Purchasing Commercial Real Estate – What You Should Know
If you’re considering purchasing commercial real estate for the first time, or already started the process of searching for commercial real estate for sale, there are a number of things you should know. Commercial real estate transactions are much different than a typical home purchase. It’s advised that you always consult a commercial real estate professional before moving forward with a purchase, but we will cover some of the basics here so you can at least know what to expect.
The property you’re looking at may currently be used as an office, a restaurant, or any other use that you wouldn’t expect to create any environmental concerns. However, this property may not have always been used for its current purpose. The commercial real estate you’re considering purchasing may have once been a gas station, a dry cleaner, or any number of other businesses that either stored, or created, hazardous chemicals or waste. There may also be concerns within the building itself, especially if it’s an older building. Decades ago, things like asbestos and lead paint were used within buildings. Buildings that have been vacant for a while may have toxic mold, especially if there are any leaks in the roof.
To avoid the pitfalls of purchasing a contaminated property, you will likely want to have an environmental study done. If you are purchasing a property with bank financing, your lender will most likely require the environmental study. The key purpose of this assessment is to qualify for the “innocent land owner defense”which allows a purchaser who performed adequate due diligence to avoid liabilities from previous environmental contamination. The environmental study will begin with a Phase I Environmental Site Assessment (ESA). The purpose of this assessment is to determine any potential or existing environmental liabilities. The company handling the Phase I ESA will research the site through property records to determine the previous uses of the property as well as the neighboring properties. They may also make a site visit to see if there are any visible signs of contamination, or anything that would cause contamination such as chemical or fuel storage tanks, asbestos, signs of mold, or other evidence of contamination. If the assessment finds that there’s no reason to believe the site is contaminated, you’re done with the environmental study piece of your due diligence.
When a Phase I ESA shows that there is reason to believe the site is contaminated it is recommended you move on to a Phase II. The scope of a Phase II ESA all depends on the findings of the Phase I. This process may involve soil samples, ground water analysis, monitoring wells, indoor air sampling, or any other tests required to determine if there is in fact contamination and the extent of the contamination.
What happens after a Phase II is totally dependent on the findings, as well as your intentions with the property. The level of contamination may require cleanup efforts, or actions to prevent the spread of the contamination. Depending on the extent of the efforts needed, you may decide the property isn’t worth it. The report may show that the contamination is contained and doesn’t pose a significant health risk at the moment. In this case, you may decide the land is still suitable for your use and you have given yourself protection against liability from the contamination (as long as you don’t add to it.)
While the commercial real estate you intent to purchase may have all of the physical characteristics you’re looking for, you will have to find out if your intended use is allowed at this location based on the local municipality’s zoning ordinance. Most municipalities have a zoning ordinance which keeps certain uses in specified areas. When looking at a zoning map you will usually see that there are areas designated for residential, offices, commercial, industrial, agricultural and possibly others. These different areas are often broken down even further into classifications like high density residential, or light or heavy industrial. These ordinances are put in place to prevent things like a factory being built in the middle of a residential neighborhood or a high-traffic shopping mall being developed on a road that can’t support the traffic.
If you determine that your intended use isn’t allowed based on the zoning, you still have a couple of options available. You can petition the local municipality to change the zoning of an area or property. In order to do this you will have to show a good reason as to why the zoning should be changed and that it won’t negatively affect other nearby property owners. You may also be granted a variance, which will allow you to operate your business in this zoning area. There are also special use permits which will allow you to operate your business with your intended use. Zoning changes, variances and special use permits may have certain conditions that come along with them to help protect current property owners in the area as well as future development in that area.
Many municipalities have a master plan, which may be different than the current zoning in some areas. This master plan is based on the direction the municipality wants to go in terms of future growth. In this case, your intended use may fit with their master plan, which will make the process of requesting a change of zoning much easier. In either case, you will want to be well prepared in presenting your case to the local government.
Valuations of commercial real estate are much more complex than with residential houses. Sellers and buyers often have very different opinions of value on a commercial property since there is usually more than one way to determine what the property is worth. The difference in opinion of value can often be hundreds of thousands of dollars and even millions. This is a huge difference, and you don’t want to rely solely on the seller’s idea of what the property is worth when purchasing commercial real estate.
