Here are some of the top 5 mistakes to avoid when investing in CRE:
1. Looking at Pro Forma Numbers
One of the things that you will start to see as you’re searching for properties is that there are two sources of income in the financial statement. Number one is the actual revenue / actual net operating income of the property. Number two is the pro forma income / pro forma net operating income. And these numbers are different because one is the current number and existing financials and the other one is an imaginary number. It’s an imaginary number based on what the real estate agent thinks the property could make after you buy it. You have to be very careful because commercial real estate brokers don’t have the same obligations around disclosures or telling the truth as residential real estate agents do, so take everything that they give you with a grain of salt on the pro forma numbers.
You want to have a realistic financial analysis on how you are going to add value to that property. And some of the things could be: cutting costs, rent increases, bringing in new tenants to fill up current vacancy, etc. And of course you want to make sure that you do market research to see what is the existing rent per square foot going for properties in that area. What are existing property prices going for per square foot in that area, you also want to make sure that you review existing vacancy in that area, for other properties. If you are looking at purchasing a property that is currently 75% full, however all of your neighbors are 70% full or 60% occupied, it’s unlikely that you will be able to get to 80%, 90%, or even 100% occupancy. Make sure that you take a look at these numbers from the neighboring properties.
2. Always take a look at who your tenants are
Is this the right mix of tenants? If it’s a retail building – when are their leases expiring? If the majority of the tenants have lease expiration dates coming up all around the same time in the next three years, that’s not a good sign. Why? Because what if something happens to the economy or what if something happens to the local market and these tenants all decided to leave at the same time? Not only are you looking at the tenant mix and when their leases expire, you are also looking at how much these leases are currently at: are the leases above market price? Are the leases currently below market price? Why is this important? When I was looking at a retail center in Reno, it was 76% occupied and the seller was in the process of signing a new lease with a new tenant. However, that lease was below market rate, it was below what all the other tenants were paying. Why? From the seller’s perspective, when you add a new tenant to your building, you’re able to show that you have more income on the property. However they’re signing a not-so-great lease just to show these higher numbers for the buyers. It is important that you take a look at the leases because if they just signed a 10 year lease with this new tenant, you are stuck at that low price for the next 10 years.
In terms of the tenant mix, and this applies for a retail, you want to have tenants that balance each other out, meaning you don’t want to have five sandwich places in your center. You want to have a sandwich shop, a nail salon, a massage therapist. There is a term that they are using nowadays called Internet Resistant Tenants, this applies mostly to service providers because service providers are not going anywhere (yet). They do need an office to provide their service. You want to make sure that you have internet resistant tenants in your center and that you would attract those tenants in the future as well. For me, I would not want to have a shoe store in my center because I do think that unfortunately a lot of those are going to be going out of business very soon.
3. Survey the property for environmental issues, as well as the laws within that city
There are a lot of very difficult cities to do business with, San Francisco is a prime example. For instance, if you want to convert an office into a Starbucks, you’re going to have to go through a lot of approvals with the city. If you want to convert something to a residential building, it might take literally years to get that approved, a lot of people in the neighborhood will make a big deal out of it, and they will make it very difficult for you to get approvals in a short period of time. So check what you can do with that property without having a lot of issues. Also, if you end up spending a lot of money in a particular property, you might activate some requirements and new laws within the city. For example, I was looking at a restaurant the other day that has two floors and we were thinking of keeping the restaurant downstairs and then upstairs we were thinking of converting that into an office and rent it to a startup. However, if we ended up spending a lot of money converting that space into an office space, this might trigger us to have to install an elevator in that building since there is no elevator in the building today. Make sure that you check with the city first before buying the property and confirm that it will not trigger having to install an elevator because that can cost you a lot more thank you expected, at least a hundred thousand dollars to install.
On the environmental side (we discussed this at another episode before) you have to do a Phase I and Phase II report, which means that they will take some samples from the ground and the groundwater to make sure that it is not contaminated, if it is contaminated, you are going to have to clean that up yourself, and it can cost a lot of money – this can kill a lot of deals.
These reports can cost around $3,000-$5,000 but they have to be done, and it’s part of the game. Another thing for you to know about Phase I and Phase II reports is that if you are next to a gas station, the ground of the property is very likely contaminated. If it is a big name gas station like Shell or Texaco, you will be fine because they do end up cleaning that up themselves. However, if it’s a mom and pop gas station, you will have a very hard time getting that land decontaminated. Also, if you are next to a dry cleaner, the ground may also be contaminated, so you really have to make sure that you get this report done, and you can always try to get the seller to do the report for you.
4. Get all surveys done
Get a structural engineer to make sure that the building is solid and has no problems. Get a roof inspector to make sure that your property has a solid roof, and depending on the type of property, you might want to have a few other surveys done such as: the foundation, the windows, and HVAC units if applicable (heating, ventilation and air conditioning) – you might want to check how old they are and if they will have to be replaced at any time in the near future.
5. Take a look at hidden costs and contracts that will have to be honored by you after the sale
For example, some properties may have contracts that are two, three years long for online advertising and those were part of the costs that you were planning on cutting after you took over the property. However, the contract doesn’t end for at least another couple of years. You also may have to pay local taxes that the seller was responsible for paying, and there may also be some insurance bills that you may not need that the seller purchased and now you’re responsible for paying. Some tenants may also be owing money, they may not have paid rent for the last month or two, and you are the one going to be responsible for collecting that overdue payment, sometimes the seller will put in the contract that that is their money, however, since you’re the one doing all the work in collecting the unpaid rent, you should be getting that money yourself.
These are all things that you should be aware of. There are, of course, other things that are important to do, as we discussed in our due diligence podcast, and you should always make sure that you work with a professional especially in the beginning in order to covert all of the due diligence items that you will need to go through as you are purchasing that property.