Investor 101: Putting it All Together

Putting the Basic Factors Together

Sorry it’s been so long since the discussion about debt service coverage ratios, but it’s now time for the next part. In determining how you evaluate potential commercial projects/acquisitions, there are many factors including but not limited to: the capitalization rate aka cap rate; debt service coverage rates; cash flows; expenses; and deferred maintenance. Each one of these are important to the evaluation of not only the merits of purchasing but also whether or not it is a good short and long term investment. Since the criteria will vary depending on the project type (i.e. multi-family under or over 4 units, retail commercial, warehouse, mixed-use) specific criteria and how to evaluate them will be more thoroughly covered in the 201 series.

In a previous blog, I related how easy it is to alter the value of properties by a more liberal cap rate than will be utilized in the appraisal. This means the cap rate is lower than it should be, with the result being a higher value than what may be used by the appraiser. Another way to alter the value is to not show the vacancy rate or all of the expenses. This has the effect of showing an artificially high net operating income and distorts the value. Don’t be surprised when the lender finds the discepancy, because they’re taught to. Be diligent in your examination of the income and expenses, it can save you money. I know this from many years of experience as a commercial banker.

Debt service coverage ratios cannot be faked. In most cases, the lender will look to the prior tax returns on the property from the current owner. If the information is not available, the lender will estimate the expenses high and the income low to be on the conservative side. All that said, they will look for the debt service coverage ratio to be at least 1.20 – 1.25:1. That means the net operating income divided by the potential debt payment will meet that ratio. If it doesn’t and there is no reasonable way to get it there through remodeling, rent increases, or expansion, be prepared to put more of your own money into the project. Especially in this economic climate, the lenders do not need to have any additional real estate problems on the horizon, so expect them to be very diligent in their analysis of the project and your own financial capacity. You may also be introduced to the concept of “Global Cash Flow.” All this does is to account for all of your current investments and their impact on your cash flow. If you have a business that needs to have cash contributed to it then make sure you have sufficient capacity to handle that also besides the new project.

Speaking of your financial capacity, when you invest in commercial real estate, you need to be sure and have enough cash reserves to cover 3-6 months of expenses. In multi-family, this may be more considering the vacancy rates for the area and the remodeling or updating of the units or the cost and time it takes to make the unit rentable. This also occurs in commercial space, as there are often tenant improvements or other adjustments to the rent and clean-up after a tenant leaves, in order to obtain a new tenant. In this climate, there are way more spaces available then there are tenants so the rents are very competitive and bargains are out there for those that are willing to look. All you have to do is drive the area that you want to invest in and look at what is available. If there are lots of open spaces, the rents should be adjusting downward. When evaluating property to invest in, make sure you’re looking at good hard numbers and not fluff. Take into account the fact that rents are adjusting downward so even numbers that are from the past year may be too high on the income side. Use those numbers only if there are leases that would run past the purchase date and hopefully for at least the next year. Also try and get an accounting from the owner on whose rent payments are slow. Many will not disclose this as it is a forewarning of potential foreclosures or tenant evictions.

One of the things I coach my investor clients on is how to sucessfully interact with lenders to get their project approved. When approaching lenders, just be aware that if you don’t have all of the information that they need you will be going back and forth with them several times to get the property’s basic financial profile established. Don’t get frustrated as this may take some time. Just know that they want to make good loans that make YOU money. This is to their benefit and yours. Good Hunting!

There are many ways to look at certain types of investment such as: large multi-family; motels; mixed-use; retail; wholesale; custom investments (real estate developed for a certain use and client); and many more.  I will always be available to discuss and consult on these other types so feel free to contact me.

Dave Sato, Realtor
dave@seattlepowersearch.com
(425) 213-6411