also true that
you will realize a profit or loss by your exit strategy, or lack of one.
Given today's economic environment, i.e., recession, it is paramount
that investors' thoroughly investigate and understand the
considerations above.
Whether you are an experienced investor with many properties or a
beginner contemplating your first deal, understanding all these critical
points as well as performing a detailed and comprehensive analysis
(due diligence) based on today's realities will better position you for
success.
7. questions then are: How will this affect expected returns on the
investment? How will this impact money needed for property
renovations and other capital reserves for expected or unexpected
major repairs? Is the required use of more funds going-in to the deal
(equity) and the resulting return on that money to make it profitable
better-invested elsewhere? There are a host of other questions and
calculations needed to fully assess the feasibility of financing the deal
especially given the environment we are in today. For example, is
there a strong leasing market today to support higher effective rental
rates and rate increases in the future that will more than cover higher
debt service requirements today from lenders?
Exit Strategy: How long do you expect to hold the property? What
will be the market when its time to sell? What governmental
regulations (e.g., zoning and land use) have changed since the
acquisition? What will the credit/lending markets look like? What will
the demographics and employment projections look like?
These questions require a crystal ball to answer. Of course, no one
knows for sure. An exit strategy, preferably formulated before the
acquisition, is as important as the decision to purchase. The exit
strategy should be the basis for any decision to invest or not. A well
thought-out investment program always starts with an exit plan. This
is especially true in investment real estate. It is often said that you
make your money when you make the purchase. It is also true that
you will realize a profit or loss by your exit strategy, or lack of one.
Given today's economic environment, i.e., recession, it is paramount
that investors' thoroughly investigate and understand the
considerations above.
Whether you are an experienced investor with many properties or a
beginner contemplating your first deal, understanding all these critical
points as well as performing a detailed and comprehensive analysis
(due diligence) based on today's realities will better position you for
success.