How can I evaluate an off market potential commercial investment?

Question

Hello,

I am a new investor looking to make my first commercial RE investment.  After working with an agent of a little over a year, I have been unable to find a suitable investment property as most in my area are which are listed are overpriced for investment.  I am now looking at off market properties and still have a commercial agent  who can get information for me.  That said, I'd like to evaluate properties myself.  Any advice regarding resources to evaluate and assess the value of a prospective property would be appreciated.  I've looked at the calculators on Bigger Pockets but they all seem geared towards properties that are listed and/or already have a selling price.

Thanks,Eric

Ellie Perlman · Answer

The key is to know the comps in your area and the cap rates, for a marketed deal as well as an off-market one. There are market reports such as the CBRE one, though it tell you the general cap rate in the market (vs the sub market), but it's a good place to start. https://www.cbre.us/research-and-reports/North-Ame...

You can also ask the broker for a sale comps, but you must do your own due diligence - trust but verified. I use CoStar to provide me with that info, but even that tool is not perfect. After a while, you will know the area cap rate, and that will help you to at least vet the deals initially.

Henri Meli · Answer

Agree with @Matt Engle . Commercial Real Estate, you need to get the income data.  There are diffent types of commercial real estate. Multi family? Office building? Retail? Mixed use? Storage? ... etc.

For the expenses, a rule of thumb is usually to use a minimum of 50% of the income as expenses. Even if the seller provides you with expenses, if they are below 50% of income, just use the 50% number to be safe.

Good Luck.

Theo Hicks · Answer

Make sure that when you underwrite the deal, you are creating a pro forma for the entire hold period and not just for one year. Most basic financial calculators only account for one year, which is a no-no for commercial properties (assuming you mean multifamily)

John Gilles · Answer

@Kirt Sangha I am a real estate appraiser Southern California. I mainly appraise single-family homes in Orange County and apartment buildings in Los Angeles County. There are many factors that will go into your development deal. Some of which I would be familiar with and some of which I would not.

First, you said this property is in Los Angeles, but it would be important to know if that means the city of Los Angeles or the area of Los Angeles. Assuming you are in the city of Los Angeles, you would need to look at the zoning Development Standards for a property in the R3 zone. I can tell you that the minimum site area per dwelling unit is 800 SF, which on a 49,000 SF lot, would allow for approximately 61 units. However, there is also a height limitation in the R3 zone, which I believe is 45 feet. Also, @Wren Martin noted, you will be required to have adequate parking. In the R3 zone, any unit with more than three habitable rooms (1 Bed = 3 Rooms; 2 Bed = 4 Rooms; etc) would require two parking spaces. Based on your number of units (46), you would need 92 parking spaces, which would likely need to be underground, thus adding significantly to the cost. You would also need to meet minimum front, side and rear setbacks.

Now, let's look at some of the building numbers. I don't know building costs, so I will go with the numbers provided by @Wren Martin. He suggested costs of approximately $380 - $560 PSF. Let's go with a middle number of $475 PSF. If you have 46 two-bedroom apartments at 800 SF per unit, you will have 36,800 SF of GBA (Gross Building Area). Multiply the GBA by the cost per SF ($475) and you get construction costs of $17,480,000. Remember, this number may not include the underground parking. Adding the building costs to the land acquisition costs and you are looking at just under $19,000,000. Let's say, for example, that you can actually build for $250 PSF, that would lower you total construction costs to $9,200,000. As you can see, knowing you cost of construction is extremely important in determining your basis.

Lastly, let's talk a little about Cap rates. Over the past couple years, Cap rates generally range from the low 3% to the high 5% in the city of Los Angeles. One of the reasons that cap rates are so low in our area, is that there is a shortage of housing and vacancies are very low. Cap rates are effected by many factors, including location, market spread (difference between actual income and pro forma income), expense ratios, vacancy, and so on. Also, in the city of Los Angeles, any building built prior to 1978 is under rent control, which will also have an impact on the Cap. A Cap rate is really a reflection of the risk to the investor. Lower risk = lower cap rate, higher risk = higher cap rate. As an example, in a rent-controlled building with large market spread (long-term, low rent tenant vs market rate tenant) you will have a lower cap rate because there is less risk that the long-term tenants will be moving. On the other side, if your building (rent-controlled or non-rent controlled) is full of tenants paying market rents, there is some risk to the cash flows, as a downturn in the economy could encourage your market rent paying tenants to look for cheaper rent somewhere else.

