15 Important Questions before Acquisition Commercial Real Estate

Spend time on the initial screening of a project to verify whether you desire to move forward, because the next steps are expensive.

In the real estate game, your focus must be on problem identification. Every project has its weaknesses. The successful real estate entrepreneur identifies the problem areas and figures out ways to eliminate or mitigate those issues. It is now time to play 15 questions.

Commercial Property

 

1. What is the seller motivation for selling the project?

2. Should you go see the project? It is essential that it be seen before the buyer makes a firm commitment. If the property is around the corner, of course, go view it. If the property is far, do more analysis before go to see it. A lot can be accomplished much more efficiently at your desk rather than by running off to view the dirt.

3. Should the area surrounding the project be viewed? It is essential that you view the neighborhood surrounding the project. If there is a toxic dump next to the project, or boarded-up buildings, or a run-down nursing home that emits an unpleasant odor.

4. What is the purchase price per square meter in comparison to reproduction cost per square meter?

5. What is the market rental rate? Determining this factor might involve discussions with leasing brokers or other knowledgeable sources. Are any concessions, such as free rent or tenant improvement allowances, being given to lease space? If so, what is the typical concession.

“In the real estate game, your focus must be on problem identification.”

6. What is the vacancy factor in the project? What is your perception as to how easily the vacancy can be filled, at what rent, and at what cost?

7. How are the tenants doing? This is particularly important for any anchor tenants. What is the creditworthiness of the tenants? What, if any, tenants are likely to default?

8. What is the net cash flow? What is the cash-on-cash return? Is the net cash flow sufficient to induce your investors to support this project?

9. What, if any, fix-up expense does the project need? Does the project need only cosmetic repairs, such as paint and landscaping, or is a more extensive facelift required? Are there any major structural issues or other major expenditures needed?

10. Are there any environmental issues? If the site contains or contained a gas station or a dry cleaner with a plant, this matter becomes highlighted.

“Every project has its weaknesses. The successful real estate entrepreneur identifies the problem areas and figures out ways to eliminate or mitigate those issues.”

11. What is the status of the financing? Must the borrower obtain new financing or can an existing loan be assumed at favourable rates? If new financing must be obtained, can the existing loan be repaid and at what cost?

12. What is the gross amount of cash that must be invested in the project?

13. What is your investor reaction to the project? 

14. Are there any natural hazards that you must be concerned about, for example, earthquakes, hurricanes or floods?

15. Are there physical problems associated with the project, for example, a lack of adequate parking or shop space with depths that are not workable for the majority of potential tenants?

How Real Estate Developers Assess a Construction Project

Imagine you are driving in your car and you see a large vacant lot near a hospital with a huge sign on the property captioned “Land for Sale.” The sign also has a broker´s name and phone number.

Developer vs Engineer & Architect

• How do you determine whether or not a project makes sense on this piece of dirt?
• What are the criteria for judging if a development project is viable?
• Is an office building the highest and best use for this property?
• What if there is already an office building that is almost entirely vacant, but the employees are having a difficult time finding affordable living space?

The first step is to collect additional information about the project. You call the broker listed on the “for sale” sign and ask general questions.

• Is the property still for sale and, if so, what is the asking price, lot size, and zoning?
• Would the seller consider a joint venture?
• Is there an architect involved and, if so, has he completed a preliminary site plan and/or construction drawings?
• Are there any potential problems with the site such as compacted land, drainage issues, or environmental problems?

Making further inquiries as you go along, as well as retaining the proper experts to help you gather information, will hopefully clear up many of the unknowns. You hire an engineer and an architect who reviews zoning and determines the type of construction that is permissible and the potential density of your project, given the site constraints.

You might hold a meeting with the appropriate city planning official, with your engineer or architect in attendance, to better understand what the property is entitled for, that is, exactly what may be built on the site at this time.

• What does the city or appropriate governmental entity want on this site?
• What are the set back restrictions?
• Are utilities, for example, gas, water, electric, brought to the site?
• Does the city have any special rules, such as unusual drainage requirements?

If you elect to go further with the project the site should be placed under contract, since money must be spent on due diligence items at this point.

From the buyer perspective: the purchase and sale agreement should allow the buyer an adequate period of time to conduct due diligence without risking capital with the seller. Enough money must be spent on due diligence at the initial stages of the project without additional nonrefundable funds being paid to the seller.

From a developer point of view: the ideal scenario is to tie up the dirt without committing nonrefundable monies until he is ready to put a spade in the ground.

From the seller perspective: a reasonable period should be given the buyer during which he may explore the viability of the project and the site but then the buyer must commit so the refundable good faith deposit becomes a nonrefundable deposit, applied to the purchase price if the buyer closes, yet retained if the buyer fails to close.

The Advantages of Acquisition on Specific Property Type and Location

When buying real estate, don’t be all over the board. Concentrate on a subset within a subset, that is, concentrate on a specific property type in a specific geographic location.

Commercial Real Estate

Why narrow your concentration? There are several advantages.

You learn the language and nuances that are unique to that property type.

You learn to focus on issues that are associated with that type of real estate. For example, if you are involved with shopping centers, percentage rent clauses may have to be negotiated. What is a percentage rent clause and what are the usual and customary points of negotiation associated with this type of provision? If a supermarket is doing annual sales of $2000/m2, does that mean they are doing well or does it take $4000/m2 to have a successful store? Apartments may have rent-control laws and problems associated with a high turnover rate as well as issues surrounding furnished versus non-furnished units; hotels track daily occupancy rates. What does a “star report” contain and what are the differences between three-, four-, or five-star ratings? When you are involved with medical office buildings, you know from experience that the tenant improvement costs are significantly higher than those for generic office space. You also learn how to create a tenant mix that generates synergy between the various users.

