Choosing a Commercial Property With Financial Benefits : When valuing commercial real estate, it is important to understand the financial factors created by the property. This is before you price the property or deem it a good fit for purchase.
In doing this, it is not only the financial factors of today that you need to pay attention to, but also the factors that have shaped the history of the property over the last few years.
In this case, what is meant by ‘recent time’ is the last three or five years. It’s surprising how property owners try to manipulate the building’s income and expenses at the time of sale; they can’t easily change a property’s history and this is where you can uncover many property secrets.
Once the history and current performance of the property is fully understood, you can then relate it to the accuracy of the current operating expense budget. All investment properties must operate on a managed budget on a monthly basis and monitored quarterly.
The quarterly monitoring process allows for budget adjustments when unusual income and expense items become apparent. There is no point in continuing with a property budget that is increasingly out of balance with the property’s actual performance.
Fund managers at complex properties will typically make budget adjustments every three months. The same principles can and should be applied to private investors.
So now let’s look at the main issues of financial analysis that you can focus on in your property evaluation:
1. The rental schedule must be sourced from the property and thoroughly checked. What you are looking for here is an accurate summary of current rental occupancy and rent paid. It is interesting to note that rental schedules are notoriously wrong and not up to date in most cases.
This is a common industry problem stemming from the lack of diligence of property owners or property managers to maintain records of rental schedules. For this reason, the accuracy of the rental schedule at the time of the sale of the property needs to be carefully checked against the original documentation.
2. Property documentation reflecting all types of occupancy must be sourced. This documentation is usually the lease, occupancy license, and side agreement with the tenant. You should expect that some of this documentation will not be registered with the property rights.
Lawyers are quite familiar with going after all property documentation and will know the right questions to ask property owners beforehand. When in doubt, conduct an extensive due diligence process with your attorney prior to any settlement.
3. Lease guarantees and bonds of all lease documentation must be sourced and documented. These things protect the landlord in the event of default on the part of the tenant. They must pass to the new property owner upon completion of the property.
How this is achieved will depend on the type of lease or bond collateral and may even mean that the collateral will need to be reissued upon sale and settlement to the new property owner. Lawyers for new property owners will usually look into this and offer a solution method at the time of sale.
Importantly, lease guarantees and bonds must be legally collectible by new property owners based on the requirements of existing lease documentation.
4. Understanding the type of rent charged across the property is critical to property performance. In a single property with multiple tenants, it is common for various rents to be charged across multiple rents.
This means that net rent and gross rent can be seen on the same property and have different impacts on the expense position for the owner. The only way to fully appreciate and analyze a complete rental situation is to read all rentals in detail.
5. Searching for outstanding bills on the property should be the next part of your analysis. These allegations usually come from local councils and their assessment process. It could be that a special fee has been raised on the property as a Special Levy for the police station.
6. Understanding the cost of spending on property in the local area is essential for your own property analysis. What you should do here is compare the average spend for similar properties locally with the subject property in which you are involved.
There needs to be similarities or similarities between certain traits in the same category. If any property has significantly higher expenses for any reason, then that reason must be identified before any process of selling or adjusting the property is considered. Property buyers don’t want to buy something that costs above the industry average.
7. A property depreciation schedule should be maintained annually so the profits can be integrated into any property sales strategy when the time comes. The depreciation available on the property allows for reduced income and therefore less tax to be paid by the owner.
It is normal for accountants for property owners to draw up a depreciation schedule each year at tax time.
8. The rates and taxes paid on property need to be identified and understood. They are very close to property appraisals conducted by local councils. The timing of board appraisals is usually every two or three years and will have a significant impact on the rates and taxes paid in that appraisal year.
Property owners should expect a reasonable rating escalation in the years in which the property appraisal will be conducted. It pays to check when the next property appraisal in the area will be conducted by the local council.
9. A site survey assessment and rental area on the property should be inspected or carried out. Nonconformities are usually found in this process.
You should also look for excess space in the common areas of the building that can be converted into rental space in any new tenant initiative. This excess space becomes a strategic advantage when you are renovating or expanding a property.
10. In analyzing historical cash flows, you should look for any impact arising from rent reduction incentives, and vacancies. It is very common for rental deductions to occur at the start of the lease as a rental incentive.
When you encounter this, documentation supporting incentives should be retrieved and reviewed for accuracy and ongoing impact on cash flow. You don’t want to buy a property only to find your cash flow dwindling every year because of the incentive agreements in place.
If this incentive agreement exists, it is desirable that the existing property owner waive or adjust the impact of the incentive upon property settlement. In other words, the existing property owner must compensate the new property owner for any inconvenience caused by the future incentives of the property.
11. The current rent in the property should be compared with the market rent in the area. It could be that the rental property is not balanced with the market rent in the area.
If this is the case, it is necessary to understand what impact this will have in leasing any new vacant areas that arise, as well as in negotiating new leases with existing tenants.
12. The threat of falling market rents at the time of lease review can be a real problem in this slower market. If the property has a future market lease review provision, then the lease needs to be examined to identify whether the lease may fall at the time of that market review.
Sometimes leases have special requirements that can prevent the rent from going down even if the surrounding rents have already done so. We call these clauses ‘ratchet clauses’, concluding that the ‘ratchet’ process stops the occurrence of lower market rents.
Be careful here though that some retail property laws and others may prevent the use or enforcement of the ‘ratchet clause’. When in doubt, see a good property attorney.
So these are some of the important financial elements to look at when valuing commercial Investment Properties. Take the time to analyze the income and expenses at the property before you make a final choice regarding property prices or acquisitions.