As an asset class, an investment in commercial real estate offers several benefits: income, capital gains, tax advantages, and portfolio diversification. As a private equity firm who specializes in the purchase and management of commercial real estate, we believe that there is a strong argument for the inclusion of this asset class as part of a broadly diversified portfolio of risk assets.
But, purchasing a commercial real estate property can be complicated and difficult. It can take years of experience and dozens of transaction repetitions to get it down to a science. Fortunately, we have both. In the article that follows, we have simplified the commercial real estate property purchase process into 10 steps. Once finished, readers will have a good feel for the effort and detail that goes into making a commercial real estate property purchase.
We follow the broad strokes of this checklist with every purchase that we make. To learn more about our current property offerings, click here.
1. Understand the Purpose of the Investment
For individual real estate investors, the most logical starting point is to identify the objective of the investment. Doing so will help guide the choice of property type and market.
For example, if an investor’s objective is to earn a stable stream of income with little chance for capital appreciation, they would likely choose a property with high quality tenants on long term leases. On the other end of the spectrum, if an investor’s objective is growth, they may choose a real estate investment where there is potential for significant rental increases, which would result in value increases.
In short, identifying the objective of the investment can help provide a more focused approach to the acquisition process.
2. Understand the Investment Options
Generally, the options for buying commercial real estate can be grouped into two categories, direct and indirect.
A direct investment means that an individual investor – or group of investors – finds and purchases a property directly for their own account. With this strategy, they are responsible for identifying the property, finding a lender, contributing the required equity (down payment), and getting the deal closed. They are also responsible for managing the property once they own it. Many investors like this approach because it gives them a significant amount of control over all phases of the investment process and it entitles them to 100% of the property’s cash flow and profits.
With an indirect approach, commercial real estate investors allocate capital to an investment manager who pools it with capital from other investors and uses it to purchase institutional grade commercial assets like multifamily apartment buildings, industrial property, or office buildings. The investment manager can range from a mutual fund to a private equity firm or a real estate investment trust or (REIT). The upside to this approach is that it provides the benefit of commercial real estate property ownership without the hassle of managing it. In addition, it can provide higher levels of portfolio diversification and, in some cases, liquidity. However, the downside is that investors have little control over how their capital is deployed.
Once an investment option is chosen, a property can be identified and placed under contract.
3. Build a Team
Commercial real estate investing is not a solo endeavor. It takes a team to find, close, and manage a commercial asset.
If a direct investment approach is taken, it is up to the individual investor to create their own team. The exact composition of the team may vary by investor, but it usually consists of real estate brokers, real estate attorneys, property managers, and realtors. It is the job of these real estate professionals to assist the investor with the property identification, underwriting, and management processes.
With an indirect investment approach, it is the job of the investment manager/transaction sponsor to form the team. For an individual investor, one of the benefits of an indirect approach is that they get access to the manager’s team, which is typically formed over many years and dozens of successful transactions.
4. Identify a Property
If the team is successful, one of the results is a steady stream of deals and investment opportunities. This is helpful for the identification of an investment property that has potential for a profitable return. It may take reviewing dozens or even hundreds of deals before a suitable one is found.
5. Make an Offer
Once a suitable rental property is discovered, the next step is to make an offer on it. The actual process of making an offer is a relatively straightforward one. In it, an investor works with their broker and/or their representatives to deliver an official offer to the seller.
However, deciding upon an offer price is a bit trickier. This process is somewhat unique to each investor/investment firm, but it typically involves using widely accepted commercial property valuation methodologies. The “income capitalization approach” is the most commonly used in commercial real estate, but the cost approach and the sales comparison approach are also popular. In some cases, an investor may use all three and take an average to determine their final offer price.
The offer and all of the details that surround it are written up in a document called the purchase and sale agreement.
6. Complete the Purchase and Sale Agreement
The Purchase and Sale Agreement is the document that contains the official, legal offer for the property. It is typically prepared by the broker and/or an attorney and it outlines the details of the offer. The details are unique to each transaction, but it typically includes sections on things like: how much of an earnest deposit will be placed into escrow, the length of the due diligence period, what happens if there is a major issue found during due diligence, the transaction closing date, and how the property will be managed in the interim period between the contract and closing dates.
It is common for there to be several rounds of back and forth between the buyer and seller before the Purchase and Sale Agreement is finalized.
7. Secure Financing
Nearly all commercial real estate purchases are financed with some combination of debt and equity and it is the buyer’s responsibility to secure it. In a direct purchase, the investor will have to do it on their own. In an indirect purchase, this task is outsourced to the investment manager.