While an appraisal on a home may cost $300 – $400 in most areas, a commercial property appraisal will usually cost thousands. As with purchasing a home, a lender will normally require an appraisal on the property to ensure they aren’t lending more than the property is worth. Depending on the estimated price of the property, some banks may do an in-house valuation for properties that are assumed to be valued under a certain amount. If you’re buying the property for cash, or on a land contract, There are many more factors that are considered in a commercial appraisal. Like residential appraisals, a commercial appraisal will consider sales of comparable properties in the area. However, there are usually far fewer similar commercial sales than there are with homes. If you’re purchasing commercial real estate for investment purposes, such as an apartment building, multi tenant office building, or single tenant retail property, the value will be largely based on the income the property produces for the owner.
Investment Property Values
If you’re purchasing commercial real estate as an investment, like an apartment building, multi tenant office building or strip center, or single tenant retail or industrial property, the value is going to be based on the income the property produces now, and what it’s likely to produce in the future. One of the most common methods of this is to determine the capitalization rate, or cap rate. The cap rate is the amount of net income you will receive from an investment property in relation to the purchase price. The cap rate is shown as the percentage of the purchase price that you will earn in net income each year based on its current revenue. Let’s look at an example.
An apartment building has a gross income of $100,000 each year.
Its operating expenses, included property taxes, insurance, maintenance, lawn care, snow removal, management fees, leasing commissions, etc. are $40,000 each year.
The net income from the apartment building is $60,000
The asking price of the property is $650,000
$60,000 divided by $650,000 is .092 or 9.2%, which gives you a cap rate of 9.2%
Now, this cap rate may or may not be good depending on a number of factors. Look at what cap rate other similar apartment buildings have sold for in your market. Also look at the condition of the property. If it is going to require a new roof next year that will cost $50,000 you may want to add that figure to the purchase price when determining the cap rate. Look at the leases and the tenants. If all of the tenants are on month-to-month leases it’s harder to predict what the income will be over the next several months, where as having tenants in longer leases provides more predictability and stability. Another thing to consider is the rental rates. If the rates are similar to the rental rates of other similar apartments in the area, then that’s probably where they’ll stay for now. If the rents are well below market rents, you will likely be able to raise rents over the next several months or year to increase the income even more. If the rents are above market, then you will have a hard time keeping that same income as tenants move out and you struggle to rent out apartments at the same rate.
While cap rates are one of the most common units for determining investment real estate value, there are other investment calculations that are also used such as internal rate of return, cash-on-cash and others. These are more advanced methods that are beyond the scope of this posting. Again, this is where it becomes important to use the help of a commercial real estate professional that is experienced with investment properties.
W’re using the term “business property” here to describe purchasing commercial real estate that is specific to a business use that’s currently operating, and requires the operation of such business to bring value to the property. This includes properties such as hotels and assisted living facilities. When valuing these properties, you must look at the performance of the business that’s operating within the property. For a hotel, it’s best use is to continue being operated as a hotel so you must look at the performance of the current hotel operation to determine what type of return you will receive on your investment. Similar with various types of assisted living facilities. When buying these types of properties you are typically also purchasing the fixtures, furniture and equipment (FF&E) along with the going concern, or the current operation.
The actual transaction of purchasing commercial real estate is also more complex than that of a residential property. There may be several contingencies in your offer to purchase such as addressing the above concerns like having an environmental study done, receiving the proper zoning, inspecting the current leases in an investment property as well as having a survey completed on the property and having title work done to show any liens or claims to the property. Financing also isn’t as cut and dry as with purchasing a home. Instead of FHA loans, you’re dealing with SBA loans which have different lending guidelines. Some lenders will only lend on owner occupied buildings, while others prefer to lend on investment properties. Below we’ll discuss some of the various types of commercial real estate sale transactions
Cash to Seller
This one is pretty straight forward. Buyer and seller agree on a price, buyer does their due diligence and closes on the sale by paying the purchase price in cash to the seller. While these are any seller or broker’s favorite deal types since they don’t require the hassles of dealing with a bank and can close sooner, they’re not the most common.
Purchasing commercial real estate with seller financing, or land contract, is fairly common. In this scenario, buyer and seller agree on a price and terms, then the buyer pays a certain amount as a down payment, say 30%. The rest of the purchase price is paid over an agreed upon amount of time, usually with interest. In many cases, the amount owed after the down payment is amortized over a longer period of time, but has a balloon payment due within a few years. At this point, the buyer either has to come up with the cash, or get a bank to refinance the land contract so the buyer can continue making payments, but to the bank. If the buyer can’t come up with the cash or get a loan, the seller has the rights to take back possession of the property and keep any money paid. As a purchaser, it’s important to be sure that you can pay the balance off in the agreed upon amount of time.
