5 Mistakes First-Time Commercial Real Estate Investors Make
Commercial Real Estate is unlike any other investment because it is a real asset that can be affected by not only the real estate market, but also the greater financial markets, changes in consumer habits, employment, and other seemingly unrelated factors. That is why it is one of the most complex investments to make for those that are new or unfamiliar with the industry. Here are some of the most common CRE newbie pitfalls:
1. Buying the “Wrong” Property
There are many reasons a property might be the “wrong” property for a first-time investor. Some of the most common reasons (although non-exclusive) are the following:
The wrong location. Maybe the property:
is too far from the buyer’s primary residence for proper oversight or regular “check-ins”;
is in a market the buyer is unfamiliar with;
is in an undesirable neighborhood;
has poor street visibility; or
has competitors concentrated nearby.
Whenever considering a property, it is best to remember “location, location, location” and don’t just take your broker’s word for it—drive around the area and verify for yourself.
Investor experience ≠ property requirements. Perhaps the type of property being purchased is not compatible with the investor’s experience because it is too complex for a first-time investor to get familiar with in a reasonable period of time (ideally, before the property closes). Generally, the more landlord responsibility a property has (expenses, leasing, maintenance, etc.), the more items the buyer needs to get familiar with and be able to control.
Time constraints. If the property requires more time than the investor has available and/or there is not a trust-worthy and competent third-party manager in place, it can spell disaster for even the best property. A property that is poorly managed will end up with unhappy tenants, deferred maintenance, decreasing income and increasing expenses.
Capital constraints. Some properties require more capital injections than others after purchase. Whether for ongoing capital expenditures, needed renovations, or general upkeep, all properties will require some amount of capital reserves after purchase. If the amount of money the property will require is more than the investor has available or can comfortably put forward, it can cause cash-flow, occupancy, or lender problems long-term.
The property requires a major overhaul that the investor can’t handle. Sometimes the easiest way to create value is to renovate, increase rents, or stabilize the right property. However, it’s usually experience that tells an investor whether or not it’s the “right” property, what level to renovate to (and what it should cost), how to attract new tenants, and when to raise rents (and how much). If the investor is not familiar with these factors, they could accidentally end up purchasing a money pit.
2. Overpaying for the Property
It’s easy to overpay for a property if you’re not familiar with the area cap rates, or prices per square foot (or unit), especially if the real estate market is overheated, as has been the case for the past couple of years. It is important to make sure you have a broker that will work in your best interest rather than one just trying to close one deal to move on to the next. It’s also very important to research what local properties are trading at to verify the price you are offering.
3. Choosing the Wrong Loan
Not all loans are created equal and most investors end up with a loan that is inferior to what they should have. Depending on the property’s ownership structure, location, hold period, returns requirements, investors’ financial strength, and other factors, some loans are better than others. That’s why it is important to work with an experienced loan professional with a good reputation and to research different loan products. You don’t want to put the wrong type of financing on the property and end up paying exorbitant fees or prepayment penalties, signing unnecessary personal guarantees, or getting a term or amortization that is too short or a rate that is too high.
4. Not Getting Verified Financial Reports, Leases and Other Due Diligence Documentation
An unverified rent roll or a broker-prepared proforma statement/offering memorandumis not sufficient enough to close the purchase of a property or even make a realistic offer and deposit money into escrow. Make sure that the property income and expense statements come in the form of CPA-audited or prepared statements or previous tax returns and that you review each executed lease, option, and amendment. You will need it anyway to get financing on the property and it will save you the time and hassle of trying to renegotiate price later when the historical financials don’t match the broker-prepared proforma income and expenses (which are always through rose-colored glasses). Also make sure you request any previously completed third party reports (i.e. environmental engineering, structural engineering, appraisals, and surveys) to check for any potential problems. Although the seller may not be willing to provide past appraisals, they should provide the rest if readily available.
5. Missing the “Red Flags”
This is one of the largest mistakes new CRE investors make, mainly because they don’t know what they are looking for. Although not true for all sellers, some owners will try and hide or defray potential hazards or points of negotiation in order to get the highest price while not disclosing all material facts. More inquiry is usually necessary if any of the following occurs during negotiation or due diligence:
Previously supplied financials don’t match verified financials
There are leases that are coming up in the short term and haven’t been addressed with the tenants (i.e. leases renewed or renegotiated)
Actual leases don’t match the rent roll
The seller tries to stop you from speaking to property manager or current tenants before closing
Large amounts of free rent, reduced rent, or other perks were given to tenants to get them to stay
Income has been trending down or expenses trending up previous to the sale of the property
After long history of stable income/expenses, income suddenly spikes up or expenses drop (making property look more attractive)
There are cracks in the foundation of the property
There has been no substantial renovations or capital expenditures on the property for an extended period of time
Occupancy jumps up or several new leases signed immediately before property sale
There is a tenant (i.e. drycleaner, auto repair shop,gas station, etc.) that could cause environmental contamination to the property, but the seller doesn’t have an environmental engineering report available
Competitive properties are being built around the subject property