There are 6 common problems commercial real estate investors encounter (especially these days); Negative cashflow, high vacancy, poor property management, lack of reserves, loan default and eventually foreclosure. Here's how to protect yourself from these disasters:
Safeguard #1: Have an Experienced Team
The first way to safeguard from disaster in commercial real estate investing is to have an experienced team. There are several ways having an experienced team can safeguard you from potential disaster.
The current market has been on the rise now for 10 years or more. So, if you're working exclusively with someone that's been the business for 10 years and they know nothing about market volatility, you have to wonder if they will know what to do when the market drops. Having a team that knows how to navigate market volatility can really help you mitigate disaster. I have a video called The Ugly Side of Commercial Real Estate Investing. In that video, I share a deal that financially ruined a beginner investor who was getting terrible advice from someone who was supposedly experienced. You can watch that and learn how to avoid the same mistake.
No Consumer Protection Laws
Next, there is a difference between commercial real estate and residential real estate. In residential real estate there are consumer protection laws, which is great. So, if you were to purchase a home or a duplex, triplex or fourplex, by law in most states, the seller must disclose what's wrong with the property and any potential issues that could kill the deal.
In comparison, in commercial real estate it's buyer beware because the seller is not required to disclose anything. That's why we have a 30-day due diligence period, which gives you time to do your homework. You need those 30 days because there's so much to cover. How do you know what to look for? This is why you need an experienced team. You need help to find all of the elephants under the carpet over those 30 days, and there's quite a few in commercial real estate.
If you are a commercial investor you have experienced operational challenges. You will have property management challenges, contractor dilemmas with the plumber, electrician, or building contractor, and as mentioned before, there will be market volatility. These challenges are inevitable and are difficult to handle as a beginner. You need to be mentored by an experienced team, and we can provide that through our Protege Program here at Commercial Property Advisors.
Safeguard #2: Have Plenty of Cash Reserves
We also call this having a rainy day fund for when problems arise. And when you own commercial real estate, you need to have cash available that you can quickly use to remedy the situation and stop potential disaster. This is just a wise thing to do.
Property Savings Account
Every property you own should have cash reserves, or what I call a property savings account. It needs to apply to every single property that you have, even if it's a small single family home. This is not an account to pay bills but for problems and challenges that arise. Now, how much do you need to save up? Not a lot all at once, but it needs to be continual and will build up to be a great amount. You're going to start off by saving 5% of your gross income per year, every year and that money is untouchable until that rainy day. That's not a whole lot of money, but you will thank me later, guarantee.
Do Not Renovate with Cashflow
The number one reason for failure when a person is renovating a commercial property is running out of money. I've witnessed this all over the country. Do not let that happen! When you are renovating or planning to renovate your commercial property have all of the renovation money required upfront. Do not attempt to renovate from cashflow. Some people think, I have X amount of dollars in cashflow every month I'm going to use for my renovations. Don't do it. It will take too long, and it's a recipe for disaster. The safeguard here is to have plenty of cash reserves on hand and continually save up.
Safeguard #3: Have a Conservative Exit Strategy
An exit strategy is how to get your money out of a deal. If you are too aggressive in raising your rents or not aggressive enough in putting in proper operating expenses, you could end up with no cashflow or an underperforming property. You can avoid this disaster with the safeguard of a conservative exit strategy.
2 Examples of Conservative Exit Strategies:
- Cash out refinance: This is when you buy a property, put money into it, get the rents up, increasing it in value, and then do a cash out refinance and pull the money out.
- Have investors in your deal: Your goal is again, to buy a property, fix it up, increase the NOI, and then in year five, do a cash out refinance and pay back the investors and keep the property. This strategy is called syndication.
Pay Close Attention To:
1. Rent Increases: When designing your exit strategy be conservative and pay attention to the rent increases because they may take longer than you think. Don‘t think you can bring your rents from $600 to $800 in one year. That may look good on a spreadsheet but it may not be possible in reality. How are you going to get all the tenants out or get their rents up that much without them leaving or causing so much disruption that it causes you to fail? Again, be conservative.
