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Don’t Buy Your Next Real Estate Investment Without Taking These Steps Into Consideration!

Contemplating the purchase of your first (or next!) piece of commercial real estate is exciting.  Many investors start their real estate portfolios by owning single family homes – assets that are generally more time-intensive to care for, and which offer less cash flow as a general rule.  The switch toward buying commercial real estate represents a graduation or a rite of passage… you’re now in the Big Leagues of real estate investors and building a part of your portfolio which will be able to work hard for you, without your needing to put in a lot of time and effort on a regular basis.

However, before you take the dive into the deep end and start to buy commercial real estate, here are a number of important things you’ll want to consider.

1. Where can you find the best deals on the type of property you want to buy?
2. How will you analyze the property to see if it makes sense for your portfolio?
3. How big a property do you want to buy?
4. Where will you come up with the cash to use for a down payment?
5. What part of the country are you buying in, and what is the real estate market like there?  (What part of the market cycle are you in?)
6. How will you handle the financing?
7. What is your holding strategy?
8. How will you manage the property?
9. When do you plan to sell?
10. What is your contingency plan?

The funny thing about buying commercial real estate is that BUYING it is actually the easy part of the process.  Anybody with a good credit score, some money, and a willingness to jump can get into a commercial property.  The harder part about buying commercial real estate is ANALYZING and MANAGING the process correctly so that the building ends up being a blessing in your life that will help you create wealth, not a thorn in your side that will bleed you dry.

So, let’s go over this list in a little more detail, I want to share a few important concepts under each bullet point before you buy commercial real estate yourself.

Where can you find the best deals on the type of property you want to buy?

Inventory is the name of the game here and realtors hold the keys when it comes to this.  True, you can do it yourself (just like the realtors do) and contact owners directly by phone or mail.  This can work well if you’re especially interested in targeting smaller properties that not as many realtors would be interested in representing (say under $1 million, or under 8-units), or are really attached to getting a deal in certain neighborhoods (say close to your house).  Pursuing FSBO owners can be quite an effort in time and money, so this is not where I would start.  Begin by looking at what the realtors have to offer and searching for and negotiating good deals from their stock.

How will you analyze the property to see if it makes sense to add to your real estate portfolio?

Knowing  your buying criteria or “numbers” is really important before you purchase your next piece of property.  Are you looking for a turn-key solution that you can manage with a minimum of time and effort, or are you hoping to find a project where you can roll up your sleeves and add some real value by turning around a problem?  You should have a strategy in mind going in and tell you realtor to bring you properties that meet your needs.

Also, remember to look at the numbers.  Many of us are stuck on just a few “quick check” numbers to help us decide what deals to spend more time on.  Some people just look at cap rates, for example.  However, it is a good idea to slow down and take a global look at the property to snag a good deal.  For example, let’s say the owner is keeping rents down to decrease vacancies and make the property require less management effort.  If this is the case, the cap rate might be lower than average for the area.  That doesn’t mean that there isn’t upside in the deal.

However, be careful about buying on “pro forma” numbers.  Lots of realtors make a big effort to sell you on the properties potential and they show you the “blue sky” numbers, the “we-wish-the-property-was-like-this” numbers.  Pro forma’s are an exercise in creative writing… some are more realistic/accurate than others, but beware.  Negotiate to buy what’s THERE not what COULD BE there…

How big a property do you want to buy?

The size of the property is something to consider on two main fronts:  Money – can you afford to get into a bigger property?  And Time – Can you afford to manage a smaller property?

Generally speaking, bigger properties will cash flow better and are better able to support professional management.  It makes sense to have about 12-18 units in a building before hiring a residential property manager makes good economic sense (although many people do hire management even for their single family homes, it’s just relatively more costly).

Also, you’ll have different levels of competition for different sized properties.  For example, here in Seattle, we have a glut of 4-plexes on the market.  Many investors who own 4-plexes are having trouble selling them because they are very expensive relative to the income they produce, but since they are under 5 units, you have to buy them with a regular house loan instead of a commercial loan.  5-plexes are much easier to buy in our market place.

So, if you were in the market to buy a 4-plex, you could probably negotiate a better deal or some nice owner financing more easily than if you were in the market for a 5-plex.  Talk to your realtor to find out whether there’s a soft spot like this in your marketplace.

Where will you come up with the cash to use for a down payment?

For most investors, this is the question that keeps them up at night when they go to buy commercial real estate.  No cash, no property.  My partners at Grassland Investments and I have solved this problem by syndicating deals and raising private funds for the down payment.  We get 10 or so of our friends and colleagues together and raise $1 million for a down payment on a $5 million dollar property.  It works well as long as the property’s performance can meet these investors goals.  For example, we buy cash flowing properties, and then distribute the monthly income amongst the investors.  We also give the investors a chunk of the back-end profits.  Compensating investors generously makes it a lot easier to find them on your first and subsequent deals.

You can also rely just on yourself or a money partner to come up with the down payment.  Many people get their funds through

• The old-fashioned way: Saving and investing til they have enough
• Doing a 1031 Exchange and using the proceeds from the sale of another rental property to help them move into something bigger
• Taking out a line of credit (or refinancing) on their personal home or another investment property
• Investing cash from another line of business – such as fix-and-flip properties
• Windfall profits from an inheritance, bonus, lawsuit settlement, etc.
• Changing asset classes (taking money out of their stock portfolio and diversifying into real estate).

What part of the country are you buying in, and what is the real estate market like there?  (What part of the market cycle are you in?)

