To begin investing in commercial real estate, an investor first needs to understand the different sectors of commercial real estate and how profit is valued. These fundamentals are outlined in our post on “The Basics.” The next step is to understand a process called conducting due diligence and how it evaluates the quality of a real estate deal. Regardless of what sector you decide to invest in, conducting due diligence prior to investing is the most important part of investing in commercial real estate. Keep in mind that valuation methods can differ quite a bit compared to single family residential real estate and stocks and bonds.
Here are some major steps to abide by when evaluating commercial real estate.
Accurate Valuation
Accurate valuation of commercial real estate should be understood well by potential investors. Commercial real estate tends to have longer lease terms (compared to residential real estate). Most commercial real estate leases and incomes are based on usable square feet. These two factors alone lead to higher
income potentials compared to residential real estate. Location, depending on the type of real estate niche, can be an even more important factor in the valuation of real estate. The location and type of intended tenant can drive the demand for real estate up or down. For example, a restaurant building in a busy urban setting will drive higher demand then a restaurant in a low traffic residential neighborhood.
Compare Properties
Analyzing comparable real estate in the same market can help determine valuations and the current and future demands. The industry term for analyzing comparable properties is “comps.” Comps are assets recently sold with very similar characteristics such as building size, property type, and tenant mix.
Evaluate the Metrics
Commercial real estate valuation involves calculations related to finance. In order to invest in commercial real estate, one should know these basic real estate finance concepts:
Net Operating Income: This calculation refers to gross income of the property deducting any operating expenses that the property incurs. Operating costs does not include any income taxes but can include janitorial expenses, utilities, repairs, maintenance, and landscaping. The number derived from the above is the net operating income or “NOI.”
Cap Rate: The value of income producing property is determined using the “Cap Rate.” This is the ratio of NOI to asset value. Cap rates help investors determine future cash flows based on the current asset valuation.
Cash on Cash: Cash on Cash is a widely used metric to determine rate of return from the out-of-pocket cash investment. It is used by investors to determine the return of cash, on an annual basis, to their out-of-pocket cash that was initially invested when purchasing the commercial real estate property.
Together, the above mentioned metrics serve as the first step to evaluating commercial real estate. It is important that investors do their homework to fully understand deals. For example, real estate investment is a long term hold and investors are locked in for longer periods of time than compared to stocks and bonds. Not all real estate opportunities are equal so it is important to utilize the proper metrics and avoid negligent mistakes
Neglecting Due Diligence: Due diligence is perhaps the most important aspect of commercial real estate investing. Conducting market research and verifying all of the information provided on the investment is the most important aspect of due diligence. It is extremely important to learn about the local market and property you wish to invest in. Visiting the site, talking to local real estate brokers about the market, and hiring a building inspection company to assess the health of the property are few of the important tasks one should conduct before investing.
Financial Ignorance: Failing to understand income statements, rent rolls, and other statements can lead to poor decisions. It is imperative that you master the basics of real estate finance before investing so you can understand the statements provided by the seller and make your own conclusions. Investors should spend significant time in verifying the lease agreements, financial statements, tax returns, and other collateral data submitted by the seller. Outdated leases and financial statements may not show the whole picture and lead to a bad investment choice.
Not hiring and working with experts: Another mistake that inexperienced investors make is doing everything on their own. There are industry experts that specialize in different aspects of the real estate industry, and they can be a great asset to have on your team when evaluating commercial real estate. Working with real estate CPA’s, attorneys, and financial consultants is something that should be considered before investing.
Real Estate Investments are Illiquid. Inaccessibility of invested capital in real estate should be considered very seriously. Most real estate investments are held for 5 to 7 years and it is unwise to expect capital to be returned before a real estate investment is realized. A proficient investor will anticipate expenditures such as college tuition or other financial needs that may require strong alternative investments that are more liquid and easily accessible.