Successful commercial real estate investing starts with acquiring the right properties. Unfortunately, there is no one-size-fits-all definition of the “right property” — it’s all about what best fits each investor’s portfolio as they pursue their goals.
To properly evaluate commercial real estate investment opportunities, you have to start with analyzing your budget, including the likely operating costs of a newly acquired property. A sophisticated market understanding will help you forecast rental income as accurately as possible, and analyzing the location — including the politics and legal issues relevant to the area — will prepare you for the risks associated with each property.
4 Steps to Evaluating a Commercial Real Estate Investment
As you evaluate potential investment opportunities, start with these steps to strengthen your investment strategy:
1. Know your budget — and stick to it
Before you begin searching for your next commercial real estate investment, know your budget. That includes not only the property’s purchase price and the cost of obtaining financing, but also ongoing costs, including property taxes and maintenance. If you plan to hire a property manager or security staff or use any management software, incorporate those into your operating expenses as well.
As you narrow your search down to a specific property, tour it in person or have your broker do so if possible. Work with a commercial inspector to see if you will need to repair any damage (or ask the seller to do so) before you begin offering space for lease.
Your inspection will also help you understand the age and condition of plumbing, wiring and HVAC infrastructure. A real estate professional can help you understand whether any major repairs are imminent. You can also ask the current owner for paperwork detailing their utility costs.
Your real estate properties will generate cash flow through rental income, of course. But when you calculate the costs first, you’ll have a sophisticated understanding of how much revenue you need to generate for this investment to fit your criteria.
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2. Calculate your cash flow, net operating income and cap rates
To understand how much revenue you’re likely to generate from this real estate investment, start by estimating your Gross Scheduled Income (GSI). In brief, this is the total rental income that you could generate if the entire space were leased. Rents should be based on up-to-date market analysis.
Then, subtract some percentage to reflect vacancy. Rarely are commercial real estate properties fully leased all year, every year; it’s unlikely that you will collect rental income on every space every month. Use that market analysis to understand average vacancy rates in comparable properties. Then, subtract that lost income — 5% or 8% of your GSI, for example, reflecting your market’s vacancy rate — to understand your Effective Gross Income (EGI).
Next, incorporate your expenses for the first year of owning the property. Include the costs of maintenance, marketing, staff and software, but not financing. The result of this equation is Net Operating Income (NOI). Simply put, if this number is positive, you’re projecting a profit for your first year.
Finally, divide the NOI by the purchase price to calculate your cap rate, or capitalization rate. This shows your potential profit margin, or the ratio of the purchase price to the income the property generates.
The cash-on-cash return, similarly, describes how much revenue the investor generates compared to how much cash they invested, not the total purchase price. The cap rate and cash-on-cash return are identical when buyers pay all cash. But if a hypothetical buyer puts 25% down and pays off the rest of the property over 5 years, their cash-on-cash return would be significantly higher than the cap rate. The rental income the building generates is replenishing their cash on hand.
Many real estate investors prefer to use the Internal Rate of Return (IRR) rather than the cap rate to understand whether a property fits their investment criteria. The cap rate doesn’t account for growth in either rent or expenses, nor does it consider the cost of financing or future capital expenditures.
The IRR, on the other hand, starts with calculating future cash flows and the eventual sales price, and discounting back to the purchase price. An old property might have a low purchase price and therefore a high cap rate, but the future expenses might result in a less attractive IRR over time.
Calculating an IRR can be challenging because of all the cash flows that you have to consider. Work with a real estate professional to understand this metric and to apply it to the property you’re evaluating.
3. Evaluate your financing options
In residential real estate, there is one financing option that is vastly more common than all others — the 30-year mortgage. That is not the case in commercial real estate. Some properties do carry a long-term, fixed-interest commercial loan, although interest rates are generally much higher than residential loans — often 6% to 11% rather than 3% to 5%.
The U.S. Small Business Administration offers backing for a variety of commercial property loans, focusing on smaller dollar amounts and specific populations, including veterans.
Conventional loans from banks will typically cover between 65% and 85% of a property’s purchase price. This is called the loan-to-value ratio. The amount left over is what the purchaser is required to cover up front.
There are a number of other financing options for commercial real estate investments. Some property sellers will “carry paper” themselves, meaning the buyer pays them for the property over time with interest.
Different properties will come with different financing options depending on the seller and purchase price. Make sure to evaluate the financing options available with each potential investment to see if it fits into your company’s financial projections for the coming years.
4. Understand the building and its tenants
Finally, examine the property itself. Make sure the size and location are appropriate for your needs, both at present and in the future. Look closely at its condition and plan for any repairs the building will need immediately or within the first year.
Beyond that, make sure to understand the rules governing the property. Zoning laws regulate what types of businesses can operate on any given property and what changes owners can make to buildings. Also, talk to neighboring business owners about qualitative aspects of the neighborhood — the things numbers can’t capture, like foot traffic, problem storefronts and litigious neighbors.
If the property in question has existing tenants, make sure you know in detail the terms of their leases. If you anticipate that you will make significant changes to the property or to the lease terms that tenants are accustomed to, familiarize yourself with local rules about tenant rights, including how much notice property owners have to provide in the event of a rent increase.
How WindWater Evaluates Commercial Properties
At WindWater, we evaluate commercial real estate investments based on four analyses:
- We start with a Financial Analysis, which reviews the costs associated with a property.
- In our Market and Competitive Analysis, we review the performance of comparable properties and consider the challenges each sector faces.
- Our Location and Site Analysis drills into block-by-block details of the property’s location.
- Finally, our Political and Legal Analysis considers threats from potential lawsuits as well as the opportunities offered by city zoning and planning authorities.
Altogether, these analyses result in one strategic analysis that seeks to answer the central question: Should you make this investment? If it’s in line with your company’s goals and objectives, if you’ve evaluated and decided against the alternatives, and if you’ve carefully reviewed every potential red flag, you’re as ready as you can be to invest in real estate properties.