Looking to expand your portfolio by adding commercial investment property to the mix? As is the case with anything that is new, moving from residential to commercial investing can be a little nerve wracking. However, there’s a saying that goes, “the fun begins once you step out of your comfort zone.” Besides, becoming a better investor means taking a continuous journey towards improvement and growth. For some of you this may mean building a substantial residential portfolio. But for those of you who have the itch for commercial investing, we have some valuable tips to share to help you along the way.
When To Make The Switch To Commercial
In the game of Monopoly after your fourth house, you go commercial with a hotel. Even though it’s a game, there is a certain brilliance about the concept. With your first purchase, usually your personal home, you join the club of land ownership. Your next step is to punch through the naysayers in your circle to purchase your first investment property. With this property you learn property improvement, upkeep and tenant (or quick sale) hurdles and pitfalls. Your third property allows you to think through the process minus the beginner jitters. And, your fourth property allows you to expand on your earlier lessons, develop your skills and settle into a comfort zone. But you are an investor, a lion, and comfort zone is just not your thing. If you are like us, after one week on the beach, we go looking for real estate. You are now ready to begin considering the challenge of commercial investing.
Success take perseverance, diligence and hard work and it doesn’t happen overnight. The amount of information, research and analysis you need to do can be overwhelming but as long as you take continual action you will bring yourself closer to your desired goal. Finding the right property may take several months and you often will be spending money during the due diligence phase only to realize that you do not want to proceed with a project. But, rather than sitting on the sidelines and waiting for the ideal moment to invest you need to understand that there will never be a perfect time to get into commercial real estate.
Jumping right into commercial property without taking the time to educate yourself would be the same as jumping into a lake when you don’t know how to swim. As with residential real estate it is important to take a look at the economic fundamentals of the city/town you are planning to invest in. As with any investment, don’t focus on the past but rather get an understanding of what will drive growth in the area. Is the economic development office active in attracting new business or investment into the city? What is the projected job growth in the region? A growing number of jobs means more people coming into the area and so on.
Commercial real estate investing also differs from residential investing in many other aspects. Understanding these differences will determine whether you sink or swim. To begin with, there are several different categories of commercial property (multi-family, office, industrial and retail) so it’s important that you understand the differences between them.
For example, an apartment building will have multiple individual tenants and may require more active property management. Depending on the province you are in there may also be limits on how much you can increase rent each year which is a key factor in forcing appreciation on your property. Keep in mind that one method of valuating commercial property is based upon its income providing potential and any limit to this can slow the appreciation. In addition, there may be repair and improvement costs that you, as the building owner will be responsible for. You will need to keep your units in good condition in order to attract quality tenants. In contrast, an industrial building would attract a completely different tenant profile. In this case your tenants would be business owners who have a vested interest in maintaining their unit as it is their place of business. In addition, leasehold improvements in these types of properties are often the responsibility of the tenant. As an investor, you benefit from the improvements that they make.
These properties all perform differently and have varying degrees of risk associated with them. We suggest staying up to date on the various types of commercial property markets by reviewing local real estate reports or even joining appropriate organizations (ie. apartment building owners association for the area). Commercial real estate brokerages also usually have quarterly reports that detail what is happening in the area.
Build a Strong Team
Take the time to talk to other investors who already have commercial real estate in their portfolios. Their feedback and personal tales from the trenches will probably be the most valuable information you can obtain. They can walk you through the process, share some challenges they have faced and how they overcame them. Investors with hands-on experience can talk to you about things that you would never come across in a textbook or course. For example, your lender will require a Phase I environmental report before approving your financing. Take the time to find out the history of the property, what was there beforehand (for example, acquiring a property which may have previously been a gas station could mean substantial cleanup running sometimes above and beyond $100k before you can proceed with your project).
You will also need to build relationships with experienced realtors, lenders, and other real estate professionals who focus specifically on the commercial side of things. Ask other commercial investors for referrals and feedback on individuals or companies that they have used. Keep in mind it’s not only the specific lawyer/accountant/lender, etc. that you are working with but also their entire team. For example, develop a good relationship not only with your lawyer, but also their legal assistant. They often handle the bulk of the administrative work and it can be invaluable to have them as an ally when things need to get turned around quickly. By surrounding yourself with an experienced and credible team you can supplement yourself in the areas where you may be lacking. Each of these team members will bring a different skill set and opinion to the table which will give you the information you need to make informed and timely decisions.
Gather the Right Information
There are a multitude of things that you need to investigate in determining whether a commercial property is suitable or not. It all begins with information gathering so we recommend creating a checklist of the information you require to do your analysis. Some of the basic documents you will need to do a thorough assessment of a potential opportunity are:
At least 3 years historical financial statements and tax returns.
- All lease agreements.
- All management and/or service agreements.
- Phase I environmental report if already available.
