Ten Easy Steps to Purchasing a Commercial Real Estate Investment Property
Purchasing Commercial Real Estate in a Nutshell
1 - Determine Your Needs - figure out what's right for you!
2 - Read the Market - understand where and when to buy.
3 - Find a Property (and seller) - discover the right property for
you.
4 - Perform Basic Valuation - figure out how much the property is
worth.
5 - Put in a Starting Bid - make first contact with the seller.
6 - Submit your Letter of Intent - outline the formal terms of the
purchase.
7 - Perform a Complete Valuation - use the hard numbers to revalue
the property.
8 - Perform Due Diligence - do a deep dive to uncover any defects in
the property.
9 - Close the Deal - sign the final sales agreement.
10 - Running your new Commercial Real Estate Investment - things to
look for in your first few months as a commercial property owner.
Determine Your Needs
What timeframe are you looking to purchase in? How much capital can
you access for the purchase, i.e. how much property can you afford?
Are you planning to invest a lot of time working on the property?
Are you looking for an income property or long-term appreciation?
Read the Market
Timing is one of the most critical aspects to the purchase of a
commercial property. Since property location is fixed, it is highly
susceptible to the ups and downs of the local economy. So, it is
important to evaluate the status of the general locale, whether it
be a county, city, or state. The economy will influence the overall
availability of tenants, and therefore, the likelihood (or not) that
your property will be occupied.
Find a Property (and Seller)
There are a wide variety of ways to find investors for your
property. Here's where online commercial real estate multiple
listing services such as cimls.com are useful. Just go online and
browse properties in a desirable market (note: that this does not
necessarily have to be where you reside). Other sources of sellers
include:
-Commercial Real Estate Brokers: most brokers are aware of a large
number of properties and have good connections with current sellers.
-Real Estate Clubs: most localities have regular meetings of other
investors who are interested in the -commercial real estate market.
Networking with this peer group can be both informative and
lucrative.
-Local Classified Ads: a simple way to find local properties that
are potentially not listed anywhere else.
Perform Basic Valuation
There are two essential types of valuation to conduct.
1 - Absolute Value
A commercial property's absolute value is based upon the amount it
is expected to appreciate, and the revenue it is expected to
generate.
2 - Relative Value
The relative value is the going price for a property of a given type
in a specific market. This is useful for comparison shopping, since
the relative value of a property may often times be lower than the
absolute value (this is a good indicator of a strong purchase).
For a complete primer to commercial real estate valuations, please
see our other article: Commercial Real Estate Value 101.
Make Contact with the Seller or Commercial Broker
This is the starting point of negotiations. Both the initial
timeline and price are initial guidelines set forth by the seller to
begin the conversation - they are rarely the rule. Throughout the
negotiation process, you will discover more about your respective
motivations and a price that justifies a sale to both parties. The
key piece of information to start your complete valuation is the
Operating Statement. Ideally, you can collect 2-3 years of the most
recent Operating Statements broken down by month. This will outline
the property's revenue and expenses over time. Using this
information, you can perform the initial valuation as well as look
for trending in the numbers (has profit increased or decreased?).
Perform Complete Valuation
Using the operating expenses and other information gathered from the
seller, a buyer may revaluate the initial pricing of the property.
Additionally, this is the time where a buyer has the data to begin
developing models around the expected revenue from the property.
While only projections, these models serve as critical negotiating
tools relating the time it takes to recoup your property investment
as a critical part of the selling price.
It is also a good idea to run the final deal by your mortage broker
and lender - they will often times ask good questions or poke holes
in inconsistencies - the lender is on your side. If you fail, the
lender fails - use your ally!
Submit your Letter of Intent
Send out a Letter of Intent outlining your interest in purchasing
the property and tentative terms of the purchase. This is the first
formal bid in the process - essential to opening the way to give you
the information necessary to fully evaluate a commercial property.
Essential elements to the Letter of Intent include:
-Location: formal address with the property name to
ensure that there are no misunderstandings
-Price: total sum you are willing to pay for this property
-Purchase Date: the effective date at which the seller and buyer
agree to sign the Purchase and Sale Agreement
-Inspection Period: period during which you will evaluate all
aspects of the property with the help of licensed professionals.
