As we previously discussed, there is a range of benefits and risks associated with investing in commercial real estate, that you need to be cognizant of before making commitments to a property. Now that you have become familiar with these unique elements of the commercial real estate investment process, it is time to explore the best practices when it comes to investing. It is easy for new investors in the commercial real estate field to take on too much, too quickly, and feel out of their depth.
What You Should Do
With all of this in mind, if you are prepared to invest in a commercial property, there are a few key things you will want to do before committing to an investment:
In-Depth Due Diligence
This will be the most time-consuming, but also potentially the most rewarding, as it will provide you with invaluable insight and knowledge about the property. You will want to be exhaustive in your process to catch everything. This means, reviewing the financial performance of the property in the present and the past, to get an idea of the returns you can expect. You will also want to conduct market research for the area the property is located in to get a better idea of potential customer levels and possible foot traffic.
Examining the physical condition of the property is also going to be a must, to determine what issues should be addressed before taking over a property, or what potential work and repairs may be necessary in the future. Ideally, you should have professional examinations conducted during this process, so you can have documentation of the condition of the property and objective recommendations.
Pay Attention to Value Metrics
There are a number of value metrics that you will need to pay attention to if you are to make a serious investment in commercial real estate. These will include details such as the sale price of the property in question, as well as comparable sales in the local area. Similar buildings and properties in close proximity should provide an accurate indication of the fair market value of the property.
You should also consider the gross rent multiplier to begin with, as this will give you a rough guideline of what the payoff period for the property will be, without factoring in other expenses such as repairs, vacancies, insurance costs, and property taxes.
At the same time, you will also want to keep in mind what kind of cap rate you are looking at with each potential investment. These percentage values can be a useful metric for many investors to identify the level of risk that they are comfortable assuming and pass on properties that exceed their tolerance threshold.
Choose the “Right” Industry
With Office, Industrial, Retail, and Multifamily properties to choose from, you need to pick the industry that is going to be the best fit for you. Each type of property has its own unique risks and benefits that you will want to be fully aware of. What makes retail properties exciting to one investor, might mean a host of headaches for another investor, so you should be absolutely sure you are ready for any and all responsibilities. You will want to evaluate the pros and cons of each asset class and select the best fit for your needs as an investor and capabilities as a landlord.
What You Should Not Do
Now that we have covered the vital steps that you should take when investing in a commercial property, we should cover some of the major pitfalls that you will want to avoid. These are some of the biggest mistakes that new investors will make when trying to get started in the field.
Go it Alone
One of the biggest mistakes many new investors make with commercial real estate properties is trying to do everything on their own. These types of properties require careful consideration and evaluation to make a solid investment decision, which is going to translate into searching for a lot of information.
Successful investors in commercial real estate rely on teams of professionals to do quite a few things, such as setting the overall strategy, performing the necessary market research, sourcing viable properties, and even carrying out property management after the property has been acquired.
Focus Only on the Potential ROI
Too often, new investors can get caught up in the potential return that property could yield them, and lose sight of the full scope of the responsibilities that a property will carry, as well as the reality of what the income flow will look like. Focusing only on the possible return doesn’t take into account the time value of money or even the timing of periodic cash flows that could occur. Additionally, the longer an investor has to wait on possible returns, the more difficult it becomes to forecast accurately what those returns would realistically look like.
Instead, you should focus on elements that will give you more actionable and realistic income expectations, such as the recurring cash flow, any potential appreciation in property value over the long term, and the internal rate of return.
Often going hand-in-hand with focusing too much on potential returns, many investors also underestimate the overall costs that they could face with an investment. These costs can range, from paying property taxes and insurance costs to paying for repairs and renovations as needed. Repairs and renovations especially can quickly add up to a considerable cost if not accounted for from the beginning.
To avoid this, issues for repairs should ideally be identified during due diligence, and planned for as best as possible, so you aren’t blindsided by the cost. However, there will still be other costs that come up at a moment's notice that you will need to be able to address, so budgeting in repair costs will be necessary. Minor repairs can be expected fairly regularly during ownership, you can also likely expect to handle water leaks, electrical issues, infrastructure issues, or other unforeseen issues at least once during the ownership of a property, depending on the age and condition of the building.
Overextend Yourself Financially
The final pitfall that should be avoided is that of over-investing. True of any kind of investing, you should not over-invest, or place yourself in an unsafe position by committing more money than you can afford to lose. If all of your money is tied up in a single property, and an emergency strikes on that property or in another aspect of your life, it could lead to disastrous consequences.
Savvy investors know how much risk they can afford, and look for a balance between risk and fiscal responsibility. This balance will look different for every investor, but the basic rule of never investing money that you can’t afford to lose is a great starting point. It is also important to remember that investing in real estate, especially commercial real estate, is a long-term investment strategy, and should be treated as such. It will typically bring lower but more consistent returns, and individuals looking to make a lot of money fast may feel burned by the need for patience.
Brendan Jost >
Acquisitions & Dispositions Manager
Brendan Jost serves as the Acquisitions & Dispositions Manager at SimonCRE. He plays a vital role in the day-to-day management of the company's disposition pipeline and investment sales team.