For the majority of folks in the United States, their home is their first and often their only real property investment. After buying a house, any further discretionary funds typically go into savings, money market accounts or the stock market. But with bank savings rates at historic lows, and the stock market vacillating at record highs, it made sense to me (after my initial shock!) when my 20-something daughter, with seemingly no prior interest in real estate at all, asked me what advice I would give to young professionals (or novice investors) who might be considering investing in commercial real estate. So, to all newcomers to commercial property investment, here are my thoughts.
The motivations and purposes for buying a home to live in, versus acquiring a commercial property for a financial return, are distinctly different. Buying a home is a personal and emotional process, while buying an investment property revolves around analyzing risk and reward.
We have all heard the somewhat overplayed cliché “Location, Location, Location!” While I can’t disagree with the importance of this particular property attribute, I think that when it comes to commercial property investing, especially for the novice investor who has proportionately more to lose, I would instead suggest, “Due Diligence, Due Diligence, Due Diligence!”. I would define due diligence as “a thorough investigation and analysis of a property to establish its assets and liabilities and evaluate its investment potential”.
One of the three primary areas of “Due Diligence” relates to investigating and understanding the location/market. One should understand what is happening demographically in the community in which they are considering investing? Since the continuity and stability of the rental income stream is imperative, it is important to invest in an area where jobs and/or population are growing (i.e. a positive demand side). On the supply side, is the extent of competing property limited by the area’s geography, zoning or political climate? If so, such barriers to entry could protect and increase the return on your investment.
The second area of “Due Diligence” relates to examining the physical property. Discovering an unexpected condition that was not planned or budgeted could ruin your anticipated return for years, or even worse, cause a forfeiture of the property. In addition to completing typical due diligence items such as pest, roof, HVAC, and building inspections, one must not forget a comprehensive analysis of the following items: i) Title condition: especially any “exceptions” to title insurance listed in the preliminary title report. Is the property subject to CC&Rs, a road maintenance or reimbursement agreement, undesirable easements/encroachments?; ii) Use: does the building’s design fit the current zoning, or was the zoning changed after the building was built thereby rendering the originally intended use non-compliant?; iii) Environmental/ADA issues: I almost always recommend that commercial property buyers protect themselves by having on file a baseline environmental survey showing no evidence of recognized environmental conditions (including asbestos). ADA (“Americans with Disabilities Act”) laws are becoming more stringent each year and meeting these requirements on certain properties can be extremely expensive; iv) Parking: Insufficient parking is a huge contributor to frequent tenant turnover; v) Energy efficiency: Energy costs continue to increase and are becoming an ever more important consideration for tenants; vi) Design flexibility: Does the building lend itself to various uses and/or tenant sizes that will appeal to a greater pool of leasing prospects?
Last, but certainly not least, the third zone of “Due Diligence” relates to financial analysis. From a macro perspective, where does the economy currently sit within the economic cycle? Is it a beneficial time to buy? Is positive financing leverage available? Are the property’s tenants financially sound with good rent payment histories? Have you thoroughly examined their leases, including any modifications, options, etc.? Since leases legally validate the income stream, they should be well understood! Have you “underwritten” the deal with conservative assumptions of anticipated rent, lease-up period, required tenant improvements, operating expenses, reserves, etc?
As the above questions demonstrate, making a sound financial decision regarding commercial property investment requires detailed investigation and analysis in order to determine if the anticipated financial rewards are worth the identified risks. A novice investor would do well to work through these various “due diligence” items with the help of a commercial real estate professional.
Lock specializes in acquisitions, dispositions and leasing of commercial and investment properties. He has over 25 years of experience in the field, including over 15 years in the Grass Valley/Nevada City area. His “Commercial Property Review” newsletter, full of current Nevada County market trends and specific property details related to industrial, office and retail properties, is available at highlandcre.com or by calling Lock at 530-470-1740.
