With so much competition in Class A neighborhoods, the idea of renovating a distressed commercial property in a Class A or B neighborhood might seem like a good idea.
But is it worth the risk?
How Can You Tell If The Property Is A Money Pit?
Make no mistake: a distressed commercial property will cost you money, though it won’t necessarily be on the front end. There’s a reason why it’s cheaper to buy than similar properties, though that reason may not always be financial.
Sometimes owners need to raise cash or aren’t interested in managing a property that isn’t in line with their investment goals.
Family circumstances like death or divorce can also play a role, particularly if the new owners find themselves without the experience or time to take on a new business project.
And last, if the income property was originally purchased by more than one owner, and those owners have decided to dissolve their partnership, then the property could also find itself on the market as a distressed property.
Budget For The Unexpected
Distressed commercial property will always be full of surprises. And although the owner may be guilty of hiding some secrets, the truth is when a property has been neglected for a long period of time – even if it was occupied – there will be problems even the owner isn’t aware of.
Obviously you’ll need to do a walk-through and have the investment property inspected, but you should expect to find problems that will only reveal themselves during renovation.
Although you won’t be able to tell exactly what might happen, you can get an idea by taking into account how old it is, how long it’s been distressed, as well as any special issues that might arise due to how the building was used in the past.
Each issue that comes up will drain just a little bit more profit from your portfolio unless you can turn the property around.
Due Diligence Is Even More Important With Distressed Commercial Property
Due diligence is even more important with a distressed commercial property, especially since the protection normally offered by indemnities and warranties is fairly limited. At the same time, any additional issues you discover can help you negotiate a lower purchase price.
Here are some of the things you should look for.
Though a building inspection won’t reveal all of the property’s faults, it’s still the first step to determining whether or not the property has profit potential, or is too far gone to rescue. It will also give you insight about whether or not the asking price reflects the building’s true value.
You should definitely consider getting multiple appraisals, and specialists when practical. An expert who specializes in distressed properties is even better.
Also, don’t forget to schedule an ALTA survey, Phase I environmental site assessment.
If there are tenants in the property, it is essential you review all leases or operating contracts.
This is especially important with retail or industrial properties, since your end goal is to populate the property with tenants paying market rate prices. Of course if the property is distressed, the tenants will likely be paying lower than market price, but if their lease allows them to pay the same price after extensive renovations, then that’s a no-go.
On the other hand, if you have decent tenants and want to keep them, you’ll need to check to ensure the lease isn’t about to end, or that there isn’t a co-tenancy clause that allows them to reduce the rent or terminate the lease if an anchor tenant leaves.
Obtaining any and all financial records on a distressed commercial property is perhaps one of the most important steps of all.
Not only will you need to check for liabilities, judgments, as well as any key contracts with suppliers, but you’ll also need to verify the debt that the property has on it. It’s unfortunate but true that in some instances, investors have found themselves with less rights to an asset than a creditor – even after the property has been purchased.
You’ll also need your lawyer to do a litigation search to reveal any existing and potential claims and disputes. For example, in addition to creditors, there might also be court cases coming up among the investors or partners themselves.
Zoning can be particularly challenging for a distressed commercial property, especially if the property is in the midst of being built.
Check the current zoning and land use of the property, and make sure that any pending approvals are also included.
Be wary of any zoning or site plan approvals that stipulations. These may have already expired if they were attached to time restrictions. The last thing you want is to end up with a property that can’t be used for the purpose that it was built.
Purchasing a distressed commercial property – if done correctly- can be a lucrative way to create cash flow and get a foothold into markets that would otherwise be inaccessible.
However, it requires investors to be incredibly savvy in order to succeed.
Do your due diligence, make sure you understand the market well, and consult with a lawyer in order to ensure you maximize your profit potential.
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