When To Say “No” to a Commercial Real Estate Property Investment Opportunity
When you decide to invest in a real estate syndication, you’ve already set aside your investment money, and you’re looking at possible investment options, there comes a time when you want to know which deals to avoid and which ones to pursue.
Perhaps there are certain warning signals you should be aware of or some crucial information about the underwriting side that you’d want to grasp so that you can make an informed decision.
That’s why you’re here today, my friend.
In this blog post, I’ll walk you through the data an underwriter considers in a deal, address some potential hazards, provide several example number ranges that we search for on a regular basis, and assist you with understanding the basic elements of the commercial real estate industry and prospective investment possibilities therein.
I’d like you to know that my team does extensive research on each investment opportunity and, on those that do make it through, even more analysis. Today, you’re getting a look at the behind-the-scenes work.
Why Underwriting is Such a Valuable Component
Imagine underwriters as the good-guy gatekeepers who, as your first line of defense against bad investments, filter out transactions that don’t match investors’ requirements.
It’s our goal to consider all the details, draw on our past expertise, and ensure that we have the opportunity to create value and purchase great bargains for our investors.
The Negative Aspects of a Competitive Real Estate Market
A deal might appear to check all the boxes at first glance — maybe it’s in a great location with a significant net increase in population, high median incomes, excellent schools, potential for rent growth, and projected good returns for investors.
The unfortunate part is that other investors want in on these deals too, and the bidding for these seemingly ideal commercial properties becomes fiercely competitive. Money pours into these deals, bidders from all across the country emerge out of nowhere, and cap rates are driven down, making it no longer worthwhile for us or our investors.
As you know, any investment comes with inherent risks — rising building and renovation expenses, inflation, interest rates, and even unanticipated difficulties like plumbing issues.
What if we told you there are a few methods we use to think about all of these variables so that none of us wastes money or time on commercial real estate that isn’t worth it?
How to Recognize When It’s Time to Pass on a Property: The Details
When you invest in commercial real estate, your goals are numerous. You want to make money, minimize your taxes, and have a hands-off investment while also protecting your money from loss.
To prevent losing money on a bad real estate transaction from the start, you must successfully select an investment option from a poor real estate deal right away.
Whatever the property type, you’ll want one that can produce the returns and financial security you require in the time frame required, with as little risk as feasible. We generally seek for value-add transactions that would return an 18 IRR (minimum) within approximately 5 years.
There are some syndications’ business plans that make sense on a shorter term, such as three years. However, these are typically pricey up-front and resemble a home real estate fix-and-flip in terms of cost and risk. These are high-risk investments with significant potential returns; the large danger being taken by such extensive remodeling.
If you’d rather lower your risk significantly and keep something for a long-term cash flow strategy, you may acquire a property that is already making a monthly or quarterly profit. You could discover this sort of transaction on a new construction Class A or B+ apartment complex that is in excellent condition and requires no repairs.
Red Flags For Real Estate Investors
To discover the warning signals, read between the lines at any time you’re flipping through photos, touring a property, listening to a webinar, or reading an investment summary.
If you go on a property inspection and discover that the pool is closed during the dog days of summer, you may have questions. If the property manager appears unaware or unsure why the pool is shut or when it will reopen, your worries should escalate significantly.
If you notice debris in every nook and cranny, defective paneling or roofing, or unkempt landscaping, it’s reasonable to suspect property management is ignoring issues that are more difficult to detect. It would not come as a surprise on this type of property to discover dissatisfied tenants and deferred maintenance within apartments or walls that may be rotting.
Be aware of a property manager who is too quick to point out positive attributes and fails to mention any challenges or serious concerns about operating costs. If you find properties that have been on the market for a long time or are priced well under their value, proceed with caution. This often suggests that there are unknown issues.
We’d have to receive a greater return (18 minimum) in exchange for completely remodeling, re-tenanting, and adding a new property management team if there are red flags like this. Rather, we’d be starting from the ground up, and if the numbers check out on a property like this with an IRR of 12 or 14, it’s not worth it.
Now, it’s critical to realize that we don’t choose projects based on IRR. We compare the amount of effort (more work equates to more risk) we’ll have to put into bringing the property to market versus the amount of return. More work (i.e., risk) should always equal greater returns, and those returns should be data-driven.
How Seasoned Commercial Real Estate Investors Look At A Potential Investment Deal
Are you still unsure whether to accept? Let’s dig into the nitty-gritty math side of things. Take their T12 financials and make any necessary tax rate adjustments, then look at our going-in-place cap rate. We have a few years at the current, going-in cap rate since taxes won’t hit on our acquisition until year 3.
When a new tax assessment is issued, the cap rate will then have a minor downward adjustment. Meanwhile, we’re always expecting something to alter with the current expenses profile.
When we acquire property, real estate taxes, payroll, insurance, and administration costs may need to rise or fall; it’s critical to understand how cash flows will be impacted by our potential change of ownership.
To begin, calculate what your month-one income will be based on the going-in cap rate. Then compare current rents and unit mixes to those of comparable asset types in the region. You’re attempting to discover the potential value in the company plan while pulling comps.
In other words, will the rent rate reflected by similar commercial real estate in the area be high enough to cover the cost of needed renovations on this property while still providing cash flow?
Look for comparable units, built around the same year as yours, that have already been renovated and use their current rates to calculate your anticipated commercial property lease rates.
