Top 10 Mistakes When Investing in Commercial Real Estate
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I regularly assist accredited investors in reviewing prospective commercial real estate investment opportunities as well as preparing investment opportunities and structuring commercial real estate projects on behalf of my clients.
As a result of my representation of real estate investors over the past 14 years, I have identified the top 10 mistakes made by investors in commercial real estate:
1. Just Looking at the Returns
I regularly have clients that bring in several investment opportunities for review and advice, and some automatically prefer the project with the highest ROI (return on investment) without looking at any other factors. As the four ways to make good money in real estate are cash flow, appreciation, equity growth and tax benefits, one can not afford to just look at returns. In addition, investors frequently just focus on ROI. Contrary to popular belief, ROE (return on equity) provides a better measure of the speed of wealth creation and the tax efficiency in doing so.
With regard to cash flow, one can work on decreasing expenses and/or increasing revenue. On the expense side, it is good to look at the maintenance costs, the management fees, and other expenses which cannot be passed through to the tenants and discuss possible ways to reduce these expenses. On the revenue side, it is good to explore whether the lease rate can be increased, what can be done to decrease vacancy rates, whether additional leasable space can be added and whether additional revenue streams can be added from cell phone tower leases or billboard leases on the property.
With regard to appreciation, as one has no control over the general market, it is helpful to review those areas of appreciation which can be controlled. If the property includes some vacant land or if the parking ratio is significantly higher than needed, is it possible to add a bank drive-thru, restaurant pad site or other development? If there is room to increase rental rates when tenants move out, then this is another factor that one can control which will positively impact appreciation.
With regard to equity growth, it is helpful to review the financing and understand if the mortgage payment is just interest or includes principal plus interest and what amortization schedule is being used to calculate the principal payment. The equity growth is best built by making principal and interest payments on the mortgage over a shorter amortization period. However, for cash flow purposes, a 25 or 30 year amortization may be used in lieu of 10 or 15 years.
With regard to tax benefits, investors not only receive the benefits of depreciation of the building and equipment, but may also receive interest deductions. On the flip side, investors may also sometimes receive what is called “phantom income”. Projects can generate phantom income when they create taxable income for investors without generating comparable cash flow, typically because all or part of the operating income is used to make principal payments, which, unlike most interest payments, are not tax-deductible. Thus, an investor will owe tax on this income, even though the investor isn’t receiving cash to help pay the tax. It is crucial to understand if “phantom income” is likely to be received in a specific project and what plans there are to mitigate this issue for the investors.
2. Not Understanding the Local Market
I recommend all investors not only visit the property personally, but also tour the neighborhood where the property is located. Prior to visiting the property, it is helpful to look at Google Earth or a similar program to see the property from above and look at the adjacent property uses as well as the larger neighborhood. Further, as property values are determined mainly by local market conditions such as rental rates, occupancy levels, demographic trends and competitive space supply, it is important to obtain some local demographic statistics such as (a) existing population; (b) projected population growth; (c) projected job growth; (d) average household income; and (e) median household income. Many cities or counties have an economic development authority or similar agency which collects this information and makes it readily available at a single place. Much of this information can also be obtained through the U.S. Census Bureau at http://www.census.gov/.
If the property is an office building, then we recommend potential investors to ask themselves if they would want their own company to have an office in the building. If “no”, then this may be an investment opportunity that you should avoid. If “yes”, then it is helpful to explicitly identify why. What about the building would attract you to have an office there? Is the location ideal? Is the access easy to get in and out of? Is there plenty of parking? Are there any other tenants in the building that use more than their proportionate share of parking spaces?
To the extent that this is not possible or practical to personally visit the property, then there are many real estate agents or property consultants throughout the country that are available to provide you with additional information about the demographics of the area as well as sources or industries for projected job growth, major employers in the locale, and household income information.
