How To Avoid Bad Commercial Real Estate Deals

Apr 5, 2016

The best way to avoid a bad commercial deal is by investigating every aspect of the commercial deal before you close. This is accomplished through due diligence, which allows you to systematically investigate an investment property’s physical faults, financial problems, or legal title issues.

Due diligence isn’t a hasty process and can take weeks and often months to complete. However, when done thoroughly, the due diligence process will ensure you find out any and all information about the property so you can decide if the property offers you a great deal.

This is especially important since unlike residential real estate, commercial real estate is “buyer beware.” There are no safeguards or consumer protections if the property isn’t as it was originally represented. So be sure you take the full time – which is between 30-60 days- to vet the property, making sure to apply for an extension if the process will take longer than the allotted period.

Another advantage due diligence offers is the opportunity to renegotiate a deal based on problems uncovered through your investigation of the property. Since there are no disclosures, it is possible you might discover, for example, that a major repair or upgrade needs to be done on the property. You can take that information back to the table to create more equity in the property.

Important Factors To Take Into Account About Due Diligence

important factors to consider in due dligenceThere are several important factors about due diligence that will have an impact on how well you complete the due diligence process.

  • Attitude Is Everything

Assuming the best of everyone might be great in most instances, but when undertaking the due diligence process it’s best not to accept any information from the seller unless it has been proven by you. Don’t believe anything the seller tells you – whether verbal or written – until you prove it yourself when checking out the property.

  • Ask For More Time If You Need It

One of the most important is that while you’re given between 30-60 days to inspect the property, the actual process can take much longer, sometimes several months. In order to overcome this, it’s quite common for investors to request an extension on the contract.

Make sure to ask for it in writing, and be sure ask for the extension well before the due date; being late by even one day could cost you thousands of dollars. Your earnest money deposit will become non-refundable, and you’ll either be forced to close the deal or forfeit the entire amount.

  • Due Diligence Costs Money

The due diligence process isn’t cheap. You’ll need to pay for inspections and reports, often from numerous providers.

Despite the cost, the due diligence process is not the time to cut costs. Doing so will not only brand you as unprofessional, but more importantly, you could miss a critical piece of information that could cost you thousands of dollars, or worse, cause you to assume the deal is a good one when it’s actually a deal-breaker.

Another handy tip: walk around with the inspector as they look at your property, asking questions as you go along. You’ll learn valuable information about the property that might not be noticeable in the written report, and you’ll also learn valuable tips on what to look for when checking out an investment property.

  • Get Someone Familiar Involved With The Neighborhood

No, this doesn’t mean you’re interested in getting all the dirt on the seller. It does, however, mean that a drive-by with someone who is intimately familiar with the neighborhood will give you details you would not have known either on your own or from an inspection.

Valuable details like which businesses are planning on opening up in the future, which properties are dead ends, and changes in the makeup of the population are just a few of the tidbits you might discover. For example, in a retail area close to where I live, there are a few retail properties that despite the excellent location, never seem to get off the ground.

  • Have A Plan Going In

It’s important to have a written business plan when you start the due diligence process. Even if you’ve already considered the details of the deal or you have a team of people helping, writing out a business plan allows you to clearly see how the property fits in with your investment goals.

A written business plan will also help you determine which faults in the property can be entered into the negotiation process, and which have the power to negate the deal. Furthermore, a clear exit strategy will actually drive your offer, allowing you to determine what your profit margin on the property must be and line up the financing necessary for the deal.

  • Make Sure You Have All The Necessary Documents

Inspection, financial, title, appraisal contingencies all need to be in the lease.

Inspection contingencies allow you to either renegotiate or walk away from the deal depending on what the report reveals. A financial contingency is tied to the appraisal contingency, as it allows you to exit the deal if you’re unable to secure financing for the property. And lastly, an appraisal contingency allows you to renegotiate or walk if the price listed on the appraisal is less than the offered price.

  • A Quick Formula That Holds Its Own Against A Pro-Forma

A pro-forma is a table that allows you to predict the cash flow of a particular income property. The most important part of the pro-forma is the top line, which contains a prediction of the cash flow of the property if there were 100% occupancy.

Because a property will never be 100% occupied at all times, the vacancy allowance is a figure that takes vacancy factors into account. It is calculated in a number of ways, which include simply deducting a percentage of the cash flow from the potential rental income, or even using sophisticated software to correlate market conditions with predicted downtime between leases.

However, the pro-forma is a lengthy process, and not necessarily the quickest or best way to make a decision about an investment property. Instead, you can use the quick formula below to help you determine the amount of money the property needs to be making in order to for you to close in the deal.

Here’s How The Pro-Forma Works:

how the due diligence pro-forma works

  1. Calculate your annual operating expenses.
  2. Determine your expected mortgage payment and add any other payments you need to make to anyone who is financing the project.
  3. Add the two figures together.
  4. Divide the result by the gross potential income of the property.

This number (times 100) is your occupancy factor, which will give you the percentage of occupancy you need to have on the property in order to break even. Anything below that number means you will be losing money; anything above means you will be securing a profit.

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