Key Factors For Evaluating Commercial Property For Sale

The secret of evaluating commercial property lies within a model where one property can independently be evaluated against another property.

The basis of any model is to ensure that proper calculations are made with regards to the sustainability of any property for sale in the market. This entails doing the calculations. If the calculations do not work then you should not make the investment.

Our model has the following attributes:

A Summary

The summary makes provision for the size of the property to be purchased expressed in gross lettable area (GLA). It also makes provision for the rent that can be obtained for the commercial property to rent. This is crucial since this will provide an indication whether you can compete with other similar properties in the same area. It makes provision for the nett rental income that is obtained from the property since this determines the value of the property.

Variables

The variables include the average interest rate over the past 20 years. It should also include the average inflation rate over the past 10 years which should be factored into the calculations. Annual rental increases should be factored in which will result in the yield to be obtained over into the future for at least a 10 year period. Provision for a vacancy rate is crucial when compiling your model. All expenses are captured in this section,

The Assessment

The assessment is the culmination of all the previous part into one view of the model. This will include the NAV (Nett Asset Value) determined on an annual basis. This will also include the gross rental income associated with the property with all escalations included. All expenses are reflected here inclusive of the monthly loan payments based on the average interest rate over the past 20 years. Calculating the gross rental income less all relevant expenses will result in the pre-tax cash flow on a monthly basis. From here all tax obligations can be calculated resulting in an after tax cash flow calculation. Determining your ROI (Return on Investment) is a direct result of these calculations. The IRR (Internal Rate of Return) is derived from these calculations making it a crucial tool to compare different properties.

Combining all the attributes of a model dedicated to evaluate commercial property for sale will ensure that you make the correct decision time and again. Most commercial property for sale are offered as commercial property to rent. It is therefore crucial to ensure that the correct investment decision is made based on pure calculations.

10 Things Every Buyer Needs – To Close A Commercial Real Estate Loan

For nearly 30 years, I have represented borrowers and lenders in commercial real estate transactions. During this time it has become apparent that many Buyers do not have a clear understanding of what is required to document a commercial real estate loan. Unless the basics are understood, the likelihood of success in closing a commercial real estate transaction is greatly reduced.

Throughout the process of negotiating the sale contract, all parties must keep their eye on what the Buyer’s lender will reasonably require as a condition to financing the purchase. This may not be what the parties want to focus on, but if this aspect of the transaction is ignored, the deal may not close at all.

Sellers and their agents often express the attitude that the Buyer’s financing is the Buyer’s problem, not theirs. Perhaps, but facilitating Buyer’s financing should certainly be of interest to Sellers. How many sale transactions will close if the Buyer cannot get financing?

This is not to suggest that Sellers should intrude upon the relationship between the Buyer and its lender, or become actively involved in obtaining Buyer’s financing. It does mean, however, that the Seller should understand what information concerning the property the Buyer will need to produce to its lender to obtain financing, and that Seller should be prepared to fully cooperate with the Buyer in all reasonable respects to produce that information.

Basic Lending Criteria

Lenders actively involved in making loans secured by commercial real estate typically have the same or similar documentation requirements. Unless these requirements can be satisfied, the loan will not be funded. If the loan is not funded, the sale transaction will not likely close.

For Lenders, the object, always, is to establish two basic lending criteria:

1. The ability of the borrower to repay the loan; and

2. The ability of the lender to recover the full amount of the loan, including outstanding principal, accrued and unpaid interest, and all reasonable costs of collection, in the event the borrower fails to repay the loan.

In nearly every loan of every type, these two lending criteria form the basis of the lender’s willingness to make the loan. Virtually all documentation in the loan closing process points to satisfying these two criteria. There are other legal requirements and regulations requiring lender compliance, but these two basic lending criteria represent, for the lender, what the loan closing process seeks to establish. They are also a primary focus of bank regulators, such as the FDIC, in verifying that the lender is following safe and sound lending practices.

Few lenders engaged in commercial real estate lending are interested in making loans without collateral sufficient to assure repayment of the entire loan, including outstanding principal, accrued and unpaid interest, and all reasonable costs of collection, even where the borrower’s independent ability to repay is substantial. As we have seen time and again, changes in economic conditions, whether occurring from ordinary economic cycles, changes in technology, natural disasters, divorce, death, and even terrorist attack or war, can change the “ability” of a borrower to pay. Prudent lending practices require adequate security for any loan of substance.

Documenting The Loan

There is no magic to documenting a commercial real estate loan. There are issues to resolve and documents to draft, but all can be managed efficiently and effectively if all parties to the transaction recognize the legitimate needs of the lender and plan the transaction and the contract requirements with a view toward satisfying those needs within the framework of the sale transaction.

