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ߜ When is it the best time to go bottom-fishing? If you aren’t a bold risk taker, you may find this advice uncomfortable (so consider yourself fore- warned!). Maverick investors buy at the bottom phase or at the front end of the recovery phase. This is called “bottom-fishing” for deals. This is where the big, big money is made. Maverick investors are brave and courageous trendsetters. They’re usually the first investors in the worst part of town, and they’re usually banking on the area to come back big time. If they play their cards right, they come out on top, and if they don’t, they simply walk away with an “aw, shucks.” Now that’s bravery! Trends are your friends True friends are always around when you call on them, and they won’t ever let you down. And economic and demographic trends are your true friends in commercial real estate investing. And best of all, these trends aren’t terribly complex or difficult to determine. Here are the three trends that are plainly fundamental when investing in any commercial real estate: ߜ Job growth: This trend makes perfect sense: Where the jobs are, people are. And where the people are, demand exists for apartment rentals, office space, and consumer goods. Job growth is an excellent indicator of a healthy real estate market. The best place to start in researching job growth is to contact your local economic development department or chamber of commerce and ask for historical and current job growth data. ߜ Development: This trend is all about supply and demand. After all, if a shortage of office space or apartment housing is evident, you clearly have a demand for new development. On the other hand, if you see that the city is overbuilding, it’s an indication for you hold off and reassess. ߜ In the path of progress: It isn’t too difficult to spot this trend with your own eyes. Whenever new building and development is either coming your way or surrounds your property, you’re in the thankful path of eco- nomic development. You can feel the “buzz” of prosperity around you. 32 Part I: Getting to Know Commercial Real Estate Investing 06_174913 ch02.qxp 11/21/07 4:31 PM Page 32 Chapter 3 Evaluating Commercial Real Estate In This Chapter ᮣ Familiarizing yourself with important lingo ᮣ Determining a property’s worth ᮣ Examining a few analysis examples ᮣ Valuing properties the professional way ᮣ Surveying those things that create value ᮣ Knowing the difference between a good deal and a bad one T here’s a myth going around town that you need to be an accountant with an Ivy League degree to evaluate and analyze office buildings, retail cen- ters, and apartment complexes. Don’t believe the hype. If you can count and do some basic math, you’ll have no problem figuring out what your cash flow and return on investment are for any piece of commercial property. In fact, we guarantee that after you read this chapter and follow along with the exam- ples, you’ll be able to figure out what a commercial property is worth just like those sophisticated investor guys you see with their pocket protectors and fancy spreadsheets. This chapter explains what creates value in a property, shows you how to ana- lyze an apartment building and a shopping center like a pro, explains how to know a good deal from a bad deal, and provides invaluable guiding principles of investment that will keep bad properties out of your portfolio — guaranteed. Talking the Talk: Terms You Need to Know Throughout this chapter, we use some terminology that you need to be famil- iar with. Having these terms under your belt is crucial on two fronts: 07_174913 ch03.qxp 11/21/07 4:31 PM Page 33 ߜ We presume you’re reading this book because you want to invest in com- mercial real estate. Most likely, you’ll be using a real estate broker to help you locate and close the deal. Real estate brokers know — and use — most of the terms mentioned here. Gaining thorough understanding of the terms levels the playing field. If you can speak their language, you gain instant credibility and a relationship advantage over someone with- out your knowledge and understanding. ߜ Just by increasing your word power, you gain increased confidence, which enables you to make sound, efficient investment decisions, and gives you an increased ability to hold your position, especially in negotiations. Here are the words you need to know to navigate this chapter and talk the talk: ߜ Capitalization rate: Your capitalization rate is your net operating income divided by the sales price. Also known as the cap rate, it’s the measure of profitability of an investment. Cap rates tell you how much you’d make on an investment if you paid all cash for it; financing and taxation aren’t included: Cap rate = net operating income ÷ sales price ߜ Cash flow: Your annual cash flow is net operating income