3. Not Underwriting the Sponsor of the Project
Just as important as understanding the local market and underwriting the property, one should also underwrite the sponsor. Here are some questions that should be asked: Who is putting the deal together? What experience do they have in doing similar deals and how did those previous deals turn out? Are any of their investors from previous deals investing in this new deal? Is the sponsor involved in any litigation? Have they been sued by any of their previous investors? A number of states have an online judiciary case search system that allows you to see if the sponsor is involved in any litigation. In addition, many states also have a Securities Division that permits searches to see if there have been any complaints filed and administrative actions against the sponsor.
4. Not Underwriting the Current Tenants
To the extent financial statements on the underlying tenants are available and have been provided, then it is helpful to review the financial well-being of the tenants. Frequently, financial statements are not available from the tenants. In this event, The Law Offices of Kirk Halpin & Associates, P.A. recommends compiling a chart categorizing tenants of the building by industry, such as information technology, medical, non-profit, manufacturing, education, government contracting or real estate, etc. To the extent that a substantial portion of the building is leased to tenants in one industry, then a down turn in that industry could have devastating results on the returns.
To the extent that one wants to obtain additional information about the tenants, reviewing their respective websites is helpful, but there are also a number of companies that collect information about small and mid-sized businesses such as http://www.manta.com/ or http://www.dnb.com/us/. Keep in mind that some of these business owners may self-report information so the reliability or credibility of this information should be treated accordingly.
The other key is to review the rent roll to determine when various leases expire. To the extent that many leases expire within a few months of each other, then it should be anticipated that it may take a while to replace the tenants and restore cash flow. There need to be assumptions in the pro forma of lease marketing down-time and time needed for a new tenant to fit out its space before it begins paying rent. Obviously, it is ideal if the expiration dates of major leases (i.e. representing more than 10% of the space in the building) don’t lapse in the same year.
Also, it is crucial to determine whether there are any personal guaranties of the leases from the principals of the companies that are tenants in the building.
5. Being Over-Leveraged
Several years ago, it seemed that a property would appraise for the purchase price without many questions asked, and then some banks would loan 85% to 90% of the purchase price of the property based upon the appraisal. Many sponsors did not contemplate a down-turn in the market and expected the property to continue appreciating such that it would be easy to refinance the property when the loan matured. In addition, many loan documents contain covenants with the lender which require a certain loan-to-value ratio and provide the lender with the right to obtain an appraisal on an annual basis. To the extent that a new appraisal shows that the value of the property has decreased, then this could require a large principal payment from the sponsor and/or investors in order to maintain the loan-to-value ratio. This same issue presents itself at the time the original loan matures.
To the extent that the sponsor purchases a property for $10 million and raises $1.5 million from investors and borrows $8.5 million, then the property has an 85% leverage based upon the purchase price. If the bank orders a new appraisal which shows the value of the property now being $9 million and the loan documents require the borrower to not exceed an 85% loan-to-value ratio, then the sponsor and/or investors would be required to make an $850,000 principal curtailment to reduce the outstanding principal to no more than $7.65 million.
To the extent that the same sponsor initially raised $2.5 million and borrowed $7.5 million, then the property would have had a 75% leverage based upon the purchase price. If the new appraisal showed the value being $9 million and the loan documents required the borrower to not exceed an 85% loan-to-value ratio, then the sponsor and/or investors would not be required to contribute any additional funds.
6. Not Asking Questions About Where Additional Cash, If Needed, Would Come From
Based upon the mistake in #5 above, it is possible and even likely that additional cash will be needed especially if the property is over-leveraged. However, even if a property is not over-leveraged, there may be additional cash needs if one of the lead tenants vacates the property early. It is extremely important to understand from the operating agreement or partnership agreement whether cash-shortfalls come from the sponsor and/or the investors.
To the extent that the corporate documents provide that cash shortfalls come from only the sponsor, then it is crucial to understand the sponsor’s ability to cover cash shortfalls, understand how this may change the return to the investors, and ask “what if” questions about what happens if the sponsor doesn’t or can’t cover a cash shortfall. To the extent that the sponsor contributes additional cash based upon a shortfall, then this may provide that the sponsor will receive a priority return before the investors.
