by Winston Rowe
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Hotels or motels in the limited service category are usually boutique properties. These hotels are smaller and don’t normally provide amenities such as room service, on-site restaurants, or convention space.
Extended stay hotels. These hotels have larger rooms, small kitchens, and are designed for people staying a week or more.
Land
Greenfield land refers to undeveloped land such as a farm or pasture.
Infill land is located in a city has usually already been developed, but is now vacant.
Brown fields, are parcels of land previously used for industrial or commercial purposes, but are now available for re-use. These properties are generally environmentally impaired.
Special-Purpose
The above categories of real estate cover the major types of commercial real estate. However, there are plenty of other types of commercial real estate that investors construct and own.
Examples of special purpose commercial real estate include self-storage, assisted living facilities, car washes, theme parks, bowling alleys, marinas, theaters, funeral homes, community centers, churches and restaurants.
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The Due Diligence Investigation Overview
It’s important to be diligent in your analysis of the finances and of the physical property to be as certain as possible that the price you pay is fair or the prospective property is not a looser.
Winston Rowe & Associates assists clients with expert due diligence analysis free of charge for commercial real estate transactions.
Check us out at winstonrowe.com for more information.
Property Income and Expense Data
If you’re considering the purchase of an income property, you need to know as much as you can about its income and expenses.
If you’re considering the purchase of an income property, the information you receive will probably come either directly from the seller or indirectly, through the seller’s agent.
Each of the following income and expense items on this list will need to be verified with supporting documentation from the seller.
Example Income & Expense List
Gross Scheduled Rent Income
Other Income
Accounting
Advertising
Insurance (fire and liability)
Janitorial Service
Lawn/Snow
Legal
Licenses
Miscellaneous
Property Management
Repairs and Maintenance
Resident Superintendent
Supplies
Taxes
Real Estate
Personal Property
Payroll
Other
Trash Removal
Utilities
Electricity
Fuel Oil
Gas
Sewer and Water
Telephone
Property Taxes
Look to see if the current owner has received some sort of tax abatement that may expire or may not apply at all to a new owner. Also, look for evidence of a “phase-in” of a new assessment.
Local governments are also masking taxes as “fees”, for example; excessive inspection fees, annual parking permits for your tenants or expensive business licenses.
Utility Bills
Most gas, electric, and water companies will give you usage information if you go online for their smart meter data. This is the most efficient way to collect expense data on a property.
This needs to match the seller’s income and expense statement data, if not ask for an explanation.
If what you’ve uncovered turns out to be an honest mistake, you’ve served notice that you are a diligent commercial real estate investor.
The same holds true for the rest of the information contained within the income and expense statement.
Sections of the Seller’s Tax Return
If the owner holds the property as an individual, then the income and expense information probably appears on Schedule E, and he or she can show you just that form.
The seller may own the property as a limited liability company (LLC) or some other form of partnership, in which case the property has its own tax return.
When you get the correct supporting IRS document, have the client sign an IRS 4506 (t) form.
This will enable you to get a copy of the business tax return. If a seller will not allow you to contact the IRS to verify information, most likely the documents presented are fraudulent.
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Representations about the Leases
Tenant leases are the cash flow for the commercial property and are also considered an asset.
The lease documents are the assets that you are buying; the seller included the building for free. You need to understand it and its cash flow value.
You’re going to be subject to the terms of those leases, and do the leases agree with the seller’s representations?
You want to know.
How long is each lease?
Do tenants have options to renew, and at what rates.
The age of the tenant leases. If the leases all start around the same date, a seller may have leased up the property with less than optimal tenants just to generate cash flow to list the property for sale.
It’s important that the leases are subordinated upon the sale, which means you own the tenants and the leases not the former owner.
Review the leases making sure that they are legal binding documents and were prepared properly.
Verify the identity of each lease holder ensuring that they are who they say they are. Sometimes a business may get sold or transferred without the property owner’s knowledge.
Or an apartment tenant may have sub-leased.
In the purchase agreement, have language making the seller liable for the representations contained within the tenant leases.
These basic questions will have an important effect on your analysis of the current figures and on the forecasts you’ll make about the property’s future performance and risk.
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Investigate Comparable Sales and Market Rents
Through the power of the Internet, it’s fairly easy to check the sales of comparable
Properties, there are many quality sources of data for this.
One problem you may have is the lack of enough comparable sales.
In this phase of your due diligence, is the leg work part. Picking up the phone to check rental rates and drive around looking at comparable properties in the area is a good idea.
You may discover that the property is priced to high or is not worth investing in because the market rents can’t support debt service, operating expenses and taxes.
