On its face, commercial real estate (CRE) seems like a safer bet for an ambitious investor than many other types of investment. Stocks can be flighty and have little more success than gambling. Venture capital can be even more risky and take a long time to net you even a cent. Even in real estate, a residential property could easily cost more than it makes and have limited ROI. By contrast, CRE can have returns that rise to skyscraper heights, and it serves tenants who are responsible and established, with their livelihoods tied up into their workspace.
But if the foundation isn’t strong, a tall building is just a bigger liability should it come crashing down.
Types of Commercial Real Estate Properties
Start by knowing everything about the businesses that will use the property you’re considering investing in. The most common types that might come to mind are multi-family buildings like apartments, and office buildings, but every structure dedicated to operating a business is a potential investment. Farmland, retail spaces, medical offices, and hotels all have easy to understand business models, and tenants can be left to their own devices to profit and get you your rent on time. It will vary by tenant and by the deal, but they will all have a moderate amount of risk starting out.
There are also special property types that may have extra regulations, including everything from gas stations and bowling alleys to churches and mobile home parks. There are opportunities everywhere, but the more specialized the property, the more know-how you need to make a sound investment and to manage the property in a profitable manner. Do you know how to inspect whether farmland is of a high enough quality for an independent tenant to succeed and keep making rent? Do you know what the incomes of people in the area of a gas station are and their public transportation options, and what an increase in gas price will do to its ability to turn a profit? Without this industry-specific knowledge, you run a bigger risk when dealing with sellers of these properties.
Avoiding Risk in Commercial Real Estate
Risk is part of any deal, but even investors new to the CRE game can avoid the worst of it by keeping aware and scrutinizing every detail. It’s important to keep the longer timeframe of such deals in mind, since all but the most established investors will be giving up significant liquidity on these deals. Finance should also be on your mind – a commercial real estate property will ideally pay for itself shortly after purchase, in small monthly doses.
That all being said, what are some of the biggest red flags that can help a new CRE investor keep out of risky deals?
1. Pre-payment Penalties Built into Your Property’s Contract
As a responsible investor, you plan to make purchase a property with a strong opportunity for ROI, and while the getting is good, you want to pay off as much of your own debt as possible so the building becomes all profit, less expenses. However, even in long-term deals like CRE, it is possible to be locked into a fixed repayment schedule so that the seller can collect all the fees and interest they feel they can profit from.
There is one type of pre-payment fee that isn’t so bad, which is the step-down fee. In it, there is a fee that is a percentage of the total price which will be charged to you, that itself decreases each subsequent period, incentivizing you to wait as long as possible before making a bulk repayment and becoming the outright owner.
The other types of pre-payment fees are the real red flags:
- Defeasance is a method of reducing risk for the lender by allowing you to not prepay with cash, but instead use that cash to swap another cash flowing asset in place of the original collateral, in this case the CRE property. A common example is Treasury bonds. Now the lender receives the same cash flow and a less risky investment, but you are locked in with another long-term investment and the potential to pay greater than the loan balance when making prepayment, depending on federal interest rates.
- Yield Maintenance or Breakfunding is another prepayment penalty that locks you in to pay the lender the full amount. As the name implies, they will net the same yield as though you had made all the scheduled payments all the way to maturity.
- SWAP or Interest Rate Swaps are set up such that an outside investor called a “Swap Party,” is involved apart from your loan so that you can have fixed interest while the lender can have the variable interest they prefer. You pay the Swap Party, and they pay the lender. This introduction of a third party leads to additional profits being scraped from your loan, and the Swap Party does not have an interest in your investment’s success as the lender might. If you have to prepay, massive fees will be applied by said party without the same negotiation potential that a lender has.
2. Poorly-Designed, Unclear, or Deceitful Valuation and Contracts
Outside of the financial arena, there are other red flags in a CRE deal to keep aware of. If you’ve spent any time investing in this industry, you have no doubt heard of its unicorn – the “triple-net property.” This term, when used truthfully, means a property wherein the tenant is responsible for:
- All operating expenses and taxes
- Insurance, including liability and casualty insurance
- All maintenance, from structure to mechanical parts, plumbing and more
This is obviously attractive for a buyer because that means they can keep every cent of rent they collect once the property is all paid for. However, this term, and many others like it, have been used and abused to the point where they are often little more than marketing speak, like “Premium,” “All Natural,” or “Original.”
What this example illustrates is the necessity of due diligence on your part – inspect every line of the contract and verify every claim. It’s a red flag when euphemistic claims are frequent, and hard facts and details are obscured in communications and documentations. In fact, by bringing a checklist of tough, unambiguous questions with you to your meetings with the seller, you can simply gauge their character from their reactions. Do they squirm, are they frustrated by them, are they eager to move on or simply lack clear answers to honest questions? Many bad deals can be avoided with a simple thorough look.
3. A Building with a “Fixer-Upper” Situation That Can’t Always Be Fixed
Whether you’re risk averse or not, as an investor you are geared towards general optimism and seeing opportunities that haven’t been uncovered yet. A “fixer-upper” is a common sell in residential real estate, where amateur Property Brothers look for the best houses to flip. Though it’s unlikely that a dilapidated building will be in your crosshairs for CRE, it may have other less than ideal attributes keeping its price low.
However, it is a potential red flag when a seller is advertising an “undiscovered opportunity” and pushing you to move fast before you lose out. A diamond in the rough is no good in CRE, because it’s all about location, location, location, and the rough is part of the sale. You cannot guarantee an area in a downturn will gentrify soon because of one organic coffee shop, any more than you can guarantee that a main street restoration project will undo years of crime which has run rampant on property values.
The Bottom Line on Commercial Real Estate Deals
The above three situations are a few broad warning signs of a bad commercial real estate deal, but the key to overcoming all of them is not to get swept up during the sell, and read through all the documents with an analysts’ understanding. The real benefit of investing in CRE is that there’s a strong paper trail and lots of supplemental information that can be reliably interpreted for strong ROI.
Of course, when it comes to the financial aspect, that’s another major hurdle. It’s one thing to know you can profit from a property, but quite another to secure the loans to make it happen over the long term. In this case, it’s best to rely on experts who are unaffiliated with specific institutions and interests, and therefore can always have your interests in mind. If you ever need help with this significant portion of a commercial real estate deal, we at Bellevue Capital Group are happy to guide you towards success.