Cheat Sheet

Commercial Real Estate Investing For Dummies

From Commercial Real Estate Investing For Dummies by Peter Conti, Peter Harris

Thinking about becoming a commercial real estate investor? Commercial real estate is many things, so knowing some common misconceptions about it can keep you straight amidst the confusion. Remember that big commercial deals need to be checked out before you make the final move to buy, so learn some fail-safe measures for risk-proofing your investment and understand how to use due diligence to uncover hidden problems.

Ways to Mitigate Risk in Commercial Real Estate Investments

Is commercial real estate risky? You bet it is, but risk is a facet of doing business — any business. You can't avoid it. But here's the good news: Risks can be managed to levels of great certainty. Being successful in commercial real estate nearly always means taking calculated risks.

You may have thought that risk-proofing was impossible, but you'd be surprised at what a little knowledge can do to your investment portfolio.

  • Do proper due diligence. Due diligence is the process you go through when verifying the financial documents of the property, performing a physical inspection, and checking out the legal pieces of the property, such as the title. Ninety percent of all deals die during due diligence. So, if you don't do a thorough job, the consequences can be costly. You may end up buying a property that's a money pit. However, when done properly, due diligence can actually help you make your sweet deal even sweeter.

  • Don't overpay. Overpaying is common among new investors. Don't be the investor in a deal where the agent sets a record price on selling a property! If you're buying apartments, make sure that you're aware of what price you're paying per unit. If you're buying a shopping center, make sure you know how much you're paying per square foot. In both cases, see what the recent market closings value your property at. Paying too much will lock up the property's cash flow for a long time.

  • Have expert market knowledge. Knowing your market like the back of your hand sets you up for success. Before you close on your deal, make sure you know the following:

    • How competitive your rents are with other similar local properties

    • When and if there's a "slow season" for rentals so you can plan ahead

    • Whether there's rent control in your city, which would inhibit you from raising rents as you thought you could

    It's also a good idea to inquire on crime statistics on the property in question by calling the local police department.

  • Hold your goals loosely. You should keep your investment's exit strategy flexible at all times. In fact, have several exit strategies ready at any given time. Market conditions change. Your personal circumstances can change rapidly as well. So, don't get wrapped up in executing just one exit strategy, because it may no longer apply.

  • Know where you are in the real estate cycle. There are four parts to any real estate cycle: expansion, contraction, recession, and recovery. Each part of the cycle demands that you pay detailed attention to your investment decisions. Understanding real estate cycles helps you take the correct actions with the best timing. There's nothing like timing the market like a pro.

Myths and Questions about Investing in Commercial Real Estate

Like any complicated business, commercial real estate investing has its share of myths and questions. Knowing this information brings forth some valuable truths that will rescue you from the trappings of confusion.

The following are some pretty common misconceptions about investing in commercial real estate:

  • You must start off in residential real estate to get into commercial real estate. There's no rule, rhyme, or reason stating that you must first invest in residential real estate in order to make the leap into commercial real estate investing. These fields are two different animals, two different languages, and two different consumers. It's like comparing apples to oranges.

  • Only the rich need apply. As you can probably imagine, this myth is just that: a myth. It isn't true that you have to be rich to get involved with commercial real estate investing. You can be as creative in your financing here as you can be when investing in homes.

  • This game is only for big-time players. In commercial real estate it doesn't matter where you start, and it doesn't matter if you only want to devote part of your time to do it. Having a full-time job or being a single-parent doesn't matter either.

  • Commercial real estate investing is riskier. Compared to what? If you compare it to stocks, do you have control over the companies you own stock in — in areas such as income, expense, debt, management, and insurance? Probably not. However, you do have these five controls in commercial real estate investing. If you compare it to residential real estate investing, what happens if you rent out your single-family home and the tenant moves out? What's your monthly income then? The answer: Nada. If, on the other hand, you own a 24-unit apartment building and one tenant moves out, what's your monthly income? Answer: 23 paying tenants worth of rent! What's more risky?

  • Commercial real estate is too complex for simple folks. Again, this isn't true. Remember when you got your new smartphone? You had no idea how to use it. It seemed too complicated, and it had entirely too many buttons. But there was a manual to get you started. After that, through repetition and practice, what seemed much like a puzzle is now fully understood and appropriately used. Getting to know commercial real estate investing is the same concept. You have quite a few things to master, but it isn't rocket science.

Real estate, like the rest of life, does have risks. If it didn't, it probably wouldn't be as fun. And it surely wouldn't pay off with the incredibly strong rates of return that it does.

Commercial Real Estate Due Diligence

Due diligence is the process of "doing your homework" on the property that you're thinking about buying as an investment. It's the process of checking, double-checking, and confirming any important information that was used to determine whether the property is a good, average, or bad deal.

Due diligence can be broken up into three main specialized parts: physical, financial, and legal.

Physical inspection

For the physical part of due diligence, where you actually walk around and inspect outside and inside the property, you should hire a professional inspection company. We believe that the physical part is the most important of the three because these types of mistakes are the most costly to correct and are the most damaging to the property's long-term value.

The best way to find a property inspection specialist is through a referral by an individual or a company that has experience with this part of due diligence. You can also ask your local commercial real estate broker for a referral. If you have no luck there, try entering the key word "commercial property inspection" into your favorite search engine. A handful of sites is bound to pop up.

Financial investigation

When it comes to the financial part of due diligence, hire an accountant who has real estate investment experience. Accountants aren't all created equal. Qualify your accountant by verifying that he or she has commercial real estate accounting experience, not just single-family residence accounting experience or general business experience. In some cases, the investment you're considering may be one of your largest. Would you trust the advice of an accountant with little experience in one of your largest financial endeavors ever? By far, the best way to find a qualified accountant is by referral. Call on one of your investment buddies and check out who they're using. And again, make sure that referral has commercial real estate accounting experience.

Here's a tip to stand on: Don't believe any financial information or books and records given to you by the seller. Double-check everything. Turn things inside out and hold each financial statement up to the light for proof. We recommend that you get deeply involved in the financial aspect of due diligence. Verify each dollar of income reportedly coming in and verify every dollar reportedly spent on the property by reviewing actual billing receipts.

Legal inquiries

The legal side of due diligence is most often done by an attorney and aided by a reputable title/escrow company. These folks look at things such as the following:

  • Defects on the title and survey

  • Any potential environmental problems

  • Proper and improper special uses and encroachments that affect the property

These are all potential deal killers.

Be sure to have tenant leases thoroughly reviewed and audited. After all, when you buy a commercial property, you're essentially buying the leases and the property comes for free. Contracts imposed on the property, such as employment contracts, service contracts, and warranties, all need to be scoured over with a fine-toothed comb.

All attorneys are not created equal. Attorneys specialize in areas of law. Please don't have a family law attorney represent you when purchasing a large shopping center. That's like having a foot doctor give you an eye examination. Instead, hire a real estate attorney. The real estate attorney that you hire doesn't have to be local, but needs to be familiar with laws in the state in which the property is located.

As for selecting a title/escrow company, that's a little easier than selecting an attorney. Title and escrow companies, by law, are neutral parties; they can neither favor the buyer nor the seller (nor the real estate agent). If you enter the key words "commercial title companies" into your favorite search engine, you'll get a few to start with. We find it advantageous, however, to work with an office that's local and is familiar with closing practices of that city or state.

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