Evaluating Your Commercial Real Estate Investment
Before you underwrite an investment, consider these four critical aspects related to the project.
Before you invest in any commercial real estate project, you need to evaluate several criteria. There are four main categories to focus on as you do this due diligence:
- The physical characteristics of the real estate
- The operating performance of the property under consideration for acquisition
- The credit of the intended tenant
- The general economy and local market conditions
These four “rules” apply whether you’re investigating a potential single-tenant, triple-net leased property or any other commercial real estate.
1. Physical Characteristics
Real estate investors will tell you that it’s all about location. That much is true. But in determining a property’s suitability for investment, it may pay to conduct further analysis. Consider these kinds of questions:
- What is the underlying land value?
- What are the ages of any property improvements?
- Have you considered a replacement cost analysis
- Where are the tenant’s competitors located?
- Have you conducted a traffic count study?
- Does the property have possible alternative uses?
- Have there been recent comparable transactions in the area?
- Is there enough parking and visibility from the street?
So, while it may be all about location, it’s also about a lot of other things as well.
2. Operating Performance
For properties that have an existing tenant under lease, it’s important to know not only the basics such as how many years remain on the lease (including any option years) but also the likelihood of exercising the option or renewing the lease. You can help determine this by reviewing the historical sales and profitability of the location, including the trend of sales and net income. Ask:
- Does the tenant have a history of renewing on option years?
- Do they insist on renegotiating rents or other terms before exercising options?
You will also want to determine rent coverage as a percent of sales and whether percentage rents exist and can be factored into future asset-level performance.
3. The Tenant
Income producing commercial real estate can frequently be only as good as the tenant occupying your property. No one wants a vacant property and the associated costs of maintaining it while you hunt for a replacement tenant.
In addition to the operating performance of an occupied property as noted previously, it’s important to review your tenant’s management capabilities and perform a credit analysis of the tenant’s corporate entity.
- Does management have enough experience?
- Are they overly leveraged?
- What is their competitive position in the marketplace?
The Local Market and the Economy
It’s important to understand local and national economic trends that may affect your tenant—and you as the landlord. Consider the following:
- How is the local economy? Is it based on one major employer or industry?
- How is the national economy? Is it ascending?
- Is inflation a factor to consider?
- Where are interest rates headed and how will that affect capitalization rates?
- Is the local real estate market overbuilt and saturated with vacancies?
These are only a few of the many micro and macro considerations to evaluate as you conduct proper real estate acquisition due diligence. Many of these same questions will help you evaluate whether it’s time to dispose of a property you currently own.
By asking these questions, you should be able to effectively negotiate a suitable purchase or sale price that will allow you to enter into transactions with acceptable returns and stable cash flow. And, importantly, be able to position your portfolio for value-driven growth.
Bill Deegan
Bill Deegan has more than 40 years of real estate development, accounting, finance and sales experience. Deegan served as senior vice president of the New York State Urban Development Corporation, a major public authority in New York State with more than $2 billion in real estate assets, including more than 10,000 rental units. In the private sector, he participated in the development of single-family and resort properties in Central America, was involved in the syndication and distribution of real estate limited partnerships and real estate investment trusts and has consulted with several businesses on the implementation of business strategies designed to enhance shareholder value. Deegan maintained an active license as a certified public accountant for more than 30 years and is a graduate of Pace University in New York.
