Tom Stilp JD, MBA/MM, LLM, MSC
Will Rogers said, “Buy land! They ain’t making any more of it.” During this country’s worst depression, President Franklin Delano Roosevelt advised, “Real estate cannot be lost or stolen, nor can it be carried away. Managed with reasonable care, it is about the safest investment in the world.”
No doubt about it — Real estate can be an attractive investment, providing cash flow, appreciation and tax benefits. (See Stilp, T. Making Money Going Into the Deal: The Art & Science of Real Estate, available on Amazon).
But if a real estate deal is poor, you lose your entire investment, and worse, get into “debt hell” if you over-paid for the property. The trick is to know how not to overpay. There could be a whole book written about the topic, yet there are a few areas we can summarize here that will help.
There is no prescribed list of disclosures required for commercial real estate transactions. You must undertake your own due diligence to analyze risks before moving forward with any purchase. Below is a brief overview —
Location, Location, Location
One of the most fundamental risks of real estate is whether the underlying property will maintain its value over the course of the investment. Although you don’t necessarily have to select residential investment property in a neighborhood where you would live for residential real estate, it is important to buy property where someone wants to live.
Investment properties with leases have risks associated with the tenants’ ability to pay rent and perform other lease obligations. Single-tenant properties rely on the creditworthiness of one party, and perhaps a guarantor. You must assess whether the tenant will renew or extend the lease at the expiration of the term.
If the property has two or more tenants, there is likely some degree of common area expense and management. This could be limited to exterior areas like parking lots and landscaping, or it could be more extensive, including reception, meeting or fitness facilities. Your lease agreements should address not only payment of common area expenses and taxes, but also the use of parking and other common areas, hours of operation and the like.
Many real estate investors use financing to improve cash flow and to acquire more expensive properties for the same equity outlay. The largest risk of any prospective loan is whether there is recourse, meaning that the borrower is held personally liable if the loan cannot be repaid in full when due. Most lenders will require individual borrowers to provide a personal guaranty for all loan payments, and any deficiency if the property is sold through foreclosure. Non-recourse loans are generally only available to business borrowers and parties with strong relationships with their lender.
Commonly measured by the loan-to-value ratio (LTV), which is the outstanding loan amount divided by the current market price of the property, the larger the more risky. The lower the LTV, the greater equity cushion you have to protect you if you need to sell the property and pay off your loan. Another measure of loan risk is the debt service coverage ratio (DSCR). This metric compares the amount of your loan payments with the amount of income your property generates (DSCR = net operating income/debt service). Lenders commonly offer more competitive rates or terms for properties with a lower LTV and or a higher DSCR. However, failure to maintain a LTV or DSCR may trigger a loan default.
Lenders often require borrowers to leave a certain amount of funds in reserve to protect against unanticipated loss in rental income and prospective capital costs. If a vacancy or capital need exceeds the reserves, the borrower will have to come out of pocket or risk default.
Understanding and evaluating risks before buying a property is critical. Having completed millions in real estate transactions, work with someone who has not only done deals, syndications, loans, but drafted agreements and gone to court to know what is important and what works in the real world.