How To Analyze a Commercial Real Estate Deal
How to Analyze a Commercial Real Estate Deal
By Ed Rogan, Owner, Co-Founder
Investors are increasingly looking to put capital into commercial real estate. There are many options to choose from: multifamily, office, retail, industrial, hospitality and land development are the major property types to consider. Within each of those property types, investors must then decide whether to invest in Class A, Class B or Class C properties. This decision will depend, at least in part, on whether they’re investing in a primary, secondary or tertiary market.
Feeling overwhelmed yet? You’re not alone! The commercial real estate industry can be a complex web for first-time investors looking to get started.
One way to make the decision-making process easier is by understanding how real estate professionals analyze a commercial real estate deal. There are certain factors that an industry expert will always look at, both at the micro- and macro-level. General market trends, for example, is one of the macro-level factors to consider. But there are many property-specific details that must be analyzed, as well. Each of these factors will influence whether to invest in a commercial real estate deal or not.
Assess general market trends
Someone who’s looking to invest in commercial real estate might learn about a deal in a few different ways. One way is to scour the market and identify deals on your own, something most first-time investors find challenging. Another way is to express interest in investing, and then look for partners who can bring you deals for consideration.
In either case, the first step when evaluating a prospective deal is to consider the general market trends. At a very high level, an investor will want to understand where we are in the market cycle. Market cycles generally last +/- ten years. It can be risky to invest at the market peak, but trying to pin down the market peak can be a fool’s errand. Few can predict when the market will turn with any real certainty. Instead, use market cycle as a rough guide when making investment decisions.
Where we are in any given market cycle will affect all commercial real estate, regardless of specific location.
Therefore, a more useful barometer when analyzing a commercial real estate deal is the hyper-local market trends. For example, let’s say a fund manager is looking for you to invest in a submarket of Houston, Texas. You’ll want to learn more about the drivers of that submarket. Ask questions like:
- Is the population growing or contracting? If the population is growing, who’s moving here and why? Similarly, is the population young and diverse or is it aging?
- What are the area’s major economic drivers? Who are the major employers? How diverse is the local economy? What is the unemployment rate (and is that trending upward or downward)?
- What is the median household income? How much do households spend on rent, on average? How much discretionary income do households have to spend?
Now start to investigate questions that pertain specifically to the property class in question:
- What is the average vacancy rate for properties of this type?
- How much is in the pipeline for new construction of this property type?
- Which buildings would be considered your biggest competitors?
- What would be driving demand for this property type and why?
The answers to these questions will help inform whether or not investing in that property type, in that submarket, is a wise decision. For example, a submarket in which there is a growing, diverse population attracted by an expanding tech economy might be a prime candidate for new multifamily apartment construction, particularly if your analysis finds limited inventory and little in the pipeline for the next 3-5 years.
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Conduct commercial property analysis
Let’s say you’re convinced to invest in a specific submarket based on a favorable assessment of its general market trends. Now is the time to conduct a commercial property analysis. A commercial property analysis is essentially a comprehensive evaluation of several quantitative (e.g., the numbers) and qualitative (e.g., owner’s motivation to sell) factors that will influence the viability of a particular transaction.
The numbers (years, dates, income, etc.)
Anyone who is considering investing in commercial real estate will want to spend some time getting familiar with a basic pro forma. The pro forma, usually presented in spreadsheet form, will start with an assumed sales price. It will then outline all of the property’s income and operating expenses in detail. It will capture rents collected on a monthly basis. It will account for occasional vacancies. It will have line items built in for routine expenses, such as taxes and insurance. The pro forma will also capture other annual expenses, such as landscaping and snow removal, which may be up to the owner’s discretion.
There are many inputs into a pro forma. These inputs are critically important to understand, as they will help a prospective investor determine their potential return on investment (described in more detail below).
