Commercial real estate investors freak out a lot. Yes, we mean freak out. Go ballistic. Throw a temper tantrum. Lose it! Commercial real estate investors are known to freak out when projects don’t go as planned. One of the reasons is unrealistic expectations that were inadvertently created during the evaluation phase. Once you’ve located a commercial property you’re interested in purchasing, you must evaluate everything. In many areas of the country there are entire housing subdivisions that were abandoned without a single home being built. The developer just didn’t do the homework and was expecting to turn a quick profit without fully evaluating the potential before the project began. Don’t let it happen to you.
Evaluating the potential of commercial real estate depends entirely on the area in which it is located. We can’t provide an exact formula because every situation is different. We have no idea if you’re trying to flip an old gas station or develop a 20-acre strip mall. We’ll provide the basic information you need to evaluate commercial property. It’s up to you and your team to determine the value based on your area and your exact goal for the property.
When evaluating commercial real estate you should always analyze three scenarios: best case, worst case, and break even. Sellers of commercial property will often present only the best case scenario. If you’re looking at residential rental property, beware of a proforma analysis. A proforma analysis will show the potential income of a rental property if all of the units are rented. It does little good to know the potential income of 12 apartments if only 4 of them are currently rented. You want to see the actual income based on the current rentals, not a hypothetical figure based on 8 additional units being rented.
Best case, worst case, and break even scenarios are fairly obvious. You want to know how much you stand to profit if everything works out perfectly and how you stand to lose if all hell breaks loose. For an apartment building, the worst case scenario would be to have all of the rental units vacant. The best case scenario would be to have all of the units occupied. Somewhere in between is your break even scenario. An accountant would call it “working the numbers backwards.” By plugging in all of your expenses, you need to know exactly how much income the property must generate in order for you to break even. In the case of an apartment building, regardless of the number of units that are rented your fixed monthly expenses might be the mortgage payment, property taxes, maintenance, repairs, insurance, etc. If your break even analysis shows that at least 5 apartments must be rented in order for you to break even and there are currently 4 units rented, you know you’ll be losing money from the day you acquire the property.
As another example of evaluating the potential, let’s say you’re considering an office building. The asking price is $350,000. Total cost to rehab the building is $250,000. If you intend to flip the property, the selling price after the building is renovated would have to be at least $600,000 just to break even. If you intend to lease out the building, you’ll need to estimate the total lease income from the individual units. Let’s say there are 20 units in the building. Before you purchase the property you’ll need an expert to determine the estimated lease value of the units. You’ll also want to analyze the three scenarios mentioned above – best case, worst case, and break even. The evaluations might determine that you stand to earn $25,000 per month if all units are leased. You’ll lose money if at least 10 units aren’t leased. You’ll break even if 14 units are leased. You must have these scenarios evaluated before you purchase the property!
The one factor no expert or investor can predict or analyze is future changes in the market. Real estate markets are constantly changing. Sometimes the change will not work in your favor. During the 12 months it takes to rehab an office building, an out-of-state developer might pop up a new office building complex on the other side of town. Your office building that’s still being renovated might suddenly become obsolete. Banks are constantly closing and opening at new locations. Medical offices often move from one area to another. If your property is located in an area that seldom sees change, consider yourself one of the lucky ones. It’s not unusual for strip malls, shopping centers, and entire commercial districts to die when a new development opens on the other side of town.