11 Steps for Investing in Commercial Real Estate
By William Scott Callahan, Winter Park, Orlando. More than three decades experience as a commercial real estate attorney and investor. This article is designed to create a step by step process for investing in commercial real estate.
1. Identify Your Goals.
This seems like a simple task, but it can be a little more complicated than you think. Everyone wants the real estate that they own to appreciate in value. But that shouldn’t be the end of your analysis. The better you understand your goals, the less likely you are to make a mistake. For example, what is your risk profile? Is it extremely aggressive or really conservative? Most investors lie somewhere in between those extremes. Another factor to consider is the duration of the investment you’re looking to make; is it short term or long term? Do you need this investment to generate income or not? Once you identify your goals, then you can start to focus on what to buy.
2. Where and What Type of Real Estate for Investment.
Although real estate is generally considered its own asset class, there are different types of real estate to consider as you narrow your search for the right property. Do you want to own raw land, and if so, where? Or do you want to own a fully leased office building, and again where? In some respects, it is generally good advice to buy what you know, which means real estate in your geographic region; but if your level of sophistication is high, your geographic considerations may be wider. You may be more familiar with certain types of real estate than others — retail versus industrial, for example. If you have an area of expertise, stick with that (i.e. multi-family, industrial, retail, etc.). Keep in mind that your analysis should focus on how best to meet your investment goals.
3. Research, Research, Research.
Once you pick an area for investment and the type of real estate you want to own, you have to roll up your sleeves and find the specific property you want to buy. Although you may have identified the general area where you want to invest, you need to determine the submarket with the most potential (i.e. core business district, urban, suburban, rural). This is where a knowledgeable commercial real estate agent familiar with your geographic focus can help. With the agent’s expertise, you can identify hot submarkets and those that aren’t, as well as areas that are more expensive and mature versus those that are up and coming. Your agent can also educate you about pricing and keeping within your budget. This exercise will further narrow the choices so that you can identify a few different properties that meet your investment requirements. With that information, you can start to formulate an offer to purchase the property.
4. Starting the Buying Process.
Once you have identified a property that you want to buy and the price you want to offer, it’s time to put together a letter of intent (LOI) to submit to the current owner. An LOI contains the general terms of the purchase such as price, initial deposit, additional deposit, any due diligence period, financing contingency, closing date and other significant terms. It’s not a contract and therefore isn’t enforceable like one. Because it is very basic and isn’t enforceable, buyers and sellers like to use these to build consensus before going to the expense of putting a contract together. If you aren’t able to reach an agreement, everyone has saved a bunch of time and money.
Either your agent or your attorney can help you draft your LOI. Pay attention to the purchase price deposits and due diligence period to confirm that you can meet the financial and investigative requirements that those provisions contemplate. The due diligence period can be an especially tricky item, so make sure you know what diligence is required to determine that the property is suitable and how long it will take you to complete the inspections. If you can’t fully understand the condition of the property within the due diligence period, you will either have to negotiate an extension of the due diligence period or terminate the contract. If you aren’t able to obtain an extension or to terminate before the end of the due diligence period, you could lose your deposit, so giving yourself enough time is important.
5. Drafting the Contract.
Once the LOI is signed by the Buyer and the Seller, it’s time to draft the purchase and sale agreement (PSA). It’s wise to have an experienced real estate attorney involved in this process, either drafting it or reviewing it. While the LOI is the outline of the business terms, there are lots of details that the PSA needs to include and if you’re not careful here, a mistake can be expensive. It is important to pay a lot of attention to the details of the transaction in order to avoid those mistakes.
One way to go about this process is to review the general form of a PSA and identify the sections that cause you the most concern. Examples include the purchase price and deposit sections. When will your deposit become non-refundable? The inspection period section is also important. What does the Seller have to deliver to you and by when (i.e. permits, leases, etc.)? Can you extend the inspection period if you don’t get that information you need or if you find out there is an issue with the property? Closing date issues are also important. Is it a date certain or does it take place only after you have fully examined the property and its condition? If not, can you extend the closing date? Remember that this entire process can be expensive, legal fees, inspection fees, etc., so you will want to have as much control of and flexibility with this process as you can negotiate. Those are just a few examples, but there will be more. Meet with your attorney and have them go over the issues in each section that concern you. Your attorney can then draft the contract to address those areas.