-Deposit: sum of money to be held in escrow to validate your
intent to purchase the property. This amount is usually around 3%,
and is typically (but not always) refunded/credited back upon
completion or dissolution of the sale
-Access: confirm that you and your representatives (inspectors,
etc.) will have the access needed to evaluable the property
-Commission: outlines amount or percentage of commission to be paid
by the respective parties
Once the terms of the Letter of Intent are agreed upon, the buyer
will put down a deposit. At this time, the assumption is that if
there are no surprises unearthed by the final investigation the deal
will go though at the agreed upon price.
Perform Due Diligence
Previously, the pricing on the property is typically based upon the
assumption that nothing else is wrong with the property. During due
diligence, the buyer should be on the lookout for potential deal
breaking issues with the property, or major issues which can be used
to bargain down the asking price. It is the buyer's job to play
detective here to make sure that every piece of the seller's story
fits. Once the purchase closes, it will be very difficult to reverse
- even in the case of major issues with the property.
Some key pieces of the commercial real estate investment property to
evaluate include:
-The Rent Roll: This is a full list of the current tenants, their
lease terms, and lease term end dates. Take a look at all of the
leasees and renters to evaluate their credit worthiness and overall
quality - this will determine the initial risk of your cash flow.
Additionally, if you plan to reposition the property (for example,
transform a strip mall into a high end restaurant row) - this is
where you can begin planning to transition your clientele.
-Estoppel Letter: This letter, which is sent to all tenants, legally
confirms their lease terms and payments.
-Property Survey: Understand the exact perimeter of your plot of
land.
-Expenses and Capital Expenditures (for 2-3 years): This
provides notice as to the conditions of the major aspects of the
building and facilities. Recently replaced items (a.k.a. capital
expenditures) should be in great condition. Watch for increasing
expenses (i.e., HVAC repair bills). These indicate failing
appliances, and good reasons to lower the bid price.
-Environmental Reports (Phase I): Occasionally, commercial land may
have special properties that restrict its use. This can range from
hazardous chemicals to being inhabited by endangered species. And,
while unusual, an unseen environmental hazard can render a property
useless (and valueless).
-Land Use/Zoning: It's always good to have a commercial real estate
attorney double check the use laws regarding your property. These
professionals may also be able to inform you of any upcoming changes
in zoning.
-Real Estate Tax and Insurance Bills for the previous three years:
these items should validate the figures already given to you in the
seller's operating expenses report for the last three years
-Service Agreements: These agreements will serve as the starting
place when the buyer staffs a new property by using existing
vendors/property managers.
-Title Evaluation: Believe it or not, the title to a property
(proof of ownership) is often subject to fraud, liens, or other
legal entrapments. It is essential to have a specialized Title Agent
and Commercial Real Estate Attorney evaluate the property's title.
Buyers should strongly consider purchasing title insurance from a
commercial title agent, which will protect them from many common
title issues.
-Find a Management Company: This step is a non-essential, but it
resolves a major risk (and may result in an ally) before fully
committing to the deal.
-Written Commitment for a Loan: Surprisingly, often a great deal is
closed, but the buyer is unable to pay. To avoid this issue, buyers
should run their due diligence and information though a Mortgage
Broker and Loan Agent to ensure that they have a commitment for
financing before the deal is closed.
Once a buyer has completed all of these items (and more!), he or she
is ready to formally sign off on the inspection period. If there are
any issues discovered during this process, the buyer has an
opportunity to renegotiate the price or other terms of the deal.
However, if no issues are found, the buyer can sign off on the
inspection period, and the deposit becomes non-refundable -
committing the buyer to the deal.
Close the Deal
At this point, the hard work is over. The buyer and seller will come
together to draft the Purchase and Sale Agreement. This represents
the formal commitment to purchase the property. It's best if both
parties have the agreement reviewed by their respective attorneys.
Before you close - check the latest profit and loss statements for
up to date information to ensure that there are no unforeseen trends
or sudden changes. If all is well, then the Purchase and Sale
Agreement will be signed and the deal is officially closed.
Start Running your new Commercial Real Estate Investment
Now that the sale is over, the real work begins. Some action items
for the new owner include:
-Transferring utilities to the new owner (you!)
-Sign up vendors/service providers for services such as maintenance,
janitorial work, landscaping, and security - or have a management
company do it for you.
-After three months, you should have enough experience with the
rhythm of the property to look for ways to cut expenses and increase
revenue.
-You can also start to reposition or upgrade your property in order
to increase revenue or prepare it for resale.
-Think about relisting your property. Pick an ideal price - if there
is an eager buyer, it could be your turn to turn an early profit!
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