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Key Questions to Ask Your Realtor Before you Buy a Commercial Property

Cooksquared Enterprises is very close to taking its first humble step back into investing after a two year hiatus. After a disappointing stint in Greensboro, we have settled on 32 units in Winston Salem, which is about an hour away. Over the past two weeks I have been going back and forth with the broker, asking a ton of questions, clarifying local business practices, and doing my best to get in touch with the seller. Through all of this I thought it might be helpful for other investors to understand the major questions I ask of my realtor when looking at a deal. For you veterans out there, read on and feel free to add some value in the comments section if I miss anything.

First, I am more of a new age investor. I do everything in Excel, using my own personal models painstakingly put together through trial and error. Even if you are not an Excel investor, I personally suggest writing down key learnings from every deal. It’s always good for a laugh when you look back at how long the list was from your first deal, plus it really helps you reflect on what you did well and what you can improve upon. For those of you interested in a very simple model to get you started, I am more than willing to share one if you email me (mc140@cornell.edu). Please remember that I am an apartment investor, so all of my models are based on purchasing apartments.

Once I put the deal in my model, the analysis begins. Typically, the first question to my realtor is where the numbers are coming from. There will be three main areas to focus: Rent rolls, expenses, and cap rates. Typically, Net Operating Income (NOI, which equals Rent roll minus recurring expenses) will be projected and then divided by the current cap rate. Watch out for two seller tricks. The first is to project an unreasonable NOI. For example, many sellers will simply increase rent rolls by 5-10% (or more) and not include a market vacancy rate. The second is either not increasing expenses or property taxes, or not including a labor component if they were acting as property manager (or both). These two items can be sniffed out relatively easy. Simply asking the agent why they were or were not included. If this confuses you, still ask the questions below because it will let the seller know you are an informed interested investor.

This brings us to the first set of questions:

  • Based on a five year trend in NOI/Rent Rolls, how did the seller get to their number?
  • When do the leases in place expire and what is the current market rent?
  • What is the market vacancy?
  • Is there a property manager, if yes, what is their reputation? If no, is there a line item in expenses for property management?
  • What is the going rate for property taxes? Has it been increasing? (In all my years of investing I have never seen property taxes decline, so I have not included that question here)

These questions should help you tighten up your model, if you are doing one. If you are not using one, these questions will give you an idea of how “aggressive” the seller has been with their projections so that you can adjust your bid accordingly. The next set of questions should focus around the prevailing cap rate. In hot areas cap rates tend to cluster in one area, while in cooler markets they can be all over the place. Cap rates should differ on the age of the property and expected rent growth. Therefore, an older property in a weak rental neighborhood should have a higher cap rate than a new property in a hot area. Every seller loves their property and will try to be as aggressive as they can with their cap rates. Again, your realtor can help you here. First, get a set of good comparables. In addition to asking your realtor, you should be working with sites like Loopnet and Costar . Both of these sites can help you get a good handle on what cap rates current properties are listed at. Here is the second set of questions you should ask:

  • How old is the property and what major repairs have been done in the last five years?
  • What has the vacancy rate been for the past 5 years (market and specific property?
  • How long has the property been on the market (keep in mind commercial properties have a much longer selling period, so a year is not uncommon; however, more than a year should be a red flag)?
  • Why is the cap rate of this property lower than the cap rate of property X five blocks away? If higher, don’t ask; rather ask the other property why they are lower. It might speak to poor management or other flaws in the property you are interested in only locals know about.

All of these questions will help you formulate your first offer. Additionally, the questions show the seller that you are seriously considering the property and not wasting their time. The result of all of this analysis should be a data based asking price that you are happy with. It may be 5% or 30% (or more) below the list price, but you have concrete evidence to say why you think it is reasonable. These kinds of bids are always listened to (not always accepted, however). The opposite of this strategy is to simply knock off 5% to 30% arbitrarily and submit an offer. The danger is two fold. One, you may simply offend the seller and their agent, resulting in you not getting the bid. Even worse, they may accept immediately, and you come to realize their projections were inflated by more than 30%, essentially leaving you hosed.

