Categories: Education

8 Mistakes to Avoid Before Investing in
Commercial Real Estate

Introduction

Commercial real estate can be one of the best investments around, due to recurring cash flow, property appreciation over the long term, and tax benefits that only real estate investors enjoy. However, real estate investing isn’t always as easy as it might seem.

But before you begin investing in real estate, it’s important to learn from the mistakes that other investors have made. You’ll save valuable time, money, and build your commercial real estate portfolio much faster while avoiding the traps that other investors fall into.

Lack of Planning

Yogi Berra, former New York Yankees catcher, once said “If you don’t know where you are going, you’ll end up someplace else.”

In commercial real estate, that someplace else is more often than not is an investment that underperforms year after year, until it is eventually sold for less than the original purchase price.

Planning begins before the property is purchased with an exit strategy that identifies how and when you are going to sell. For example, investors with the goal of maximizing IRR know that as time goes on the internal rate of return from the property decreases due to the time value of money.

Knowing where you want to be five or ten years from now also makes it easier to develop a business plan and select the best investment strategy for your specific goals and objectives. With the way the multifamily market has been performing, it can be tempting to jump at the first deal that crosses your desk.

However, getting emotionally involved in a potential acquisition can make it difficult to think clearly and lead to unwise investment decisions.

There’s a tremendous amount of time, energy, knowledge, and money involved in analyzing and investing in commercial real estate. It’s always better to have patience and wait for the best opportunity to come along that offers maximum cash flow, minimum management responsibilities, and the highest overall long-term profitability

Related Link: Gross vs. Net Lease in Commercial Real Estate

Doing It All on Your Own

Investing in commercial real estate is much different from buying a house. There are about 3 million active real estate licensees in the U.S., according to the National Association of Realtors (NAR), mainly because pretty much anyone can get a residential real estate license to buy or sell a house.

To be fair, there are some outstanding residential real estate agents that know how to network and find the best deals. But the fact is the MLS provides every piece of market and sales data buyers and sellers need to know, which greatly reduces the need for an experienced residential agent.

Commercial real estate is completely different. Experienced CRE investors never try to fly solo and do everything on their own, because oftentimes the most profitable commercial real estate opportunities are the ones that aren’t being marketed to the general public.

Successful commercial real estate firms have proven experience putting together private equity real estate investments that are accessible, well-managed, and aligned with the long-term goals of the investor.

Some brokerages work with investors who are comfortable with the higher-risk strategy of putting money into underperforming assets such as retail centers and office buildings.

Other firms such as Smartland specialize in helping commercial real estate investors profit from risk-adjusted returns from multifamily properties. These professionals have the expertise and established networks to oversee a project from start to finish, offering a turnkey investment experience for sophisticated commercial real estate investors.

Looking to get started in commercial real estate? Contact Smartland to learn more about where you can invest.

Related Link: What are Illiquid Investments?

Choosing the Wrong Type of Property

There are four major commercial real estate asset classes: Multifamily, Industrial, Retail, and Office. The global pandemic and resulting recession has affected all real estate asset classes in general, but some much more so than others.

In many markets across the U.S., the office and retail sectors are still struggling. The retail asset class continues to see tenants go bankrupt and storefronts close, increasing vacancy rates and driving down retail rents as more people shop online.

Property offered for sale at below market price typically has significant amounts of deferred maintenance or material defects with repair costs that can be difficult to accurately estimate.

Working from home is becoming the norm for most businesses, with remote work becoming permanent, according to a recent article from Forbes.

In fact, over the next four years, an estimated 70% of the workforce is expected to be working from home at least 25% of the time. While employees are happier and reportedly more productive, remote work also means less demand for office space in the years ahead.

On the other hand, real-life commercial real estate investors are overwhelmingly choosing multifamily as the best property type to invest in this year.

The asset class is benefiting from people being home more often, and from the migration from urban to suburban and secondary markets as tenants seek more affordable housing and a better quality of life.

Cities such as Cleveland have seen median rents increase 6% year-over-year, with more people choosing to rent rather than own.

Although median household incomes in the Cleveland metropolitan area have grown by more than 7% over the past year, renter-occupied households make up 55% of the total occupied housing units in Cleveland, as more residents embrace renting as a permanent lifestyle option.

Choosing the Wrong Property Management Company

One of the key factors affecting the profitability of a commercial real estate investment is strong property management. The best property management companies can help to increase property cash flows, generate a higher appreciation rate over the long term, and reduce overall investment risk.

In the multifamily sector, full-service apartment management includes marketing, leasing, and 24-hour maintenance. Multi-channel marketing both online and offline is used to reach as many prospective tenants as quickly as possible.

Tenant screening to select the most qualified tenants includes credit and background checks, rental history reports to eliminate tenants with eviction histories, and income and employment verification.

After a unit has been leased, cutting-edge property technology and interactive management software are used to improve cash flow with online rent payments, process maintenance requests, and communicate with staff and owner/investors.

In-house maintenance specialists are available 24/7 to quickly and cost-effectively handle heating and cooling, electrical, and plumbing repairs. By providing the best possible rental experience to tenants, occupancy levels can stay close to 100% with tenants renewing their leases year after year.