Once that is done, the PSA is sent to the Seller and the negotiations commence. This process can take either a short or long period of time. Set expectations based on the time frame you need to meet. If you don’t have a signed contract within that time period, then it may be time to move on to another property. If you are able to get the PSA signed, then the process begins and it’s time to get to work making sure that the property is in the condition that you require for you to make your investment and purchase the property.
6. Starting Your Due Diligence.
Now it’s time for your attorney and other experts to go to work. Hire people who are experienced in buying real estate of the type you’ve selected. If you’re not going to manage the property yourself, get your property manager involved in this now too. This list is extensive, so you or someone knowledgable will need to quarterback the process. You need someone to look at the title to the property and understand what limitations there are on operations; zoning and land use issues are important to understand. All required permits should be issued before closing, so make sure that is reviewed. What is the physical condition of the property? How expensive will any repairs be? Are repairs contemplated in the price you agreed to, or do you need to renegotiate the price? How about financing? Who will make a loan on the property? Make sure that you have identified your lender and that you get them involved right away because they will also need adequate time to perform their due diligence, appraisals, title review, etc. If the property is leased, make sure the leases are in the form and duration that work for you. All of these items are crucial and must be thoroughly examined before you can finish your due diligence and be comfortable allowing your deposit (and any additional deposit you are required to make) become non-refundable.
7. Changing the Terms of the Transaction.
Once you complete the due diligence on the property you’re buying, you have to decide if the original terms still make economic sense. For example, did your due diligence reveal any environmental issues, construction defects, or deferred maintenance issues (like roof replacement)? Are there any title issues that popped up that prevent you from using the property the way you anticipated (such as use restrictions or access issues)? Those are only a few general examples, but there are many issues that can arise during your inspection of the property that may impact your opinion of the value of the property; in mostly a negative way of course.
If that happens, it may be appropriate to renegotiate the terms of the purchase. The most common one is price. If you think the property is less valuable after the inspection than you thought before, then it is appropriate to reduce the purchase price under the contract to a more acceptable amount. Your impression of acceptable will no doubt differ from the seller’s, so some negotiations may be necessary If it’s just a math equation (the original purchase price less the unexpected costs that you will need to incur), then you should be able to successfully convince the seller that an adjustment is appropriate. If the unexpected costs aren’t easy to define, it will likely be more difficult to persuade the seller to reduce the price. In the end, it’s all about what you can negotiate. Once you get the Seller’s bottom price, you can decide if the value still exists to meet your investment goals. If it doesn’t, terminate the contract. This needs to be done before the due diligence period expires, otherwise you may lose your deposit.
There will also be times when the inspection period isn’t long enough for you to complete your due diligence on the property. More often than not, it is because you discover something that needs to be investigated further. Environmental issues are a good example of that. If your environmental report (known as a Phase I report) shows that there may be contamination on the property, then you’ll need to get a Phase II report and that will take more time. If that can’t be completed during the original inspection period, then you will need to extend the inspection period. The same applies to permits, construction defects, etc. All sorts of issues can arise that call for further investigation and may require the inspection period to be extended. You can expect that the Seller will be reluctant to give you additional time. You must be prepared to terminate the contract (again before the original due diligence period expires), if the Seller won’t grant the extension. This can become a game of “chicken,” so be prepared to walk away from the deal. Remember that no deal is better than a bad deal every time.