minus debt service. You can also figure monthly cash flow by dividing your annual cash flow by 12: Annual cash flow = net operating income – debt service Monthly cash flow = annual cash flow ÷ 12 ߜ Cash-on-cash return: To find your cash-on-cash return, divide your annual cash flow by the down payment amount: Cash-on-cash return = annual cash flow ÷ down payment ߜ Debt service: Debt service is calculated by multiplying your monthly mortgage amount by 12 months: Debt service = monthly mortgage amount × 12 ߜ Effective gross income: You can find your effective gross income by sub- tracting vacancy from gross income: Effective gross income = income – (vacancy rate % × income) ߜ Gross income: Gross income is all of your income, including rents, laun- dry or vending machine income, and late fees. It can be monthly or annual. ߜ Net operating income (NOI): Your net operating income is your effective gross income minus operating expenses: Net operating income = effective gross income – operating expenses 34 Part I: Getting to Know Commercial Real Estate Investing 07_174913 ch03.qxp 11/21/07 4:31 PM Page 34 ߜ Operating expenses: Your annual operating expenses of the property typically include taxes, insurance, utilities, management fees, payroll, landscaping, maintenance, supplies, and repairs. This category doesn’t include mortgage payments or interest expense. ߜ Vacancy: A vacancy is any unit that’s left unoccupied and isn’t producing income. Remember: A unit that’s vacated and rerented in the same month isn’t considered a vacancy; it’s considered a turnover. ߜ Vacancy rate: Your vacancy rate is the number of vacancies divided by the number of units: Vacancy rate = number of vacancies ÷ number of units Figuring Out What a Property Is Worth When you first hear the word analysis, you may freak out — especially if you aren’t a spreadsheet guru. We were intimidated by that word when we first started out, too. But through the years, we’ve come to look at property analy- sis more simply. The dictionary definition of the word analysis is “a separa- tion of the whole into its component parts.” So, we break down any property analysis into its component parts: income, expense, and debt. That’s it. We take a look at the income information. Then we take a look at the expenses. And finally, we add a loan or mortgage to the overall picture. We combine them to come to a conclusion as to whether this deal makes money. Analysis made simple. The size or complexity of the deal doesn’t matter. Separate the deal into its three component parts: Analyze and compile the income part; analyze and compile the expense part; and analyze and compile the debt part. Any deal can be broken up into these parts. When you have these parts, you can calcu- late the net operating income, cash flow, cash-on-cash return, and cap rate. It’s that simple. Before you can figure out what a property is worth, you have to decide what you really want from the property. You may want a stream of passive income every month. Or you may want to hold a property long term to build your wealth. Or you may want to buy it, rehab it, and sell it for a profit. Not-so-obvious tips on analyzing When you’re analyzing any property, keep the following in mind: ߜ Be leery of broker proformas. Proformas are brokers’ presentations of data on the property that reflect a best-case scenario or even a perfect- world situation. For example, even though the property may have eight 35 Chapter 3: Evaluating Commercial Real Estate 07_174913 ch03.qxp 11/21/07 4:31 PM Page 35 36 Part I: Getting to Know Commercial Real Estate Investing The technical meaning behind the numbers Cap rate, cash flow, cash-on-cash return, and net operating income are investment terms that we show you how to use in this chapter, but what do they really mean to you as an investor? Here’s the in-depth explanation: ߜ Capitalization rate: A cap rate is used as a measure of a property’s performance with- out considering the mortgage financing. If you paid all cash for the investment, how much money would it make? What’s the return on your cash outlay? Cap rate is a standard used industrywide, and it’s used many different ways. For example, a high cap rate usually typifies a higher risk invest- ment and a low sales price. High cap rate investments are typically found in poor, low- income regions. A low cap rate usually typ- ifies a Iower-risk investment and a high sales price. Low cap rates are typically found in middle-class to upper income regions. Therefore, neighborhoods within cities have “stamped” on them their assigned cap rates. That said, if you know what the NOI is, and you know the given cap rate, you can esti- mate what the sales price should be: sales price = NOI ÷ cap rate. For example, if the NOI is $57,230 and you want to make invest- ments into 9 percent cap properties, the price you’ll