In these tough economic times, we’re going back to basics when considering real estate investing. Whether investing in commercial real estate, defined as office, retail, hospitality, and industrial real estate, or in multifamily residential real estate, it’s a different time now than in the recent past. For the savvy investor, it’s time to go back to basics and understand not only the real estate market, but just as importantly, an understanding of the capital market in order to achieve some level of success. This is even more important for the novice real estate investor.
During the boom from 2002 to the first half of 2006, capital was plentiful for all property types. Most types of property were easily financed on easy terms. As cash looked for opportunities, lenders opened the tap and investors could tap into a variety of sources to finance acquisitions. Gone are the days when lenders made loans based on a property’s potential future income and appreciation. As a result, most buyers during this time period paid a purchase premium in anticipation of property values continuing to rise at double-digit rates, as they have for most of this time.
Today we are in completely different conditions. Today, it’s more important than ever to get back to basics. For investors planning to purchase, there are several considerations and calculations at the property level, as well as at the finance level, to assist in properly evaluating a purchase. Qualified and experienced professionals can be invaluable in this area to help ensure success.
A necessary first step is to define goals for each property in relation to ownership, property operation and management, and an eventual exit strategy. The following summary outlines the key points important to a successful investing program, both for the beginner and the more experienced real estate investor.
Property types: Different property types require different property management and operations, and have different income and expense profiles. An example is a full-service office building in which the owner pays all building operating costs and maintenance without passing the buck to the user. Of course, the rental rate paid by the office occupier reflects the operating costs, but leases may contain cost freezes that prohibit any amount above a certain dollar amount per square foot that can be passed on to the occupier of the space. In this case, the owner will have to absorb an amount that exceeds the amount of the stoppage of the increase in expenses. Conversely, the owner of a retail shopping center usually passes all costs of the property to the user without compensation or stop costs. Therefore, the operating costs of a shopping center will usually be less of a burden for a retail owner than for an office building owner due to the contractual (lease) ability to pass all costs onto the tenants. This is just one of the main considerations when thinking about investing in an office building versus a shopping center, which is used here. Different property types will experience different vacancy rates, rental rates and expense ratios and will depend on the market. All of these factors are important when evaluating a purchase. Lenders also rely on historical market performance and property performance profiles when evaluating their underwriting criteria as a basis for how much they will lend, what level of income is required for annual loan debt service, and many other real estate transaction, market and management factors. Different types of property have different aspects of operation and costs, as well as financing, which must be carefully studied in order to be successful.
Facility location: The old adage in real estate is Location, Location, Location. Yes, this is true even for commercial real estate. A comprehensive analysis of location factors is critical to a successful investment program. Due diligence is required, and the first step is a geographic analysis that includes elements such as transportation systems, major employment centers, demographic and economic data, and a host of other information useful in evaluating the broader area where the property is located. A very useful tool to assist in this analysis is a GIS, or geographic information system. Once the broader market area has been analyzed, a narrower focus on the real estate market location is necessary to rule out any specific factor that may add to the property’s value, such as a large employer in the market, or any factor that reduces the property’s value. such as a new zoning ordinance that limits building uses and heights. Once these analyzes are done, it is also important to conduct due diligence on the specific property being considered. This ranges from the importance of conducting a structure inspection to environmental/soil studies to all related legal and physical site and zoning and other local regulatory assessments to ensure there are no problems or potential problems.
Legal and tax considerations: There are several different ownership entities that can be used when investing in real estate, with their own tax and legal implications. It is important to have a fundamental understanding of each type and how each type affects you and your tax situation. An experienced team of specialists in the field of law and taxation is important to help in solving these issues. For example, forming an LLC may not be the best organization in terms of tax consequences. LLCs are a popular vehicle for owning real estate for liability reasons, but not necessarily for tax reasons. For example, operating a real estate investment business and having employees may require a different business entity, such as a Subchapter S corporation, rather than operating as an LLC. There are too many problems and potential risks to go it alone. Having a team of professionals to handle all aspects of legal and tax matters is essential. The same can be said for having real estate professionals who understand not only the real estate market, but also the capital market, as well as experienced negotiators working on your behalf. Having a team of seasoned professionals in your corner is always smart.
Funding: Today, more than ever, it’s a tough credit market. Creditors are not in the mood to lend. With the changes in the lending and lending environment today, it is very difficult to get financing for any transaction. Gone are the days when lenders made their decisions based on pro forma estimates of cash flow and property appreciation. Understanding the current situation is not only important, but even more important today so that everyone has a chance at a successful investment program. In the recent past, this was called the game of leverage. This is still important, however, any acquisition will require higher capital than in the past, resulting in lower returns than with a more leveraged deal. Some questions arise: How will this affect the expected return on investment? How will this affect the money needed for property renovations and other capital reserves for expected or unexpected major repairs? Is it necessary to use more of the funds coming into the deal (equity) and the resulting return on that money to make it profitable, better invested elsewhere? There are many other questions and calculations that are necessary to fully evaluate the feasibility of financing a transaction, especially given the environment we find ourselves in today. For example, is there a strong leasing market to support asking rents and future rate increases that will more than cover lenders’ higher debt service requirements? Again, having a team of professionals working for you to help evaluate and advise on such matters is an important part of the process and overall analysis.
Exit Strategy: How long do you plan to hold the property? What will the market be like when it’s time to sell? What government regulations (such as zoning and land use) have changed since the acquisition? What are the credit/loan markets? What will the demographic and employment projections look like? You need a crystal ball to answer these questions. Of course, no one knows for sure. An exit strategy, preferably formulated before the acquisition, is as important as the purchase decision. An exit strategy should be the basis for any decision to invest or not. The above questions, along with many other specific property, legal, tax and financial considerations, will help formulate an investment program and its likelihood of success; success here means making a profit. Otherwise, why would an investor participate in a venture without the possibility of making a profit? A well thought out investment program always starts with an exit plan. This is especially true of investment real estate. It is often said that you make money when you shop. It is also true that you will make a profit or a loss with your exit strategy or lack thereof.
Whether you’re a seasoned investor with multiple properties or a novice looking to make your first deal, understanding and doing your due diligence with attention to the details of the more important real estate investment processes and engaging in the necessary due diligence will contribute to any successful investment. investment program. In particular, given today’s economic environment, it is critical that investors thoroughly research all the issues that may arise with the property, as well as understand the financing, legal and tax aspects of owning an investment property.