Aside from the pro forma, there are other numbers for an investor to consider, such as the year the property was built, the date it was remodeled (if any), square footage, lot size, number of units, the length of current ownership and more.
Expenses and remodeling
As noted above, the pro forma should account for all known and anticipated expenses. This includes yearly expenses, such as property taxes and insurance. It will also include monthly expenses, such as utilities and property management. These are generally known expenses and can be predicted to hold relatively steady year-over-year assuming the status quo remains.
The pro forma will also want to capture variable operating expenses, such as landscaping and seasonal expenses such as snow removal. For example, a property owner may only pay for snow removal as needed, which can cause the price to go up or down each month depending on average snowfall. During a particularly mild winter, an owner might save hundreds or thousands of dollars on this line item. A look back at the previous five years is a good way to ascertain an average to plug into the pro forma.
The same strategy can be used to account for other operating expenses, such as as-needed repairs and maintenance. This is the budget that usually captures something like a new heating system – an expense that long-term owners are bound to incur, but the timing of the expense may be unknown (and therefore, budgeted for in case needed).
Remodeling is another major line item, assuming the prospective buyers intend to take on any substantial renovations upon sale. Remodeling is usually a significant cost, particularly in value-add projects in which the new owner is looking to reposition the property.
Related: Why Multi Family Class is a Good Real Estate Asset Class
Property history
The property history is important for any investor to consider. There are many aspects to property history, ranging from when the property was built to ownership history. You’ll generally want to know:
- When the property was built
- When the major building systems (e.g., the HVAC system, roof, etc.) were installed, and
- How long the current owner has owned the property.
Ownership patterns can be quite telling. For example, if a property tends to turn over frequently, this could be an indication that the asset has historically underperformed.
On that point: performance is another key piece of property history. Performance can be measured by things like current vacancy rates and current rents (as benchmarked against the market average).
Assurance
Assurance is a somewhat obscure term as it pertains to commercial real estate. Generally speaking, assurance refers to there being some sort of validation that the property is worth pursuing. Assurance could include, for example, strong evidence of demand for that property type.
For example, when Amazon announced it had selected Crystal City in Arlington, VA as the location for its east coast headquarters (dubbed “HQ2”), this was the assurance many needed to invest in local real estate. Amazon announced that it would be bringing 25,000 new jobs to this headquarters, which real estate experts confirmed would drive demand for new multifamily housing.
Indications
Indications is another relatively obscure term used by those analyzing a commercial real estate deal. Indications essentially refers to a property owner’s intentions related to a specific transaction. A common pitfall among many first-time investors is they fail to look for specific indications that an owner will be a willing party to a transaction. The investor (fund sponsor or the like) will expend tremendous resources modeling a deal only to realize the property owner has no intention of selling.
Sample scenario
A family has owned multiple contiguous parcels of waterfront real estate for decades. The father, who was responsible for the initial development on these parcels, is aging and interested in retiring. He’d like to pass the real estate business down to his children.
That business now includes a few small duplexes plus a 30,000 mixed-use development that includes office space above ground-floor retail. A more established real estate development firm sees this as an opportunity: if they can convince the owner to play ball, the developer envisions building a 200-unit waterfront apartment complex across this owner’s existing portfolio.
The developer has an initial conversation with the owner, and the owner shows enough interest for the development company to pursue the deal. The developer goes on to spend thousands of dollars on initial due diligence: they get a survey, hire an architect, do some preliminary massing and test fit studies, run a pro forma, meet with the city about the variances that would be needed, and more. Yet the developer failed to really understand the current owner’s intentions.
The developer invested valuable time and resources before the owner gave any real indications that he’d be willing to sell. Ultimately, the seller would not budge and reaffirmed his interest in passing down the real estate to the next generation.
Building and lot analysis
An investor will want to conduct a building and lot analysis as part of the due diligence process. In laymen’s terms, this means looking at the existing lot and understanding its size and configuration. It also means investigating the local zoning ordinance to understand how the property is zoned, and as a result, what can be built on that lot.