The next thing to decide is where to buy.  In the past, many people have been constrained by the idea that they should invest in their own back yard where they can keep an eye on the property.  If you want to invest in your area, that’s fine, you can do so.  But consider comparing your area (and it’s current market cycle) with other parts of the country that might be better investments.

When I buy commercial real estate, I like to buy in areas that are RISING in value and which have a balance between values and rents so that I can get a positive cash flow.  There are a lot of investment markets, on the coasts, for example, where properties rise in value, but you can’t get positive cash flow unless you put 50% down to buy the property.

There are other areas of the country with great cash flow, like the Midwest, where property values can be very stagnant and appreciation is little to none.

Before you decide where to buy your next commercial property, don’t just consider the parts of town where you live, consider the entire nation.  This is especially true if you’ll be buying a property large enough to support commercial management, anyway.

Financing Your Commercial Property

There are lots of ways to handle financing.   You can

• Get bank financing for 80% of the purchase price and use your own cash for a down payment.
• Get down payment money from a refinance of another building, or a line of credit.
• Raise private money from friends and colleagues for some or all of the purchase price.
• Go to a hard money lender.
• Get owner financing or have the owner take back a second mortgage.
• Assume the mortgage officially.
• Take over the financing subject to.
• Use a contract for deed.
• And you can even buy on a Lease/Option basis.

How you finance the property is only limited by your creativity.  However, remember the golden rule of real estate:

He Who Has The Gold Makes The Rules

If you need help financing the property, be prepared to pay more for it.  If you come in with more of your own cash and/or better credit, you should be able to put a better deal in place and save yourself some money on the purchase price and/or the cost of the financing.

What is your holding strategy?

Before you buy any commercial property, it’s a good idea to know what you plan to do with it.  Is it a “value added” play where you will drastically change management, change the use of the building, or remodel it in order to increase its value?  Or are you stepping into a “turn-key” situation where you’ll have very little to do except cash your checks?

It’s important to know the answer to this situation going in.  Value Added deals can be more profitable, but can tend to demand more effort, money and/or expertise.  Be careful and have a knowledge support team and some extra resources behind you if you’re going in to turn around a problem property.

If it’s your first commercial real estate transaction, get your feet wet in the shallow end of the pool, and look for something that won’t present too big a challenge your first time out.

How will you manage the property?

Property management is of critical importance to the success of an real estate venture.  The bigger the property, the more important it’s management is.  Property management is often the last thing an investor considers when he’s planning to buy a commercial investment.  This is a dangerous approach.  Sharp investors I know find the MANAGEMENT COMPANY FIRST and then look for good deals in the areas the management company services.

Having learned the hard way how quickly a bad property management company can damage a property’s physical structure and value, I now am much more concerned with quality property management, even for small commercial buildings.

The management company must know you, understand the type of property that you are letting them work on, and have good systems in place to ensure fast evictions, fast apartment turn-arounds, on-time bill paying and competent cash management, and have adequate supervision of staff who maintain the property.

With any new property management company it is imperative that you supervise them heavily with surprise inspections and audits to make sure that your property is being well taken care of.  If you ran an airline company, you wouldn’t hire the first guy who said he had a pilot’s license to handle your property.  You wouldn’t hand your stock portfolio over to a manager who said he was great at beating the market, would you?  You’d do your homework and look for proof.  You need to do the same thing here.

If you need help managing your commercial real estate, or understanding whether your current property manager is competent, I STRONGLY recommend the forensic services of Roger Maupin in this regard.  He supervised the removal and replacement of our bad property management company on a 150+ unit complex and saw the financial losses they created by mis-management of our buildings.  Roger is well aware of the cost of a bad management company, and can help you avoid paying through the nose for your manager’s incompetence.

When do you plan to sell?

You should always buy a commercial property with a plan on when to sell it.  You can always change your plan, but having an initial holding-time strategy in place is important.  This can affect your tax strategy, your financing structure, your capital improvement program, and more.  Before you buy, be sure you take this into account.

Is your property purchase meant as a fast-as-possible fix-and-flip?  Is it a 5-year hold as you ride the market cycle up?  Or will you hold it until you die and then pass the building on to your kids?  It’s important to have a sense for this before you get into the property.

What is your contingency plan?

When it rains, it pours.  As I write this in December 2008, many investors are wringing their hands and tearing out their hair as property values continue to sink and foreclosure rates are up across the country.  Others are biding their time, with cash in their pockets and blood in the streets, starting to look for great deals they can snap up when confidence is down.

As the falling real estate market of the last year has taught us, nothing lasts forever, and what goes up must come down.  I think there was also something about “the best laid plans…”

The bottom line is that things don’t always go our way.  The government can change the zoning requiring costly building upgrades.  Businesses providing an economic base for the area can downsize or move.   The economy can soften.

Although we hope that none of this happens to you or your commercial real estate investments,  these things do happen.  The difference between the people who survive these downturns, and make money during them, and those who go belly-up is often the difference between those who planned for problems and those who didn’t.

In my opinion, cash, or access to cash, is one of the best ways to protect yourself against costly changes in the marketplace.

Don’t overleverage yourself to get into properties.

Maintain healthy reserve accounts and budget for capital expenses in every building you own.

Live below your means.  It’s safer to grow a little slower than you think you can, than to let the momentum of your property acquisitions run away from you, and wind up play catch-up.

Leverage is the big risk-factor here, so use it wisely.

If you have bought or are looking to buy a piece of commercial real estate, please stay organized.  Let us know how we can help!  We regularly answer reader’s questions here on our blog, so feel free to write!

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