offer will be $635,889 (57,230 ÷ 9 percent). This is a good way to come up with your first offer price — at the very least, it’s a starting point. ߜ Cash flow: Positive cash flow is king, and it’s one of your primary objectives in invest- ing. Positive cash flow creates and main- tains your investments’ momentum. When purchasing an apartment building contain- ing more than five units (considered com- mercial), a bank’s basis for lending is the property’s cash-flow capabilities. Your credit score is a lower priority than the cash-flow potential. An apartment building with poor cash flow will almost always appraise much lower than its comparables for the area. Finally, positive cash flow keeps you sleeping at night when property values drop, because your bills and mort- gage will still be paid. ߜ Cash-on-cash return: This is the velocity of your money. In other words, how long does it take for your down payment to come back to you? If your down payment were $20,000, how soon would your monthly cash flow add up to $20,000? If your cash flow added up to $20,000 in one year, your cash-on- cash return would be 100 percent. If it takes two years, your cash-on-cash would be 50 percent. If it takes three years, it would be 33 percent. Commercial real estate investing can pro- duce phenomenal returns. Cash-on-cash returns of over 100 percent aren’t uncom- mon. Now, if you were to go to your local bank and deposit $20,000 into its most aggressive CD investment for one to three years, what type of cash-on-cash return could you expect? Maybe 2 percent or 4 percent? You need to put an emphasis on cash-on-cash return when you invest simply because you need to know how fast you can get your down payment back so you can invest it again — and again. ߜ Net operating income (NOI): This term is one of the most important ones when ana- lyzing any deal. The net operating income is the dollar amount that’s left over after you collect all your income and pay out your operating expenses. This amount is what’s used to pay the mortgage with. And what’s left after you pay the mortgage is what goes into your pocket — your cash flow. 07_174913 ch03.qxp 11/21/07 4:31 PM Page 36 unrentable vacant units, the broker proforma will reflect those units as if they were producing income. So, be careful in your analysis when you see the word proforma. It isn’t how the property is actually performing. Here’s the bottom line: Never make offers based on proforma data. ߜ Look deeper into the price. When analyzing apartments, always look at sales price per door or price per unit. Get information on what local apartments have sold for recently on a price-per-unit basis. For example, if you know for a fact that the last three sales of apartments on the same street sold for $45,000 per unit, then you know in your analysis that paying $65,000 per unit may be too much. Knowing your price per unit allows you to make quick decisions if the real estate agent is asking too much or if you’re getting a steal of a deal. ߜ Not knowing expenses can cost you. One of the most understated and misunderstood aspects of property analysis is expenses. Of course, plugging actual and true operating expenses into your analysis isn’t easy, because often that data isn’t available. You’ll get your most reliable expense data from your property manager or from a professional property manager who manages similar proper- ties, not from the broker. Look at property expenses three different ways: • Look at it in expenses per unit. Basically, divide the total expenses by the number of units. • Look at expenses as a percentage of the income. For example, as a general rule, for apartment sizes that are greater than 50 units, we take expenses to be at least 50 percent of the income. • Look at expenses in the form of expenses per square foot. You get this number by dividing the total expenses by the total square footage of the living space. ߜ Don’t forget about the taxes. Be wary of property taxes stated in your analysis or given to you by the broker. Brokers who present property data rarely have the new property taxes in their spreadsheets. New taxes refer to what your new tax bill would be upon transfer of ownership. For 37 Chapter 3: Evaluating Commercial Real Estate Always keep your eye on the NOI and look for ways to increase it by either raising rents or reducing expenses. As the NOI increases, so will the value of your property. In fact, if you’re in an 8 percent cap neigh- borhood, for every $100 that the NOI increases, your property value will increase by $1,250. Is that a good return for your efforts or what? You know that cap rate = NOI ÷ sales price, but you can also flip the calculation: sales price (or value) = NOI ÷ cap rate. Therefore, you can figure a new value by dividing your new NOI or increase of NOI by the going cap rate. So $100 ÷ 8 percent = $1,250. Now, if you can increase your NOI by $20,000, your property value will have gone up by $250,000 ($20,000 ÷ 8 percent = $250,000). 