Commercial real estate transactions are complicated. There are a lot of moving parts that must be managed and there is often a last minute rush to complete all of the necessary tasks in a short window of time before the scheduled closing date. For this reason, they can also be very stressful.
Fortunately, the process used to purchase a commercial real estate property is very similar, regardless of property type or location. For this reason, investors can create and work from a checklist to help ease the complexity and stress of getting a deal done.
In this article, an 8-step checklist for buying commercial property is presented. Once finished, readers will have a better understanding of the information and effort needed to consummate a commercial real estate transaction.
To standardize and scale our own purchasing efforts, we always work from a series of checklists of our making. To learn more about the investments currently being offered by First National Realty Partners, click here.
Buying Commercial Real Estate Checklist
Step #1: Identify Assets of Interest
There are a wide variety of commercial real estate property types and asset classes, each of which have their own risks, benefits, and operational quirks. Investors tend to specialize in a specific property type and asset class so they can learn the ins and outs of investing in them.
Broadly, there are four widely recognized commercial real estate property types: office, retail, multifamily, and industrial. Each of these property types can be subdivided into a “class” that acts as a shorthand for its location, condition, and general risk. Class A assets are the newest and least risky. Class D is the oldest and most risky. Classes B and C are somewhere in between.
Deciding upon and communicating these characteristics to brokers can help narrow the search for a property.
Step #2: Initial Screen and File Organization
Because there are so many properties to choose from, there are often multiple layers of “screening” activity that must occur to narrow them down to a handful of target candidates. Properties can be screened based upon a number of characteristics like location, age, tenants, profitability, and potential renovations needed.
Once the potential pool of assets is narrowed down to a handful, additional research can be performed by requesting a significant number of documents from the seller. These documents could include things like: cash flow and other financial statements, environmental reports, certificates of occupancy, recent tax bills, utility bills, liability insurance, rent roll for current tenants, zoning information, documentation on easements, building permits, and evidence of existing security deposits. After reviewing these documents., an investor will have a better idea of the property’s condition and potential invest-ability. If it is acceptable, it can make sense to proceed with an offer.
Step #3: Valuation and Offer
If a commercial real estate property meets all of an investor’s criteria and they would like to make an offer, one of the most consequential decisions must be made, how much to pay.
In commercial real estate, the value of the property is based on the amount of Net Operating Income it produces and a market based capitalization rate (cap rate). Net Operating income is calculated as a property’s gross income less its operating expenses and the cap rate is estimated based on the recent sales of comparable properties. With these two data points, and their own assessment of risk, investors can calculate the value of the property and the price they are willing to pay for it. Often, this number is backed into based on a set of growth assumptions and return requirements.
If the calculated value is in the neighborhood of the asking price, an offer is made.
Step #4: Research Financing Options
A typical commercial real estate purchase is financed with a combination of debt and equity. There is a significant amount of work that goes into obtaining both.
Debt is most commonly thought of as the loan provided by a bank or “senior lender.” Because there are so many financial institutions that offer debt financing, it is important to compare and contrast key loan terms like: interest rates, term, amortization, guaranties, covenants, and collateral. The various inputs can be run through the property’s financial model to see how they affect potential returns. The facility with the most favorable terms should be chosen.
Equity is the money that must be raised to bridge the gap between the property’s purchase price and the amount of debt that a lender is willing to provide. This money is raised from real estate investors who want to participate in the cash flow and profits produced by the underlying properties. The most frequent avenues through which to raise real estate investment capital are high net worth individuals and/or institutional investors.
Once financing for the property has been lined up, it is placed under contract. The Purchase and Sale contract – which is often prepared by a real estate attorney – outlines the details of the transaction, including the due diligence period.
Step #5: Inspections and Due Diligence
During the screening process, the real estate property receives a preliminary review, but once it is under contract, the official due diligence process begins. This includes a detailed inspection of the property – and the land surrounding it – to ensure its condition is as advertised by the current property owner. Typical due diligence activities include: physical walk through of all units and a review of: property warranties, insurance policies, the title search, the phase i environmental survey, the title insurance policy, tenant estoppel(s) and the alta survey.
Because there are so many activities that need to be completed during the due diligence phase, investors often work from a due diligence checklist to ensure they don’t miss anything.
Step #6: Begin the Appraisal Process
While the real estate investor makes their own assessment of property value, this is not the number that the lender relies on when making a loan. They will order an independent appraisal and the final loan amount is often based on the number that the appraiser comes up with.
On their own, the appraiser reviews all of the information described in step 2 above and they pull “comps” or recent sales of comparable properties to see how they compare to the property they are reviewing. Independently, they will calculate their own Net Operating Income and use their own capitalization rate to arrive at a value. Often, a loan on a commercial purchase is subject to the lender’s receipt and review of an appraisal. If the final value comes in where it needs to be, the lender will issue a loan commitment.
Because an appraisal can take 45-60 days to complete, it is in the best interest of both the buyer and seller to promptly comply with an appraiser’s request for information, lest they delay the transaction.
Step #7: Find Regulations and Zoning Issues
As part of both the appraisal and inspection process, there is a lot of emphasis placed on the commercial real estate property’s current and projected use and whether or not it is in compliance with local rules, regulations, and zoning requirements. This is especially important in new developments and major renovations where the opening of the property could be delayed by local authorities.
Step #8: Clean Up Legal Issues
If there are any issues discovered during the appraisal, due diligence, and/or regulatory review, they need to be corrected. Sometimes it may be a minor fix that is relatively inexpensive. Other times, it could be a major issue that threatens the viability of the transaction.
For example, a minor issue could be that a number of disabled parking spaces need to be added or some signage needs to be brought into compliance with local rules. But, if the groundwater is found to be contaminated or the property’s density is found to be in violation of zoning rules, these are major issues that are time consuming and/or expensive to correct. Further, the cost could become a point of negotiation between buyer and seller and could have a major impact on the viability of the transaction.
Ideally, everything is fine and the transaction can proceed to closing.
What is The Difference Between Purchasing and Investing?
From the standpoint of an individual commercial real estate investor, there is a major difference between buying a property outright or investing in one. The key difference is who is responsible for all of the work described in the steps above.
In a purchase, the investor must do the work themselves or hire someone to do it. Doing it on their own can be problematic because there is a significant amount of work to do and completing it requires some amount of experience to navigate all of the potential pitfalls. Hiring someone to do it can be incredibly expensive.
One of the main benefits of a commercial real estate investment – like the ones we offer – is that the investor can outsource all of this work to the transaction sponsor who has both the resources and expertise to ensure it is completed correctly. For many investors, this works out to be the better choice.
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 firstname.lastname@example.org for more information.