You can establish a relationship with other individuals or entities that provide services or are otherwise involved in that area.

By focusing on a specific product type, the likelihood of repeated contact with the same individuals is enhanced, and consequently your ability to get to know helpful parties in your designated field is significantly increased. You can cement relationships with real estate brokers, commercial lenders, potential tenants, venders, and so on. To illustrate, if you have vacant space in your neighborhood shopping center and you own two other neighborhood shopping centers in the general market area, would it not be a logical leasing tactic to approach your existing tenant base to see if any of those tenants might consider opening another store at your other location? Becoming active and participating in applicable trade organizations is an effective way to foster additional relationships and contacts.

You gain experience and learn over time what works and what does not work.

A standard lease for one product type may vary significantly from that needed for another product type. A death and disability clause may be important in a medical office lease, where the doctor’s personal services are important in relationship to his ability to pay the rent, while a pet clause or an age restriction may be more apropos in a residential lease. The concerns centered around managing a high-rise office project, for example issues regarding heating and air conditioning as well as elevator service, are quite different than concerns related to a mobile home park, where most problems revolve around the common areas such as the pool and the club house.

Key Economic Ingredients in a Lease in Commercial Real Estate

To gain a complete understanding of commercial real estate, learning about the basic lease provisions that drive a transaction economics in crucial. The following 7 provisions should be understand to properly grasp the economics of a lease transaction:

Economic Lease in Commercial Real Estate

1. Type of Lease: is the lease a gross, modified gross, triple net, or bond lease? (explain in previous post) An understanding of the lease type will shed light on which party bears the cost burden and/or the responsibility for various operating services.
2. The Parties/Liability: If an entity, as opposed to an individual, care must be taken to understand who the tenant is as well as the tenant´s financial strength. A subsidiary of a large public company signing the lease does not obligate the parent company. You might want to seek the guaranty of the parent. One the lease is signed, the tenant is signed and the tenant is dependent upon the landlord to provide necessary services.

3. The Premises: after the premises are clearly identified, it is necessary to quantify the size of the lease space. Is the tenant renting based upon usable or rentable square meter?
4. Term: the length of time a tenant is willing to commit to leasing a suite is a crucial area. The landlord seeks as long a term as he can obtain; the tenant usually desires to minimize his term and therefore his liability exposure, while possibly cushioning this posture with options to extend the lease.
5. Security Deposit: most landlords think of the security deposit as a fund that is available when a tenant moves out to ensure that he leaves the premises in good condition. It could be used to repair damage to the premises caused by the tenant or to clean the premises upon termination of the lease. If the landlord files bankruptcy, the tenant could find itself as a general unsecured creditor in its attempt to recover its security deposit.
6. Parking: if the lease is silent as to parking, tenants should be aware that the landlord has the right, at a later date during the lease term, to enact a policy to charge for parking.
7. Renewal Options and Termination Rights: usually renewal options and termination rights are drafted to solely benefit the tenant. If the option fixes the rent at a level that is below the current market rent when the option is exercised, then the landlord is often faced with the reality that the option will be exercised. If the option rate is at or above market, the tenant will most likely ignore the option and renegotiate the lease terms.

These lease provisions covering the dollars and cents of the transaction are usually the responsibility of the business individuals involved in the negotiation.

Four Basic Types of Leases in Commercial Real Estate

Four Basic Types of Leases in Commercial Real Estate

Leases are contractual binding agreements between a landlord and a tenant. The lease document controls the rights and liabilities between the parties. You must understand the nature or type of lease you are dealing with. It is important to clearly understand what the monthly/yearly base rent is, how much and when the rental adjustments are, and who bears the various operating cost burden as between the landlord and the tenant. These obligations will directly affect project cash flow and return.

The main differences between lease types concern which party will be responsible for the monetary obligations associated with the operation of subject property and what, if any, obligations the tenant has regarding the mechanical systems, the roof, and the exterior walls of the projects.

Gross Lease:

The operating expenses such as utilities, janitorial, landscaping, trash pick-up, management fees, and so forth are typically contracted and paid for by the landlord. Nevertheless, tenant shall pay its pro rata share of operating costs and taxes over specific calendar year operating costs and taxes. The landlord is responsible to maintain and repair the project systems such as heating, air conditioning, and ventilating, the common areas, the exterior walls, and the roof. A gross lease is usually found in office buildings.

Modified Gross Lease:

Certain operating costs, usually utilities, electric charges and janitorial expenses, are passed on as a direct expense to the tenant. Tenant shall pay as additional rent, without any right of deduction or offset, the actual charge for utility usage for the premises. The utilities shall be placed in tenant´s name and billing shall be made directly to tenant. One expense is a direct charge and the other is over a base year, there could be a charge in on category while there is no charge in the other box.

Triple Net Lease:

It requires the tenant to pay its pro rata share of operating expenses, not over a base year amount nor limited to certain operating costs, but rather to pay 100% of the actual operating costs associated with his percentage of the project. The obligations of maintenance and repair for mechanically feasible passes on to the tenant. However, for the roof and structural integrity of the building remains with the landlord.

This type of lease is commonly found in a retail shopping centre.

Bond Lease:

The tenant is not only responsible for the maintenance of the interior leased area, but usually is also responsible to maintain and replace, if necessary, the building systems, as well as to repair any damage that occurs to the exterior, including the roof and the structural components of the project. The destruction and condemnation risk is passed on to the tenant. Hence, if the building is destroyed by an earthquake, even if the tenant did not carry earthquake insurance, the tenant must continue to pay rent and must rebuild the structure!