07_174913 ch03.qxp 11/21/07 4:31 PM Page 37 example, the current owner may have owned the property for 30 years and his property taxes may have increased only slightly in those years. But when you take over, the tax assessor will reassess the property value, most times based on your sales price. So it’s quite possible that your taxes may increase three to five times from what the previous owner paid. Do your research by calling the property tax assessor’s office and ask how property taxes are reassessed upon transfer of ownership. ߜ Verify your analysis. When we’re analyzing a deal in which the broker feels that we can either raise the rents or decrease the expenses after we take over, we always verify the broker’s projections. To verify whether raising the rent is possible, we call properties in the area and do our own rent survey; it only takes a few minutes to do and the information is invaluable. To verify whether we can reduce expenses, we call our property manager or contact another professional property manager and run the expense scenario by him; easy to do — with results worth their weight in gold. ߜ Get a thumbs up from your money guy or gal. When we get excited about a deal during our analysis, we send it to our lender. He looks at it from his point of view: Are the numbers good enough to get a good loan on it? We may run our cash-flow projections based on a 15 percent down payment, but he may spot something in the financials that may only qualify the property for a 25 percent down payment. If your lender won’t do this for you, get another lender. ߜ Keep in mind that concessions may penalize your future. When you’re presented with information about the tenants, ask about any move-in specials given to the current tenants. Those specials are called rent con- cessions, and concessions are given when the market is weak and ten- ants need to be enticed to move in or renew their leases. Usually, the tenants are given one month rent free and it’s usually the 13th month of a 12-month lease. The problem with this is that if you’re acquiring the property, you won’t receive rent from that tenant on the 13th month of the lease. And this gets worse if 50 percent of your tenants have this concession, especially if their 13th month is the same month — this means that 50 percent of the tenants will not be paying you rent that month. Ouch! Breakeven analysis When analyzing property, we always want to know what our breakeven point is. The breakeven point is the point at which occupancy income is equal to our mortgage payments. In other words, if we know that our breakeven point is 70 percent occupancy, we know we’re able to at least pay our expenses plus mortgage without going into a negative cash-flow position. So for a 38 Part I: Getting to Know Commercial Real Estate Investing 07_174913 ch03.qxp 11/21/07 4:31 PM Page 38 property that’s highly leveraged or has a large mortgage payment, its break- even point is higher than usual — meaning, you have more risk if you’re negative in cash flow. To calculate your breakeven point, add up all your property’s operating expenses and annual mortgage payments and divide by the gross potential income. Gross potential income is what the income of the property would be if it were 100 percent occupied with paying tenants. Here’s the equation: Breakeven point (%) = operating expenses + annual mortgage payments ÷ gross potential income Here’s a quick example: Let’s say your operating expenses are $75,000, your annual mortgage payments are $35,000, and your gross potential income is $200,000. To find your breakeven point percentage, here are the calculations: $75,000 + $35,000 ÷ $200,000 = 55% This means that at 55 percent occupancy, we’re breaking even when it comes to cash flow (see Figure 3-1). Anything over 55 percent occupancy sends us to cash-flow positive. Conversely, if we drop below 55 percent occupancy, we’re in negative cash flow. $200,000 gross potential $110,000 55% Occupancy rate 0%100% Total expenses + annual mortgage payments Positive cash flow Negative cash flow Figure 3-1: The breakeven point in this example is 55 percent. 