2. Actual Operating Expenses: When considering a deal, pay close attention to the source of operating expenses. Where are you getting the reported operating expenses from? Are you getting them from the agent who is just reporting what he has? Are you getting them from the seller? The seller may not be reporting all the expenses. How do you know that you have all the expenses? To get accurate information you need to get advice from someone who knows. At Commercial Property Advisors, we have properties across the US, which gives us the ability to accurately evaluate what the expenses are for almost every type of commercial property all across the US.
3. Physical and Economic Vacancy: When you calculate your cashflow, you need to look at both the physical and economic occupancy, especially now with eviction moratoriums. Physical occupancy refers to the units that are occupied. Economic occupancy refers to the tenants that are actually paying. You may have 100% physical occupancy, but if only 7 out of 10 tenants are paying, you have a 30% economic vacancy. Don't be fooled by that. Ask the question, out of those 10 people, how many are paying?
4. Exit Cap Rates: Be conservative when calculating exit cap rates because they are highly sensitive. If the cap rates today in your market are six cap, and you determine that when you sell they'll be five cap, that’s a big leap and could be a mistake. You are counting on property values all over that area going go up by 1% on a cap rate, which is a lot. Instead be conservative in your estimates. So, if your market cap rate right now is at 6%, perhaps you do 5.8 or 5.75. Only go down a little or don't go down at all.
5. Don't trust any Pro Forma Information Given to You: Any pro forma information not generated by your own research cannot be trusted and must be verified by an experienced mentor. Just because someone gives you a beautiful pro forma of how the property could perform and it wows you with great cashflow and returns, don't trust it yet. Do your own research.
Safeguard #4: Long-term Loan
You need to get a long-term loan which enables you to ride out any market volatility. Commercial loans are different from residential loans. With residential loans the payments are fixed and amortized over 30 years. In commercial, your payments are amortized for 30 years, but the loan is due in five years. The reason for this is banks don't want to be on the hook for 30 years, just in case the neighborhoods change. And they make a lot more money if you refinance in five years.
But here's the problem. If you recall, from 2008 to 2012, property values dropped and lenders stopped lending. It was exceedingly difficult to get any loan done. At the same time, many loans that matured went into loan default. Why? What happened was lenders refused to refinance short term loans that came due to refinance. Even though you had a 100% occupied, cash flowing property, lenders said, "So what?" We don't have a loan product for you."
All the lenders said the same thing. It was so frustrating. And some investors went into loan default and had to give their properties back to the lender because there was no loan for them, or they had to sell the property for much cheaper because property values had dropped. A safeguard in this situation could have been financing with a longer term loan, and a five year loan is not long term. The most common long-term loans are 7, 10, 12 or even a 30 years. Yes, a 30-year fixed commercial loan is available, however the interest rates are higher. Again, this is something that you learn when you go through several ups and downs in the market.
Now, here's the big question. When will property values drop again? No one knows. So, the safeguard from the disaster of going to loan default because you can't refinance is to get long-term debt to ride out market volatility.
Safeguard #5: Buy Property that Will Be in Demand
Purchasing property that will always be in demand makes sense. The big question is, what's going to be around 25 years from today, worth more and still in demand? In my opinion, it will be:
- Apartments and mobile home parks - everyone needs a place to live
- Industrial - e-commerce will continue to grow
- Storage - we need a place to store our material possessions
Safeguard #6: Buy Existing Properties
Don't build new. To safeguard from disaster buy existing properties that are already performing, have tenants, income and cashflow. When you build new construction, here are the issues:
- It takes too long. It can take years to break down permits, drawings, approvals, and financing. Too many things can go wrong during this process.
- You're betting on market dynamics remaining strong while you're doing your construction, so that when you're done, you have something that's in demand.
- Building new is absolutely NOT for beginners!
- It is capital intensive. A lot of money needs to go out while you're waiting for something to happen. Again, too many things can go wrong when you're dealing with something this capital intensive.