Discover 3 risk factors you MUST know when evaluating any potential commercial investment. Learn why these risk factors are so important, how to calculate them and how to apply this knowledge to your own deals so that you can mitigate your risks.
Mitigate the Risks of Commercial Investing
Watch a NASCAR race and there are several comparisons between NASCAR racing and commercial real estate investing. Both are exhilarating, fun and rewarding, but in both there is risk. NASCAR drivers mitigate the risks in the race by implementing these three strategies:
- They have a professional pit team of mechanics and engineers.
- They practice at racing speed.
- They know the track inside and out.
Likewise, in commercial real estate we have similar strategies that help investors mitigate the risks:
- We work with a proven team.
- We practice with real deals and real numbers.
- We know our markets extremely well and know all the trends.
At Commercial Property Advisors, we teach these three risk mitigation strategies to our protégé students. They are foundational in this business, however they are just the beginning. When you are evaluating any commercial investment, there are 3 incredibly important risk factors you must know. In fact, they are so crucial to building a successful deal that I recommend you abandon any deal where the risk analysis for these 3 factors hasn’t been done.
Warning! DO NOT move forward with a deal until you evaluate these 3 risk factors:
- Determine what your debt coverage ratio is.
- Know your exit cap rate.
- Calculate your breakeven occupancy point.
Risk Factor #1: Debt Coverage Ratio (DCR)
You must calculate the DCR of every commercial deal. The debt coverage ratio measures the ability to pay the property’s mortgage payments and expenses from the income generated from the property. The DCR is calculated by dividing the annual net operating income (your income minus your expenses) by the annual mortgage payments.
Calculate the Risk:
For example, if you have an NOI of $50,000 and annual mortgage payments of $40,000, the formula will look like this: 50,000 / 40,000 = 1.25
In this example, the DCR of 1.25 means you are cash flow positive. The property will generate 1.25 times more (25% more) income than is required to pay the mortgage payments.
On the other hand, if you have the same NOI of $50,000 but the annual mortgage payment is $55,00, your formula will look like this: 50,000 / 55,000 = 0.90
In this scenario your debt coverage ratio is below 1, which means you have negative cashflow and there is not enough cash flow to pay the property’s operating expenses and still have enough remaining to pay mortgage payments. This is a high-risk deal. The property can only cover 90% of the annual debt payments.
As an investor, the first thing you need to do on any deal is calculate the DCR to ensure the debt coverage ratio is greater than 1. If you have an NOI of $50,000 and $50,000 in annual mortgage payments, the DCR is 1 and you are just breaking even. This is too risky. You want a DCR greater than 1 which indicates a property as cash flow positive. My recommendation for almost any commercial deal is a minimum DCR of 1.20. Anything lower is too great a risk factor and you need to renegotiate the deal.
Risk Factor #2: Exit Cap Rate
You must know your exit cap rate. The exit cap rate is the market cap rate at the time you plan on executing your exit strategy, either selling or refinancing. To determine the market cap rate, calculate the cap rates of three deals that have closed in the last 12 months, find the average and that's your market cap rate. This is different from the deal cap rate. Selling or refinancing is your exit strategy so you must determine the market cap rate at the time you intend to exit your deal.
Calculate the Risk:
Here’s an example of how your exit cap rate projection can affect a deal:
- Property Purchase Price: $600,000
- Market Cap Rate Assumption at time of Purchase: 6%
- Exit Strategy: Sell in 5 years for profit
To determine the projected value of the property in five years, we need to divide the NOI by the market cap rate. If the NOI is $50,000 per year and we assume the cap rate in 5 years is going to be down to 5% the formula would look like this: 50,000(yearly NOI) / 5% market cap rate = $1,000,000
Your assumption is that in 5 years the property will increase in value by $400,000. That’s a considerable profit. But what if this assumption is incorrect because you didn't know the exit cap rate or you calculated it incorrectly? What if the market cap rate is 7% in 5 years?
The formula would look like this: 50,000 / 7% = $714,000
You can see how this miscalculation can be a costly mistake. Selling at $714,000 means you are probably just breaking even after paying real estate commissions and closing costs. So, by making a bad assumption you made a $286,000 mistake. This is why it’s so important to know your market and the exit cap rate; the cap rate that the market will bear when you decide to sell or refinance. Again, you must know what your exit cap rate is going to be so you can calculate how much money you will make when you exit the deal.
Risk Factor #3: Breakeven Occupancy Point
The breakeven occupancy point in commercial real estate determines the point at which the property’s operating expenses plus mortgage payments are equal to the amount of income it produces. In other words, what occupancy level is needed for the property to breakeven. For example, with a 10-unit apartment building, what percentage of the total units in the building need to be occupied for all the yearly costs to be covered by the cashflow being produced? If three people move out, are you producing enough cashflow? At what point are you producing negative cash flow? Knowing the breakeven occupancy point answers those questions for you, enabling you to evaluate how risky your deal is.
Calculate the Risk:
To determine the breakeven occupancy point, add the annual operating expenses and annual mortgage payments together, then divide by the potential gross annual rental income.
Example formula: 75,000 (operating expenses) + 65,000 (mortgage payments) / 200,000 (potential rental income) = 0.7
This indicates a 70% breakeven occupancy point. When you have more than 70% of the units occupied, you're cashflow positive, anything below that and you are operating in a deficit. As you can see, this is a crucial figure to know when evaluating the risks in commercial real estate.
Value-Add Property: How can knowing the breakeven occupancy point be helpful when investing in a value-add property? Well, when renovating you'll know exactly how many units you need to get done to start cash flowing. Knowing your breakeven occupancy point gives you a benchmark of what you need to reach before breaking even and start cash flowing, which enables you to evaluate how risky the deal is.
Commercial Lenders: Most lenders of commercial apartment deals do a maximum breakeven occupancy point of 85%. I think this is too risky and prefer a breakeven occupancy point of 80% of lower. I want a deal with more room, so I recommend a breakeven occupancy point of 80% max. Remember, anything below the breakeven occupancy point is negative cash flow.