39 Chapter 3: Evaluating Commercial Real Estate 07_174913 ch03.qxp 11/21/07 4:31 PM Page 39 Establishing and following guiding principles When you’re looking at any types of income properties and analyzing them, you need to have a set of guiding principles for investment. We’ve established some starting guiding principles for you. These principles will set the stan- dards for your investments and help you set working goals moving forward. Without them, you’ll wander aimlessly in the real estate investment game. We’ve used these standards for years ourselves and with our clients, and we’ve saved many people, including ourselves, from passing up that great once-in-a- lifetime deal or buying that deal that really stunk. Your guiding principles are basically fail-safe measures to guide you into cash-flowing, wealth-building investments and to keep you out of negative cash-flowing ones. Here are our guiding principles: ߜ Make sure that you have a positive cash flow. We believe that having positive cash flow keeps your momentum going. Positive cash flow allows you to leave your day job if that’s your goal. Positive cash flow allows you to invest more money, and it opens doors for the next investment to flow right in. ߜ Have a cash-on-cash return of 10 percent or greater. A good cash-on- cash return puts velocity on your money. It keeps your cash flow posi- tive when you have those not-so-good months. A good cash-on-cash return allows you to brag to your investor buddies about what a well-run property you have. ߜ Have a cap rate of 8 percent or greater. A great cap rate means your NOI is healthy. A healthy NOI is stable and growing, which means your property value is doing the same. A great cap rate also gets you the best loan terms. These are only starting guiding principles of investment. You have to start someplace, right? You may be thinking, “But you won’t find any 8 caps in my city!” And you may even believe that it’s impossible to find double-digit cash- on-cash returns. Or you may be convinced that it’s impossible to cash flow positively unless you put down 50 percent. Well, our reply to that type of thinking is this: Sooner or later, you’ll be convinced and support the theory that at any one time, there are great deals out there waiting for you. Running the Numbers on Some Properties Now that you have some basic commercial property investment terms and principles under your belt, we want to walk you through analyzing two prop- erties. This is where it gets fun! 40 Part I: Getting to Know Commercial Real Estate Investing 07_174913 ch03.qxp 11/21/07 4:31 PM Page 40 Be sure to follow these tips when analyzing your own retail property deal: ߜ Look at the price per square foot. When analyzing retail, one of the first things we look at is the price per square foot. It’s an easy way to com- pare apples to apples and oranges to oranges. It’s also a way to get a reality check to see if you’re paying too much for the property compared to other recent sales. ߜ Be conservative in your number crunching. What you’ll find when you own a few retail centers is that incomes given to you by either the broker or seller are overstated and expenses are understated. Really take a hard look at each item given and then take a conservative approach when run- ning your numbers. ߜ Replace your reserves. One of the most overlooked expenses when ana- lyzing retail is the replacement reserve. Replacement reserve is an amount set aside every month to pay for property items that wear out and need to be replaced, such as roofs, siding, sidewalks, parking lots, heating/ air-conditioning equipment, and so on. When these items come up for repair or replacement three to five years after you take ownership, the money has to come from somewhere — refinancing, your pockets, your partner’s pockets, or a reserve account you cleverly set up ahead of time. ߜ Look at the parking ratio. The parking ratio for your retail center is more important than you think. The standard to begin with is four spaces per 1,000 square feet. If you don’t have enough parking, it can create a problem down the road. ߜ Consider class. All commercial properties fall under classifications — A, B, C, or maybe even D. Class A properties are newer, have top-of-the-line features, are in the best locations, and attract the highest-quality tenants. As you go into the lower classes, location, age, and construction become less desirable. Pay attention to what class property you’re evaluating because as classes differ, so do location, price, rent, and occupancy. ߜ Match rent rolls to estoppels. The rent roll is a list of tenant names showing what they pay in rent, in addition to when the lease agreement expires. Estoppels are letters sent to the tenant by someone other than the landlord to confirm in writing the terms of the lease, including rent amount, lease expirations, and any other options they have agreed on. Estoppels are used because the tenant may not be paying the landlord in rent what she has agreed to for whatever reason, or the landlord may have made a side agreement with the tenant that can’t be confirmed or enforced by new owners. When the tenant-signed estoppels are received, you can compare them to the rent rolls and actual signed leases for income verification. ߜ Check in with your money guy or gal early. Before digging too deep into your analysis, call up your lender buddy and present the rent roll, the type of tenants, and financials to her. Have the lender review this 41 Chapter 3: Evaluating Commercial Real Estate 07_174913 ch03.qxp 11/21/07 4:31 PM Page 41 [...]