Although many investors who get their start in the single family realm never aspire to bigger and better things for various personal reasons, there are those for whom eventually dealing with larger properties seems like a natural progression for their business practices to take. If you are one of these entrepreneurs, you shouldn’t let a fear of the process of purchasing multifamily and commercial properties hold you back from stepping up to the new challenge when you are ready.
This is simply a different realm of investing, meaning a slightly different game to play, but one that is in many ways no more complicated or risky than the single family game, and which is definitely more rewarding in terms of the profits produced versus the time spent. With a little patience and time spent studying, the rules of the commercial real estate game are surely within your grasp.
Value, as defined in the world of commercial real estate, is based on a property’s current cash flow, taking into account any deferred maintenance issues that need to be addressed. When negotiating in this world the key principle is that you buy at wholesale price, not retail. The wholesale price is the price justified by the property’s current condition, including income, expenses, deferred maintenance, and your desired cap rate.
When calculating cash flow and cap rate always remember to factor in ALL expenses: mortgage payments, including principal, interest, taxes, and insurance, vacancy, maintenance, utilities, management, and any other specific expenses related to the property. Be very thorough with your due diligence and inspections. And never base your offer on pro forma cash flow figures.
Pro forma rates are figures projected into the future. Remember that “pro forma” means “imaginary”. As for the target cap rate you choose, this can be a point of negotiation but is somewhat dependent upon appreciation. The lower the appreciation, the higher the cap rate you should demand, and the higher the appreciation, the lower the cap rate you should accept.
Financing works differently in the commercial world than in the single family realm as well. The main difference is that it is the property that needs to qualify for financing, not the buyer. This is actually a very good thing because it means that the credit history of the person or entity making the purchase is irrelevant, and that you have the safety net of having the deal scrutinized by a lender to make sure the purchase is a justifiable outlay of capital.
Another important difference is that lenders rarely fund more than seventy percent of the purchase price for these types of transactions. Therefore you should always ask the seller to carry a second mortgage for as much of the difference as possible in order to minimize your out of pocket expenses.
Finally, understand that increasing value is the name of the game with commercial properties. You should have a plan ready to implement following the purchase for how to increase the property’s cash flow and thus its value by decreasing vacancy, increasing rental value, and decreasing other expenses associated with the property.