Buying Commercial Property

GROSS RENT MULTIPLIER.............................	Market Value Gross / Schedule Rent OR Purchase Price/Annual Gross Rental Income
CAP RATE...........................................................	Net Operating Income (NOI) / Market Value OR Net Operating Income/Selling Price
MARKET VALUE..............................................	NOI / Cap Rate
OPERATING PROFIT........................................	NOI / Total Income
DEBT COVERAGE RATIO................................	NOI / Annual Debt Service
CASH FLOW BEFORE TAX............................	NOI - Debt Service
CASH ON CASH RETURN...............................	Cash Flow Before Tax / Down Payment OR After Tax Cash Flow/Initial Equity Investment OR Pre Tax Cash Flow +Tax savings/Init Equity Investment
TOTAL YIELD....................................................	Cash Flow Before Tax+ Principle Payments
RETURN ON EQUITY.......................................	Total Yield / Down Payment

Commercial Real Estate, also known as "Income Property", is valued by the amount of income that it produces. The only way to determine the value of the property is to determine what the income and expenses are on a property. If you can verify the income (through tax returns, bank deposits, copies of checks, etc…) you will have a very good understanding of what the purchase price of a property should be. This will tell you what the past owner has done. If you have greater or lesser property managerial skills, you might have different results.

Realtors will often be very conservative with expenses, and very liberal with revenue. If you want to be successful your goal is to be analytical and gather as much raw data as you can. Ways to validate expenses are:

1) Go to last three years of tax returns on property. (Sellers seldom OVERSTATE income. They might overstate expenses.)

2) Verify expenses through getting copies of invoices, utility bills, and any other receipts, if possible.

3) Verify income through bank deposit slips, copies of rental checks, and copies of leases.

4) You want to get a copy of the rent roll to determine WHEN people have paid their rent. If you have more than one or two renters that are consistently late on their payment, it is a problem property. Also, is this a monthly rental, yearly lease, or week to week rental? Week to week rentals have great cash flow, but they are extremely management intensive. You must determine the level of effort you wish to produce to make a return on your investment. A trophy property might have lower revenues, but still be a better investment than a property that has high maintenance, repair, and management costs.

5) If the property owner states that they will not provide any information to you, you need to explain that an income property is valued according to the income that it receives. The only way to fairly evaluate a property is through looking at the tax returns. ("Trust me" doesn't cut it when getting income verification. The age old question is; if they would lie to the I.R.S., which has the power to put them in jail, why should they tell you the truth?) A business broker in the office once went out to do a listing. He asked to see the books. The owner asked, "Which set?" The broker asked, in shock, "How many sets of books do you have?" The owner answered, "Four. One for my partner, one for the I.R.S., one for one for my accountant, and the real one. They are all color coded so we know which set of books to work on. Which one do you want?" Needless to say, the broker did not take the listing. Trust, but verify everything that the seller tells you.

What is the current condition of the property? Is it in good shape? How does the exterior of the property look? (Always clean up and repair the outside first. Renters care more about how it looks from the outside, than about the interior. Their friends might never come inside, but they will always look at the exterior. It will make it much easier to rent.) Before you can rent it for the prevailing area rent, you will have to be up to the prevailing neighborhood standards. If you want to get premiums, you will have to be better than the other apartment complexes.

When a seller is thinking about selling, the first step may be to reduce expenses by scrimping on maintenance. Every dollar a month that is saved in expenses adds $100 to the value of the property. That deferred maintenance may not be obvious at first glance, but it needs to be done. You want to take a close look at the costs needed to get the property up to excellent shape, and add 20% to that when estimating costs. (In time, you will become very good at estimating repair costs…or you will go bankrupt.) My father used to have duplexes, and did all of the maintenance himself. He didn't count his time as a cost. You must count your time, or the current managers' time as a cost, or you will not have valued your time correctly. (If you don't paint the apartments, you will have to get someone else to paint them. They will not work for free.)

The wisest investment you can make, after you have the property under contract, is to get a licensed property inspector. Go to www.ashi.com for the American Society of Home Inspectors web site.

I once had a student call me about a 120 unit complex that was vacant. It had been vacant for the last year. The owner of the property was talking about NOI and the cap rate and I asked the student, "How can they have Net Operating Income if it is vacant?" A vacant multi-family unit could be a great find, or it could be a nightmare. You must be extremely cautious when looking at a property that has had multiple vacancies for a long period of time. If it is less than pristine, it will be extremely hard to develop the "heat" necessary to get everything rented again. In order to value a property, it should be at least at 90% occupancy. If it is lower, you have a potentially large problem. (I also had him check with the building department to see if there were any code violations that needed to be cleared up before he could rent. Also, if a property is condemned, it is possible to have its multiple units zoning downgraded to single family, and not be able to have it upgraded again. Check it out before you buy.

My parents and family owned an RV park. We had the "super servant" mentality and we gave service above and beyond what anyone would expect. We slowly grew the business, and we gave all types of "extras" to our campers. During the winter months, we would typically have 120% occupancy. An RV park at the other end of town, that had much more capital and had much more expensive facilities started at about the same time, with the same number of partners. They went bankrupt while we succeeded. How? Because they hired minimum wage employees to do the work and they absentee managed it. Their employees didn't care about doing any "extras". They wanted to do the least amount of work necessary to avoid being fired. The same concept applies to a commercial property. Is it owner managed? Are they great managers? Or do they just care about sucking the money out of the property. If they are absentee managers, does the management team do a good job, or are they just doing the minimum necessary to get free rent. (The most expensive employee in the world is a manager receiving free rent. They have absolutely NO motivation to do anything.) Will you be managing the property? Do you really want to knock on doors and collect rent each month?

The most important aspect of a property is its location. With commercial properties, it is even more important than residential. Does the area have a high crime rate? Is it too close to the highway (or too far away?) Is it close enough to shopping? Is it on a busy road? Is it in a war zone? What is your impression of the area? Then get an objective opinion. If you get the "grimace" response to news that you are looking at a property in a certain area, you might want to reconsider.

A commercial appraisal is a wonderful thing, it is beautifully written, packed with all types of information and statistics on the area, and is usually irrelevant, as well as being expensive. There are no guarantees that people that have been renting will continue to rent. There are no guarantees that if you buy a strip mall that all of the tenants will stay in business, or stay with you. If you have an apartment complex, and the interest rates change, you could have a flood of renters becoming first time home buyers. In other words, nobody knows what the value of the property will be. The best way to artificially appreciate the property is to make it so much better, and provide so much more inherent value, that people would prefer to live in your units, rather than others.

To determine the value use the age old formula: Market value of the property= Net Operating income / cap rate. In other words, if the net operating income is 100,000 per year, with the cap rate being 10%, then the value of the property is $1,000,000 dollars.

There is no easier way to become a millionaire than to buy a commercial property and let the tenants pay the mortgage. There is also no easier way to become bankrupt than to purchase commercial property without having commercial property knowledge.

You have to take into consideration all of the above mentioned variables, and more, in order to adjust the price accurately. In other words, do your due diligence!