So interest rates are low, prices are dropping and you’re thinking about buying a commercial building or space for your business (or perhaps as a side investment for yourself). There are a lot of people telling you what a great time it is to buy, so what’s the problem? You will need to carefully analyze the opportunity to ensure that you’re not only buying at the right price, but also acquiring an asset that will not adversely impact you in the future. In other words, your success doesn’t hinge on your timing; it depends on how well you can evaluate the property.
Here are a few considerations before we start looking for a property:
Is It Really For Sale?
Is the owner really selling or using you to effectively appraise the property for the lender? Professional appraisals provide lenders with a precise estimate of value, but not always an accurate one. If you are not actively negotiating transactions in this market, how could you possibly know what a building is worth (based on the replacement cost, income or comparison approaches)? Replacement costs are falling, income will be driven down by a combination of aggressive tenants and distressed and replacement owners and comps are very quickly outdated. The only true test for some lenders is what bona fide third party offers the owner can obtain through marketing the property for sale. Those offers may end up merely enabling the owner to refinance their expiring or defaulted debt, not creating a transaction.
Is It Really Not For Sale?
A far better method for acquiring an asset (once we’ve determined that owning an asset is ideal) is to determine the ideal property based on your business needs. This goes deeper than budget and location; it explores related infrastructure, sustainability and changes to your business. From there, let’s identify potential fits that are not “on the market” and then research the owner’s situation and building’s true value. This process will yield stronger options at better values.
Replacement Costs
Developers aren’t building, in part, because buyers can purchase an existing asset at a much lower price than the cost to build one. Two years ago, this was not the case; both users and investors bought, in most cases, at prices substantially higher than the cost to build, which drove up land prices as the focus shifted to new development further out in the suburbs. You need to evaluate the true replacements costs of the property and justify to yourself and your lender that the particular asset is worth the price.
Pro forma
What could you lease or sell the property for if your business was no longer a good fit for it (or if you’re not the only occupant)? How long would it take and how much would it cost? Among other costs, count on tenant improvements, abatement, operating costs and brokerage & legal fees. Given those costs, at what price should you pay for the building?
Availability of Debt
Can you get a loan and what are the terms? Count on somewhere between 55-65% Loan-to-Value (in other words, having to put 35-45% down), and that’s if the lender believes the story (both yours and the building’s). You’re probably looking at a 5-10-year term (amortized over 25 years with a balloon payment at the end of the term) at a rate above 6%.
Viability of tenants and market
If there are other tenants, what is the default risk? Looking at prior year’s financials isn’t good enough anymore. How viable is their business model going forward?
Ownership Structure
What pressure is on the owner to sell? What debt is on the property and how much control does the owner have (not much, if he’s in default)? What type of owner is it? Is it a REIT that needs to free up cash or pension fund that is oversubscribed to real estate in their portfolio?
Alternative Ways to Invest
As an investor, perhaps there’s a better return in providing equity or buying the loan from the lender? Distressed owners are willing to offer 20%+ returns to investors, and lenders wanting to get bad loans off of their books will sell the debt for a substantial discount in some cases.
Building Due Diligence
There are also the more obvious due diligence items like is the building structurally sound, are the mechanical, electrical and plumbing systems in good repair, is the building ADA compliant, is the property devoid of hazardous materials, are the utilities serving the building adequate, what easements and other encroachments may impact the property and how well will the building accommodate your specific buildout?
Don’t buy the hype when it comes to real estate. Some buyers (both users and investors) made good investment decisions a few years ago, and some buyers are making ruinous purchases today. Buyers of a few years ago that planned long-term, built out or maintained the building properly to add value and aligned their real estate to their sound business model are largely going to do very well. Purchasers jumping at lower prices without looking beyond their initial requirements may have a rougher go of it in the coming years. There’s not a “good time” or “bad time” to buy, just an ongoing need for thorough evaluation.
