Starting this week I will be posting a regular weekly column dealing with a particular topic. Nothing too in depth but hopefully instructive with a bit of humor.
There are so many potential mistakes when buying a commercial property it’s hard to pick just ten. Hopefully posting these will help some of you avoid some of the classic issues that can sink a purchase. The following are in no particular order. All are important to get right and each one may play an outsized role in a particular deal.
- Punching above your weight class
- Failing to line up all the pieces
- Failing to fully underwrite and evaluate financials
- Not fully vetting partners
- Not having a lawyer – a commercial real estate lawyer
- Not understanding the market
- Rushing to Purchase and Sale Agreement (PSA)
- Rushing the DD period
- Failing to complete and understand inspections and DD items
- Being in a hurry
Punching Above Your Weight Class:
If you weigh 165 pounds you wouldn’t sign up to fight someone who weighed 230 pounds. So, why would you do the same when buying commercial real estate. Simple, your ego. Your ego says you’re as smart as that investor you met the other week and he’s buying $10m dollar office buildings so you can too.
Well slow down there ego my boy. If you let yourself be led into deals well above your experience level you are exposing yourself to substantial increased risk. You may be able to pull it off but more than likely somewhere along the line you will get into trouble and you won’t have the experience to get yourself out.
Best advice is to move methodically and grow your portfolio and experience organically. This will allow you time to understand the systems and issues that come up at each level of investing. Plus you may find that you like $1m retail properties and just make a portfolio out of those. If you do decide to jump into a deal well above your experience level make sure you have a trusted partner and advisor who can shepherd you. Not in the good times but when things get sideways. Everyone looks like a genius in an up market.
Failing to Line Up All The Pieces:
What does that even mean? Line up all what pieces? Well in the buying process there are numerous moving parts and they all need to be dealt with in time. You can’t get loan approval until you have a Purchase and Sale Agreement (PSA) executed (an obvious but useful example). And you can’t get loan approval until you have to put together a ‘book’ or promote package that will include all of the principals financial details along with a full write up of the property and submitted it to the lender. So, there’s a lot to do and generally never enough time to do it.
Before you even tour a potential purchase you should understand the financial and/or value add proposition thoroughly and be confident that it could work based on your requirements. If you have partners you should have their buy in before pursuing a property beyond a cursory review. You should also talk to your banker before touring. Bankers typically have lots of experience and may have worked on the building you are considering before. If they have, or if anyone they know has, their insight can prove invaluable. Ditto if you’re working with a broker. They can potentially tell you the recent history of a property and obvious issues.
Oh and you’ll usually have to get all this done in an atmosphere of desperation as there always seems to be another buyer that shows up and starts talking about making an offer the moment you do. Get used to rushing. So, the more you can prepare and line up all the pieces before hand the smoother things will go, hopefully.
Failing to Fully Underwrite and Evaluate Financials:
As noted above you should have a solid understanding of how the property is going to make money before you look at it. You should understand the rents and expenses so you can observe obvious issues, like the added expense of patching the roof every spring if that is what is being done.
This starts with evaluating the financial information provided to you by the seller. Not the proforma nonsense the sellers broker shows you that makes the property look great – next year – but the current income and expenses. Once you have looked at these and what you see looks viable then it’s worth going to the next step. Learn what and APOD and Cash Flow are and get very comfortable building them for every property you look at.
Once you have looked at the building specific financials you should get at least a sense of the neighborhood fundamentals as well to see how this property compares. Look at recent sales of similar buildings. Look at asking lease rates for similar space. You will not come up with a specific mark you are looking to hit but you will develop a feel for the area and be able to understand when something looks out of place. When a property’s rent numbers are 30% higher than similar buildings around it that should be a big red flag.
Don’t fall in love with how a building looks fall in love with the financials.
Not Fully Vetting Partners:
Just because they have money doesn’t make them good partners. In fact many times it can make them bad partners. Partners are what can be called a necessary evil in the commercial real estate world. Whether you’re considering private equity, personal friends and family or a traditional bank they all think of themselves as partners. You need to consider any relationship in depth and realize that any partnership can go South no matter how good things look when you start.
A couple things to fully understand with any partner are their motivations for joining you in the deal and their terms and expectations. Banks and private equity partners will typically have these criteria in writing and be able to clearly articulate their terms and expectations. Friends and family not so much. So, it’s imperative that you sort these things out before getting financially tied to someone.
The number one reason commercial properties are put up for sale is because of partnership issues. One partner wants to sell. A partner has died and his family wants to sell. One partner has remarried and his new wife is a broker and is pushing him to sell so she can make a commission. There are millions of stories that will show you that just because someone is smiling when you are buying a property doesn’t mean they’re going to be even talking to you in a year. Protect yourself and vet potential partners thoroughly.
Not Having a Lawyer – a Commercial Real Estate Lawyer:
Not surprisingly the next mistake is not having a solid lawyer in your corner before you get into a deal. There are so many pitfalls in the world of commercial transactions going into a deal without competent council is like walking into a lion cage with a raw steak on your head. You will be killed, quickly.
Let’s be very clear here: your family member who practices divorce law is not what you need and is more likely to get you into trouble than keep you out of it. Mostly by way of ignorance. Commercial real estate law is focused on actually finding a way to do the deal while mitigating as many risks as possible. Lawyers from other disciplines typically end up wanting to mitigate all the risk in a deal which is not ever possible. So, they end up killing the deal.
