Whether you prefer investing in an added value retail center, assisted living facility, multifamily apartment, or triple net property, you know even a “sure” deal can be plagued by unexpected problems.
Construction woes, inadequate financing, unexpected renovation costs – at one time or another, even the most experienced of investors have found themselves facing the break-up of a deal after weeks, or even months of time, money, and effort.
On the other side of the coin, there are times when it seems as if the market is ripe for the taking, and then the decision needs to be made as to whether you should continue to hold the property, or take advantage and sell to the highest bidder.
In either of these cases, it can be hard to stick to logic rather than listening to your emotions. After all, the wrong decision could cost you hundreds of thousands, if not millions, of dollars.
Fortunately, you don’t need a crystal ball in order to make the best decision. In fact, there are two words that are guaranteed to help you make the right decision in every single case: an exit strategy.
Act Rather Than React
A detailed exit strategy ensures you use a calm, logical approach to the situation rather than reacting with your emotions. Acting instead of reacting decreases the inherent risks of commercial real estate investment since when a tricky situation arises, you will have already planned out several different ways of navigating even the most marginal of deals.
Whether you the solution involves repositioning, refinancing, selling outright, or using a 1031 tax exchange, you as an investor will have a number of strategies to choose from.
In addition, a realistic exit strategy based on an evaluation of all the options allows you maximum profit by selling the property when it reaches its’ highest point of value. Even properties that are merely average performers can be profitable since careful planning makes it easier to sell the property while it is still performing.
Buyers love these kinds of investment properties – and in fact, they are the type that 90% of investors seek- because they are easy to get financing for and easier to transition into.
Sound good? Great. Here’s how to get started creating an exit strategy that even the most experienced of investors will find useful.
Start By Estimating Your Risk Tolerance
The earliest stages of creating a successful real estate deal start even before you consider your first income property.
If that sounds impossible, then consider this: in order to build a portfolio that meets your investment goals, you’ll need to first decide what types of properties you’d like to invest in. Contrary to popular belief, choosing the best type of income property to invest in doesn’t depend on what you like or feel comfortable with; it depends on what your risk tolerance is.
Simply put, risk tolerance is the difference between what you expect will happen, and what actually does happen. The predictions you make are based on two types of assumptions:
Market assumptions are based on factors like:
- capital flows
- mortgage rates
- investor demand
- cap rates, and
- underwriting terms.
Property assumptions are specific and only affect the property in question. Factors such as vacancy rates, operating expenses, lease renewals, and rent levels are some common examples.
Making The Right Assumptions
In any CRE deal, you as an investor must make dozens, if not hundreds, of decisions on whether and how much to buy into a particular assumption.
Commercial investment properties that perform pretty much according to what you’d expect are termed low-volatile, and those that are unpredictable – due to the number of external factors that aren’t under your control- are termed high-volatile properties.
Investors who deal with high-volatile properties know there is a higher chance for things to go wrong with the property. At the same time, however, the pendulum can swing the other way as well, presenting the investor with higher profits.
Low volatility properties are more predictable, and therefore they are inherently less risky. The same factors that make them less risky also mean that ROI will be lower than a high-volatility property. These investment properties are valued for the steady reliable income they provide over long periods of time.
In reality, a balanced portfolio benefits with a mix of low and higher-volatility commercial real estate properties, but the exact percentage of each will vary greatly from investor to investor.
Once you’ve done your due diligence and examined the pros and cons of the investment, a cash flow statement, also known as a pro-forma, is created. This will help you determine whether or not the numbers add up to property with profit potential.
Of course, even when the potential for a decent ROI is identified, a large chunk of that potentiality will depend on how long you can wait for the money to start rolling in, as well as how much money is needed to put into the property before you start to see positive returns.
Clear investment goals that state exactly what you outcome you need to happen with the property in order for it to be a win for your portfolio are essential, and the cornerstone of a well-laid exit strategy.
In the event that a property doesn’t fulfill your investment goals, then it will become necessary to implement an exit strategy which will allow you to divest yourself of the property with minimum damage and maximum profit.
While even more experienced investors leave this step until the end – i.e. when the property begins to show itself as under-performing (a mistake where the investor considers the property with rose-colored glasses or simply assumes that current conditions will continue)- experienced investors know the best time to create an exit strategy is before a deal is even signed.
Take These Factors Into Account When Creating An Exit Strategy
The exit strategy you choose will depend on your investment goals in general and goals for the property in particular. Below are several factors to take into account when creating your exit strategy:
- Short and long-term goals
Whether you’re considering selling an investment property or simply waiting for the property to accrue value, you need to define both short and long-term goals.
Don’t confuse these with the actions you need to take in order to increase profitability. For example, you might choose a long-term goal like, “The property should have a tenant vacancy of less than 5%.”
You would then write the short-term goals that need to be put into place in order for that to happen. One goal, for instance, might be to create an effective tenant retention plan. Another might be to implement a direct marketing campaign to potential tenants.
You’ll also want to be specific about how you plan on accomplishing these goals, so that the who, what, and how are also spelled out. These are termed objectives and are a critical part of a successful implementation.
Include names of people who will be held accountable for each goal; create a notebook either online or use a simple binder and organize each goal according to the person who will be responsible.
If you work alone, make sure you schedule regular times to work on each goal, as well as meetings (preferably with a mentor or another investor) to evaluate your success.
You’ll also want to make sure you include a time frame that you expect the goal to be accomplished. To make things easier, stick to standard time frames like 3 months, 6 months, or a year. Short term goals are usually accomplished within 3-6 months, while long-term goals are a minimum of a year.
Your schedule may differ depending on the type of property you purchase, and your initial investment goal (repurpose vs ready to go property, for example). This makes it easy to schedule regular meetings to evaluate, revise, and create goals.
- Time to close
There will be delays at every step of the closing process. Even something as simple as the length of the due diligence period will be up for grabs. That’s without including typical hot-button issues like how much of a deposit to put down, who will be responsible for environmental issues, and more.
Tack on the amount of time spent in contract, and it could be quite a while from your first tour of the property until you have a signed contract in hand.
You’ll need to decide how much time you’re willing to invest in seeing the deal through from start to finish. Keep in mind that you’ll need to invest significant amounts of money on the way. Everything from inspectors to lawyers will cost you money, aside from the time spent contacting various parties.
Some other important factors include:
- purchase price,
- condition of the property,
- supply and demand,
- market conditions,
- financing options,
- location of the property,
- profit potential and
- property value.
Each of these should have specific numbers associated with each one that defines the limits of what you consider success or non-performance. Make sure to spend the time understanding these factors, as they will determine which of the real estate exit strategies an investor should pursue.