You’ve finally found a commercial investment real estate property that seems to have it all:
- a reasonable price,
- a well-known national company (not Starbucks, but close) and
- a high cap rate.
It seems like the stars have finally aligned, and the only thing left for you to do is to sign a contract and wait for the profits to start rolling in. What you don’t realize is that the property could be a disaster in sheep’s clothing.
LOCATION ISN’T EVERYTHING – BUT IT’S PRETTY CLOSE
You’ve heard it so often it’s become a cliché: a good location is essential to success. Sometimes, however, it’s tempting to ignore the obvious when faced with a national chain. The truth is that even a popular mega-brand can’t always overcome the effects of a poorly placed property.
There are several factors that determine whether the location is a favorable one. Traffic flow is one of the most obvious factors, and includes the presence of both vehicular and foot traffic. You also need to check that the property can be easily seen: you don’t want potential customers to have to search for your commercial property in order to find it.
The amount of nearby traffic, is heavily influenced by another critical but often overlooked factor: the population demographics. It’s essential that both the local and city population should show a reasonable increase in growth.
Diminishing numbers of local residents means that the area is headed for a downturn, which puts your property at risk of depreciation. A city whose population is steadily decreasing is likely suffering from economic woes which will almost certainly impact your commercial property investment NEGATIVELY.
Another important factor that should be checked are the household incomes and spending patterns, both locally and throughout the city. Use these to analyze whether or not the commercial property is a good fit for the neighborhood and surrounding areas. For example, while it might seem logical that a food wholesaler might do well in any neighborhood, a lower middle class population might be less able to afford the cost of buying in bulk.
And lastly, check the size and condition of the surrounding land. Is it adequate not only for the present tenant, but future tenants as well? Is it zoned for other uses? Lack of zoning options can lower the resale price significantly. As for the parking lot, check to see how the size compares to the general parking availability in the area. Inadequate parking space in an area where space is at a premium, will discourage customers who don’t have the time or energy to deal with looking for a parking spot.
HOW IS YOUR POTENTIAL TENANT’S CREDIT?
The best tenants have a solid credit rating from a trusted ratings organization, and have access to public credit markets. An easy way to check a tenant’s credit is through one of the main credit rating agencies, such as Standard and Poor, Moody’s, or Fitch.
These agencies can tell you if the tenant has an investment grade rating, which indicates that the tenant will most likely have the means to continue paying rent, even in a volatile economy. Usually this would refer to a tenant that is part of a national chain, and has access to public credit markets, although occasionally a very strong local business is able to pass muster.
If a potential tenant doesn’t have an investment grade rating, examining the credit report carefully can give you important clues about their financial stability. Check for bankruptcies, deliquencies, and high revolving credit balances, which point to a high risk tenant.
An up to date financial statement will also reveal important information about a potential tenant. Not only will it reveal how deep their pockets really are, but it will also reveal whether or not they have sufficient funds to cover costs during a downturn. If they are a start up company, some of this information won’t be available, but you can still determine whether or not they have adequate funds to cover start up costs.
LEASES: BEYOND THE FINE PRINT
A commercial property lease should be at least 10 years or longer. A triple net lease is the best option for commercial income properties, as it requires minimal management, and most of the expenses are paid by the tenant. Plus, even though the lease is long term, you can still include rent increases over time.
If there is an existing lease, make sure the escalation clauses don’t favor the tenant over the owner. Check the expiration date of the lease, and whether or not the tenant has a renewal option. This could play an important role in the overall income of the property, since it’s important that the new lease rates are comparable to similar properties in the same area.
AND THE WINNER IS…
If after evaluating all of the above, you decide the property is a good investment, you still have one last hurdle to overcome: the purchase contract. The purchase price of commercial investment real estate should be based on a fair, cash on cash return of about 6% or higher. Look carefully at the price per square foot of the rent. Occasionally an unscrupulous seller tries to gain a higher price for the property by inflating the price. Checking the rental prices per square foot of other properties in the area will reveal whether or not this is true for the property you’re interested in.
A commercial income property can be a good source of passive income – if you know how to avoid potentially disastrous stumbling blocks. Don’t rush to close a deal for fear of “losing out”on a great price. Instead, allow yourself plenty of time to investigate the property thoroughly, and follow the tips above to make sureyou find the commercial property that’s best for you.