When real estate investors recognize the tremendous advantages commercial real estate can offer over residential, the transition from one to the other is a logical step. But, key differences between the asset classes exist, particularly the complexity of commercial deals. This reality begs the question:

Once I’ve found a potential commercial real estate investment, how should I actually analyze the deal to see if it makes sense?

In the following article, we’ll address this question by outlining the major steps necessary to analyze new deals.

Step 1: Determine Your Investment Strategy

Most real estate investors carve their own niche and focus on a particular real estate strategy, from historic tax credit rehabs to value-add acquisitions to from-the-ground-up new construction and everything in between.

However, each commercial real estate deal is unique, and your particular strategy may need to adapt to fit the potential deal.

Looking at the potential deal you’ve found, you’ll need to ask:

● Does this particular deal fit my real estate investment strategy?

● If not, what type of strategy both aligns with my experience and the unique nature of this particular investment?

Once you’ve answered those questions, you can begin to look at the local comps that align with the strategy selected for this potential investment.

Step 2: Assess Local Comps

As commercial buildings lack the uniformity of residential, these comps require more work. But, finding accurate comps is critical to assessing the deal, because they’ll tell you if you’re paying a reasonable price.

As financing is king in any real estate deal, finding solid comps will determine whether or not a lender will actually provide you a loan.

To factor in the unique nature of commercial real estate, you’ll want to find comps that as closely as possible align with your target in the following areas:

● Zoning designation

● Lot and building size

● Building condition and year built

● Location and surrounding area

● Unique characteristics of the building or its lot

Tax records are a great place to start to track down the above information. Local appraisers and brokers with geographic area and property type expertise are also great sources of information.

Drop us a note if you would like us to send comps from your area.

Step 3: Review Current Leases

Next, you need to assess the income-generating potential of the property.

Put simply, will this deal actually make money?

To answer this, you need to dig into the current leases and property financial information. This includes asking the current owner for the following key items:

● Current rent rolls

● Property financial statements (for at least the past three years)

● Tax returns / partnership K-1s

● All current leases

Information from the first three bullets above, when combined with the acquisition price, will provide you a good sense of the revenue-generating potential of the property (and bridge the gap between what feels like a good deal and what actually is a good deal).

The final bullet - reviewing current leases - is a critical part of your due diligence, as any new owner will be bound to these lease terms. Furthermore, a long-term, below-market lease may make or break a deal.

After reviewing these leases, have tenants sign an estoppel. Your lender may not require this step, but it provides assurances that tenants won’t try to back out of previously agreed upon terms.

Step 4: Forecast Construction/Renovation Costs

Reviewing the financials and lease information from Step 3 gives you a good idea of money coming in, but accurate construction/renovation costs are critical to understanding money going out.

Other than the actual acquisition, these costs will likely be your largest expense. Failure to accurately gauge construction/renovation costs may lead to real estate catastrophe - not having a large enough initial loan to finish the project.

Once the property is stabilized, these costs will ultimately determine the size of your permanent financing, the monthly installments of which will drive property cash flows.

Considering the above, an accurate construction/renovation budget is a critical part of any commercial real estate deal.

While experienced investors may be able to put together a fairly accurate budget, new investors should absolutely have a contractor or two put together a bid.

These forecasts will play a key role in analyzing the overall deal, and they’ll certainly be reviewed by your lender prior to loan approval.

Step 5: Confirm Lender Terms

No matter how attractive a deal, without confirmed financing, it’s nothing more than wishful thinking.

And, these costs constitute the final piece to the deal analysis puzzle. Having said that, you’ll need to meet with multiple lenders to outline your prospective deal.

Each lender will have different requirements (so it helps to have relationships with a variety of lenders), but, you’ll need a term sheet from each with the following key information:

● Loan-to-value or loan-to-cost terms of the loan

● Interest rates (fixed or variable, pegged to what benchmark?)

● Amortization and length of the loan

● Bonus: option for a mini-perm loan to bridge the gap between the construction loan and permanent financing

While term sheets will likely include far more than the above bullets, this information will drive the final step in analyzing a commercial real estate deal.

Step 6: Run the Numbers!

With the information from Steps 1 - 5, you now have all the information you need to analyze, or underwrite, your commercial real estate deal.

Depending on investor preference and experience, underwriting can be done using commercial real estate software or your own spreadsheets. Regardless of which path you choose, underwriting calculations incorporate the following inputs:

● Purchase price and associated acquisition fees

● Construction/renovation costs

● Loan costs and required down payment

● Monthly net operating income (rents minus operating expenses)

With this information as inputs, any underwriting software or spreadsheet should return the following key performance indicators as outputs:

● Return on investment

● Internal rate of return

● Net present value incorporating investor hurdle rate

● Monthly cash flow

● Debt service coverage ratios

Congratulations, you’ve now analyzed a commercial real estate deal!

But, we recognize that, even after outlining the above steps, the commercial underwriting process can be a daunting task for new investors.

That’s why we’re here to help. The Pocket Broker team lives and breathes commercial real estate, so drop us a note to see how we can help you achieve your unique objectives!

The How-To Guide for Analyzing Commercial Real Estate Deals