Option to Buy
Sometimes a buyer wants to be able to purchase a property, but either doesn’t have the funds available now or has some other things to work out in order for the purchase to be beneficial to them. In this case, a buyer and seller both agree on a sale price, and the buyer buys an option to purchase for that price within a certain amount of time. The amount paid for the option will usually be applied toward the sale price, if the option is exercised. During the period of time that the buyer has the option to purchase the property, the seller can’t sell it to anyone else and must sell to the buyer if the buyer chooses to exercise their option. If the buyer does not exercise their right to purchase the property, the seller keeps the option money and can keep the property or sell to anyone else they choose.
Options are a useful tool when planning a development, but don’t want to tie up the capital required to purchase the property yet. It allows time to get other things in place before purchasing. It’s also a great tool if you happen to know of a planned development that will make the property much more valuable in a year or two and want to take advantage of that appreciation without making the full investment now.
Lease With Option to Buy
A lease with an option to buy allows a purchaser to move into a property now without having to raise the money to purchase it yet. Sometimes a bank is more likely to lend on a property when they see that the business has been operating successfully in the location for a certain amount of time. A lease with option is also a valuable tool when you’re waiting on the sale of your own property to have the capital to purchase or are waiting on capital from any other source. There are many reasons to lease with an option to buy, but the important thing to know is that each of these deals are different. Some require the lessee/ buyer to buy the option, like above. Some will allow for a portion of the monthly rent to be applied to the sale price. Some may require that the lessee/ buyer lease for a minimum amount of time before being able to purchase. These are all things that are negotiated between buyer and seller.
A sales/ leaseback is when a buyer purchases a property, and immediately leases it back to the seller. There are several reasons for this type of deal. Sometimes the seller isn’t going to be ready to move out for a while, but wants to take advantage of somebody willing to buy the property now. The seller may need an influx of cash for business operations so they are willing to sell the property and pay rent. Some companies will change their business model to be in lease spaces instead of their own buildings for various reasons. This is a good situation for a buyer that either doesn’t have a use for the property yet, or wants an investment property with a successful business in place as the tenant.
Purchasing commercial real estate can be done many ways, including deal types that haven’t been mentioned here. If one thing is certain in commercial real estate it’s that no two deals are the same. When determining the best method for you when purchasing commercial real estate it is wise to consult with a commercial real estate professional that’s experienced with various types of purchases.
Cost of Ownership
Being able to purchase the commercial property you want is one thing, it’s another thing to be able to afford the property once you own it. Expenses such as property taxes, property insurance, lawn care, snow removal and maintenance are usually greater than that of residential properties. For example, replacing an air conditioning unit or a furnace can costs tens of thousands of dollars. Plumbing issues can also be much more complex than in your home. As the property owner, you have to be able to cover those costs as they arise, especially in an apartment building or office building. Before making the purchase, look at what the property taxes are each year and if they have been going up or down. Get an insurance quote from a few companies as well as lawn care and snow removal. Request to see what the maintenance costs have been over the past few years and have a qualified inspector look for anything that may need repair soon, such as HVAC systems, and the roof. If you are receiving financing for the purchase you will want to factor in the interest expenses. Make sure you understand all of the costs associated with purchasing the commercial property you are looking at.
As you can see, there is a lot involved with the commercial real estate sales process. When purchasing commercial real estate it is extremely important to allow yourself enough time to conduct adequate due diligence to ensure you can use the property for your intended purposes, that environmental concerns won’t hold you back, and that the property is worth what you are about to pay for it. Also make sure that your business revenue, or rent from tenants can not only support the costs of the property, but allow you to be profitable. As mentioned several times above, it is always wise to consult an experienced and knowledgeable commercial real estate professional. In many cases it is advisable to seek guidance from more than one professional. A commercial real estate agent will be valuable to understand market conditions and local property values as well as help you negotiate a fair deal. An accountant experienced in commercial real estate will help you to understand tax implications and benefits on the purchase, the future sale, and the income generated form the property. An experience real estate attorney will help to keep you protected throughout the transaction, as commercial real estate contracts are usually pretty extensive. Purchasing commercial real estate can be a great investment as long as you take the time to fully understand all of the factors affecting the deal and work with qualified professionals to ensure your success.
To learn more about what a commercial real estate agent can do to help you purchase commercial real estate, read about our buyer representation services.