Evaluating the Property
In this article we discuss how to evaluate a commercial real estate property.
The ability to assess a particular property’s potential lies at the core of your real estate investment activity. While analyzing a particular property in the portfolio of the fund you are looking at, no matter the vehicle you’re considering, try to look at both the current state of the property and its future income generation potential.
First of all, look into the property description in general. Ideally you would like to see a brief but full property description. This includes key characteristics of the real estate asset like age, last renovation date, number of units/bedrooms and/or the size of the property in square feet, unit mix, tenant mix, main amenities, and unique selling points. If after reading the property description you still have questions in relation to what this asset possesses, this is a yellow flag.
Make sure the manager isn’t hiding anything. A well-written property description is meant to give a true full picture of the asset in question and push you into the purchase. The description should be brief, professional, clear, concise, thorough, and detailed, with no generic text present.
Depending on whether the investment strategy includes a renovation budget, you expect the property in a good condition. The newer the property, usually the higher the price per square foot although some older properties are so well maintained that there is not much of a difference between them and much newer ones.
You must be provided with a list of historical renovations including the cost and dates the renovations were performed. This way you will be able to judge current physical state of the property and evaluate the underwritten capital budget for the investment period.
The demand for property amenities is always evolving. The amenities are especially important in multitenant commercial properties where common areas should be maintained as the tenants will not be able to adjust amenities on an individual level. In an office building for example the most sought-after amenities would be availability of conference spaces, easy access to parking and transportation, outdoor spaces, dining options, fully equipped fitness center and on-site retail.
In residential properties tenants want some outdoor space as a terrace or balcony, storage space, laundry and walking-distance retail space, and availability of a parking space especially off-street is particularly important.
In multifamily properties for example the unit mix matters a great deal. However, the right unit mix depends on the building itself, the market, location and current tenant preferences. Do people in the area prefer a singles lifestyle or are they creating households? Are people getting married more often or applying for divorce? What is the birthrate in the area? What is the earnings potential?
Due to recent demographic trends, newly developed multifamily properties are 90% either studio or one-bedroom apartments, although this really depends on the current market. Try to identify what people need today and will need in the next 5 to 10 years.
As for office property on the other hand, tenant mix and tenant quality are of high importance. Tenant quality refers to the credit worthiness, stability and number of tenants occupying the space. For example, you have been pitched a property that is 100% occupied with the leases secured for the next 10 years. If the quality of these tenants is low, the probability of these tenants partially or fully defaulting on their lease payments is much higher than with high-quality tenants. Tenants of high quality have a built recognition in the international or local market and high credit rating.
As a rule, large national or international tenants, say Facebook or Amazon, are considered highly desirable and of a lower risk of default than recently established start-ups. To evaluate the tenant quality in a residential property, assess tenants’ criminal and/or credit issues. In a retail property, the tenant mix is very strategically set. Any shopping center manager wants to have for instance Zara or H&M (or Dior and Michael Kors, if the mall positions itself as luxurious) as tenants. These are anchor tenants in the retail facility. Every shopping center must have a few anchor tenants. The purpose of anchor tenants is to drive most traffic to the mall. These tenants usually have the best lease terms.
Finally, see if the commercial property is properly diversified in tenant concentration. On the rent roll you should expect to see a few tenants, with none of them occupying a larger part of the building and lease expirations not concentrated in one single year. The amount of diversification of course depends on the size of the property; it is easier to diversify larger properties.
For example, you are considering a property with 100 tenants in place and none of them occupying more than 3% of the rental space. This is a very well-diversified property, because the moment the largest tenant leaves 97% of the income is still safe. However, if you are considering a property with 100 tenants but the largest tenant occupies 30% of the rentable area, this is a low-diversified building and the moment the largest tenant leaves the premises you will lose 30% of the rental income.
Single-tenant buildings are not that simple, however. If you are looking at a property that’s 100% occupied with a single tenant and the lease is secured for the next 10 years, all looks good. What if this single tenant defaults on the lease payments somewhere in the middle of the holding period? The rental income on the property goes down to 0%. Thus, when considering investing in a single-tenant property, make sure the tenant in place is highly stable financially or they have a sufficient rental guarantee or deposit clearly stated in their lease agreement. Deposits are usually paid at the beginning of the lease term and equal to 1 – 2 months of rent.
Ideally you should be interested in looking at in-place lease agreements for the tenants mentioned in the asset description. If you trust a sponsor, make sure they did this for you or are planning to as part of a full due diligence process. Initially though you should skip through the rent roll for the property which must be shared with you. If they do not share a rent roll straight away, request one. While analyzing a rent roll look at the following:
1. When analyzing therollover on the property, the lease end dates should be staggered, meaning that not many lease ends happen on the same date. This prevents the possibility of a high vacancy rate overnight.
2. Lease Term Composition. On the one hand, fixed lease terms means stability of your future cash flow. On the other hand, if the leases are locked on fixed terms for the next 5 years, this would prevent you from taking advantage of growing rents in the market. If there are break options allowing tenants to break the terms of the lease before the expiry date, you should get a discount for these leases as they are treated as shorter term. You cannot afford to overpay for rent that’s not guaranteed, although this is the strategy for when a property includes replacement of leases. The in-place break options will be very helpful. Nonetheless, if you want to invest in repositioning the property you must pay less for it, thus negotiating a discount for every break option.
3. Fixed Rents have the same effect as fixed lease terms. During market shift periods, property rents stay stable. During downturns this is a good thing as when the market rates go down tenants still have to pay higher rate. This on the other hand bring up an issue of unaffordability meaning the higher the gap between the market rent and the rent required from the tenant, the higher the probability of this tenant defaulting on the rent payment. Some tenants have agreed to rent increases which are a good thing and means your cash flow is guaranteed to increase with time. Any rental increases will be included in the Proforma income, so you will pay for it in advance.