In this video you’ll discover the top 4 reasons to walk away from a commercial real estate deal and how to navigate the dangers if you encounter them.
Purchasing commercial real estate is like buying a car. You really want it but sometimes it’s just not worth the money – maybe it needs too much work or the seller is shady. As a coach for commercial real estate investing, one of my primary responsibilities to my Protege Students is to say no when a deal is bad. Sometimes they are emotionally attached to the property; they may have a relationship with the seller, or they have watched the property for a long time and really want the deal. Our job is to give them a frank answer based on facts, not emotion. Here are the top 4 reasons to walk away from a commercial deal.
#1: Walk Away if the Numbers Don't Work
The first reason to walk away from a deal is when the deal is over-leveraged. Over-leveraged means you have too high a mortgage and not enough income and it’s a common trap for beginner real estate investors. Here is an example of what that might look like. In this scenario, it looks like the numbers work, but appearances can be deceiving. In actuality the debt is pushing down the cash flow on the property which makes it a dangerous deal.
10 Unit Apartment Building: Units renting for $708/month
Annual Income: $85,000 (10 units x $708 x 12 months = $85,000)
Annual Expenses: $30,000
Net Operating Income: $55,000
(The formula for calculating the NOI is income minus expenses $85,000 - $30,000 = $55,000)
Annual Debt (mortgage): $47,000
Cash Flow: $8,000/year or $667/month
(To calculate the annual cash flow subtract the debt from the NOI $55,000 - $47,000 = $8,000/yr)
On the surface this looks like a cash flowing property. So what’s the problem? Why would we as coaches tell you to be very cautious at this point or walk away? The problem is a cash flow of $667/month is too low. All you need is one tenant to walk away and your cash flow is negative. The building will be 90% occupied which sounds good but your cash flow is negative because the debt is too high compared to the NOI. What if you have a broken window? These days broken windows cost $700 to replace. The property could have one hundred percent occupancy, but with one broken window to replace, suddenly, it’s cash flow is negative. This is too close for comfort. If this is the best you can do, you need to walk away from this deal, it's not worth doing.
Debt Coverage Ratio
The metric that professional real estate investors and lenders use to measure the ability for the NOI to cover the debt is called the Debt Coverage Ratio or DCR. It measures the ratio between the NOI and the debt.
To calculate the DCR divide the debt from the NOI: $ 55,000 (NOI) / $ 47,000 (Debt) = a ratio of 1.1
Lenders require a DCR of 1.2. The .2 is your buffer above the mortgage and indicates the deal is cashflow positive. A DCR of 1.1 means you’re barely positive cash flow and it’s too risky. A DCR of 1.2 or greater is what I recommend because otherwise you can have a broken window, or one tenant move out and you're negative cash flowing.
To learn more about Debt Coverage Ratio, I go more in depth in my teaching 3 Risk Factors You Must Know in Commercial Real Estate.
There is a solution to this scenario, and this is when having a mentor or coach becomes important. To improve the deal, you need to implement two strategies:
- Improve the NOI by raising the rents or reducing expenses: This will affect the ratio between the NOI and debt and increase the DCR to 1.2 or higher. If you can figure out a way to get the rents up quickly or reduce the expenses to increase the NOI, then we can pursue the deal.
- Implement creative financing or seller financing techniques: These are strategies we use at Commercial Property Advisors. I would not recommend trying to use these strategies yourself as a beginner commercial investor. There are too many variables that could trap you. Instead, get a coach or mentor to help you implement them.
#2: Walk Away from a Shady Seller
You can't do a good deal with a bad seller. Here is a real-world example of this from a deal of one of our students. Initially, our student had a good relationship with the seller. He built rapport talking on the phone, emailing, going for coffee and visiting the property. However, once the student was able to get the property under contract, the seller went silent for seven days. In those seven days the seller is supposed to turn over income expense statements, rent rolls, and property information. We received nothing and our student starts panicking and asks, "Peter, is this normal?" My answer was, "No, it’s not normal procedure or behavior".
Suddenly, the seller reappears and delivers the due diligence documents. However, much of it is missing and what is there doesn't look real. As a coach looking at financials for the last 20 years, they looked fabricated to me. So I told the student, "Hold on, go back to the seller, inquire more and get more information."
