By Michael S. Mallaber
Have you been thinking about investing in commercial real estate?
There are many ways in which investors can get started but, first and foremost, the many risks involved in owning and managing commercial real estate should be understood.
Some investors begin by purchasing small projects – for instance, a five-unit or larger residential apartment project or a small office/retail building with just a few commercial tenants. That may take a smaller equity stake from the investor, and might even minimize or eliminate the need for conventional bank financing if the seller is willing to hold a small mortgage to assist with the purchase.
Such an investment allows the investor, or landlord to become acclimated to dealing with tenants and the types of issues that can arise, such as taking phone calls in the middle of the night because a heater stops functioning, or listening to a tenant explain that they don’t have the rent because their business traffic has slowed that month.
Some investors may look for quick “fix and flip” properties, in which they can invest for a short period of time, turn around and sell at a profit – hopefully. The proceeds then would be re-invested into a larger investment and keep growing. That investment strategy may have worked 15 or 20 years ago, when more tax advantages were available for real estate investing and fewer investors were trying to take advantage of a quick profit. It is much more difficult in today’s market to realize the same returns.
Other investors take a team approach, with friends or family each taking various property management responsibilities. While doing so may limit an investor’s time requirements for managing the properties, it also will reduce the investor’s return on his or her original investment. Keep in mind, however, that a team approach also could limit losses: Not all great ideas bear fruit.
Regardless of the strategy chosen, eventually investors may find themselves face to face with a banker who can help with financing or refinancing an investment. Investors should understand what bankers look for when evaluating a request for financing:
- Management experience/depth;
- Demonstrated ability to repay;
- Adequate collateral; and
- Investor liquidity.
How can the process of obtaining financing be simplified?
Bankers like to see a successful track record of real estate investing. History has a way of repeating itself, and those who can demonstrate a strategy that has been tested through different economic times have a huge advantage.
Does the investor have somebody to handle leasing, service calls or major repairs, or will all of that be done by the individual investor?
An investor who has a full-time job must demonstrate that someone will have the time and experience to handle the overall management of the property.
Ability to repay
Will the project show the historical ability to repay the loan, or is the repayment dependent on future changes to either revenue or expenses?
A project’s net operating income is the cash flow a banker will look for to support repayment of the loan. NOI is the difference between a project’s gross rental income (less vacancies) and all operating expenses associated with the property (ie, real estate taxes, insurance, utilities, snow removal, management expenses and a replacement reserve for unforeseen capital repairs).
NOI is used to calculate the project’s debt service coverage rate, defined as NOI divided by the annual debt service of all debt (both principal and interest) associated with the project. Most lenders require that a project show a minimum 1.2 to 1 DSCR.
If the seller is assisting with subordinate financing, this should be considered in the calculation since the project should demonstrate enough cash flow to service all debt being financed at a minimum, break-even level.
Most bankers like to see cash equity in commercial real estate investments. Depending on the type of investments – for example office, retail, apartments, hotels – a bank usually does not lend more than 75 to 80 percent of a property’s fair market value. The balance (20 to 25 percent) can be in the form of the investor’s cash equity or a combination of subordinate seller financing, possibly even other funds borrowed from family or friends.
The bank will engage an independent professional to value the property. The appraiser will research market rental rates for similar properties, report on comparable recent sales and analyze the cash flow of the property, and derive a value using an appropriate capitalization rate.
Cap rates reflect what the market has paid in a return on the cash flow of similar type properties, and provide the investor and the bank with a means to derive a value estimate from a cash flow stream. If a property reports an NOI of $50,000 per year, for instance, and the appraiser supports a cap rate of 10 percent, it equates to an approximate valuation of $500,000 – that is, $50,000 divided by 10 percent.
Liquidity is determined through an assessment of cash, mutual funds, stocks or, at minimum, readily traded assets that easily can be turned into cash within 30 to 60 days.
Liquidity enables an investor to support the project in the event rental income stream is disrupted and also provides some assurance to the bank that any unforeseen capital needs for the property can be funded. Investors should be careful not to invest too much of their liquidity. Keeping 10 percent or more of an individual’s net worth liquid is a good place to start.
Commercial real estate investing is a proven, viable option to grow an individual’s net worth, when it’s done properly. Unfortunately, some investors fail, which can lead to great financial stress, or even bankruptcy. Sticking to the basics, understanding the risks and resisting the urge to grow too quickly should help prospective investors to optimize returns and avoid the pitfalls of investing.
Michael Mallaber is vice president, commercial services, at Canandaigua National Bank; phone (585) 419-0670, ext. 50649; e-mail email@example.com.