Purchasing commercial real estate as an investment is not the same as purchasing residential properties. The current or future income derived from the commercial building determines if the property is a good investment or not. Typically, there are three commercial real estate investors that have different objectives; therefore, they will look at the building differently. The following are the three investment objectives an investor might consider:
Rehab Investors: This type of investor is looking for a property that is run down or in need of repairs. They want to purchase the property at a low price, fix up the property and bring the property to full occupancy or with a low vacancy rate.
Management Investor: This type of investor purchases a property that currently has a decent occupancy rate and has little to no deferred maintenance. The current owner is not running the property at full occupancy due to poor management of the building. This investor will purchase the property and increase the cash flow by managing the property better than the previous owner.
Buy and Hold Investor: This type of investor will purchase a property that currently has a high occupancy rate and has no deferred maintenance. The investor watches the trends in the market and will purchase when he knows rental rates are low. Once the market rental rates increase the investor will raise the rates which will increase the value of the building.
Once an investor has located a commercial building to purchase based on location and price range, the investor will want to review the current financial history of the building to determine a pro-forma financial statement for the next year of operation. Also, the investor will want to determine what similar buildings (Class A, B or C) in the same condition are currently renting for in the market. Furthermore, an investor will want to determine a market cap rate base on what similar buildings have sold for in the market.
Most seller will try to inflate the income or deflate the expenses provided in the historical financial statements. You should request up to three years of historical financials so that you can determine any trends in income or expenses. If you are dealing with a “Mom and Pop” type of operation, then the historical financial statements might portray an inaccurate picture of the financial ability of the building. Furthermore, if the building is currently in foreclosure or owned by a bank, then the historical financials for the building may not be available.
If you are provided with any historical financials, then you will want to determine a trend in the income and expenses to be used for your income and expense estimate. Also, you can obtain comparable expenses from a real estate broker or appraiser that has data on the same property type you are purchasing. With the comparable expenses you can determine if the expenses for the building are higher or lower than other buildings and determine if there is room for improvement with the property once your purchase.
Next, you will want to survey similar property types in the area to determine a market rental rate for your building. If you are purchasing a multifamily property, then you will want to find similar buildings with the same number of bedrooms, bathrooms, square footage, amenities. If you are purchasing an office building or retail property, then you will want to determine a rental rate based on price per square foot and with similar lease types (Full service, gross, percentage, modified gross).
The final step is to determine a market cap rate that you should use for the valuation of your building. Of course you will have your own cap rate (yield rate) that you desire but if you know what similar buildings are selling for, then you will have more negotiating room with the seller. To determine a market cap rate you will need to find similar buildings that sold and compile the cap rates from those buildings to determine your market cap rate. You should have about four to five arms length comparable sales for this analysis.
Once you have compiled all of this information, then you are ready to determine a market value for the property you intend to purchase and to start preparing your offer to the seller. If you and the seller are unable to come to an agreement on a purchase price, then you will repeat the process with your next offer.
Also, before you submit your offer you will want to determine if the property will meet your investment objectives. Some most common investment ratios an investor will consider are as follows:
•Cash on Cash Return = Annual Before Tax Cash Flow / Cash Down Payment
•Rate of Return = Annual Before Tax Cash Flow / Purchase Price
•Gross Rent Multiplier = Purchase Price / Annual Before Tax Cash Flow
•Internal Rate of Return = This calculation is used for larger buildings or more sophisticated investors.
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