At this point, we are suspicious, but we proceed with the inspection. The seller didn't show, so they had to reschedule the inspection which delayed everyone. When our student was finally able to get in to inspect the apartment building, the seller didn't have the keys for three of the units and when the student knocked on the door the tenants didn't answer. Right after the inspection the seller's tone changes. He becomes aggressive and dominating and our student is confused. Luckily, he had us to walk him through it.
If you find yourself in a similar situation, you need to start asking questions:
- Is the seller's hiding something?
- Why is he not showing up?
- Why is he rushing you?
- Is the seller's trying to get you to terminate the contract? Why would he do that?
The seller may be behaving this way because he received another offer and he wants to take it instead. Whatever the reason, the big question here is what does your gut say to do? You have two choices: you can pursue this deal, or you can cut ties with seller and move on. A bad seller does three things, they dominate, intimidate, and manipulate. When you encounter a seller with these traits, remember you can't do a good deal with a bad seller. As a beginner investor you need to walk away.
The only solution is to get a coach or mentor to help you navigate these dangerous waters.
#3: Walk Away from Poor Demographics
You can fix a property, but you can't fix a location. There is no coaching solution to fix this situation so as a mentor, this is a flat-out no. There is no upside potential here and you're just going to be stuck. What does poor demographics mean?
High Crime Area: These areas tend to have the higher cap rates on paper. The property may be a nine or ten cap deal, lots of cash flow, great returns, but that's only on paper. The reality is in areas with high crime they tend not to pay rent. They pay their cell phone bill, their food costs and other things, and then they pay their rent. Paying their rent is probably four or five in priority so it's not somewhere where you want to be as a beginner.
Declining Population: Find out why the population is declining. It can lead to other discoveries such as, high property taxes, high cost of living or poor city management.
Lack of Job Creation: With a lack of jobs, you have lack of tenants and little rental income.
Degrading Infrastructure: Infrastructure like bridges, roads, and utilities cost the city money to maintain. When a city or area is poorly governed the infrastructure starts to crumble because there’s no money to maintain the sewage system or roads and the utilities are antiquated leading to power outages and lack of water. When the infrastructure starts to degrade, it leads to lack of jobs, declining population and high crime.
Walk away. Again, no matter how good the deals are, you need to walk away because there's no hope for these areas right now. You don't want to be the first to invest there and wait ten to twenty years for the problems to get fixed.
#4: Walk Away from Grade 4 Renovations
When the property has a “down to the stud” renovation you should walk away. There are four grades of renovation for when you want to renovate and raise the rents.
Grade 1: You go in, clean up and re-rent it.
Grade 2: This is more commonly done and is fairly inexpensive. You may need to replace the carpet, some window shades, patch some walls and touch up the paint.
Grade 3: This grade is where you get the most bang for your buck because with this renovation you can increase the rents the most. You renovate the kitchen, the bathrooms, new flooring, and new paint.
Grade 4: When you walk into a unit and there's no flooring and no sheet rock, that’s a grade 4 reno. Maybe it’s a burn unit or maybe flooding happened, whatever the reason, it’s stripped to the studs.
There are three reasons why beginner investors should walk away from a grade 4 renovation commercial property.
- The number one cause of property failure is running out of money. Down to the stud renovation costs a lot of money, possibly four or five times the cost of grade two renos. And when there's a lot of money involved there's greater risk. This is the reason we are so cautious with beginning students.
- When renovating you are dealing with unreliable or dishonest contractors and these contractors will know if you're a beginner and take advantage of you. There are good contractors out there, but unfortunately there are a lot of bad ones that will cause you to run out of money.
- As a beginner investor, time and money are not on your side. And you don't have the experience to know how long it takes to put new flooring down, renovate a kitchen or paint three bedrooms. That’s one reason contractors can take advantage of you. Therefore, walking away from down to stud renovations is a good thing if you're a beginner.
As a beginner, you need to have someone on your team who's experienced in renovation so that you avoid these pitfalls. At Commercial Property Advisors we have done thousands of renovations and can help guide you through the process. Our team has the student's best interest in mind when they do the deal. We want them protected, so we have a saying that helps guide this principle,
“Some of the best deals that we've ever done are the ones we walked away from.”