While the credit decision to issue a loan commitment focuses primarily on the ability of the borrower to repay the loan; the loan closing process focuses primarily on verification and documentation of the second stated criteria: confirmation that the collateral is sufficient to assure repayment of the loan, including all principal, accrued and unpaid interest, late fees, attorneys fees and other costs of collection, in the event the borrower fails to voluntarily repay the loan.

With this in mind, most commercial real estate lenders approach commercial real estate closings by viewing themselves as potential “back-up buyers”. They are always testing their collateral position against the possibility that the Buyer/Borrower will default, with the lender being forced to foreclose and become the owner of the property. Their documentation requirements are designed to place the lender, after foreclosure, in as good a position as they would require at closing if they were a sophisticated direct buyer of the property; with the expectation that the lender may need to sell the property to a future sophisticated buyer to recover repayment of their loan.

Top 10 Lender Deliveries

In documenting a commercial real estate loan, the parties must recognize that virtually all commercial real estate lenders will require, among other things, delivery of the following “property documents”:

1. Operating Statements for the past 3 years reflecting income and expenses of operations, including cost and timing of scheduled capital improvements;

2. Certified copies of all Leases;

3. A Certified Rent Roll as of the date of the Purchase Contract, and again as of a date within 2 or 3 days prior to closing;

4. Estoppel Certificates signed by each tenant (or, typically, tenants representing 90% of the leased GLA in the project) dated within 15 days prior to closing;

5. Subordination, Non-Disturbance and Attornment (“SNDA”) Agreements signed by each tenant;

6. An ALTA lender’s title insurance policy with required endorsements, including, among others, an ALTA 3.1 Zoning Endorsement (modified to include parking), ALTA Endorsement No. 4 (Contiguity Endorsement insuring the mortgaged property constitutes a single parcel with no gaps or gores), and an Access Endorsement (insuring that the mortgaged property has access to public streets and ways for vehicular and pedestrian traffic);

7. Copies of all documents of record which are to remain as encumbrances following closing, including all easements, restrictions, party wall agreements and other similar items;

8. A current Plat of Survey prepared in accordance with 2011 Minimum Standard Detail for ALTA/ACSM Land Title Surveys, certified to the lender, Buyer and the title insurer;

9. A satisfactory Environmental Site Assessment Report (Phase I Audit) and, if appropriate under the circumstances, a Phase 2 Audit, to demonstrate the property is not burdened with any recognized environmental defect; and

10. A Site Improvements Inspection Report to evaluate the structural integrity of improvements.

To be sure, there will be other requirements and deliveries the Buyer will be expected to satisfy as a condition to obtaining funding of the purchase money loan, but the items listed above are virtually universal. If the parties do not draft the purchase contract to accommodate timely delivery of these items to lender, the chances of closing the transaction are greatly reduced.

Planning for Closing Costs

The closing process for commercial real estate transactions can be expensive. In addition to drafting the Purchase Contract to accommodate the documentary requirements of the Buyer’s lender, the Buyer and his advisors need to consider and adequately plan for the high cost of bringing a commercial real estate transaction from contract to closing.

If competent Buyer’s counsel and competent lender’s counsel work together, each understanding what is required to be done to get the transaction closed, the cost of closing can be kept to a minimum, though it will undoubtedly remain substantial. It is not unusual for closing costs for a commercial real estate transaction with even typical closing issues to run thousands of dollars. Buyers must understand this and be prepared to accept it as a cost of doing business.

Sophisticated Buyers understand the costs involved in documenting and closing a commercial real estate transaction and factor them into the overall cost of the transaction, just as they do costs such as the agreed upon purchase price, real estate brokerage commissions, loan brokerage fees, loan commitment fees and the like.

Closing costs can constitute significant transaction expenses and must be factored into the Buyer’s business decision-making process in determining whether to proceed with a commercial real estate transaction. They are inescapable expenditures that add to Buyer’s cost of acquiring commercial real estate. They must be taken into account to determine the “true purchase price” to be paid by the Buyer to acquire any given project and to accurately calculate the anticipated yield on investment.

Some closing costs may be shifted to the Seller through custom or effective contract negotiation, but many will unavoidably fall on the Buyer. These can easily total tens of thousands of dollars in an even moderately sized commercial real estate transaction in the $1,000,000 to $5,000,000 price range.

Costs often overlooked, but ever present, include title insurance with required lender endorsements, an ALTA Survey, environmental audit(s), a Site Improvements Inspection Report and, somewhat surprisingly, Buyers attorney’s fees.

