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Investing In Commercial Property

By Tabitha Jean Naylor

When you are investing in commercial real estate, regardless of market conditions, you must learn how to properly evaluate a commercial property to determine if it is a great deal or a dud likely to cost you money rather than earn you money. Here are a few tips to help you on the road to successful commercial real estate investing.

Learn the Basics

When you start out in commercial real estate investment you need to learn what the insiders already know-the basic language of commercial real estate, how commercial real estate is valued, how much cash you need for down payments, how to calculate income, and which commercial properties generate the best cash flow. Find commercial investor clubs, so you can learn more about the area you are interested in investing. Other investors can be your best source of information. Learn to listen carefully to what others are buying, how they are utilizing the property, and what kinds of cash flow and income properties are generating in the area. Develop relationships with commercial brokers who can bird dog potential properties for you.

Create an Action Plan

Before you begin to look at properties you need to have a clear plan that lays out all of the parameters of the deal including how much you can afford to pay, how much cash you have for a down payment, where the financing will come from, how much income you require out of the deal, the amount of monthly cash flow required to cover all of your ongoing monthly costs related to the property, money for any required renovations or repairs, and contingency funds for property emergencies to start with. Also include a timeline for purchase, holding (If repairs or renovations are needed), and a plan to fill your property with tenants. If there are already tenants in the building then you need to know how many there are, what they currently pay, when leases come up for renewal and how many vacancies you will need to fill at the time you take ownership of the building.

Learn the Numbers

It is important to know and understand the common numbers or metrics used to evaluate a deal. These metrics include:

  1. Net Operating Income
  2. To calculate the net operating income for a property you take the property's first year gross operating income and subtract all operating costs for the year. The resulting number is your NOI. You want a positive NOI number and the higher the better.

  3. Capitalization Rate
  4. The capitalization or "cap" rate is used to calculate the value of an income producing property. To compute a cap rate for your property you use the sales price and then determine the net income operating income (annual operating income-annual operating costs). Let's use an example of $24,000 for the NOI. Take the NOI figure and divide it by the sales price to come up with the cap rate: $24,0000 divided by $300,000 =.08 or an 8% capitalization rate. The cap rate is used to estimate the net present value of future profits or cash flow. Some also refer to this as the capitalization of earnings.

  5. Cash on Cash
  6. Commercial investors that rely on financing to purchase their properties use a cash-on-cash formula to compare first year performance on competing properties. This formula takes into account that the investor does not require 100% cash to purchase the property and also accounts for the fact that the investor will not keep the entire NOI because some of that income will be used to make mortgage payments. To uncover the real cash on cash, investors must accurately determine the amount of money required to invest to buy the property, or their initial investment including financing costs.

  7. Look for Motivated Sellers
  8. Search for sellers who are anxious to sell their property and are willing to sell below market value. Motivated sellers are those willing to negotiate. It is equally important to evaluate the income potential of the property accurately. Even if you can pick up a property under market value, it is no guarantee it is a good deal. You must take into account all of the fundamentals so you are assured of a good income producing deal and not simply a good price on the property.

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