How To Analyze Commercial Real Estate Deals An Introduction To Investment Underwriting
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So, you think you’ve found a potential commercial real estate investment.
Now what? Since commercial properties are more complex
than residential, determining what your potential returns will be and what you can afford to
pay isn’t as easy as seeing what other properties have sold for in the neighborhood.
You’ll actually have to: * Determine what could be a potential comp
* Study the current leases (or lack thereof) * Decide which investment strategy to use
* Estimate your construction and renovation costs
* And get term sheets from your lenders Once you’ve done all of that, you can finally
analyze the numbers to figure out if the investment will make sense for you.
Here’s our quick guide on how to analyze commercial real estate deals.
Look For Comparable Properties ________________
You may feel like you’ve found a deal, but you need to confirm that.
Comparable properties will help you verify that you’re paying the right price and can
also give you an idea of what you could do with the investment.
Banks will also use these to determine whether or not they’ll lend on the project.
When reviewing comps, you want to find similarities (or get close!) in:
* The zoning * The size of the lot and building
* Condition and year of construction of the building
* Geographic location * And any unique aspects of the property
Finding commercial comps can be tough, though. Since there isn’t a centralized database
of commercial real estate listings, we’ve found our best comps from utilizing tax records
(especially CRS Data), brokers specialized in that geographic location or property type,
and local appraisal firms.
Review The Offering ________________
Now, it’s time to dive into the deal’s numbers.
If you feel like your acquisition price is within a fair market range, you need to review
whether or not the deal will make money. Yes, the price may be supported by the comps,
but if there are tenants with long-term, under-market leases, the deal may not make since.
So, you’ll want to get any and all financial information possible on the property.
Ask the owner for: * Rent rolls
* Profit and loss statements * Tax returns / K-1s
You should also review each and every lease to see what terms to which the owner and tenant
have agreed. As the incoming owner, you will be bound to these terms, too, which can make
or break the deal. Whether your lender requires it or not, you
should also have tenants sign an estoppel. The estoppel confirms the terms presented
to you in the lease or by the seller and will uncover verbal agreements or other documents
that haven’t yet come to light that could impact the terms.
Determine Your Investment Strategy ________________
If you’re like me, you probably have a go-to real estate investing strategy.
Maybe you prefer value-add, long-term hold, or new construction - there are a number of
different strategies out there. But that strategy will need to be tailored
to the project. Once you’ve reviewed the financials and
leases, you may end up having to take a different direction with the property than you had originally
anticipated. After determining your investment strategy,
you’ll have a better idea of renovation needs.
Construction / Renovation Estimates ________________
Construction and renovation could be your biggest expense, other than acquisition.
Getting these numbers right is crucial to your success.
And if you don’t get the numbers right on the front end prior to purchasing the building,
you may not have a large enough loan to cover these costs and finish the job.
So, once you’ve figured out your strategy, put your construction budget together.
If you’ve handled renovations before, you may be able to throw together a quick back-of-napkin
number. Of course, you would be wise to have a contractor
(or two) come out to put together an actual bid for you. Your lender will likely want
to review these numbers, so it will help you with your acquisition.
Gathering Term Sheets From Lenders ________________
Your loan costs are the final piece before fully analyzing the investment.
So, you’ll need to meet with several lenders, present them with the deal, and receive term
sheets. Each lender will have different project requirements
and appetites for asset types, so it certainly pays to have multiple banking relationships.
Term sheets at a minimum will typically provide: * Loan-to-value or loan-to-cost terms
* Interest rates * Amortization and length of the loan
They can often go much further into detail and include other documents they will require
from you, the personal guarantors, collateral, etc.
Analyzing The Real Estate Investment ________________
Now that you’ve gathered together every aspect of the deal, it’s time to underwrite
it. If you don’t have any underwriting software,
here’s where I highly recommend that you invest in a high quality program that suits
your needs. Some investors create their own spreadsheets
or you can buy a pre-built program (message me for recommendations) - whatever gets the
job done. These spreadsheets / programs will have calculations
that take into account: * Purchase price and acquisition fees
* Construction & renovation costs * Down payment and loan costs
* Rental rates / monthly income If done correctly, you’ll be able to enter
in only the few numbers above and crank out returns on investment, internal rates of return,
monthly cash flow after debt service, and so much more.
Of course, it never hurts to have a back-of-napkin formula to check if a deal potentially works,
but nothing competes with a full-service `