Twenty Questions for Buyers of Commercial Property

Section 1031 of the Internal Revenue Code allows sellers of real estate that is not their primary residence to exchange their property for “like-kind” property or properties.  The definition of a “like-kind” property is any real estate that is held for “investment purpose.”  This creates a very large number of opportunities for exchangers to consider from multi-tenant income properties to raw land.  Given the myriad of investment opportunities for the 1031 exchange buyer there are many factors the exchangers need to be aware of when purchasing new assets.

1. Why has this opportunity come my way?

This is a particularly good question to ask if you are an out of state or out of town buyer.  Why have all the locals passed on this deal? Is this coming your way because of a relationship you have with a broker?  Often properties have been shopped and get a ‘stale’ feel to them that turns off the market so that even when the asking price is reduced making it an excellent deal, the locals still won’t bite.  Other times local players may know something about the property.  

2. What is the local market doing in comparison to the rest of the nation?

If you are located on the coasts, you know something about this.  Rapid property inflation in Florida, New York and California have created selling opportunities over the past couple of years, while other areas, for instance, the Denver market are just now coming out of a period of overbuilding where vacancies are going down and rents are headed up.  There has been increasing construction in industrial, multi-family and office buildings in Denver.  Is this a time to “re-locate” your capital and lock in significant gains?  Strategically playing the exchange game is one way to avoid recessionary impacts.

3. Where are market rents in comparison to rents in the prospective property?

This is a key question for value-added players, those looking to add sweat equity for instance.  If you are more of a hands-off investor, re-habilitating and re-tenanting a property may not be for you.  On the other hand, if rents are significantly lower than market rents, hiring a brokerage company to re-lease space at market rates may lead to a much greater return.  Sometimes properties have simply been ignored by their owners who may have had health issues or been too busy to stay on top of things.

4. When are leases up?

Here is a key question for buyers of multi-tenant properties.  If there is a significant amount of space coming available at once (over 20%), you may end –up competing against yourself or there is the alternative that many tenants will have the option of leaving in a bad market.  Checking the timing and options of leases is essential.

5. Who is guaranteeing the leases?

Are leases guaranteed by a parent corporation?  Often franchisers will not have such a guarantee, so while you may have what appears to be a strong national tenant in place, the lease and ability to pay may be in the hands of the local franchisee.

6. Why is the seller selling?

This would appear to be an obvious question.  You may not always get a straight answer.  Are there hidden pitfalls, unhappy tenants, environmental issues?  Or perhaps the owner just wants to retire, is getting a divorce or is in ill-health.  Sometimes a great deal is just that. 

7. Who is the potential buyer for this property?

One of the major objections to tenant-in-common investments is that there is no secondary market to dispose of your interests.  There is often a built-in hold period to the master agreement forcing a sale that may occur in a down market.  Before you acquire an investment property you should think about how to dispose of it.  Unforeseen financial considerations in your life could drastically alter your holding period.  Are there buyers readily available in the local market?  Are the benefits of ownership not readily apparent as in an industrial building that is not visible from a major street? 

8. What financing is available?

Understanding the benefits and pitfalls of financial leverage is key when investing with financing.  What are your realistic expectations as to returns?  Are they greater than the financing available?  What will markets do in the future when you may want to re-finance.  How much down payment will be required?  These are some of the major considerations upon which to run your analyses of for an investment property.

9. Who is the tenant?

Is this a “mom & pop” operation or a fortune 500 company?  What are the prospects that they will be in business five years into the future?  Has this tenant been in the location for a significant amount of time thereby building up a significant local client base?   What is their industry doing? Tenants such as Blockbuster Video and Movie Gallery have caused headaches for landlords as their industry has consolidated and faced increased competition from online sales.  On the other hand, many investors flocked to grocery anchored centers during the last recession based on the belief that people will always need groceries.  Many did quite well while some were burned as Wal Mart and Target started to take a larger share of the grocery market.  Answers to these questions will often involve outside expert advice. A sudden merger or bankruptcy can drastically alter your cash-flow and is part of the risk you will be taking with income properties. 

10. What are my goals?

Only you know, but it may be such considerations as having regular cash-flow, larger returns including appreciation of the asset, tax considerations, creating a retirement fund, or taking larger risks in order to obtain a larger return.  Are you an owner/operator of a business that needs space? 

11. For land, what are the political hurdles to future development?

Land investment generally provides the greatest return, but is the longest hold of any investment.  Raw, unentitled agricultural land has often been a target of investors.  However, there are many partnerships that have held a property for decades and end up unloading it as their members approach retirement.  Land has the disadvantage of not offering income (or minimal farm leases) while being taxed, so there is money going out, but not being received.  Agricultural assessments provide by far the lowest tax requirements, making parcels of several hundred acres owing in the hundreds of dollars. 

