While commercial real estate in the U.S. continues to be a safe haven for investors seeking higher yields with relatively low risk, new investors often worry they will find themselves in over their heads, saddled with the next Mr. Blandings Dream House or Money Pit.
However, investors can minimize their investment risk exponentially by doing some basic homework on their potential investment properties. We recommend always looking into these 5 factors as part of due diligence when determining the potential risk factor for any investment.
1) History Of The Property
When looking to invest in a property, one of the first things investors should look into is the history of the property to find out what type of uses the building, or land the building is situated on, has been used for in the past.
Finding out if the building has possible asbestos issues, or if the land has ever hosted a gas station, dry cleaner or other business where the possibility of toxic environmental issues could be a concern, or has had a history of past structural or mechanical issues, can minimize your risk of getting saddled with costly future expenses.
A phase I environmental report is always recommended when making a real estate purchase.
2) Tenant Credit
Whether you’re purchasing an investment property with existing tenants, or planning on leasing out your property once it’s purchased, making sure you have good tenants with a positive credit history can save you from costly future property management concerns.
And while purchasing a property with a creditable tenant as an existing lessee, who has the financial stability to maintain their lease for the long term, may cost you more on the front end, it can save you from spending money in the future on legal fees or expensive renovations in the event that a less creditable tenant vacates the property before their lease term and leaves you having to attract new, more creditable, clients to fill the space.
3) Financial Terms
Another area to educate yourself on before investing in a property are the loan terms and what they will mean for you right now and what they will mean for you in the future so you can make sure to strike the most favorable terms for your situation.
Ask questions like, “Will the loan be a Non-Recourse, Partial Recourse, or Full Recourse loan? Will it be a floating or fixed rate loan? Will there be a swap or not? Are there defeasance fees if I decide to sell before the loan matures?”
These questions will help keep you informed as to all of the potential financial risk factors as well as assist in your overall plan for the investment.
4) Market Trends
Market trends are another important area of research when choosing in which potential property to invest.
One of the main things to look for are the vacancy rates for the area over the last 3-5 years. Obviously, you’re not going to want to pay as much for a building that has an average vacancy rate of 40%, compared to one that has an average vacancy rate of 4%, especially if the surrounding area has ample vacancy increasing competition for tenants.
The other is to try and determine if the property is in an upward trending area, or in an area situated in a downward trend. Locating potential sites in new up and coming areas that are just starting to take root, is often a great strategy for investing while the prices are still low, and then seeing substantial investment value growth as the area fully develops. Factors that can influence these trends include: zoning changes, improved infrastructure, new developments, and lack of supply in adjacent areas.
5) Have A Plan For The Property
Finally, before you sign on the dotted line, one of the biggest factors in minimizing your investment risk is to have a detailed plan for the property. Simply buying land on gut instinct, just to own property without any plan on what you will do with it, can often be a costly mistake.
We recommend sitting down and writing a detailed plan for what you intend to do with the property/building/land you plan to purchase. This should include any developments/improvements you plan to make and what you approximate the return on those developments/improvements will be. It should state what your rental plan is for the property, how long you plan to hold onto the property, and what the intended use will be for the property. Will this be an income producing property, a value added asset property, or do you simply want to hold onto the land long term for a future date?
Finally, your plan should include a detailed exit strategy, how/when do you plan to off load the property after you purchase it? What will your estimated costs for selling the property be and what sort of tax liabilities will you be accountable for if you choose to sell?
Investing in commercial real estate can be daunting at first. However, with a solid plan in place, a little research and by properly educating yourself on the potential properties you can substantially minimize your investment risk.
CRUNKLETON & ASSOCIATES