In these tough economic times it’s all about going back to basics when contemplating real estate investing. Whether investing in commercial property, defined as office, commercial, hotel and industrial property, or multi-family residential property, it’s a different time than in the recent past. For the seasoned investor, it’s time to go back to fundamentals and understand not only the real estate market, but also understand the capital market in order to achieve some level of success. This is even more important for the beginning real estate investor.
During the heyday of 2002 through the first half of 2006, capital was abundant for all types of property. Most types of property were easily financed on easy terms. With opportunity money available, lenders turned on the spigot and investors were able to access a variety of sources to finance an acquisition. Gone are the days of lenders making loans based on potential future property income and appreciation. As a result, most buyers during this time period ended up paying a premium for their acquisition in anticipation of property values ​​continuing to appreciate at double-digit rates as had been the case for much of this time.
Today we are in a totally different environment. Today it is more important than ever to go back to basics. For investors contemplating an acquisition, there are several property level and financial level considerations and calculations that must be made to help properly evaluate a purchase. Qualified and experienced professionals can be invaluable in this area in helping to ensure success.
A necessary first step is to identify the goals of each property as it relates to ownership, operations and management of the property and an eventual exit strategy. The following summary outlines the main considerations that are important to a successful investment program, whether at the beginner stage or at the level of the more experienced real estate investor.
Property Types: Different types of properties require different operational and property management considerations, as well as have different income and expense profiles. An example is a full-service office building in which the owner pays for all building operating expenses and maintenance with no pass-through to the user. Of course, the rental fee paid by the office user reflects the operating expenses; however, there may be spending limits in leases that prohibit any amount above a certain dollar amount per square foot from being passed on to the user of the space. In that case, the owner must absorb the amount that exceeds the limit of the increase in expenses. In contrast, the owner of a retail shopping center will typically pass all ownership expenses on to the user with no offsets or spending caps. Therefore, the operating expenses of the retail center will typically be less of a cost burden for the retail owner than for the office building owner due to the contractual (lease) ability to pass all expenses on to the tenants. This is just one important consideration when contemplating investing in the office building compared to the shopping center example used here. Different types of properties will experience different vacancy rates, rental rates, and expense ratios and will be market driven. All of these factors are important when evaluating a purchase. Lenders also rely on historical market metrics and property operating profiles when evaluating your underwriting criteria as a basis for determining how much to lend, what level of income is required to meet annual debt service on the loan, to many other operating properties. , market and management factors. Different types of properties have different operating and expense considerations, as well as financing, which must be thoroughly investigated for success.
Property Location: That old adage in real estate: location, location, location. Yes, it’s even true in commercial real estate. A thorough analysis of location factors is crucial to a successful investment program. Due diligence is required and a first step is a geographic analysis that includes items such as transportation systems, major employment centers, and demographic and economic data to a host of other information useful in assessing the broader area where the company is located. property. A very useful tool to assist in this analysis is GIS, or Geographic Information System. Once the larger market area is analysed, a narrower focus on the real estate market location is necessary to rule out any particular factors that may add value to the property, such as a major employer locating in the market area or any factor that detracts from the value of the property. as a new zoning ordinance that restricts building heights and uses. Once these analyzes are done, it is also important to do your due diligence on the specific property under consideration. This ranges from the importance of performing a structure inspection to soil/environmental studies, all related legal and physical lot and zoning and other local regulatory assessments to ensure that there are no actual or potential problems.
Legal and tax considerations: There are several different ownership entities that can be used when investing in real estate with their own tax and legal consequences. It is important to have a fundamental understanding of each type and how each type affects you and your tax situation. An experienced team of legal and tax professionals is important to help you navigate these issues. For example, setting up an LLC may not be the best entity for tax implications. LLCs are a popular vehicle for real estate ownership for liability reasons, but not necessarily for tax reasons. For example, operating a real estate investment business and having employees may require a different business entity, such as a subchapter S corporation instead of operating as an LLC. There are too many potential problems and risks to go it alone. Having a team of professionals to handle all aspects of legal and tax considerations is critical. This can also be said of having real estate professionals who understand not only the real estate market, but also the capital market, as well as experienced negotiators working on your behalf. It is always prudent to have a team of experienced professionals on your side.
Money: Today, more than ever, it is a difficult credit market. Lenders are not in the mood to lend. With the changes in credit and credit environments, it is extremely difficult today to obtain financing for any business. Gone are the days when lenders based their decisions on pro forma estimates for cash flow and property appreciation. Understanding the current situation is not only important, but even more so today, crucial for anyone to have a chance at a successful investment program. Leverage was the name of the game in the recent past. It remains important, however, that any acquisition will require a higher equity position than in the past, resulting in lower returns than with a higher leverage position going into the deal. Some of the questions then are: How will this affect the expected returns on the investment? How will this affect money needed for property renovations and other capital reserves for expected or unexpected major repairs? Is the required use of more funds for the deal (equity) and the resulting return on that money to make it profitable better invested elsewhere? There are a number of other questions and calculations necessary to fully assess the feasibility of financing the deal, especially given the environment we find ourselves in today. For example, is there a strong leasing market to support future rental rates and rate increases that will more than cover lenders’ higher debt service requirements? Again, having a team of professionals working for you to help assess and advise on these issues is an important part of the overall analysis and process.
Escape strategy: How long do you expect to keep the property? What will the market be like when it comes time to sell? What government regulations (eg, zoning and land use) have changed since the acquisition? What is the credit/loan market like? What will the demographic and employment projections be like? These questions require a crystal ball to answer. Of course, no one knows for sure. An exit strategy, preferably formulated prior to the acquisition, is just as important as the purchase decision. The exit strategy should be the basis of any decision to invest or not. The above questions along with a number of other property-specific legal, tax and financial considerations will help formulate the investment program and its likelihood of success; here success means making a profit. Why else would an investor participate in an endeavor without the possibility of a profit? A well thought out investment program always starts with an exit plan. This is especially true in real estate investments. It is often said that you make your money when you shop. It is also true that you will make a profit or loss on your exit strategy, or the lack of one.
Whether you are an experienced investor with many properties or a beginner contemplating your first business, understanding and performing detailed due diligence of the major real estate investment processes and participating in the necessary analysis will contribute to any investment program. successful investment. Particularly given the current economic environment, it is of the utmost importance that investors carefully examine all the problems that a property may present along with understanding the financial considerations and the legal and tax considerations for owning investment real estate.