12. What are the physical limitations to the property?

If you are a value-added investor you may want to examine the possibilities of expansion.  Is there space for a pad site in front of the center?  Can buildings be physically expanded by increasing their footprint or adding an additional story?  How would the local municipality react?  Are their neighborhood groups that would object to increased traffic or having views interrupted?  Is there some sort of moratorium in place against a specific use such as auto dealerships?  Properties in “joint-planning areas,” such as in counties and cities are especially susceptible to the political process.  One of the essential items to examine is environmental impacts from previous tenants or owners.  Buyers should always hire professional certified consultants to look at these key considerations.  

13. How will the property appreciate? Are there bumps in leases? Overage rents?

Are you looking to ride the wave of the market place?  Is the property set up to maximize your profits through scheduled increases in rent?  Is there a chance to re-negotiate lease rates, options to extend leases?  Are the leases tied to scheduled increases in rent or to an index such as the CPI (Consumer Price Index)?  Some are tied to how well the tenet does meaning the landlord captures a percentage of sales above a certain point.  Has this point been reached in the past?  A well performing asset will separate itself from the market when it is time to sell. 

14. What are local market conditions?

Is the local economy in an upswing or downswing?  Key to understanding this is to observe if there are investors coming in from out of the area or internationally.  How does Wall Street and institutions feel about this particular market?  Will they be investing or disinvesting?  Are rents headed up or down?  What are local professionals saying? This is one of the hardest factors for out of market investors to grasp.  Not being on the ground daily can put you at a significant disadvantage to sellers of property that are. 

15. Is this the right type of property for me? Industrial, office, etc.

Different tenants have different requirements.  It is more likely that an industrial user will make a greater request of their landlord for greater power availability, truck access, noise abatement, etc. than office tenants who may only be concerned with internet access and parking spaces.  If you are not familiar with the requirements of a property type, learning on the job is a difficult task.  This is when property managers can be essential.  Pride of ownership is another consideration.  However, the best returns are often in shabby looking buildings in down-ridden neighborhoods compared to new, well-finished retail properties at high profile locations. 

16. What are the management responsibilities?

What are the costs of managing my income property versus contracting it out?  Do you want to be involved with 5AM snow removal issues or would you rather just receive regular rent checks?  Who will be responsible if there is an unforeseen event that would require the parking lot to be closed off while repairs are occurring?  Multi-family properties are infamous for unforeseen problems arising in the middle of the night that need immediate attention. 

17. What are the operating costs?

An obvious consideration as most investors will look at the net operating income a property throws off, however there many offerings that only highlight the gross number or potential gross number.  Many offerings will use a “pro-forma” cap rate and income statement.  These are obviously based on puffing and conjecture of the sales agent.  The numbers must be thoroughly investigated and verified.  An experienced commercial broker can assist you in this process. 

18. How long is the hold period?

This depends upon the individual factors of an investor.  How many cycles do you anticipate going through before disposition?  Many investors simply plug in ten years as a hold period. This helps compare apples to apples with different investment options.  However, if these factors are varied slightly, it can drastically alter the investment prospects in comparison to one another.  Is this a new retail center that may require some time before lease-up and stabilization?  Do you want to hold this property in your IRA or keep as a retirement asset?  Perhaps you want to pass it on to your kids. 

19. What is my risk level?

What if there is a cash-call on an investment, a downturn in the market? Am I overleveraged in one market?  Do I like financial market risk? Or simply want a stable income to supplement my employment income or support my retirement?  Every investor will need to spend a lot of time asking these questions.

20. How does this fit into my portfolio?

What other assets do you hold?  Are you overleveraged in one particular area in equities, bonds, gold or other assets?  Is this property in a market with other properties you own?  Are you solely interested in one type of property?  Many investors, both armature and professional, specialize in one type of asset whether it is industrial or multi-family because of familiarity with the market and process of investment analysis.  Does it not make sense to enter into multiple property types?

These questions are designed to point the experienced and inexperienced investor in the right direction when selecting a property for exchanging in the 1031 process.  While many of these questions may seem to be obvious to the experienced 1031 investor, they each represent major pitfalls and opportunities in commercial real estate.  Being able to foresee these questions and issues before investing will help the 1031 exchanger decide on the best investment and be better able to manage risks.  A simple checklist will make buyers of commercial real estate enjoy the 1031 process and provide a better overall experience in the marketplace.  Happy hunting.