Now, just because a lot is zoned for one use doesn’t mean it can’t be redeveloped for other property uses. But there is likely to be what’s called an “entitlement process,” in which the prospective buyer (or developer) goes to the town to seek permission to build what it is they want to build, and this may entail getting certain variances or zoning changes needed to build something different than that already permitted for the location.
Example
A 2-acre lot with two single family homes might need a variance in order for a developer to demo those homes and build a 20-unit apartment building in its place. Variances like these will usually require support from local neighbors which can make it, on the one hand, an onerous proposition, but on the other hand make it a good time to get to know who owns the neighboring parcels and also establish relationships with them. Maybe they would like to sell too.
NOI
NOI stands for “net operating income” and is one of the key inputs into the pro forma mentioned above. NOI is calculated by taking the property’s gross operating income and subtracting the sum of all operating expenses.
NOI = Gross Operating Income – Operating Expenses
Gross operating income is the property’s total annual income, including rent and any fees collected for things like parking or coin-operated laundry. The operating expenses include all expenses necessary to maintain a piece of property, such as taxes, insurance, utilities, and property management. Repairs and maintenance are considered operating expenses, but improvements and renovations are not (these are classified as capital expenditures).
Calculating a property’s NOI is an essential piece in determining its fair market value, as commercial real estate is valued based on its income-generating potential. The NOI expresses an objective measure of a property’s income stream.
Cash flow
NOI and cash flow are two terms that are often mistakenly used interchangeably. NOI is the amount of income (profit) a property generates during a certain period of time from operations, whereas cash-on-cash is a measure of all income and expenses, including debt service and other expenses.
A property’s net cash flow can be calculated using this formula: NOI – debt service payments, tenant improvements, leasing commissions and capital expenditures.
Here’s a simple example: if a property generates $200,000 in NOI but has $100,000 in debt service payments and $40,000 in capital expenditures, then its net cash flow is $60,000.
Cash on cash return
Some investors will often use “cash on cash” return as an indicator of the value of a property. The cash on cash return is a metric that calculates the rate of return on a rental property, taking into consideration the financing method.
Cash-on-Cash Return = Annual Pre-Tax Cash Flow / Total Cash Investment x 100%
To calculate cash on cash returns, an investor needs to plug in their exact cash investment along with gross rents, and then apply an accurate accounting of expenses. The cash-on-cash calculation factors in financing costs as amortized across monthly mortgage payments, as this significantly impacts an investor’s cash-on-cash returns.
Example:
Down payment: $62,500
Closing + Rehab costs: $12,500
Annual NOI: $16,800
Debt Service: $15,000
Annual Cash Flow: $16,800 - $15,000 = $1,800
Total Cash Investment: $62,500 + $12,500 = $75,000
Cash-on-Cash Return: $1,800 / $75,000 = 2.4%
Most investors will want to look for a property that has a cash-on-cash return of at least 8-12% or more. That said, the cash-on-cash calculation is less precise a metric than the internal rate of return (IRR) or other indicators of the potential of an investment and so, as is true of all metrics, should be used in unison with others to paint a full picture.
Cap rates
In commercial real estate, “cap rate” stands for capitalization rate. It is a formula that is used to estimate the potential return an investor will make on a property. The cap rate is expressed as a percentage, generally between 3% and 10%, though the rate can certainly be higher or lower depending on the nature of a deal and the asset class being analyzed.
The cap rate is calculated by dividing net operating income by the value or cost of the building and expressed as a percentage.
For example, a building that generates $500,000 in NOI and costs $10 million to purchase, will be yielding a 5% cap rate.
Cap rates usually have an inverse relationship to property value; the more valuable the property, the lower the cap rate and vice versa. For example, it is reasonable to expect a fully-stabilized, Class A property located in a core market to have a cap rate of 4% or less. Meanwhile, an opportunistic value-add deal in a secondary market could reasonably be expected to have a double-digit cap rate given the greater risk associated with these kinds of deals.