The Underwriter’s Sample Numbers
Let’s assume that after renovations are completed, we can charge an extra $337 per month per unit. Roofing, siding, kitchen and bathroom improvements, pool repairs, and replacement of all polybutylene piping cost $17,000 each unit. Increasing rent by $337 per month results in an extra $4,000 in yearly income. We divide $4,000 by $17,000 to get a 22.5% return on investment. When we look at returns on investments of 18%, 20%, and 22% or more, we see that we’re getting enough revenue to justify the renovations.
Examining the Various Financing Choices
Finally, we must look into our financing options. Because of the numbers provided above, we would be restricted by our current cash flow, making a bridge debt lender an excellent choice.
We consider the going-in cap rate, the potential rent increase, and the property’s existing cash flow (think month-one numbers) when deciding which financing option(s) to pursue. If you go to an agency lender, you’ll usually get a strict repayment timetable and while they may have the lowest interest rates, they won’t be flexible at all.
The Advantages of Using Bridge Debt
In this situation, a debt fund’s bridge approach might be the finest option. Floating rates, no or minimal prepayment penalties, short loan durations, non-recourse money, and a higher leverage opportunity beyond the normal 75% loan-to-value threshold are all advantages of going with a bridge loan.
The Downside of Taking Out a Bridge Loan
The disadvantage of using a bridge debt lender is that they charge a greater fee. Bridge loans have more up-front and back-end costs as well as a higher interest rate to offset the higher risk.
Exploring Profits at the Sale
After we’ve got our costs, financing, and some other fundamental figures, we need to figure out what the property may sell for in approximately 5 years after renovations are finished and tenants are paying market rates.
Let’s assume that, for the sake of this example property, renovations are complete by year three and that the property is stabilized. Our starting NOI was around $1.1 million, with a year-three NOI of about $1.6 million, demonstrating that we’ve essentially created $500,000 in additional income.
This is when we check what the brokers are saying. We end up with only a 12 percent IRR for limited partner investors after plugging in how much the brokers think the property will sell for, purchase price, renovation expenses, and increased rent.
All Considered, Are the Returns Worth It?
On this occasion, we’d opt to pass. When we consider the alternatives for commercial real estate investments that are less risky and offer greater returns than this one, the profits aren’t enticing enough for our investors.
There are no clear standards for what constitutes “excellent” returns, and the market, economy, tenant choices, management expenses, taxes — just about everything — is in a constant state of change. For the last 10 years, cap rates have been on the decline and were further reduced by Covid. The figures I gave you today may not be valid in a few years.
Overall, each commercial property’s prospective investment success should be examined in terms of risk-adjusted return. You should always be comparing returns against the amount of risk your money faces when you consider the deal’s class, location, and business plan. The higher the returns, the more risky the venture may be.
When Preferred Structure Deals Are in Your Favor as a Commercial Real Estate Investor
What if (and would it be advantageous for) a sponsor just exclude an aspect of the deal in order to alter the figures into something more appealing so that investors will buy in? In a nutshell, no one involved could benefit from this!
Because of the name, a lot of negotiations are framed in terms of a favorable return, or “pref.” In a pref arrangement, limited partner investors receive all returns up to a certain percentage until the commercial property generates more than that. As a result, the sponsor team is strongly motivated to ensure that the profits exceed the pref rate.
Yes, certain things outside of our control, such as inflation, a rise in interest rates, or a natural disaster might occur.
No one wants to work for nothing, which is why all elements are thoroughly investigated ahead of time, including supply and demand, property management, and the sponsor team’s track record.
When Is It Time To Say No To A Commercial Real Estate Investment?
Now you know all about the initial phases of commercial real estate investing that provide us a simple yes or no to determine whether we should continue delving into the details.
If the property needs major renovations and we’re expecting a 14% IRR, it’s not worth it to us or our investors, so we move on to look at the next prospective investment. On the other hand, if we find new construction with little-to-no renovation requirements that returns a 14% IRR, there’s a good reason for us to continue our research.
In other words, getting a yes or no from this stage of the real estate investing process is the easy part!
Today, we focused on a multifamily investment, but the same sort of analysis occurs whether you’re looking at retail stores, storage containers, industrial sites, or any other commercial real estate property type.
By the time a possible commercial real estate investment opportunity reaches your email, my team and I have completed this level of due diligence, as well as a sensitivity analysis and more number-crunching to assist us to win the contract, seal the deal, and put out the investment offering. If you’d like to learn more about our deal flow, we’d be delighted to welcome you as a member of my investor club and schedule a meeting with me so we can learn more about your investment objectives and assist you in reaching them!
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About the Author
Lisa is the CEO of Lisahylton.com, a real estate company that helps entrepreneurs invest in tax-efficient real estate investments. At Lisahylton.com, Lisa and her team focus on buying apartments with investors and shares the profits. This strategy enables her investors to build wealth and passive income through investing in conservative, high-quality multifamily assets.
Lisa is the host of the Level Up REI podcast where she interviews real estate investors, entrepreneurs, and business owners to share their stories and experiences building businesses and investing in real estate. After a decade of working in the financial services industry, Lisa found investing passively in real estate syndications and was intrigued by the business opportunity to invest in real estate while also providing the opportunity to others to do the same along with her.
You can learn more about passively investing in high-quality multifamily assets that provide cash flow and strong returns at www.LisaHylton.com.