When considering buying a commercial property – particularly in these turbulent times! – correctly analyzing the property financials is among the most important pieces. Good analysis can help you size up a great opportunity hidden by poor prior performance or help you avoid a major mistake with NOI ultimately being significantly less than forecast. In this article, I want to cover some of the major categories to look at and would be happy to take some time in a phone call to look over some of the minor areas to consider.
On the income side, you have two primary line items to look at. First, the current rent roll or lease summary. Assuming you are familiar with the market, you should be able to spot on a rent roll pretty quickly if the property’s rents are below market – and if so, by how much. You can also determine if a property is at the top of the market with no wiggle room on rents should the market soften with increasing vacancies or just a general economic downturn. To ensure a good analysis, look carefully at both unit mixes and the average square feet of the units relative to other properties. Again, there might be an opportunity to push rents as an example if the property has larger units of the same type than competing properties and yet is at the same rent level This could be an opportunity for increased rents of which the current owner/management failed to take advantage.
Second, looking over the historical collections is vital. It’s one thing to look at what you believe is a solid rent roll only to uncover they only achieved 80% of those rents over the past 12 months. Before running away, you need to ask some questions about the potential why (major remodels of most units for example) and carefully examine to rent roll to see if they has been a lot of turnover in the past 12 months. If so, perhaps the collections were down because the rent roll from 12 months ago had a much lower overall average rent level. Again, this could be an opportunity where a less savvy investor would walk away when you recognize the reason for the difference and perhaps use it as leverage to gain a slightly better price.
On the expense side, there are a plethora of line items to consider. For our purposes, I am only going to mention two – Repairs/Turnover and Management. When looking at Repairs and Turnover expenses, you want to focus on whether or not they are consistent historically. If there are large variations, you will want to drill down to the reasons. Given the changes in the tax code over the past several years, many owners are able to expense items which used to be depreciated. If a unit experienced a major turnover with new cabinets and flooring, that might push the expenses very high and out of norms. However, those are not ‘normal’ repair items as they may only be needed once every 15-20 years. In the past, those would have been classified as capital improvements and handled differently in your analysis. If you obtain a month by month reporting for the prior year, many times those aberrations show up and you can quickly adjust them in your projections. On the other hand, we’ve seen a number of properties with very stingy owners who do little maintenance. That can lull a potential buyer into false figures for their proforma. Most of the time, you can tell from the broker’s offering memorandum or flier containing operating data whether or not that particular expense is in line with the market. Pay attention.
Second, management expenses for sellers vary wildly! If a seller uses a management company who charges an all-in cost of 10% for a smaller property when other managers charge 6%, that’s an opportunity for a reduced expense. If the listing agent hasn’t accounted for that, you will have the ability to shave that cost down by selecting a company at market during the sale process. Another consideration as it relates to management is if the costs are too low. Occasionally you will see as an example a 30-unit apartment complex where the listing represents only a 5% management fee. While that could be the case for the current owner, you as a buyer need to know an appraiser for the lender is not likely to come anywhere close to that figure since a property that size typically needs to have at least a part time manager onsite on top of the administrative costs offsite. This category various a fair bit based on the local market. However, it’s a very important one to consider.
In just these handful of areas, I hope it’s apparent that doing your homework is vital in sighting potential properties with upside and good cash flows, while on the other hand avoiding properties for which the cash flow problems appear during the process. When the latter happens, you wind up renegotiating the price after having already invested time and resources. A really solid analysis up front helps in both cases.
Again, if you would like to talk about the items above or more specific income or expense categories, please feel free to reach out. Happy to help in any way we can!