For reasons that escape me, inexperienced Buyers of commercial real estate, and even some experienced Buyers, nearly always underestimate attorneys fees required in any given transaction. This is not because they are unpredictable, since the combined fees a Buyer must pay to its own attorney and to the Lender’s attorney typically aggregate around 1% of the Purchase Price. Perhaps it stems from wishful thinking associated with the customarily low attorneys fees charged by attorneys handling residential real estate closings. In reality, the level of sophistication and the amount of specialized work required to fully investigate and document a transaction for a Buyer of commercial real estate makes comparisons with residential real estate transactions inappropriate. Sophisticated commercial real estate investors understand this. Less sophisticated commercial real estate buyers must learn how to properly budget this cost.

Conclusion

Concluding negotiations for the sale/purchase of a substantial commercial real estate project is a thrilling experience but, until the transaction closes, it is only ink on paper. To get to closing, the contract must anticipate the documentation the Buyer will be required to deliver to its lender to obtain purchase money financing. The Buyer must also be aware of the substantial costs to be incurred in preparing for closing so that Buyer may reasonably plan its cash requirements for closing. With a clear understanding of what is required, and advanced planning to satisfy those requirements, the likelihood of successfully closing will be greatly enhanced.

Residential Vs Commercial Property Investments

Before purchasing a new investment property, you should always consider the differences between residential and commercial real estate investments. Depending on your financial means, expectations and investment plan, you will have to decide which one can be more profitable for you. Most people will invest in residential properties, as this seems to be a safer endeavour requiring less money, however, if you have the means, commercial properties can be highly profitable. You should also consider that while traditional residential property investments might not have very high returns on your investment, repossessed or foreclosed properties, can bring you a net yield of up to 12-15%.

Property Types for Residential and Commercial Investments

Houses of four units or less, to rent to private tenants are usually considered residential properties. You can invest in buy-to-let residential properties, which means that you’ll get the rental yields every month, or purchase the property solely for future resale. Residential property investments vary from more traditional buy-to-let investments somewhere near your own home to investments in overseas real estate, below market value properties or foreclosed houses. Commercial properties are for businesses, and include a variety of properties, from apartment blocks and office buildings to hotels, restaurants, warehouses and industrial buildings, just to name a few. Managing a relatively small residential property is obviously simpler than managing commercial properties, where you will often need a professional real estate management company to assist you.

Researching the Real Estate Market

While you will always need some knowledge of the property market and current conditions to make a successful investment, residential properties are simpler to research and value. It is relatively easy to compare different residential properties, their prices and investment potential in a given area. Commercial properties, however, are often unique and require specialised knowledge to value accurately and to establish an investment plan.

Risks & Yields

Residential properties are generally regarded as low-risk investments. They also tend to cost much less than commercial properties and will thus be more affordable, especially if you’ve just started building up your investment portfolio. The relatively low risks and the low purchase price, however will also mean that your profits are lower, and your return on investment will come mainly from increases in capital value.

Commercial properties, on the other hand have higher risks, but also higher potential returns. The significantly higher prices will also mean, that for personal investors, only collective investment schemes are affordable for larger commercial property investments. The relative unpredictability of the commercial property market will also bring more risks. While residential property prices generally double every 10 years, this is not true for commercial properties. You can expect a net yield of up to 7-10% on commercial properties, which is higher than the net yield from traditional residential property investments, and a large part of your return on investment will be in the form of rental income.

Rental Properties

A successful investment plan for both commercial and residential properties is to rent them out. Residential leases tend to be much shorter, usually around one year, and private tenants are often considered less reliable than businesses. Landlords will be liable to pay for repairs, which might incur unexpected additional costs. Commercial properties, on the other hand, are leased out for a longer time, 5-10 years is not uncommon, and the yearly increase in rental yields will be more significant. Businesses are also often considered to be more reliable tenants and commercial tenants are generally required to pay for repairs. You should also consider that while commercial properties can bring you a secure and high rental income, it is also much more difficult to find commercial tenants.

Exit Strategy for Residential and Commercial Properties

One investment plan is to rent out your property as detailed above. However, property flipping, or future resale can also be a profitable strategy with both kinds of investments. Residential property can be sold quite simply to another investor or somebody who intends to occupy the house, and as long as the property is in a good condition and in a well-chosen location, you should generally be able to sell it at a significantly higher price than its original purchase value. Commercial properties can bring huge profits, but the process of resale is more complicated. The property must be sold to another investor or investor group, and it should have a successful and profitable record, to be attractive to the buyer for investment purposes.