In your scenario, a new building full of market rent tenants would have a higher cap rate than a nearby building that is full of tenants paying below market levels. You will also be dealing with the time it takes to complete construction and to stabilize (fully rent out ) the units. With 46 units and using a cap rate of 5.0% and expenses of 35%, you would need to be able to achieve $2,650/unit per month, just to break even on your $19,000,000 investment. Using the same cap rate and expenses, rental income of $2,000/unit would result in a valuation of $14,350,000 and rental income of $1,750/unit would be valued at $12,558,000.

You really need to iron out the cost of construction and realistically achievable rents.

Good Luck,

John

Michaela G. · Answer

@Wren Martin, thank you, thank you, thank you! Awesome information.

Wren Martin · Answer

@Kirt Sangha development projects are probably the most risky of all places for a new investor to start.  There are so many lessons learned on every development project that even those of us who've completed several will learn something new on every project... sometimes very painfully.

California adds another level of complexity to the equation. Just getting the water permit in some municipalities can take the better part of a year to work thru the entire process.  We recently completed a small (2) story office building in Newport Beach and it took over 3 years for the entitlement process; admittedly Newport Beach might be at the extreme but you need to research how long it will take for everything in your area; I would estimate at least 18 months no matter where you are.

The actual construction timeline might be 10 - 12 months so added altogether you could be close to 3 years after you purchase the (3) houses before you execute your first lease.  This means your investor is going to need to have some very patient money.  Most investors I deal with want to see some kind of return in 12 - 18 months.  This also means you will need to be able to support yourself during this same timeline as there will only be funds going out, nothing coming in, and it will require almost full time attention to push it thru as quickly as possible.

To answer your question as to all in cost is kind of difficult since so many factors will affect the cost of construction but a rough PSF budgetary number used for a typical stick built apartment building in my area could be  $380 - $560 PSF subject to number of floors and level of finish required.  To achieve $250 more in monthly rent per unit than your competitor you will be on the high end side of the finishes / cost.

(46) units is pretty dense for the amount of land you're assembling.  I assume you will require at least (3) floors to reach the (46) units which implies you will need/want at least (1) elevator.

Then you need to figure out if you can provide enough parking for that many units.  You should have min. (1) parking stall per unit but the higher rents might require at least (2)... I know there is a lot of talk that people are moving away from cars and parking will not be an issue in the future.  While this may be true you still need to plan for parking just in case we don't get rid of our cars as quickly as some people think.

You also need to consider storm water.  Any water that lands on your property from future rains must stay on your property... at least in most of the muni's I'm familiar with in CA.  You'll need to design your landscaping and parking lot to collect this water and more than likely run it underground since you don't have a lot of excess land available to construct retention ponds.  The underground storage tanks are very, very expensive.

If I were in your shoes and was starting out with an Investor who had enough money for me to consider assembling properties that cost $1.5m pre-demo. I would do one or two existing, operating property acquisitions first to get some experience and to generate some reliable income to support the future development project.  I'm sure there are some great, emerging markets in middle america where that amount of capital could purchase a well performing asset that wouldn't require such as steep learning curve as a new development project might.

Best of Luck!

Wren Martin · Answer

@Eric Thornton as has been mentioned by @Matt Engle, @Theo Hicks, @Ellie Perlman, @Omar Khan, @Jeff Kehl, and @Henri Meli, there are subtle differences between asset classes in CRE that need to be considered when underwriting a potential deal.

But the basics of Income - Expenses = NOI divided by the current market CAP rate will give you a ball park estimate of what it could be worth, all things being equal.  Of course all things are not equal and you'll fine tune your opinion, or rather you will verify your opinion during the due diligence process.

For instance, if we analyzed @Michaela G.'s small Georgia retail property and determined that after some minor exterior rehab she would be able to negotiate NNN leases, meaning the tenant pays all expenses, with (4) local service retail business at $1,400, $1,300, $1,200, and $1,100 per month each, making a total monthly income of $5,000 or $60,000 per year net to landlord.  We would basically have the Income and Expense totals we need to do a quickie, back of the napkin analysis.

