In the previous post, I noted down several ways to minimize your risk when investing in a commercial real estate.
In this post, I’ll continue with several more critical factors you need to consider before you close on a property.
Run The Numbers – And Then Run Them Some More
There are numerous methods for determining the value of an investment, but whatever method you use, be sure to stick with it.Cap Rates, Internal Rate of Return, Net Present Value, and Cash-on-Cash analysis all have their pros and cons, but in order to make sure you compare properties fairly, you need to be consistent.
Trophy type properties that make you feel good about owning but are overpriced won’t add to your portfolio as much as a property with good numbers and great bones.
Prepare At Least Three Exit Strategies
Exit strategies are an important component of your investment strategy. Your personal circumstances, investment goals, and market conditions can all change; planning beforehand allows you to anticipate challenges and turn a difficult situation to your best advantage. Preparing at least three different exit strategies allows you to quickly react and implement an appropriate strategy.
Understand Where You Are In The Real Estate Cycle
Commercial real estate, like any business, has its ups and downs. Each of the four parts to the cycle (expansion, contraction, recession, and recovery) has its advantages and disadvantages – and despite popular opinion, you can make a profit even during a recession period.
You can only do that, however, if you know the characteristics of each cycle, so you can take advantage of key turning points at each stage. Keep in mind that even when the country as a whole may be in one stage, your particular slice of the market might be slightly ahead or behind. So any decisions you make should be based specifically on what is happening where your property is located.
Hire Experienced And Reliable Property Management
Unless you don’t have a day job or love managing your properties, you’ll want to hire a property manager.
A good property manager will help you minimize risk and maximize the profit potential of the property. If they are trustworthy, reliable, and aware of your investment goals, they can be an indispensable asset. On the other hand, even a mediocre property manager can cause a tremendous amount of damage.
Collecting rents on time, diligently filling vacancies, responding to maintenance issues and tenant complaints-each one of these has an immediate effect on your profitability.
Be Careful How You Leverage A Property (Check The Quality Of The Rent Roll)
Many investors assume that if they can leverage a property, they should. In reality, over-leveraging is a mistake many inexperienced investors make.
It’s easy to get caught by surprise when the debt coverage service ratio falls below 1, putting you at risk of defaulting on your mortgage. Instead, make sure you don’t leverage your property for more than 80% of its value.
Don’t automatically assume that because a building has few vacancies, it’s bound to make a profit. The truth is that the quality of the tenant is an important factor in maintaining a full rent roll.
You want tenants that have good credit, are stable, and if possible, are national tenants (as in triple net lease properties). You should also investigate the type of tenant – is it likely they’ll go out of business? If they do, who is responsible for the lease, them or a parent company?
Lastly, look to see if there’s a diverse mix of tenants on the property. By creating a diverse mix of tenants and making sure they all come in on staggered leases will help soften the blow significantly if there are vacancies.
Likewise, you’ll also want to investigate the length of the remaining leases. Long leases might be a blessing or a curse, depending on the tenant. In a worst-case scenario, you might not only end up with a tenant who defaults on payment, but who has a long lease, thus making it difficult to for you to remove them from the unit.
Use Your Own Proforma When Evaluating An Investment (Buy Value-Add Properties Whenever Possible)
In an ideal world, the seller would give you a complete proforma that accurately reflects the profit potential of the property. In reality, the only thing worse than relying on a seller’s proforma would be not to use one at all.
Overestimated rents, mis-tallied operating expenses, and a host of other important calculations are often missing. You wouldn’t use your partner’s lawyer if you were getting a divorce – don’t use the seller’s proforma either. Instead, ask for the actual operating statements (last three years), rent roll, and whatever other documents deemed necessary to close the deal.
If you buy a property close to market value, you have a very little margin to increase profit. Adding a new kitchen or other amenities won’t be enough to justify a rent increase, and the property is probably already in good shape.
However, when you buy a property in a good location that has the potential to add value, either through renovations, a change of best-use, or rezoning, that’s when you start to increase the property’s profit potential. Let’s face it – if you know right from the start that you can make a few changes and automatically enjoy a larger cash flow, then you’re already halfway there.
As an investor, minimizing your risks doesn’t have to be impossible; if you get used to putting aside your emotions, crunching the numbers, and evaluating all possible scenarios, you’ll have a good chance of success.
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