... companies moving in or expanding in the area? Is it the explosion of retail shopping due to the influx of young families and professionals? Find out what’s going on See where you are in the real estate cycle Are you in a rising market, at the top of the market, or in a down market? If you’re in a rising market, values will increase Ride it to the top, and then make a decision to sell or wait for the inevitable... committed to stay; any additional payments by the tenant for taxes, insurance, or maintenance; rent increases; renewal clauses and options; and all rights, privileges, and responsibilities of the tenant and landlord Following are types of leases you’ll run into in the course of looking into investing in retail shopping centers Each has its own wrinkles and stipulations, so pay attention to the small... Finding great commercial deals is a matter of having multiple fishing lines in the water and being willing to put in the work upfront, knowing the real payoff comes down the road when you find that incredible “once -in- a lifetime” deal It’s also a matter of performing a variety of different tasks, including creating relationships, sending out mailings, and focusing on the ponds that are most likely to. .. depreciation and obsolescence of the building You end up with a property value calculation of: Land value + building cost – depreciation = estimated property value 49 07_ 174 913 ch03.qxp 50 11/21/ 07 4:31 PM Page 50 Part I: Getting to Know Commercial Real Estate Investing Understanding What Creates Value What is it that really creates value in commercial real estate? Well, in residential real estate, such as single-family... We tell you who to talk to, where to go, and why you should go there Always buying in your own town can get boring and costly, so we also talk about how to go big-time and invest in commercial properties in other cities across the country Discovering the Secret to Finding Great Deals Let’s face it: Finding great commercial properties is difficult to do So what’s the big secret to being successful?... tend to get overly confident when the market just keeps going up and up and up But what goes up must come down at some point So, if you wait too long, you may miss your run at the profits 55 07_ 174 913 ch03.qxp 56 11/21/ 07 4:31 PM Page 56 Part I: Getting to Know Commercial Real Estate Investing 08_ 174 913 pt02.qxp 11/21/ 07 4:31 PM Page 57 Part II Getting Started Making Deals 08_ 174 913 pt02.qxp 11/21/ 07. .. value for the apartment building Wow, how exciting! This is what commercial real estate is all about — finding opportunity, creating a product that betters humankind, and then reaping the rewards The challenge in front of you in this example is to get the zoning changed on the 5 acres to allow an apartment building To find out more on zoning and land development, flip to Chapter 15 Leases: As the lease... 07_ 174 913 ch03.qxp 42 11/21/ 07 4:31 PM Page 42 Part I: Getting to Know Commercial Real Estate Investing deal from her perspective Some lenders may not like certain businesses For example, securing a loan for a shopping center with a dry cleaner or automotive repair place has been more difficult lately because of environmental concerns, and movie theater chains and video stores chains have come... by supply -and- demand situations.) How can you time the market to ride the wave of increasing value? Here’s how: ߜ Watch prices If the downward trend has stopped, you’ve reached bottom or almost bottom It’s time to buy and ride the wave back up ߜ Watch job reports When job growth is positive, it’s time to ride the wave ߜ Watch investors When you see other investors come in and start investing heavily... 11/21/ 07 4:31 PM Page 52 Part I: Getting to Know Commercial Real Estate Investing great deal from your broker It’s for a 5,000-square-foot, single-tenant property that’s occupied by the successful family-run and family-owned Grandma’s Corner Groceries The rent is $7 per square foot, or $35,000 per year and that includes taxes, insurance, and maintenance The current lease has five years remaining Say . $113,400 per year 42 Part I: Getting to Know Commercial Real Estate Investing 07_ 174 913 ch03.qxp 11 /21 / 07 4:31 PM Page 42 Here’s the expense breakdown: Total operating expenses = $ 57, 170 To figure out. expenses $2 87, 000 – $0 = $2 87, 000 2. Calculate the cash flow. Annual cash flow = net operating income – debt service 46 Part I: Getting to Know Commercial Real Estate Investing 07_ 174 913 ch03.qxp 11 /21 / 07. eight 35 Chapter 3: Evaluating Commercial Real Estate 07_ 174 913 ch03.qxp 11 /21 / 07 4:31 PM Page 35 36 Part I: Getting to Know Commercial Real Estate Investing The technical meaning behind the numbers Cap