8. Preparing for Closing.
Assuming you navigated your way through the inspection period and are ready to move forward with the purchase, it is time to move toward the purchase of the property. This requires some work, which is why the closing date in the contract is some time after the end of the inspection period. The reason for that is that no one wants to waste time and money getting ready for a closing before they know that the contract isn’t terminated by the buyer during the due diligence period. It’s time to get your attorney, lender, and closing agent geared up for closing on the sale. Everyone has a role here. The lender and the lender’s attorney will prepare the loan documents for the transaction. Your attorney will need to review them and negotiate any objectionable terms with the lender. You want to focus on the important issues in your negotiations, not minor issues that aren’t likely to occur. The more time your attorney spends negotiating loan documents, the more expensive the legal fees will be (both yours and your lender’s, which you have to pay). Remember that loan documents are somewhat standard, so there won’t be a lot of changes that the lender will make. Have a conversation with your attorney to make sure you both are on the same page, in order to avoid unexpected expenses connected to that time of extensive negotiation. At the same time as the lender is preparing their loan documents, the closing agent will be preparing the transfer documents and the closing statement. Again, these are standard documents and won’t require much, if any, negotiation.
9. The Closing Statement.
Unsurprisingly, the document that garners the most attention is the closing statement. This document shows the parties how much money is required to close and how the closing proceeds will be disbursed. The closing statement will include: (i) purchase price, (ii) expenses, and (iii) charges. A good closing statement also separates the buyer’s transaction from the seller’s transaction, making it easier to follow. For example, the Buyer’s transaction shows the purchase price less the amount of the deposit and any additional deposit already paid. Expenses and charges are shown and added to the amount that is owed and from that amount, credits are shown and deducted from what is due. The end result of the buyer’s section of the closing statement is the amount due from the buyer. The seller’s section is similar but it doesn’t show the deposit and additional deposit on its side unless those funds were released to the seller prior to closing.
The contract will indicate who is responsible for which expenses and how any pro-rations of taxes, association dues, rents, etc. will be made. Although this is somewhat straightforward, the timing of the closing will determine how the various credits and expenses are allocated. If the closing occurs in the middle of the year, before taxes are due, the buyer will pay their real estate taxes for the entire year when they become due. The seller will owe the buyer an amount equal to its pro-rata share of the taxes. This same type of formula is applied to rent, association dues and assessments, etc. So review the closing statement carefully to make sure that those figures, along with all of the others, are accurate.
10. The Closing.
Once the closing documents have been negotiated and agreed to and the closing statement is approved, you are ready to close on your purchase of the property. This is surprisingly anti-climactic. As the buyer, it is your responsibility to make sure that the funds you need to complete the transaction are delivered to the closing agent. This generally takes the form of two wires, one from you and one from your lender. The amounts due from both of you will be set out on the closing statement. Everyone involved in the transaction gets together in a room and sits there while the lawyers make sure that all of the documents are properly signed and the title insurance company is in a position to ensure that the title to the property can be properly transferred to the Buyer. It is also common for closings to occur remotely with the closing agent circulating documents to all of the parties for signature. Once the closing agent receives the signed documents back from all of the parties, the closing can take place, the funds will be transferred, and the deed and mortgage will be recorded. There you have it! The purchase is complete and you’re now the proud owner. Your property management team should be in a position to immediately take over the management of the property. The final step in the process is the closing dinner to celebrate the successful completion of the transaction.
11. The Closing Dinner.
This is a great tradition that you may want to start. You and the team that helped you get the deal closed can get together at a nice steakhouse or Italian restaurant to celebrate the successful completion of your purchase. Hopefully, it will be a successful investment and will meet the goals you set out at the beginning of the process.
These basic tips I have provided should help you get started in your venture, but please don’t stop here. Organizations like the National Association of Realtors, Commercial and the NAIOP, the Commercial Real Estate Development Association can provide you with a wealth of information and tips that could be invaluable to you.
W. Scott Callahan is a commercial real estate investor of Orlando and Winter Park , and the Managing Partner of Salerno Capital Partners, an opportunistic investment firm focused on providing capital to businesses throughout the U.S. A Florida commercial real estate attorney for more than 3 decades, he is now an avid commercial real estate investor and a dedicated philanthropist in the Orlando and Central Florida community, and oversees the Callahan Family Foundation.