If we then determined the local market CAP rate for small retail properties was 8%  we would estimate the rough value of her property to be $750,000.00.  ($60k NOI / .08 CAP = $750k) Of course there are almost always some expenses that need to be included in the analysis even on NNN properties, but that's easy enough to subtract before NOI.

However, the market CAP for small retail properties in Georgia may currently be 6% in which case the rough estimate of value would be $1,000,000.00. ($60k NOI / .06 CAP = $1m)

And before @Michaela G. can pay $750k or $1m for that vacant property she needs to determine exactly what it will cost to fix it up enough to attract the (4) tenants.   She also needs to determine what the anticipated starting rent will be for each suite to make sure there is enough potential future income to justify the investment.  And she needs to determine if there are at least (4) potential tenants available in her area that will want to operate future business at her property, and if those (4) business will work good together to attract the right kind of customer for each other's benefit.

She will have already determined the building had great visibility from the street; that there was plenty of parking for both tenants and their anticipated customers; that ingress and egress onto the property would be easy and safe; and that future customers could easily find the building when they're ready to come spend some of their hard earned dollars.

The good news about small retail properties is the tenant improvements (TI's) are usually minimal and often times the tenant can perform the work themselves.  @Michaela G. will focus most of her initial rehab investment on the exterior to make the property becomes a very attractive place where local business will want to re-locate and can see themselves succeeding there long term, often (10) years or longer.  She will of course set aside $3-$7 per SF for carpet and paint on the interior but anything more than that will be at the cost of the tenant or at least amortized over the term of the lease if she wants to lend them the funds for their TI's.  She will also set aside 5%-8% of each lease total value to pay Broker commissions, to help make sure she attracts the best possible tenants in her marketplace.

@Michaela G. will want to make sure the roof, and HVAC equipment are always maintained in top shape with annual inspections and service contracts.   She'll maintain the landscaping with weekly service to keep it looking just right.  She'll hire a Porter service to visit the property every day to sweep sidewalks, remove litter and debris as needed, and generally keep the property nice and clean.  She'll hire a window washer to come clean at least 3 times a year and after every storm.  She'll contract with a waste management company to provide a large dumpster at the rear of the property for tenant use which will be serviced 1 or 2 times per week depending on how much trash the tenants generate.  All of these costs (and several not mentioned) will be pooled together into the Common Area Maintenance or CAM which will be charged back to each tenant on a prorata basis per rentable square foot (RSF) or some other means of calculating as may be negotiated in the lease.  @Michaela G. will add a small management fee of 6%-8% to the CAM to compensate her for the effort of organizing all the services required to keep this small retail property a place where her (4) tenants business' can thrive for many years.

@Eric Thornton Your analysis will be exactly the same for an off market opportunity as one that is listed on market.  If you're using one of the calculators just input hypothetical purchase amounts to see what they look like... play the "What If" game.  "What if I could buy it for $680K?"...  "What if they would only sell it for $1.2m?"

Take all the experience you've gained looking at and analyzing all the too expensive deals this past year to help you recognize your great deal when you finally uncover it.  Dolf DeRoos says you need to look at (100) potential deals, make offers on (10), to buy (1).  The ratios don't need to be exact but by the time you've looked at enough deals to make (10) real offers you will know for sure that the (1) you purchase will be a great deal for you.

Best of luck!

Kirt Sangha · Answer

I am located in Los Angeles, R3 would be considered multi-family. The neighbors complex which is 23 units is also R3. I just don't know the whole process of developing the land into units to see if it will be profitable.

Michaela G. · Answer

I don't know where you are, but in Atlanta R3 means single family home with a minimum of 2 acres per lot. 1 acre is 44,000sqf, so you have a little over 1 acre. So, technically, having 2 SFR on that propery makes them non-conforming, as it's only zoned for 1 SFR.  Nevertheless, if the zoning is sfr, you wouldn't be able to build a multi-unit on the property.

But maybe R3 means something else in your area.

How can I evaluate an off market potential commercial investment?

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