Debt is the formal name for the financing offered by a bank or real estate lender. In a typical commercial real estate deal, it will account for 60% – 80% of the total purchase price. The difference between the amount of debt offered by a lender and the purchase price represents the equity required to close the transaction. In a direct investment strategy, this money needs to come from the owners of the property. In an indirect strategy, this money is raised by the investment manager from a group of individual investors.
8. Complete Due Diligence
Once the commercial real estate property goes under contract, step #7 and #8 tend to happen in parallel. Due diligence is the process of physically inspecting every aspect of the property to ensure that there are no major issues. This involves a walkthrough of all units/commercial spaces, a review of the property’s major mechanical systems like the roof and plumbing, and an assessment of the environment surrounding the property to ensure that it is not contaminated. All of these tasks are completed by both the investor themselves and/or a team of experts they hire.
If there are any major issues discovered during the due diligence process, one of three things typically happens. First, the investor could decide it is not worth their trouble to fix it and they could walk away. Second, they could attempt to renegotiate the price based on the estimated repair costs. Or, they could do nothing and proceed with the transaction as planned.
9. Perform a Final Walkthrough
After due diligence is completed, the final step prior to closing is to perform a final walkthrough of the property. The purpose of this walkthrough is to ensure that nothing has changed since the completion of due diligence and to address it if it has. More often than not, this involves physically walking the property and doing things like testing outlets, faucets, and toilets to ensure everything is in working order.
10. Close the Deal
The act of closing a deal is not one task, it is a group of several tasks that must take place in rapid succession prior to the final transfer of ownership. These tasks include things like: finalizing the loan and equity raise, performing a title search and obtaining title insurance, exchanging keys and access codes, and signing the necessary legal paperwork.
Once the paperwork is signed and the keys are exchanged, the transaction is complete. To give a sense of timing, it can take around 90-180 days to get through all 10 steps described above. It could also take more or less time depending on the specifics of the transaction and whether there are any complications.
Purchasing Commercial Real Estate FAQs
Whether purchasing a commercial real estate property directly or working with an investment manager to do it indirectly, there are a number of questions that should be asked throughout the purchase process.
Why Is The Owner Selling?
Sellers are motivated by different factors. Some may need to sell the property because their original holding period is up and they need to return money to their investors. Others may be opportunistic sellers looking to take advantage of a hot market. As a potential buyer, it is important to understand the seller’s motivation for putting the property on the market to identify where the leverage is in a potential negotiation. For example, if a seller has to sell, they may be willing to accept a lower price. Or, if they want to sell, they may not be as likely to negotiate.
What is the Property Type?
Broadly, there are four types of commercial real estate property: Office, Retail, Industrial, and Multifamily. Each type of property has its own underwriting criteria, operational quirks, performance metrics, and financing requirements. To determine whether or not a property is potentially a good investment, it is necessary to understand the type and the quirks that go with it.
How Much Can/Should I Invest?
From a risk standpoint, investors should carefully consider how much capital they are willing and able to invest. While commercial real estate is a traditionally stable investment, it is not without risk. Loss of investment capital is always a possibility and investors should carefully consider how much they want to commit to a deal.
What Is My Potential Return?
This is the main question that every investor wants to know the answer to. Commercial real estate investment returns are measured using a number of metrics, which include: Net Operating Income, Internal Rate of Return, Equity Multiple, leasing activity, Debt Service Coverage Ratio, and Capitalization Rate (Cap Rate). The results of these calculations should meet an investors minimum requirements or it may not make sense to proceed with the deal.
Purchasing vs. Investing in Commercial Real Estate
The above steps are necessary to purchase a commercial real estate property outright. However, commercial properties are expensive and a purchase may not be feasible for everyone. As an alternative, there are a number of ways to invest in commercial real estate that require less capital than a purchase. Two such options are to invest in a REIT or with a Private Equity Firm.
A REIT is a specialized type of commercial real estate investment firm that offers tax benefits to investors as long as they pay out 90% of their income as dividends. Individual investors like publicly traded REITs because they provide exposure to commercial real estate assets and shares can be bought and sold on major stock exchanges. This provides a degree of liquidity that is not typically available in a commercial real estate investment.
A Private Equity Firm is also a specialized type of investment company that purchases and manages commercial real estate assets. However, they are structurally different from REITs in the sense that they are not required to pay out a high percentage of their income as dividends. In addition, they are only available to Accredited Investors who meet certain income and/or net worth requirements. We are a private equity firm and we focus on buying and managing grocery store anchored commercial shopping centers.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate (CRE) investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
