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Understanding Commercial Real Estate Investments

Purchasing commercial real estate as an investments is different than purchasing residential properties. The current or future income derived from the commercial building determines if the property is a good investment or not. Typically there are three commercial real estate investors that have different objectives; therefore, they will look at the building differently. The following are the three investment objectives an investor might consider:

  • Rehab Investors: This type of investor is looking for a property that is run down and is in need of repairs. They want to purchase the property at a low price, rehab the property and bring the property to full occupancy or with a low vacancy rate.
  • Management Investor: This type of investor purchases a property that currently has a decent occupancy rate and has little to no deferred maintenance. The currently owner is not running the property at it’s full occupancy due to poor management of the building. This investor will purchase the property and increases it’s cash flow by managing the property better than the previous owner.
  • Buy and Hold Investor: This type of investor will purchase a property that currently has a high occupancy rate and has no deferred maintenance. The investors watches the trends in the market and will purchase when he knows rental rates are low. Once the market rental rates increase the investor will raise the rates which will increase its value of the building.

Once an investor has located a commercial building to purchase based on location and price range, the investor will want to review the current financial history of the building to determine a pro-forma financial statement for the next year of operation. Also, the investor will want to determine what similar buildings (Class A, B or C) in a same condition are currently renting for in the market. Furthermore, an investor will want to determine a market cap rate base on what similar buildings recently sold for in the markets.

Most seller will try to inflate the income or deflate the expenses provided in the historical financial statements. You should request up to three years of historical financial so that you can determine any trends in income or expenses. If you are dealing with a “Mom and Pop” type of operation, then the historical financial statements might portray an inaccurate picture of the financial ability of the building. Furthermore, if the building is currently in foreclosure or owned by a bank, then the historical financials for the building might not be available.

If you are provided with any historical financials, then you will want to determine a trend in the income and expenses to use this information for your proforma. Also, you can obtain expense comparables from a real estate broker or appraiser that has data on the same property type you are purchasing. With the expense comparables you can determine if the expense for the building are higher or lower than other buildings and determine if there is room for improvement with the property once your purchase.

Next, you will want to survey similar property types in the area to determine a market rental rate for your building. If you are purchasing a multifamily property, then you will want to find similar buildings with the same number of bedrooms, bathrooms square footage, amenities, etc. If you are purchasing an office building or retail property, then you will want to determine a rental rate based on price per square foot and with similar lease types (Full service, Gross, percentage, modified gross, etc.).

The final step is to determine a market cap rate that you should use for the valuation of your building. Of course you will have your own cap rate (yield rate) that you desire but if you know what similar buildings are selling for, then you will have more negotiation room with the seller. To determine a market cap rate you will find similar buildings that sold and compile the cap rates from those buildings to determine your market cap rate. You should have about four to five arms length comparable sales for this analysis.

Once you have compiled all of this information, then you are ready to determine a market value for the property you intend to purchase and to start preparing your offer to the seller. If you and the seller are unable to come to an agreement on a purchase price, then you will repeat the process with your next offer.

Also, before you submit your offer you will want to determine if the property will meet your investment objectives. Some most common investment ratios a investor will consider are as follows:

  • Cash on Cash Return = Annual Before Tax Cash Flow / Cash Down Payment
  • Rate of Return = Annual Before Tax Cash Flow / Purchase Price
  • Gross Rent Multiplier = Purchase Price / Annual Before Tax Cash Flow
  • Internal Rate of Return = This calculation is used for larger buildings or more sophisticated investors. Here it the definition: The internal rate of return on an investment is the “annualized effective compounded return rate” or “rate of return” that makes the net present value (NPV as NET*1/(1+IRR)^year) of all cash flows (both positive and negative) from a particular investment equal to zero.

If you are interested in purchasing commercial real estate investments, then we can help you determine a fair market value and with all the investment ratios. Contact us TODAY!!

Category: Commercial
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