The goal of this post is not to give you an exhaustive list of every question to ask your broker, but to direct you to critical questions that can help you be a more informed bidder. Do not be afraid to ask your realtor anything (its what you pay them for). Again, I hope realtors and investors a like will add to this list, so that we can create a more informed buying community.

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  • 4 comments

    4 Comments so far

    1. Marc Grayson February 23rd, 2007 12:05 pm

      This is fantastic Michael.

      I believe that Loopnet.com is now also providing commercial comparables.

      Question. Given your Excel procedure and math that is of a “special sauce” you have developed over the years from experience, have you seen or used EquityScout.com?

      I see a tour here http://www.equityscout.com/public/pag378.aspx. I’m very curious on your opinions, if it is in alignment with math you perform, and the overall knowledge and information that should be gleamed for decision-making.

    2. Michael Cook February 23rd, 2007 4:26 pm

      Marc,

      I checked out the site and it seems very basic to me. The problem with most of these sites is that you can do all of this stuff for free yourself in Excel. Excel is amazing, but you have to know how to use it. Instead of paying for software, I recommend going to a local community college and paying for an Excel class. After a good beginners class, you could do everything the equityscout site does, in about 10 to 15 minutes (no exageration) with simple templates you can create yourself. The bonus to some of these sites is they offer a database of key stats that can be helpful. Still, I have found the best results doing it myself.

      Additionally, sites like this are limiting. There are some good things on this site, but it is also missing some very important investment tools. Based on the quick tour, it does not appear to do creative financing calculations and I have no idea how it calculates cash flow. It might be good for the casual homebuyer, but it would certainly not serve serious investors that well. For the serious new investor, I recommend becoming very familiar with Excel. Get a book, take a class, or just read the manual. Once you learn it, then you can do as much analysis as you like. I am considering getting into more analysis, but I am not sure this is the proper forum for that (unless the people here make some request). Let me know if you think that would be useful.

      Mike

    3. stanislaw March 1st, 2007 3:15 am

      Even if you are not an Excel investor, I personally suggest writing down key learnings from every deal. It’s always good for a laugh when you look back at how long the list was from your first deal, plus it really helps you reflect on what you did well and what you can improve upon. This article is very nice.so click on the link for more information

      Buying Property Rental

    4. Christopher Smith March 7th, 2007 12:12 am

      Mike (and Marc…)

      Thanks to both of you for your comments. My name is Christopher Smith and I run the EquityScout.com site.

      You might be surprised, Mike, but I actually agree with much of what you say. In fact, I started EquityScout based largely on the models that I myself used to run in Microsoft Excel in order to evaluate my own real estate investment opportunities.

      I looked around the web and saw that you basically could buy two types of evaluation products: bootleg Excel spreadsheets and basic downloadable programs – many of them costing hundreds of dollars. My view was that a lot of investors would prefer to pay fifteen bucks to get access to the same functionality using a Web 2.0 application that they could access from any computer with an internet connection. No downloads. No installations.

      Your observation that you could do this for free with Microsoft Excel is…drumroll…100% correct. If you know how to build economic models in Excel and can calculate cashflow, rate of return and net present value then there is no reason for you to use a third party tool; you can build your own.

      But if you’re not so inclined then a product like ours (or our competitors’, for that matter) will give you a quick idea of how factors like price, interest rate, vacancies, rental rates, expenses, fees, taxes, etc. all roll up into an expected cashflow projection. When I identify an opportunity I bang the data and assumptions into EquityScout and take a look at the rate of return and cashflow. If it looks reasonable then I go and take a look.

      As for creative deals we’ve opted to keep it simple. ARMs, interest only loans, multiple mortgages: check. Multifamily residential: check – it’s all there in EquityScout.com’s software. Once you get more complicated than that you’re probably into territory where you shouldn’t be using a one-size-fits-all model.

      Questions/comments? You can contact us via the site.

      Regards,
      Christopher Smith
      Managing Director
      EquityScout.com