To the extent that the corporate documents provide that cash shortfalls come from both the sponsor and the investors, then it is crucial to understand (a) what happens to the extent that an investor doesn’t contribute additional cash; (b) if there are any caps on the amount of additional cash required from the sponsor and/or investors; and (c) what happens globally to the property to the extent that additional cash is needed beyond any cap and not contributed.
The operating agreement or partnership agreement may provide that an investor’s ownership interest in the property is diluted to the extent that additional cash is not contributed or it may provide that the additional cash may be contributed by another investor on behalf of the non-contributing investor and the additional cash may be treated as a loan at 18% to 24% interest. Typically, if it is treated as a loan, then the investor who contributed cash on behalf of the non-contributing investor is ensured that before any future distributions are made to the non-contributing investor the loan plus interest is repaid in full.
7. Not reviewing the underlying documents
Based upon the mistake in #6 above, it is important to review the operating agreement or partnership agreement and understand the additional cash requirements. Typically, there is an executive summary which provides a general overview, however it is important to thoroughly review all of the underlying documents.
The operating agreement or partnership agreement is probably most important, followed by the commitment letter from the bank providing financing, and then the leases, rent roll and pro forma. With regard to the operating agreement or partnership agreement, it is also important to ensure that there is a good buy/sell provision included that protects you to the extent that there is a problem partner that needs to be bought out. The Law Offices of Kirk Halpin & Associates, P.A. recommends that this provision be structured such that any partner after a certain date can provide any other partner with a price per share/interest to purchase and that other partner is either required to sell at that price or has a right to purchase the shares/interest from the initial partner at the offering price. This seems to better ensure that all partners are treated fairly with regard to being bought out of the partnership or membership structure.
Also, it is crucial to review the key business terms of the underlying leases of the property (i.e. rental rate, term, early termination options), and verify that they match the rent roll and in turn match the pro forma. The Law Offices of Kirk Halpin & Associates, P.A. recently discovered on behalf of a client during its due diligence review that the lease agreement with a lead tenant provided that the tenant was not required to pay rent during the month of August every year. This was not factored into the rent roll and dramatically changed the pro forma.
8. Not Understanding the Risks
As part of the private placement memorandum which is typically used to raise funds from investors, it is required that the sponsor disclose “risk factors” to the potential investors. It is extremely important to not only review the “risk factors”, but also understand the risks of this type of investment. For example, all things being equal, the risk of investing in a property where there are only a few tenants is much different than investing in a property where there are 10-15 tenants.
9. Not Challenging the Underlying Assumptions and Asking “What If” Questions
Obviously, if someone has taken the time to put together a pro forma and has projected various returns, then there are assumptions that they had made. Remember that this is a marketing tool, and rarely will one see a pro forma that does not look good to amazing. However, it is crucial to review the underlying assumptions and verify the validity of these assumptions and then ask questions about how the pro forma would be impacted if these assumptions are not valid. For example, if one is investing in a multi-tenanted office building, what is the projected leasing down time to find a new tenant and what is the projected build out time once the lease is signed? It is equally important to look at the vacancy rates in the surrounding area in the same product type and price point and determine what makes this building unique and why it may lease when other buildings may not be leasing. To the extent that the pro forma assumes 3 months of leasing down-time and 1 month of build-out, what happens to the pro forma if the leasing down-time is 6 months or 1 year?
10. Failing to Hire the Right Professionals
All of these mistakes can be prevented by working with an attorney who really understands the legal issues that investors may face when investing in commercial real estate or participating in joint ventures. Taking the time to find a lawyer who understands the risks of investing and can help minimize these risks is one of the best investments you will ever make.
At the Law Offices of Kirk Halpin & Associates, P.A., our experienced lawyers are committed to providing each client with the personalized attention and counsel that is necessary to help potential investors review investment opportunities. In addition, our skilled attorneys are leaders in the Maryland legal community, and they stand ready to assist you with reviewing a potential investment, structuring investments, providing assistance for real estate, development, leasing, construction, zoning, and a myriad of other legal needs.