3 Evaluating CRE TH

Evaluating Commercial Real Estate

Differences Between Commercial and Residential Leases

  • Commercial Real Estate Leases vs. Residential Leases:

    • Lease Duration:

    • Commercial leases can vary widely and often differ from one year (typical in residential leases) to longer-term agreements (2, 3, or even 5 years).

    • Examples include:

      • Month-to-month leases (e.g., self-storage facilities)

      • Long-term leases (e.g., up to five years for certain commercial properties).

  • Cash Flow:

    • The longer the lease, the greater the potential cash flow, which is a significant advantage in commercial versus residential investments.

Planning and Financial Considerations

  • Action Plan for Commercial Property:

    • Determine how much rental space is needed.

    • Assess the actual area and its capacity for net rentable square feet.

    • Analyze the expected income from the property (optimistic yet realistic expectations).

  • Evaluation of Purchase Price vs. Potential Returns:

    • Understanding the capital allocation is critical, especially when bringing in money partners.

    • Assess the expected return to partners (for example, a 10% return).

  • Identification of Key Players:

    • Know who is involved in the deal:

    • Money partners

    • Consultants

    • Management team

    • Brokerage house.

    • Commission structures (e.g., brokerage fees from 3% to 6% depending on agreements) impact negotiations.

Evaluating Vacant Properties

  • Strategies for Pursuing Vacant Properties:

    • An understanding of various metrics such as cash on cash return and internal rate of return (IRR) is important, but not the sole focus.

    • CCIM (Certified Commercial Investment Member) designation adds credibility to brokers.

  • Current vs. Future Market Rates:

    • Assess where the property is currently positioned in comparison to market rents and project future rent increases.

  • Expense Ratios and Capital Allocation:

    • Calculate the expense ratio relevant to the property type, accounting for vacancy rates and capital expenditures (typically 5% for capex).

Identifying Below Market Value Deals

  • Net Operating Income (NOI):

    • Running numbers on NOI can help determine property value and separate potential lucrative deals from less favorable ones.

  • Understanding Property Classifications:

    • Recognize the importance of property classifications (A, B, C, etc.) and their effective market pricing.

    • Class Definitions:

    • A-Class: High-end properties typically sold closer to retail value.

    • B-Class: Moderate condition and appeal.

    • C-Class: Usually older properties potentially in need of renovation, sometimes designated as C+, C-.

Assessing Value

  • Importance of Appraisals:

    • Conduct a thorough appraisal process, ideally through an MAI (Member Appraisal Institute) for unbiased evaluations.

  • As Is vs. After Repair Value (ARV):

    • Understand and differentiate between the current (As Is) value and future potential (ARV) value of properties.

    • The spread between these two figures can indicate the viability of a deal.

  • Purchase and Sale Agreements:

    • An appraiser's evaluation often includes insights from the purchase and sale agreement, helping to confirm what the buyer is willing to pay.

    • Caution is advised when lenders use in-house appraisers, as this can lead to undervalued assessments.

Due Diligence in Evaluations

  • Verification Process:

    • Verify critical details such as unit count and property zoning, ensuring that advertised data is reliable.

  • Risk Management:

    • Investigate zoning laws and permitted uses, being aware that changes can be made at a cost (e.g., need for zoning changes).

  • Thorough Review:

    • Examine all building permits and potential legal issues before pursuing a project. Key considerations include:

    • Past debts and encumbrances on the property.

    • Title reports and violations that may affect ownership rights.

Team Composition and Professional Oversight

  • Key Professionals:

    • Establish a knowledgeable team including investors, contractors, inspectors, and real estate professionals.

  • Importance of Scopes, Timelines, and Costs:

    • Clearly define:

    • Scope of work required for any renovations or repairs.

    • Project timelines that outline completion dates.

    • Total costs associated with improvements or modifications.

  • Inspection Importance:

    • Engage qualified inspectors for structural, electrical, plumbing, and other essential evaluations.

  • Understanding Financing Options:

    • If partner financing is involved, consider the implications for debt service, particularly in renovation scenarios.

Profit Potential and Market Trends

  • Market Cycle Awareness:

    • Observe trends in logistics (e.g., U-Haul movement patterns) to gauge property demand and market strength.

  • Focus Areas for Investment:

    • Seek motivated sellers in the $300,000 to $2,000,000 range, particularly in robust, recession-proof markets.

    • Adjust focus toward larger projects that provide potential for larger profits, avoiding lower-value investments.

Conclusion and Forward Steps

  • Preparation for the Next Stage:

    • Continue educating oneself on commercial property evaluations, ensuring diligent tracking and verification of all facets of potential deals.

    • Understand that ongoing due diligence is key to avoiding pitfalls and ensuring success in future real estate endeavors.