One of the most common problems for beginners in commercial real estate is getting the REAL numbers. If you don't have the actual income and expenses on a commercial property, how can you make an accurate offer? Even worse is when you think you have the real world information and it turns out to be false! How do you get the correct data? How do you even know if it's correct? Find out here:
3 Key Facts About Commercial Deals
How does commercial real estate compare to residential when it comes to consumer protection? Are they both covered under consumer protection laws? Well, when purchasing residential real estate, a single-family home, duplex, triplex, or even a fourplex, there are consumer protection laws in most states. Meaning that when the seller gives you income expense information, he must sign off that it is true and accurate. If he provides false information you can sue him. With residential real estate you have recourse, whereas in commercial real estate there is no such thing. The commercial property owner can lie through his teeth, and there's nothing you can do about it. There is no consumer protection for the commercial investor, which is why it's important to get the real numbers on every deal.
Three Perspectives in Every Deal
Every commercial deal that you look at has 3 perspectives:
- Seller's perspective
- Agent's perspective
- Investor perspective
Each of these people have different goals and as an investor you need to understand each side to negotiate the best deal and understand what the true numbers are. In fact, we do a lot training on this in our mentorship program.
Beware of Beautiful Brochures
The more beautiful the agent's brochure, the worse the deal is. Therefore, you must learn how to remove your emotions from the deal. Don't let beautiful pictures and great numbers on paper sway you. You must understand how the numbers work, what is true and what is accurate.
When looking at any deal you need 3 things:
In the initial evaluation, you need to calculate the cash flow, the cash-on-cash return, and the cap rate. You need the price, the income and expenses. Let’s look at three common scenarios and how to get the REAL numbers for each deal.
Scenario #1: No Property Expenses
You have the price and rental income from the seller or agent, but very little property expense information is given. Maybe they gave you the taxes, insurance, and repairs, but you know there's more. When you look at any deal make sure that you have a full table of the expenses.
Here is what you should expect as the minimum:
- Contract services- landscaping, snow removal etc.
- Property Management
The list for this in our company is quite a bit longer, this is the bare minimum you need to know. So, you're able to get the rental information, but very little property expense information. What do you do?
Real Numbers Solution:
To start you need to use 35% of the rental income given as expenses. For example, if you have a rental income of $100,000, you multiply it by 35%, and estimate your expenses to be $35,000 a year. This is an industry standard that we use and that lenders use as a starting point because it won't be any less. Don’t believe a seller or agent that tries to convince you otherwise. It needs to be 35% or more. It may mean that your cashflow is gone and the deal's no good. I don't want you to buy a bad deal because you use the expenses of 25%, which is non-existent in commercial real estate. The industry standard for expenses is a minimum of 35%.
Scenario #2: No Price
The rental income and property expenses have been provided by the seller, but they won't give you a price. It may surprise you to know that this scenario is quite common, particularly if you contacted the seller directly to propose a deal. The seller will wisely say, “Well, you contacted me, you’re the expert. You give me a price.”
On the other hand, if you're dealing with an agent, often they will give you property details, income, expenses, the area and address, and then require you to come up with a market offer. This strategy is a great way for the agent to get a high price.
Both these situations are common and can trip you up. Do not let it throw you off, because it's a filtering mechanism to eliminate the people who are not serious or that educated. They can’t play the game because they have no clue what to do. But that's not you because I'm going to offer you a solution.
Real Numbers Solution:
You need to calculate an offer price based on the comparable sales of other apartments or commercial properties in the area, and use the net operating income method (NOI method). Sales comparables and the NOI method are the two methods that an appraiser would use to come up with the appraised value. You need to learn how to do the same to determine the value of a property. To learn how to calculate an offer by gathering sales comparables and using the NOI method, I have a video called How to Make an Offer on Commercial Real Estate, which shows you precisely how to do that.
The second thing to remember is not to come up with a low-ball offer. If you do, you will lose instant credibility with the seller and the agent. Don't just come up with an offer that works for you. Your offer needs to be justified with your sales comp. To gain credibility you need to share your sales comparables with the seller to justify your offer, which is what experts do.
Scenario #3: No Income or Expenses
The seller doesn't keep financial records at all. He gives you the price, but that's all he or she has. You need to know how to deal with this because as you’ll discover when you get into commercial investing, this is a very common scenario.
There are two types of sellers:
- Property Investors – as an investor they keep track of their numbers, follow the market, and the property is professionally managed.
- Property Owner - they aren’t investors. They may have inherited the property or bought it 30 years ago and may only own one property. They're not sophisticated, sometimes they collect the rents in cash and keep all of their income and rent receipts in a shoe box.
This situation stops the average person in their tracks. They don't know what to do or where to go next. But I have a simple solution, don’t overcomplicate it.
Real Numbers Solution:
I want you to reverse engineer the income and expenses. As I already mentioned, to do an initial evaluation on a commercial property, you need three things: the price, the income, and the expenses.
In this situation, you have the price, but you have no income and expenses. You can solve this problem by having the seller go over the details of the property with you. First, to get the income, go over how much rent he collects on each unit. Once you’ve tallied them all up you have the income.
You do a similar thing to get the expenses. This time you ask him what he pays in taxes and for insurance. Maybe that's all he has. So again, just as in scenario number one, you now have the income, but little information on the expenses. So, you multiply the expenses by 35% to estimate the initial expenses. Now that you have the price, the income, and the expenses you can do your initial evaluation.