As you get into serious property analysis and projections, you need to know what tenants are willing to pay for space and how much owners are obliged to pay for operating expenses.
Area Demographics
Demographics is essentially your pre-deal due diligence.
This is the one area you want to deal with before you begin a serious search for an investment property.
It pertains not to a particular property you plan to buy, but rather to the location in which you plan to invest. If you’re going to get involved in this neighborhood, then you’d better know what you’re getting into.
Important things to consider in your demographic due diligence are.
What is the median income for the area?
Who are the major employers within a 10 mile radius?
Are there a lot of young family’s or is it mostly people over 60. You’re looking for a mix.
A population density of 500,000 or more is required by most capital sources.
Is the area low or high income, you need people to be able to afford the rent.
Look for graffiti, this is sometimes call the graffiti index, street crime is the number one destroyer of property values.
What are the conditions of the other propert
ies in the area?
The following is an example list demographic detail items.
Population
Population Growth
Age Distribution
Income Range
Occupational Profile
Major Employers
Median Home Price
Age of Housing Stock
Housing Mix
Apartment Vacancy
Apartment Rent (range)
Office Vacancy
Office Rent/sf (range)
Retail Vacancy
Retail Rent/sf (range)
Retail Area Traffic Count
Zoning
Local Government Issues
General Neighborhood Appearance
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Physical Inspection
Maintenance schedules need to be verified you’ll need proof that work was preformed, who performed the work, past city inspections and a permit history for major improvements or repairs.
If the physical asset is in good condition, then the income stream can flourish; if it’s in poor condition, the stream can dry up.
A property that presents you with substantial, unexpected repair costs will quickly deplete your cash flow and reduce that property’s investment value.
As you conduct the Inspection, make a note of the cost to replace or repair. This is going to be very helpful during the purchase offer and financing phases of a potential real estate investment.
Example Inspection List:
Construction type (frame, masonry)
Exterior walls (type & condition)
Roof (type & condition)
Foundation (type & condition)
Floors and flooring
Interior walls (type & condition)
Windows
Chimneys
Plumbing & fixtures
Electrical & fixtures
Water & sewer
HVAC, oil tanks
Doors & hardware
Kitchens
Bathrooms
Security
Fire protection
Sewer & Water
Elevators
Lobbies, public restrooms
Pest infestations
Site
Environmental assessment
Landscaping
Drainage
Paving
Sidewalks & curbs
Outside lighting
Trash receptacles
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Financial Analysis and Due Diligence
When you're considering the purchase of commercial income property you need to know as much as you can about the income and expenses before you even consider making an offer.
If you need help or advice with commercial property calculations and analysis, Winston Rowe & Associates always welcomes calls or emails. Please go to winstonrowe.com for help.
Here's how to make a great investment in a commercial property.
Don't trust any numbers you hear from the seller, the real estate agent or anyone else representing the seller, use a third party firm that specializes in conducting a professional due diligence investigation.
It's critical that you have a realistic idea of what the value is, and what the income and expenses will be and accuracy of the information is everything
A professional due diligence investigation will get to the hard evidence from using business analysis metrics to find out what those numbers have been in the past and what they may be in the future.
The Financial Metrics of Commercial Real Estate Investing:
Gross Rent Multiplier (GRM):
Gross rent multiplier is a rough measure of the value of an investment property that is obtained by dividing the property's sale price by its gross annual rental income. GRM is used in valuing commercial real estate.
Utilizing the GRM you can accurately determine the value of the commercial real estate prior to ordering an appraisal. Additionally, the GRM can also verify or discredit an existing appraisal.
Net Operating Income (NOI):
Net operating income (NOI) is used in the real estate market to determine the revenue that a property generates less operating expenses. NOI also determines a property's capitalization rate, or rate of return.
Occupancy:
The occupancy rate is the number of units filled divided by the total number of units. For instance, if there are 95 units occupied out of a 100-unit apartment complex the occupancy rate is 95%.
Vacancy:
Some investors prefer to use the vacancy rate instead of the occupancy rate. The vacancy factor is just the reciprocal of the vacancy. For instance, in the example above if there were 5 empty units out of a 100-unit apartment complex the vacancy factor would be 5%.
Absorption:
The absorption rate is the rate at which available rental units are rented in a specific real estate market during a given time period. It is calculated by dividing the total number of available apartment units by the average number of sales per month. For example, this figure shows how many months it will take to exhaust the supply of apartment units on the market.