Another way a good property management company keeps tenant turnover low is by offering the features and amenities renters are looking for. Millennials and Generation Z – people between the ages of 23 and 40 – make up a large percentage of today’s apartment residents.

Multifamily property managers offer features to help attract and increase tenant retention in this key renter demographic. The most attractive amenities include pet-friendly apartments, smart technologies such as home automation and virtual assistants, energy-saving climate control features, and safety features like remote control door locks.

Related Link: Top 10 Risks to Consider Before Investing in Private Equity Real Estate

Failing Due Diligence

Another common mistake many commercial real estate investors make is neglecting to perform adequate due diligence. While it can be tempting to cut corners when there are more buyers than there is good property available, conducting only cursory due diligence can create significant problems once the transaction closes.

Commercial real estate due diligence involves reviewing the financial performance of the property, the physical condition of the property, and the macro environment the building is located in.

Financial due diligence includes analyzing the property financial statements such as the rent roll, profit and loss, balance sheet, net cash flow statement, and history of capital expenses. Although many sellers may balk at the request, it’s always a good idea to ask for a copy of the seller’s recent tax returns to compare the income shown on the P&L to the income actually being reported to the IRS.

When inspecting the physical condition of the property, buyers should inspect every apartment unit whether occupied or not, mechanical systems such as heating and cooling, electrical and plumbing, and common areas such as parking and green space.

Lastly, when performing due diligence on commercial real estate, take a close look at the area the building is located in.

Analyze employment and population trends, occupancy level of similar properties in the same submarket, and new products coming to market that could impact supply and demand. Review the local zoning ordinances, and ensure that the property meets the lender’s underwriting requirements before the inspection contingencies expire.

Using the Wrong Valuation Metrics

Inaccurate property valuations that overestimate returns or underestimate routine operating expenses can lead to an investor paying more than what a property is really worth. While sales price is an important number to be concerned with, investors should pay just as much attention to valuation metrics such as comparable sales, gross rent multiplier, and cap rate.

Comparables sales takes into account the key features of the property you are investing in, such as total building square footage and lot size, number of units and unit mix, type and date of construction, and amenities such as smart home technology. Then, comps are run to identify the most recent sales of similar property in the same submarket or neighborhood.

Gross rent multiplier (GRM) is a quick and easy valuation method used by multifamily investors. To calculate the GRM, simply divide the property price by the gross rental income generated. For example, if an apartment building generates a total gross annual rental income of $500,000 and the asking price of the property is $4 million, the GRM is 8.0.

Generally speaking, the lower the GRM is the more attractive an investment may be, because the property is generating more income relative to the purchase price. However, the gross rent multiplier does not take into account the operating expenses of the property.

Capitalization rate – or cap rate – is another calculation multifamily investors use to compare the potential return on investment offered by similar properties in the same market or submarket. As a rule of thumb, the higher the cap rate is the better the investment may be, everything else being equal.

Cap rate is calculated by dividing the property’s net operating income (NOI) – which is the difference between gross income and normal operating expenses, except financing – by the property value or asking price. For example, if an apartment building valued at $4 million produces an NOI of $250,000, the cap rate would be 0.0625 or 6.25%.

Related Link: What is the Waterfall Model for Commercial Real Estate Investing?

Focusing Only on Investment Return

When commercial real estate investors use financial metrics to evaluate potential property performance, they oftentimes pay too much attention to return on investment (ROI).

While ROI is an important indicator of financial performance, the calculation doesn’t take into account the time value of money or when the timing of the periodic cash flows. As all experienced investors know, there’s a big difference between receiving $250,000 each year for each of the next five years, and $1.25 million in one lump sum at the end of five years.

The longer an investor has to wait for money to be returned on an investment, the more difficult it is to accurately forecast project returns due to cost fluctuations, and interest rate and tax rate changes.

Instead of focusing mainly on ROI, savvy commercial real estate investors take into account recurring cash flow, potential appreciation in property value over the long-term, and calculate internal rate of return (IRR) to forecast the annualized rate of return and expected future cash flow of a commercial real estate investment.

Underestimating the Costs of Repairs and Renovations

Last but certainly not least, another mistake commercial real estate investors make is underestimating the cost of repairs and renovations.

You’ve probably heard the saying that you can’t have your cake and eat it too. Property offered for sale at a below market price typically has significant amounts of deferred maintenance or material defects with repair costs that can be extremely difficult to accurately estimate. Before you know it, a deal that seemed to pencil out on paper can end up generating a much lower return because the purchase and renovation costs are higher than expected.

A common mistake commercial real estate investors make is underestimating the cost of repairs and renovations.

However, there are still some very profitable opportunities when you know where to look.

Successful multifamily developers like Smartland have mastered the art of finding and extracting hidden value that most other players in the market do not. Once an apartment building is renovated, state-of-the art technology is installed in every building to give residents the experience they are looking for.

As a result, rents are higher, leases are longer, and the return of capital to investors is greater.

Conclusion

Investing in commercial real estate can be financially rewarding, provided that you do everything you can to mitigate risk when maximizing potential returns. By investing in turnkey multifamily property with an experienced private equity firm like Smartland, investors can avoid making these eight common mistakes.

Need help evaluating commercial real estate opportunities? Contact Smartland to leverage their expertise.

Related Link: The Ultimate Guide to Investing in Rental Properties


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