Six things to consider when purchasing investment real estate

So, you’re sitting on a pile of cash like Warren Buffett because nobody won the March Madness Bracket Challenge, trying to decide where to invest next. You like the idea of owning an income-producing piece of commercial real estate where you collect a rent check each month, receive a pre-determined return on your initial investment and don’t have much responsibility. Simple, right? However, there are a number of variables to consider when you’re evaluating a commercial real estate investment offering. Performing the analysis ahead of time could be the difference between spending January hanging out on your new yacht down in the Caribbean versus shoveling snow off the roof at 2 am in a -20oF Nor’easter. Does that get your attention? It’s more important than ever to think about now, as demand for Maine investment properties has increased dramatically over the past couple years. Driven in part by historically low interest rates, investment properties in Maine -long considered a secondary or tertiary market by national standards- have gained attention on the national scene as investors search for higher yields and/or safe bets. In many cases, you won’t have a lot of time to decide whether a property is the right fit for you. By the time you finish your evaluation, it is under contract with another buyer who knew what they were looking for ahead of time and were in a position to make a quick decision. Here are six important things to consider before signing on that dotted line:

1. What type of Property do you like?

What’s your pleasure? Options include single tenant retail buildings with national credit tenants, strip malls with multiple tenants, medical buildings leased to hospitals, industrial buildings, multi-unit apartments, leased land with a building…the list goes on. Much like Dairy Queen, there are a number of flavors in commercial real estate. Some investors will declare they don’t care what type of property it is as long as it has a good long-term lease. However, I typically advise a buyer to consider a couple of questions:

• What do you know about the tenant’s industry? Is it a dying, stable, or growing industry? For instance, would you purchase a single-tenant Best Buy versus a Walgreens? An Advance Auto versus a Starbucks? How do you view these industries? How does Wall Street? If you’re financing the deal, what does the bank think?
• What other types of property do you have in your portfolio, if any? Should you diversify into other property classes or are you comfortable in that asset class because it’s what you know?

2. What is the lease rate?

The first variable I always look at is the lease rate the tenant is paying. Is it a market rent? What is the “go dark” scenario (if your tenant vacates)? Will you be able to replace the tenant with one paying a comparable rent? When looking at single-tenant investment properties, this is particularly important. For instance, drug stores like Walgreens, CVS and Rite Aid will pay $25/SF NNN or more for the right location. If they vacate the property, will you be able to get the next tenant in to pay the same rate? If not, you could be upside-down in the deal. When looking at national credit deals, I like deals where the lease rate is close to market. Tractor Supply Company (TSC) offerings are typically good examples. When doing their deals through the last economic downturn, TSC was vigilant about paying at-or-below market lease rates (even in new construction). Subsequently, as these were sold to investors, banks liked the underlying real estate fundamentals, which made for smooth, lower-risk transactions for all involved.

3. Who pays the expenses for the Property?

Is the lease “triple-net”, “double-net” or some other variation? Who is responsible for capital items like roof, structure and the HVAC system? If the property has a lot of deferred maintenance, you may be writing a big check in the coming years. Conversely, if the property has been well maintained this could be money in your pocket (and maybe a down payment on that yacht).

4. Where is the Property located?

There are investment offerings all over Maine, the northeast, and the entire USA. Ask yourself if you really want to be actively involved in the management of the investment. I love to tell the story of a friend who purchased a multi-tenanted retail location in southern Maine, an hour away from his home. It was his first commercial property. A couple months later I asked how things were going. He groaned, and told me of how he’d been on the roof the previous night, shoveling a couple feet of snow off the roof to prevent a collapse while his kids were in the car. He wished he’d purchased a property closer to home. Every time there is a problem, he has to drive an hour to address it. If you are considering a property any more than 30 minutes away from your residence, make sure you either (1) are committed to addressing property management issues as they arise; or (2) have staff or a professional property manager assigned to the property. Also, make sure you budget for a manager in the pro forma. This is often overlooked in the buyer evaluation to make the numbers work. The buyer will typically regret this later. The other side of the location coin is you should be willing to consider locations outside of southern Maine. Often, investors tell me they want an investment property in the Portland area. I always ask why. Typically, there will be a lot more interest and competition for decent investment product in Portland and the surrounding area. Willingness to consider markets such as Lewiston/Auburn, Bangor, the Midcoast and greater Augusta will open up a variety of options with stable tenants and attractive returns.

5. Who is the Tenant?

Recently, I sold an investment property that was outside of the investor’s area of expertise and geographic bailiwick. When his attorney asked him why he was purchasing the property, he said “I’m buying the tenant, not the real estate”. While an outwardly solid tenant is important, you need to ask yourself questions such as: Is there any chance the tenant might leave? Is the facility “mission-critical”? What is the tenant’s credit like? Years ago, I received a call from a distressed customer who had recently purchased their first investment property through another agency. It was a retail building with a ten-year lease in place and seemed like a solid investment. However, the owners never received a rent payment and the tenant filed for bankruptcy within 30 days of the closing. The owners needed some guidance on what to do next. I sometimes think back on this couple and wonder how much due diligence they did on the tenant, and what they had been told prior to the purchase. A little sleuthing and a lot of questions will go a long way towards purchasing that yacht in the future.

6. What are your Financial Constraints?

Everyone is guilty of it sometimes: Our eyes are bigger than our checkbooks. While lending standards are loosening, lenders still want a 70% to 75% Loan-To-Value (LTV) on investment deals, and even higher equity requirements on non-recourse deals (yes, there is non-recourse money available again!) You need to keep this in mind as you evaluate opportunities. How much do you have to spend? Can you put more cash in the deal if the appraisal is short? How much risk are you willing to take? Are you a stability versus a value-add buyer? How much return do you need to make on your initial investment?

Everyone wants a 10% cap or better. And I want to be taller with a full head of hair! Accept the realities of the market. What is an acceptable return given the current competitive environment?

One final thought is you may want to consider the idea of partnering with other investors to spread risk and make your dollar go farther. This is a highly personal decision. In some situations it’s true that “partners are for dancing”. However, there are times where you might not be able to accomplish a purchase or have the gumption to follow thru without a financial partner. Sometimes another person looking at a deal may notice a critical detail you overlooked. And you should always talk to a competent broker to assist you as you evaluate properties. If you’re in the market to buy or sell a commercial real estate investment, we’d love the opportunity to speak with you and help understand your goals and what’s important to you.