3 Things to Consider Before Purchasing Commercial Real Estate

So, you’ve decided to buy some income producing property, and you’ve decided against residential property.

Commercial property is an amazingly broad class of investments with a lot of niches, and, each niche of real estate comes with its own nuances and unique factors to consider.

So, before getting started in commercial real estate, consider these 3 things.

1.     What Niche Do You Want to Buy In?

You can be successful in any niche in real estate, but you can’t be successful in ALL of them.

The point of that saying is to show you to pick a niche and stick to it. Don’t try to buy self-storage, then office space, then try to develop a new subdivision.

You’ll make your mistakes on your first deal or two and get better each time. So, pick one and get good at it or you’ll keep making the same mistakes over and over.

When considering your future real estate niche, consider:

Your Temperament and Personality

Different types of real estate have different levels of interaction with the tenants. Also, the tenants can be very different.

Owning a multifamily complex will put you in a more regulated area where you must deal with the random whims and desires of renters. Then again, multifamily tends to pay more than other areas.

On the other end of the spectrum is self-storage which has the least interaction with the tenants, the easiest eviction process, and also earns a lot.

In between somewhere is office or retail. Dealing with a business is a lot easier than dealing with a family, and there are fewer rules surrounding the lease terms and eviction process.

Your Capital and Return Expectations

Larger property obviously costs more, and certain types of real estate tends to come larger. A great example is self-storage.

There are very few small self-storage facilities, so finding something cheap is very hard. On the other hand, it is easy to find a single tenant retail or office space which will be a lot cheaper.

So, if you have limited capital, some options may not be available to you.

How Much Work You Want

While it’s always possible to contract everything by hiring management, most new investors do some of the work themselves.

Multifamily will have the most requirements of the owner, then self-storage. At the lowest level will be office or retail, especially if you have a triple net (NNN) Lease where the tenant pays for repairs.

2.     Doing the Proper Diligence

Most people think of diligence as doing the inspection. While a physical inspection is part of the diligence process, diligence begins from the moment you see the listing up through the day you close the loan.

The more you find before making an offer, the more likely you are to find a great deal.

At each step of the analysis phase, you are making a lot of assumptions. So, the first step is to have a great real estate investment calculator to help you run your numbers.

Then, as you do more diligence you are turning assumptions into facts. The more facts and fewer assumptions you have, the more accurate your numbers will be and the more confident you can be about your purchase.

Verify the Vacancy

One of the biggest ways that a seller can manipulate the selling price is to change the vacancy assumptions. This is especially true for smaller properties.

If your area has a 10% vacancy but the seller assumes a 6% vacancy, it will dramatically increase the suggested selling price.

So, make sure you know the vacancy rate in your area. And, don’t forget, the vacancy is different for every asset class!

Understand the Expenses

Look for the trailing 12 months of expenses. If you can go back even further, then do it. Sellers will often reduce expenses and defer maintenance items to make their property appear to earn more than it does.

Look back as far as you can and see if there are any sudden reductions in expenses. If the last 3 months are significantly different than the first 3 months of the year, then they might be playing with the expenses.

Do a Little Physical Diligence Up Front

As you walk the property, look for cracks in the walls or foundations. As you walk in a unit, feel for sagging or sinking to see if there are any foundation issues.

Look at the windows age and if they open properly. This can also be a sign of foundation problems.

You can also look at any exposed plumbing or electrical to see if it’s old and will require replacement any time soon.

Another trick is to bring a pair of binoculars and look at the roof to see if it is new with good grit, or if it is old and curling up.

3.     Know Your Financing Before Shopping

The third thing to know before shopping for commercial real estate investments is your financing options. Thinking you can get 80% financing but then actually getting 65% financing is going to kill your deal.

So, speak to a good commercial mortgage broker before shopping for real estate so you know the rates, terms, etc.

Then, use those numbers in your calculator when estimating your overall returns.

Loan to Value

You really want to know what percent of financing you can get. In CRE it’s common to range anywhere from 65-80% depending on the type of loan you’re getting and also based on your qualifications.

Term vs Amortization

In commercial real estate, it is common for the loan term to be shorter than the amortization.

Basically, your payments will be based on a 25 or 30 year mortgage, but the loan will be do in 5, 7, 10, 12, or 15 years. There will be a balloon payment at the end

Prepayment Penalty

It is very common to have a prepayment penalty in a commercial mortgage. Shop for the smallest the prepayment penalty and for the shortest period of time.

That’s Just the Beginning

There are probably hundreds of different considerations to be made before purchasing any property. Each real estate sector or niche will be different, each city and state are different, and every person approaches real estate differently.

That’s why it’s so important to know what you want to invest in, what sort of returns you expect, and reduce your costs up front by verifying assumptions early.

The more you know up front, the more successful your real estate ventures will be.