Find a lawyer who works with developers and large investors and put them on retainer. Someone who is knowledgeable of the current market can also provide great insight regarding who and what they know. They may even be able to help you find a property as lawyers are sometimes the first to know, outside of family, that an owner is considering selling. They’re expensive but worth every penny if they keep you out of trouble.
Not Understanding The Market:
Real estate and especially commercial real estate is local. Very local. There are REITs and larger national owners who view the entire country as their market but each of them will have a specialist on the ground in each market they own or are interested in. Someone who is out everyday talking to people and watching all of the pieces of the market.
On average it will take you at least six months of concerted study to begin to get your head around a particular market. I don’t mean look at the asking prices of buildings on Loopnet and saying “wow! That’s a great price!” I mean understanding that the major employer in the city has just cut half it’s workers and that is rippling through the market.
Having analyzed hundreds of properties in many different markets I will tell you that most real estate is listed at just about the right price for the market that it’s in. If it looks like a deal to you it’s likely because you do not fully understand all the factors affecting the pricing. Do not be fooled by slick marketing. Learn the market. Learn why people are there. Learn the taxes and transfer fees. Learn the drivers in a local economy and the points where it is falling behind. Every city has pluses and minuses. Learn them before you jump into a purchase.
The stories of the out of town guy who flys in looks around and drops $2m on a building or project never end well. It’s a great way to make a million dollars.
Rushing to Purchase and Sale Agreement (PSA):
Speed is the enemy of understanding. Deals take time. They take time just to get to the PSA. If it’s just you as the buyer you have a checklist of criteria that should be met or at least addressed before you move ahead on making an offer. If you have partners, new partners especially, you have their checklists to clear and their concerns to address as well prior to writing paper.
Those who move fast successfully are typically very experienced in the marketplace, have all their ducks in a row as a matter of course and are not in any doubt about their financing.
You will hear the same story everywhere you go: “The really good deals are already gone.” I’ve even said it. What it really means is that you’re not looking at the market or deal in the right way. Regardless, you need to ignore the chatter and slow down. Do all the pre work that needs to be done to give you the confidence that this property might work for your goals. The faster you move the more you are likely to miss. If you’re lucky it’s little stuff you can recover from, if your not it can be catastrophic.
Don’t let anyone rush you and if anything raises a red flag for you stop and address it until you are fully comfortable with the issue before you move on.
There is always another deal.
Rushing the Due Diligence period:
In the same vein as rushing to the PSA is not giving yourself enough time to complete all the Due Diligence (DD) you and your partners require. A typical residential sale can be closed in 30 days without much difficulty these days. Closing just about any sized commercial deal in less than 60 days is very risky. There are a myriad of factors and details that need to be reviewed, verified, bid, inspected and gotten comfortable with. Again, those that move quickly in DD successfully typically have years, if not decades, of experience in evaluating properties. Until you have that you will increase your chances of success by giving yourself ample time.
A simple 10,000sf commercial property purchase could require the following: a new survey (3-5wks); a new appraisal (4-6wks); lender approval (after appraisal 6+wks); complete physical inspection (1-3wks); bids from individual service providers (2-4wks); post inspection negotiation (3-6wks); city approval for use or modification (6-50+wks).
Add to all of those that likely there will be things that come up during DD that will require you to rethink your plans for the property. In that same breath you will need to determine if it is a make or break issue or something you can live with. If you live with it you need to factor it into your plan for the property. For example if you find out in inspection that the roof leaks, you will need a bid on repair or replacement. You will need to know whether the seller will compensate for this deficiency and if not you will need to decide if you still want the building. Even then you will need to financially factor in the repair to your valuation and also your capital plan for the building.
Rushing through DD is a great way to end up owning a serious headache. Slow down.
Failing to Complete and Understand Inspections and DD Items:
As noted above there are many different items that need to be completed in the DD period. Not completing basic or required inspections or simply not grasping how the results of a particular inspection could potentially affect a property can cause no end of headaches in the future.
Using the same 10,000sf building as discussed before consider that a Phase I environmental report is recommended based on the neighborhood the building is in. When you get the report back you quickly scan it to see if anything jumps out at you. It’s late on a Tuesday and you’re tired so you don’t pay close attention to the findings where it notes that neighboring properties have had significant issues and while this property does not appear to have direct contamination it cannot be ruled out and a Phase II survey is recommended.
This kind of thing gets missed a lot. A physical inspection report for a typical house might run ten pages a commercial inspection can easily run ten times that. There is much to be reviewed and fully understood.
Being in a hurry:
You have probably sensed this one coming from it being included in many of the points above. The single best piece of advice it to slow down. Slow down in your initial evaluation; slow down in your underwriting; slow down in your due diligence and slow down in closing.
Commercial deals have many many potential issues and each has it’ sown effect on a deal. The only way to begin to understand these is to consider each of them and that takes time. So, take the time. If someone else comes in and buys the building before you can pull the trigger that’s fine. When you have a decade of experience and are working in a market you understand you too can ‘jump’ on deals because you will understand how to manage the risks. When you’re just getting going you barely understand what all the risks are.
Slow down. Commercial real estate is a long game.