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Tools for analyzing a property
Property records
Collecting and analyzing property records is a critical step for any investor considering a specific real estate deal. Property records include the deed, mortgage documents, any liens on the property, a property survey and tax records. These can be collected in several ways, but most rely on public data sources including the Registry of Deeds in which the property is located and the local Assessor’s Office.
The deed, for example, will provide valuable information about ownership history, including the name and address of the current owner, and how much the owner paid for the property and when. Evidence of liens on the property, such as a lien recorded for back taxes, could be evidence of a distressed property in which case the owner might be especially motivated to make a deal.
Financial consultants or advisors
There are many real estate consultants and advisors that can be utilized when evaluating a commercial real estate deal. In fact, most deals will involve at least a commercial real estate broker and a real estate attorney. It is always best to hire your own real estate professionals rather than relying on those representing the seller; this ensures they will always have your best interests in mind.
Anyone who is considering investing in commercial real estate will also want to consult with their CPA or other financial advisor to ensure the investment is aligned with their broader long-term investment goals.
Talking to the owners
Property records and real estate professionals can provide certain information, but typically, the best source of property data is the information provided directly by the seller. To the extent possible, it is useful to have a direct, one-on-one conversation with the seller. This will allow you to ask questions that may not be reflected in any formal or legal documents. For example, an owner’s intentions or motivations to sell are often only conveyed by the seller directly. Having access to this information can help influence your decision-making process when investing in a deal.
Let’s use the scenario from above, the one in which the long-time owner of several parcels is approached by a real estate developer. The developer had a brief conversation with the owner, but never really fully engaged to understand the owner’s motivations. Had the developer done so, they may have realized that the owner didn’t really want to sell – he wanted to leave something for his children to inherit.
Therefore, a traditional purchase and sale agreement never would have worked. However, it is possible that the owner would have considered a joint venture in which he contributed the land in exchange for a percentage of the deal, an investment he could pass on to his children when the time came. Talking to the owners is the best way to uncover unique partnership opportunities or other critical deal information.
Is it an opportunity?
Determining whether a commercial real estate deal is right for you depends on many factors. For instance, an investor who is close to retirement may have a more conservative mindset and therefore, would prefer to invest in Class A deals of any property type. Meanwhile, a younger or more agile investor may be willing to take on more risk, and therefore, may be drawn to value-add redevelopment opportunities. An opportunity that may not work for one person might conversely be a great opportunity for many others – it truly depends on the individual investor, their objectives, and their investment horizon.
Each investor should understand their own investment objectives prior to approaching commercial real estate in any meaningful way. The industry is incredibly diverse, with many property types and classifications. Trying to navigate it without understanding your own objectives could leave you spinning in all of the wrong directions. Instead, outline your goals in advance and then use the tools described today to determine whether a specific deal means those goals.
Related: The Tax Benefits of Investing in Multi-Family Real Estate
Conclusion
Many investors are put off by the complexity of analyzing commercial real estate deals. Given all that was discussed here today, it’s no wonder why.
But it’s important to keep in mind that analyzing commercial real estate deals becomes much easier with time. The first few are usually the hardest for investors to wrap their heads around. It takes some time to learn the industry jargon. Yet there are many valuable resources available online for investors looking to better understand the process. There are dozens of sample pro formas online, for example. A sample pro forma is a good way to familiarize yourself with the numbers that go into the underwriting.
Most investors will analyze dozens, if not hundreds, of deals before deciding to invest in one. And this is OK! This is how investors weed through the good deals from the great. That way, when a particularly attractive deal come their way, they have a comparative set of deals to use as a measuring stick. The more deals someone analyzes, the more confident they will be when they ultimately do decide to make their next investment.
Want to know more? Find out more about our team at Penn Capital here.
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