Commercial Real Estate Investing For Dummies Cheat Sheet

Here are some terms you need to know as you develop your knowledge of commercial real estate:

• Gross income: Gross income is all your income, including rents, laundry or vending machine income, and late fees. It can be monthly or annual.
• Vacancy: A vacancy is any unit that is left unoccupied and is not producing income. Note: A unit that is vacated and re-rented in the same month is not considered a vacancy; it is considered a turnover.
• Vacancy rate: The number of vacancies divided by the number of units: vacancy rate (%) = total vacant units @@ds # of total units
• Effective gross income: Gross income minus vacancy: effective gross income = income – (vacancy rate % @@ts income)
• Operating expenses: Annual operating expenses of the property, which typically include taxes, insurance, utilities, management fees, payroll, landscaping, maintenance, and repairs. This does not include mortgage payments or interest expense.
• Net operating income (NOI): Effective gross income minus operating expenses: net operating income = effective gross income – operating expenses
• Debt service: Monthly mortgage amount times 12 months: debt service = monthly mortgage amount @@ts 12
• Cash flow: Net operating income minus debt service: annual cash flow = net operating income – debt service monthly cash flow = annual cash flow @@ds 12
• Cash-on-cash return: Annual cash flow divided by down payment amount: cash-on-cash return = annual cash flow @@ds down payment
• Capitalization rate: Net operating income divided by the sales price. Also known as the cap rate, it is 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 are not included. cap rate = net operating income @@ds sales price

These steps in this big-picture view helps you understand how a deal is closed:

1. The buyer makes an offer to purchase and, if the seller likes the offer, the seller accepts and signs it.
2. The buyer opens escrow with an escrow/title company or attorney and sends in-earnest money as a deposit to the escrow holder.
3. The buyer starts the financing process with his lender and sends necessary documents to the lender to qualify both the property and himself (and his partners).
4. The buyer does his due diligence (such as reviewing the property’s financial statements and other property-related information as set forth in the contract) and does a physical inspection of the property.
5. The buyer examines the title and removes contract contingencies.
6. The buyer and seller satisfy any remaining obligations as set forth in the contract.
7. The buyer finalizes the loan with the lender by getting an official letter of commitment from the lender.
8. The buyer reviews the closing statement and finalizes any final closing instructions with the escrow company.
9. On closing day, the buyer signs the closing paperwork with the escrow company and makes a down payment.
10. The deed is recorded, monies are disbursed, and the seller gets the keys.

Due diligence is the process of “doing your homework” on the property that you’re thinking about buying as an investment. When investors consider physical due diligence, they need to do more than a simple walk-through of the property with an inspector. Walk-throughs are a part of physical due diligence, but only a tiny part of it. Ask the seller for the following items:

• Site plans and specifications: This group of documents includes all of the construction documents, building plans and schematics, floor plans, and use of the land documents.
• Photos of the property: Photos of the exteriors, interiors, and the surrounding land and structures should be taken.
• A structural inspection: Inspect the walls, roofs, and foundation, and make sure there are implements in place for earthquake safety.
• An interior systems inspection: Inspect the interior of the property for wear and tear, including items such as doors, windows, and weatherproofing. Then inquire about the age of the roof, any building code violations, its federal compliance, and site improvements.
• A mechanical and electrical inspection: Make sure that every mechanical and electrical system is inspected. Such systems include heating, ventilation, air conditioning, plumbing systems, and all electrical power systems and controls.
• A list of capital improvements performed: Obtain receipts and documents for any capital improvements that were made. Collect these for any improvements over the past five years.
• A pest inspection: On some types of building, an inspection for pests, such as termites, may take place. Most apartment buildings have this inspection done as part of a lender requirement.

The financial aspect of due diligence focuses on why you’re buying the property. It helps ensure that you make money by verifying the seller records of the property’s financial performance. To perform successful financial due diligence, be sure to obtain the following from the seller:

• Income and expense statements: You should at least obtain annual income and expense statements for the past three years. Also, get all of last years’ monthly profit and loss statements and review the balance sheet for the past three years.
• Rent rolls: A rent roll is essentially an attendance sheet for all of the tenants. It displays the tenant’s name, unit space, amount of rent paid, move-in date, lease expiration date, and security deposit.
• Tax returns: Obtain the property’s tax returns for the past three years. Add up all of the income and expenses shown on the tax returns. These numbers should match those from the seller’s income and expense statements.
• Lease agreements: A lease agreement can be a complex legal document. If all of the leases are the same, such as in an apartment building, have an attorney review the first few to make sure they’re valid. For every other category of commercial real estate, we suggest verifying the leases by using an estoppel letter. This letter confirms that the lease is true and accurate and is the only agreement that’s made between the tenant and the owner.
• Utility bills: Obtain the past two years’ worth of actual utility bills for the property. These bills include electricity, gas, water, sewer, trash, telephone, cable, and internet service bills. Compare the totals of each utility category to the seller’s total given on the expense statements.
• Property tax bills: Obtain the past two years’ worth of property tax bills. Verify the amounts with those given on the seller’s expense statements.

Legal due diligence can be pretty extensive, and checking on the items in this list takes a team effort. Here are the items that you need to ask the seller for:

• An environmental inspection: The environmental inspection most often used is called a Phase One Environment Site Assessment. During this inspection the inspector explores the past use of the property and the surrounding area, looking for onsite and offsite environmental problems and liabilities.
• A survey and title inspection: With this inspection, a title company can verify the property size and that the title report has the same description as the survey. You can also review any easements or encroachments on the property that could drastically affect its value and use.
• An inspection for building code violations: If a new building code causes a violation to occur after a building is built, it’s called non-conforming use, and is considered to be grandfathered in.
• The zoning code: Every property has a specific use permitted. For example, a property can be zoned as residential or commercial. So, you need to review the city’s zoning ordinances to make sure that the property’s use complies with what it’s legally zoned for. If it’s used illegally, the property can be shut down.
• The insurance policy: The property’s insurance policy can be a treasure trove of information if you can get the claims history.
• Licenses, permits, or certificates: Oftentimes you’re required to post business licenses, permits, or certificates. Make sure that you’re proactive in notification of new ownership to avoid hefty fines.
• Service and vendor contracts: Review all service and vendor contracts to make sure that you have the right to choose or discontinue the services. These types of services may include, among others, laundry machine servicing, maintenance and landscaping. Keep record of any equipment warranties and guarantees.
• A personal property inventory: Obtain a list of all personal items, such as equipment, tools, computers, furniture, supplies, and appliances that are to remain behind with the new owner. Document all these personal items in writing or consider them gone.
• Any police reports: Determine past and current police reports by calling the local police department or reviewing online crime statistics. Review the type and frequency of calls to the property. Know what’s going on before you buy.