Capital Expenditure (CapEx):
Capital expenditure, or CapEx, are funds used by a company to acquire or upgrade physical assets such as everything from repairing a roof to building, to purchasing a piece of equipment like water heaters, air conditioners, or new plumbing.
Cash Reserves:
This is very important to every potential capital source; it's the amount of cash that you set aside when running a business. A business that is not properly capitalized can fail in a very short period of time.
Internal Rate of Return (IRR):
Internal rate of return (IRR) is a metric used in capital budgeting measuring the profitability of potential investments. Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.
Loan-to-Value (LTV):
Loan-to-value ratio (LTV ratio) is a lending risk assessment ratio that financial institutions and others capital sources examine before approving a mortgage. Typically, assessments with high LTV ratios are generally seen as higher risk and, therefore, if the mortgage is approved, the loan generally costs the borrower more to borrow.
Debt Service Coverage (DSC):
The formula for DSC is Net Operating Income divided by the total debt service.
Typically, capital sources want to see at least a 1.10 DSC. This means that for every $1.00 of debt service, the property is producing $1.10 of cash-flow to service that debt.
Capitalization Rates (Cap Rate):
The capitalization rate is the rate of return on a real estate investment property based on the income that the property is expected to generate. The capitalization rate is used to estimate the investor's potential return on his or her investment.
Even though this metric is simple, most real estate brokers manipulate this number (usually by using forecasted income numbers rather than the actual numbers). Always take a stated cap-rate with a grain of salt and do your own math.
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Purchase Offer Due Diligence
When you have identified a property on which you want to make an offer, what issues would you expect to hammer out in your negotiations?
Once your negotiations with the seller are completed and a purchase contract is in place. The next step is the financing.
All of your efforts up to this point have been preparing for this.
Many prospective real estate deals fall apart during the financing phase because the deal has not been prepared properly to submit to a capital source.
Winston Rowe & Associates can develop custom commercial property lists for you. Check us out at winstonrowe.com
The following is an example of a check list to help you prepare the purchase agreement.
Example Purchase Agreement Checklist:
Price
Property inspection list
Amount of deposit
/> Offer withdrawn if not accepted by (date)
Inclusions (i.e., personal property)
Closing date
Possession date
Seller’s disclosure of known defects
Seller’s certification of accuracy of attached lease terms and operating expense data
Schedule of security deposits
Structural inspection contingency
Environmental survey contingency
Buyer’s access to property, documents, tenant records; amount of time for buyer’s due diligence
Penalty for a default by buyer
Penalty for a default by seller
Financing contingency—third-party capital source; amount and terms
Financing from seller; amount and terms
Seller’s and Buyer’s obligations in case of damage, destruction, or condemnation prior to closing
Guaranty by seller not to amend or enter into new lease agreements
Guaranty by seller not to amend or enter into new service contracts
Survival of warranties and representations
Seller’s rent guaranty in the event of vacancy before closing
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Types of Capital Sources for Financing
The distinctions between the types of commercial capital sources are less than clear at times, but we’ll do our best to break them down into the following categories.
We always welcome questions about the capital markets; check us out online at winstonrowe.com
Permanent Bank Capital Sources:
Permanent loans are usually made by either by life insurance companies, conduits, banks, or credit unions. In terms of the number of commercial loans written, banks are by far the most active makers of permanent loans.
Bridge Capital Sources:
Direct commercial bridge capital sources occupy their own niche within the commercial mortgage industry, known as the secondary lending market, which has evolved to provide financing to a particular set of borrowers, transactions and property types that other types of capital sources are unable to accommodate.
Portfolio Capital Sources:
So-called "portfolio" capital sources make commercial mortgages with the intention of retaining the generated asset as part of the company's portfolio.
The two most common types of portfolio capital sources are commercial banks and life insurance companies; but this category also includes such entities as pension funds, REITs, and credit unions.
CMBS Conduit:
Commercial mortgage-backed securities (CMBS) arose in the late '80s following the savings and loans crash as a way of enabling investors to participate in commercial mortgage lending within a managed context.
Commercial mortgages that the conduit originates become part of a standardized pool of such assets, shares of which are then sold to investors.
Thereafter, the conduit capital source may service the loan, but the interest payments are collected on behalf of the investors.
Conduit capital sources are the main source for long-term financing for purchase and refinance of conventional commercial properties.
Private Investors and Funds:
A more diverse and fluid category of commercial mortgage capital sources is occupied by so-called "private" or "hard money" capital sources.
Generally the main distinctions between these capital sources and the above "institutional" capital sources are: (1) that the loaned funds generally derive from a private individual or a group of private individuals, rather than from a company's assets, and (2) that hard money capital sources are willing to