- Survey and floorplans.
- Copies of current expenses/bills (property tax, insurance, utilities, etc.) to verify the accuracy of the financial statements.
- Copy of title – to review any existing liens or other issues registered against the property.
- Previous inspection report if available – you will have to arrange your own inspection as well.
Once you gather this information you can begin your analysis on the income producing potential of the property. This is where the time you invested to educate yourself comes in handy. Some of the basic things you would look at are:
Net Operating Income: represents the property’s income before debt service and taxes are accounted for. This number indicates whether a property is profitable or not.
Net Operating Income = Gross Income – Operating Expenses
Capitalization Rate: a rate of return on an investment property based on the income that the property is generating. If you have an expected return in mind this formula can be shifted around to calculate the maximum price you should pay for a property
For example, if you wanted to determine the Capitalization Rate (Cap Rate) and you knew the Net operating Income and the Purchase Price you can use the following formula:
Capitalization Rate = Net Operating Income / Purchase Price
In the second instance, if you knew that you wanted to achieve a Cap Rate of 7.5%, you can use the following formula to determine the maximum Purchase Price to consider:
Purchase Price = Net Operating Income / Cap Rate
Cashflow Before Taxes and Cashflow After Taxes: cashflow refers to the amount of money left over after accounting for all expenses and debt service. It is important to calculate both cashflow before taxes and cashflow after taxes in order to set aside enough for your potential taxes owing.
For example, if you wanted to estimate the income your cash produces after paying for everything, use the following formula:
Cashflow Before Taxes (CFBT) = Net Operating Income – Annual Debt Service
In the second instance, if you wanted to refine the cash flow even further, use the following formula:
CFAT = Net Income + Depreciation + Amortization + Other Non-Cash Changes
…but you would have to calculate Capital Cost Allowance (CCA) and income taxes first:
Allocated Building Value $1,300,000
Allocated Land Value $ 300,000
Property Value $1,600,000
Cashflow Before Taxes $ 155,000
Cashflow after Capital Cost Allowance (CCA)
Cashflow Before Taxes $155,000
$1,200,000 (Building Value) * 4% (CCA rate) ($ 52,000)
Income after CCA for income tax purposes $103,000
Income Taxes Payable
$103,000 * 43% (estimated personal income tax rate) $44,290
Cashflow After Taxes (CFAT)
Cashflow Before Taxes – Income Tax Payable = Cashflow After Taxes
$155,000 – $44,290 = $92,290 (CFAT)
There are many other indicators and formulas that you will need to go through to determine whether this property will work for you or not. There are too many to cover in this brief article but take the time to create a summary of the standard tools that you will use to analyze property so that it becomes a natural part of your process.
At this point you can also begin to create a budget of the anticipated expenses or capital improvements that will be required over the period of time that you will hold the property. If some of this work will need to be done sooner, you can negotiate with the seller to reduce their price in order to accommodate the additional money that you will eventually have to put into the building. Knowing how much of a reserve fund will be required and understanding all of the potential maintenance and capital improvements will ensure that you achieve your profitability targets.
Create a Business Plan
Owning a commercial property involves the same amount of work as running a business. It’s important that you create a business plan that outlines your goals, contingencies, exit strategies, long-term succession and estate planning. This is the culmination of all the research and analysis that you put into reviewing the property. You will need to include pro-forma financials showing the projected annual changes in income and expenses. You also need to determine a budget for future repairs and maintenance. Within your plan it is best to also know in advance what can be done to improve the income on the property and how to reduce expenses. The value of your commercial property is dependent on its net operating income so the more efficient you are, the more value your property will have.
Constructing An Offer
You want to construct an offer that is based on how the property is performing today, not what its potential value is. You will often be persuaded to look at the “potential” of a property and swayed to pay a price that is in line with its projected performance. However, keep in mind that the worth of a property should be based on how it is currently performing.
There will inevitably be challenges along the way. Some of the key obstacles that investors face are:
Finding the capital to invest in these larger projects – we recommend getting started by finding joint venture partners to supplement your capital requirements, or you could leverage on existing assets provided that there is enough cashflow to cover the additional interest costs you may incur by using borrowed funds.
Getting Financing – although it is often said that getting a commercial mortgage is based mostly on how the property performs, most lenders will still look for a personal guarantee. Make sure that your credit is in order or you align yourself with someone who is able to supplement the mortgage application. Alternatively you can turn to private funds but this can be more costly.
Finding a Good Property – it is difficult to find good properties as the best ones often don’t ever hit the market. We suggest talking to other investors, property managers and other real estate professionals and keeping them up to date on what types of property you are looking for. This is one way to gain access to properties before they are ever listed.
You need to create your own path and begin taking steps towards getting offers in, negotiating, and then eventually using your own project management skills to ensure that the deals close smoothly.