Have you been thinking about investing in Commercial Real Estate? There are many ways that investors get started, but first you should understand the risks involved in owning and managing Commercial Real Estate.
Some investors begin by purchasing small projects (say a five-unit or more residential apartment project or a small office/retail building with just a few commercial tenants). This may require a smaller equity stake from the investor and might even minimize or eliminate the need for conventional bank financing if the seller may be willing to hold a small mortgage to assist with the purchase. This type of investment will allow the investor, or landlord, to become acclimated to dealing with tenants and the types of situations that might arise, such as: taking phone calls in the middle of the night because the heater won’t turn on, listening to the tenant explain that they don’t have the rent because their business traffic has slowed that month, etc..
Investors may look for quick “fix-up and flip” properties where they can invest for a short period of time, then hopefully turn around and sell at a profit. Those proceeds would then be re-invested into a larger investment that ideally will continue to increase in value. This investment strategy may have worked 15-20 years ago when there were more tax advantages available for real estate investing and fewer investors trying to take advantage of a quick profit. It has become more difficult in today’s market to realize the same returns.
Other investors form a “team approach” with friends or family, each taking various property management responsibilities. While this approach may limit your time requirements for managing the properties, it will also reduce an investor’s return on their original investment, but this approach may also limit the losses, as not all great ideas bear fruit.
Regardless of your strategy, eventually you may find yourself face to face with a banker who can help you with financing or refinancing one of these investments. Investors should be aware of what bankers look for when evaluating a request for financing:
1. Management Experience/Depth
2. Demonstrated Ability to Repay
3. Adequate Collateral
4. Investor Liquidity
Following is an expansion on these criteria and some insight on how you can simplify the process of obtaining financing.
Management Experience/Depth – Bankers like to see a successful track record of real estate investing. History has a way of repeating itself, and if you can demonstrate that you have a strategy that has been tested through different economic times, this can prove to be a huge advantage. Bankers will also want to determine if the investor has somebody to handle leasing, service calls or major repairs or whether this will be done by the individual investor? If you have a full-time job and are interested in investing, you need to demonstrate that somebody will have the time and experience to handle the overall management of the property.
Demonstrated Ability to Repay – You will want to demonstrate how you intend to repay the loan. Bankers will ask you to demonstrate that the project being financed shows the historical ability to repay the loan or that there are cash flow projections that are dependent on future changes to either revenue or expenses.
A project’s Net Operating Income (NOI) is the cash flow that a banker will look for to support repayment on the loan. NOI is the difference between a project’s gross rental income, less vacancies, less all operating expenses associated with the property (i.e., real estate taxes, insurance, utilities, snow removal, management expenses, and a replacement reserve for unforeseen capital repairs). The project’s NOI is used to calculate the project’s Debt Service Coverage Ratio (DSCR). It is usually recommended that a project show a minimum 1.2:1 DSCR. A DSCR is defined as NOI divided by the Annual Debt Service of the debt being financed (both principal and interest) associated with the project. If the seller is assisting with subordinate financing, this should be considered in the calculation, as the project should demonstrate enough cash flow to service ALL debt being financed at a minimum breakeven level.
Adequate Collateral – Most bankers like to see cash equity in commercial real estate investments. Depending on the type of investments (i.e., office, retail, apartments, hotels, etc.) banks usually do not like to lend more than 75 - 80% of the Fair Market Value of the property. The balance (20-25%) could either be in the form of cash equity by the investor or a combination of subordinate seller financing, or possibly even other borrowed funds from family or friends. The Bank will engage an independent professional to value the property. The appraiser will research market rental rates for similar properties, report on comparable recent sales and analyze the cash flow of the property, and derive a value using an appropriate capitalization rate (cap rate). Cap rates reflect what the market has paid in a return on the cash flow of similar type properties. This provides the investor and the bank with a means to derive a value estimate from a cash flow stream. For example: if a property reports an NOI of $50,000 per year and the appraiser supports a capitalization rate of 10%, this would equate to an approximate valuation of $500,000 ($50,000 as divided by 10%).
Liquidity of Investors – Liquidity is determined through an assessment of cash, mutual funds, stocks, or at minimum, readily traded assets which can be turned into cash within 30-60 days. Liquidity gives the investor the ability to support the project in the event the rental income stream is disrupted. It also gives the Bank a comfort level that any unforeseen capital needs for the property can be funded. Investors should be cautious not to invest too much of their liquidity. Keeping 10% or more of an individual’s Net Worth liquid would be a good place to start.
Commercial Real Estate investing has proven to be a viable option to grow an individual’s Net Worth if done properly. Unfortunately some projects do fail, resulting in financial stress or even bankruptcy for investors. Sticking to the basics, understanding the risks and resisting the urge to grow too quickly should help prospective investors optimize their returns while avoiding the pitfalls of real estate investing.