five mistakes to avoid as a commercial real estate investor

Volume 161, No. 140

Copyright © 2015 Law Bulletin Publishing Company. All rights reserved. Reprinted with permission from Law Bulletin Publishing Company.

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Five mistakes to avoid as acommercial real estate investorFollowing several years of

a stagnant commercialreal estate market dur-ing the Great Recession,commercial real estate

investment is once again popularand, if executed properly, prof-i t a b l e.

In commercial real estate, thereis a right way and a wrong way todo most things. And in my 15years of practice, I have had theprivilege of working with hun-dreds of real estate investors.

From that experience, here arejust a few reminders, for accom-plished investors and newbiesalike, of a few pitfalls to avoid inany potential commercial real es-tate investment.

Going it aloneEven the most seasoned com-

mercial real estate investor willneed the assistance from variousprofessionals in order to not onlylocate and evaluate the appropri-ate property to acquire but toprotect the investor’s interestsfrom a legal standpoint. The ser-vices of brokers, attorneys, ac-countants and other professionalsare usually considered to be crit-ical to the investor’s commercialreal estate success.

For example, the drafting andnegotiation of the purchase andsale agreement is not a time tocut corners.

I’ve seen the most veteran realestate investors attempt to nego-tiate their own contract withoutlegal counsel — only to find afterthe closing that they have in-creased costs and liability due to apoorly negotiated and drafted doc-ument.

Financial-analysis figuresRewinding the process to before

the contract stage of the trans-action, an investor should ensurethat “the numbers” meet their in-tended goals.

Unlike residential real estate,where a property’s value is gen-erally based on neighboring prop-

erty values, or “co m p s ,” commer -cial real estate involves a complexfinancial analysis process to ac-curately assess its viability andpotential to meet the financialgoals of the investor.

In large part, what the com-mercial real estate investor is pur-chasing in a property is that prop-e r ty ’s cash flow. The same prop-e r ty ’s appreciation, loan amorti-zation and tax shelter character-istics are also extremely impor-tant and should be carefully an-alyzed.

Although there are dozens offinancial measures which can, ifcalculated properly, provide atreasure trove of informationabout a property to an investor,two of the most commonly utilizedmeasures are capitalization rates(cap rates) and internal rates ofre t u r n .

Cap rates express the ratio be-tween a property’s net operatingincome and its value. An internalrate of return is the metric ofchoice for savvy investors becauseit also takes into account the tim-ing and size of cash flows and salep ro ce e d s .

A caution to an investor, how-ever, is to be aware that in orderto calculate exacting financialmetrics for the complete analysisof a property, accurate figures(such as gross scheduled income,vacancy allowances, operating ex-penses, etc.) must be employed toavoid a “garbage in/garbage out”calculation result.

Oftentimes, a property sellerwill use pro forma figures in theoffering package and base theasking price off of such figures

rather than actual numbers.In short, pro forma figures rep-

resent what “co u l d ” be achievedwith the property if ideal condi-tions were met (e.g., increasedrents, lower vacancies, etc.). It isnever recommended to exclusivelyuse the seller’s figures in youranalysis — and certainly not proforma figures.

Do your due diligenceAnother significant difference

between residential and commer-cial transactions is that the ma-jority of commercial transactionsare on an “as is/where is basis,”but will give the buyer a free “kickof the tires” during the time gen-erally referred to as the “due dili-gence period.”

An investor’s due diligence pro-cess is extremely important, andthis time should be used wiselyand with the partnership of the

i nve s t o r ’s team members.This is the time for confirming

income calculations, reviewingleases and other documents pro-vided by the seller, confirmingzoning and development require-ments and conducting building in-spections and environmental siteassessments.

There is no substitute for care-ful scrutiny of the financial pre-sentation of a property and itsphysical characteristics.

D o n’t get emotionalFirst and foremost, an investor

should never make a decision tobuy, hold or sell a property basedon emotional factors — it shouldbe about the numbers.

As discussed above, due dili-gence is crucial, even if the in-vestor has to renegotiate at theend of the period or, more com-monly, terminates the transactionaltogether based on the results.

It is difficult to walk away froma potential property after spend-ing significant time and money inits analysis, however, it will hap-pen — and walking away some-times is the smartest move aninvestor makes.

After the deal closesBefore popping the champagne

cork and celebrating a successfulclosing, an investor should havean exit strategy for the invest-ment.

Perhaps the goal is to hold onfor a 10-year period and to achievea 15 percent internal rate of re-turn. It may be the property is avalue-add play to rehab and flip orconvert to condos.

No matter what the strategy,there needs to at least be somestrategy and a prudent investorshould continually re-evaluate theproperty during ownership.

If there is an alternate invest-ment opportunity that could gen-erate higher returns than the cur-rent investment, then the originalexit plan may need to be recon-s i d e re d .

THE REal DEAL

K. SH AY L A NBA L DW I N

K. Shaylan Baldwin, principal at Chuhak& Tecson P.C., focuses his legal practiceon commercial real estate transactions ofall kinds. He represents corporations,middle-market developers and privatelyheld companies nationwide for acquisitionsand dispositions involving farmland,office buildings, retail strip centers andother properties in a broad range of buysand sells. Shay can be reached at312-855-5441 or sbaldwin@chuhak.com.

It is never recommended to exclusivelyuse the seller’s figures in your analysis —

and certainly not pro forma figures.