How do you know the “right” price to pay for a commercial investment property? Understanding the cap rate, risk/reward relationship, and future potential of a property can be a complex process with many variables. If you get several, or even one, of key components wrong in your evaluation it could mean disaster down the road.
When underwriting the value of a commercial investment property we start with getting to understand three essential elements of the property. We look at the credit of the tenants, the physical condition, and how the current leases, and rents relate to the market.
Let’s start with the credit that will be backing your investment and ensuring stable and growing cash flow. Are the tenants national credit tenants or local mom & pop tenants? Are they start ups or long term, multiple location tenants? In the current environment, we need to ask if these tenants are “COVID proof” or “Amazon proof”?
During your due diligence period you need to carefully review each lease [or engage the assistance of an experienced commercial broker] to see what guarantees are included - personal, corporate, surety or large security deposits. Do they include a death or disability clause?
*Note - always make sure security deposits are transferred to you at closing because you will be responsible for returning them at the end of the leases.
The physical condition assessment includes a hard look at the improvements above ground, as well as an environmental assessment (Phase I or Phase II). You should have a qualified professional inspect the mechanical (HVAC), electrical, plumbing, parking lot, and roof. If you have to make capital improvements after closing you may end up with a very low ROI or possibly none at all. This also goes hand in hand with your lease review to see who pays for what in the event of equipment failure or normal repairs and maintenance.
If you are buying a condominium as an investment, carefully review the financial statement of the association to be sure they have adequate reserves for replacement of the roof, parking, HVAC and other property components. Otherwise, you may get a letter asking for a capital contribution to pay for repair or replacement of these items.
A thorough knowledge of current, and projected, market trends & conditions is essential when approaching the acquisition of a commercial investment property. Rent rates, vacancy rates, barriers to competition, new developments planned for your market and property type, are all important factors.
The remaining term on each lease must be identified, and factored into, the buy/no buy decision. Do the leases have renewal options at fixed rates or based on “fair market rent rates”? For example, you want to buy properties where the existing rents are below market and competition is high (low vacancy rate) in your property type or category. Conversely, if the rents in your target property are above market rates, you will be in for a big (and bad) surprise at renewal time.
That sounds like a headache! It’s really not too bad if you approach the process properly and thoroughly. When you add the return from cash flow, depreciation tax benefits, & appreciation, the return stack on a commercial investment property usually exceeds alternative investment options by far.