In the commercial real estate, as the saying goes, “location is everything.”
In reality, there are numerous factors that determine whether or not a property is likely to be successful, but a great location goes a long way towards increasing profit potential.
In the commercial real estate, location is graded from A to D, with A being the very best location, and D a war zone. If you’re interested in investing in an area with the best schools, newest buildings, and most expensive real estate, then a Class A neighborhood fits the bill.
Unfortunately, since there aren’t any hard and fast rules about how to classify neighborhoods, so the actual definition of a Class A neighborhood can differ from city to city and investor to investor. And not all investors use a scale from A to D; some rate neighborhoods from just A to C. Plus, to make things even more confusing, some investors pluses or minuses. Thus, you can have a B+ property in an A- neighborhood.
Instead of relying on opinion, the best way to determine if the investment property you’re interested in is actually located in a Class A neighborhood is to examine seven key factors.
1. Location
Just because a city is the latest “hot spot” doesn’t always mean it’s a great place to buy an investment property.
Some cities are perfect for a residential real estate but awful for a commercial real estate. Other cities might be perfect for multifamily, but retail might be lagging miles behind the rest of the country. So when you start considering exactly where you’d like to purchase a property, you’ll need to consider three factors: the city, the type of property you’d like to purchase, and the neighborhood where the property is located.
Ask yourself these questions:
– Is there sufficient demand in the city for this type of property?
– Is there sufficient demand in this neighborhood for this type of property?
– Is there too much of this property type on the market?
– What is the vacancy rate for this property type in this area? Have the vacancy rates over the last 3-5 years increased or decreased?
– Does the city or county council have plans to expand development in the area?
– Has there been an increase in building permits issued for the area?
Along with vacancy rate, you’ll also need to consider the absorption rate.
While the vacancy rate tells you how much supply there is in an area, the absorption rate indicates how long it takes for available space to be rented out. Low vacancy rates and high absorption rates are signs of a great location; high vacancy rates with low absorption rates mean the area is most likely not a Class A location.
2. What Is The Demand Like?
A good estimation of whether or not there is demand in the area for a specific type of investment property is essential. But don’t make the mistake of assessing the current level of demand; what you really need to know is whether that level of demand is going to continue for the long-term.
Some cities, for example, are experiencing a high level of demand right now, but when you look carefully, you can already see the signs of a waning market. Although it’s not easy to tell the difference between a city that’s about to head into a downturn and one that is merely holding steady, demographic data can help you determine economic health.
The number of jobs created, the rate of population growth, level of education of residents, and the average income in the area are all important indicators of growth patterns for the area. Once you’ve gathered all the data, be sure to graph the data so you can uncover hidden trends. Be aware too of results that are too good to be true; you might need to compare numbers from more than one source.
3. How Risky Is It?
A certain amount of risk is inescapable, and in fact, some amount of risk is necessary in order to accrue profit. The question is, how much is too much, and where is it likely to pop up with regards to a potential property?
Once you identify the types of risk a potential property is vulnerable to, you can prepare a plan as to how you can manage the risk, either by taking precautions to minimize it, or by shifting it to tenants, insurance companies, or another third party.
Below is a short list of a few of the most common types of risk.
Debt Risk
Properties in Class A locations will cost you more than a pretty penny. Most investors will need to place debt on the property in order to purchase it. Although it’s a common practice, too much debt can lead to an over-leveraged property.
A related problem is a debt maturing before the owner is able to refinance or sell the property. In a niche where there may not be much equity in a property, it may be difficult for an investor to get together enough capital to renew the loan, putting the property at risk of default.
Combine that with a debt that matures before enough equity has been built up, and the results can be disastrous.
Over leverage
Leveraging a property can be an effective strategy for building up your portfolio. Used wisely, you can use the power of leverage to purchase other properties while enjoying a healthy cash flow and building up equity at the same time. In general, the loan to value ration should not be more than 75%, and most banks or private lenders prefer not to go higher than 70%.
Tenant Risk
Unless you’re talking about a pure triple net, tenant risk is always a risk. There are two main concerns with tenants: one, rent roll quality, and two, rollover risk.
Don’t assume that all properties in Class A neighborhoods are industrial grade tenants.
Before you purchase any property, you should check the present tenants’ credit rating in order to assess their financial stability. In the same vein, the number of tenants in a property will have an influence at how exposed you’ll be with regards to vacancies: single tenant properties put you at a higher risk in a volatile market, while multi-tenant properties can cushion you from the ups and downs to some extent.
At the same time, remember that even multi-tenant buildings are rarely 100% full at all times; there will always be a certain amount of turnover. You can alleviate the risk by making sure the property has a diverse mix of tenants, making sure no one tenant occupies more than 30% of the total leasable area of a property, staggering lease expirations.
Rollover risk
Rollover risk refers to the risk a tenant won’t renew their lease when it expires. If the tenant leaves, space might be difficult to re-lease. Even if a tenant is found, the time between tenants can result in a significant loss of money.
If you find yourself in the position of acquiring a property with several upcoming lease expirations, it would be a smart idea for you to enact several measures in order to ensure you have a high likelihood of tenants renewing leases, ideally before the lease ends.
Property Management Risk
Any property that requires good management on a frequent basis is subject to risk. Good property managers aren’t easy to find, as any investor who’s ever perused a real estate forum will tell you.
Assets like retail, office, or multifamily properties live and die based on the effectiveness of their property managers, so if you’re considering one of these types of properties you should make sure you have a concrete plan on how to find, evaluate, and hire an experienced property management company.
BONUS: How Well Does The Property Match Your Investment Goals?
Even though a Class A neighborhood might be on many investors bucket lists, don’t assume that it’s right for you. Although many properties in a Class A neighborhood will cost quite a bit, that doesn’t always translate into the greatest profit. It might, but on the other hand, it might mean there is very little equity in the property.
You might also end up with less than desirable cash flow after you add up all the expenses of owning a prime property.For some investors, that might be just fine, especially if they are looking for trophy property. Others, on the other hand, might prefer a property which needs less management or has more potential for value-adding.
It’s up to you. It’s a lot like going shopping at the store when you’re hungry: don’t let your emotions rule you. Stick to your investment plan, and consult your team if you’re unsure about a particular property.
