Commercial Real Estate Investing involves many opportunities to make mistakes. Here are 5 mistakes to avoid.
Mistake #1 – Analysis by Paralysis – Getting bogged down in the minutia.
This type of investor believes that the more information they get on the property, the better will be their purchasing decision. Unfortunately, in most instances, that’s not the case. As the saying goes these investors, “Can’t see the forest for the trees.” They are too involved in the details of the purchase that they forget the big picture. Savvy real estate investors don’t get caught up in the minutia. They generally focus on a small subset of issues to get comfortable with, and this determines whether or not they’ll make an offer on a property.
Not only does the detailed oriented approach complicate the buying decision, it also lengthens the time necessary to come to a decision. Many times, another buyer comes along while Mr. Analysis-by-Paralysis continues slogging through the details and “steals” the property away from him. In reality, the seller is tired of all the nitpicky questions the original buyer has bombarded him with. He is relieved someone else is swooping in to save him from the first buyer.
Mistake #2 – Doing only a cursory due diligence on the property.
The opposite of the first mistake is the investor who does only a cursory due diligence on the property. This usually takes two forms: the first mistake is not reviewing the historical operating statements and current rent roll carefully. It’s not uncommon that a property’s Profit and Loss Statement is not transparent to the average reader. Lots of important information can be hidden in the property’s operating statements. They need to be teased out by asking the seller good, penetrating questions. For example:
- If it’s not obvious ask the seller what the vacancy rate has been over the last three years? Surprisingly, there are many operating statements that don’t show vacancy.
- Why did a particular operating expense increase/decrease dramatically last year compared to previous years?
- Are their one-time expenses in the operating statement that should be removed from the projected operating budget?
Those are a few questions that may be appropriate to ask.
The second mistake is only doing a cursory physical inspection of the property. If you’re buying apartments, you need to have your building inspector inspect every unit, the roofs, the laundry areas, the attics, the crawlspaces, etc. Find a well- qualified inspector to represent you who will provide a detailed report of the physical condition of the property.
Mistake #3 – Not having a consensus among the investors about their investing strategy for the property.
If you are buying a property with a group of investors make sure that those who are in the investor group have the same goals and exit strategy as you do. It’s not uncommon to find out after it’s too late that individuals in the investor group have different motivations for owning the property than you do.
- Some may want to fix and flip. Others may want to hold the property long term.
- Some may want to have maximum leverage. Others may want to have modest leverage in order to maximize cash flow.
- Some may want to refinance at the earliest possible opportunity to take cash out. Others may want to pay down the loan over time.
Before you decide to be in an investor group that is purchasing a property, have a meeting with the potential investors. Ask the managing member of the LLC to outline his goals and exit strategy for the property. Also get a feel for whether you would want to be stuck with these investors over the investment life of the property. If you don’t like what you hear from the managing member of the LLC or your gut tells you not to invest with one of the investors in the group because of their abrasive behavior, pass on the opportunity. It’s better that you pass on it than regret it later.
Mistake #4 – Lack of cash reserves for unexpected expenses.
One of the biggest mistakes investors make is not having sufficient cash reserves available for unexpected expenses. This is especially true for multi-tenanted office and retail properties. For example, an investor owns a multi-tenanted office building. He’s owned the building for years and it has cash flowed beautifully. But instead of putting some of the positive cash flow into a reserve account for future needs he puts it all into his back pocket.
Then one day one of his larger tenants moves out and the property no longer cash flows like it once did. Now the owner has to contribute his own cash to keep the mortgage current. He would like to get the vacant space market ready but to do the tenant improvements and pay a leasing commission will cost him more money than he has in his savings. The space remains vacant because he tries to do the leasing himself to avoid paying a leasing commission. And years pass with an under-performing property.
And the sad thing is, it didn’t need to. If the owner had established a reserve account for the eventual cost of tenant improvements and leasing commissions he would have had the funds to get his property re-tenanted.
Mistake #5 – Paying more than the property is worth to avoid capital gains taxes.
A 1031 exchange allows investors to defer their capital gains tax when they reinvest their equity into a like kind-exchange. Deferring the payment of your capital gains taxes to a later date is a HUGE advantage to real estate investors. But sometimes investors are so eager to not pay their capital gains taxes that they pay way too much for their exchange property.
If you can find an exchange property at a market price then do a 1031 exchange. But first find out what the capital gains taxes would be if you didn’t do a 1031 exchange. No one likes to pay the IRS if they don’t have to. I get that. But don’t over pay for the exchange property. Sometimes it is better to pay your capital gains tax than to get stuck with a property that will never be a good investment because you paid too much for it.
These are the five mistakes I’ve observed over the years that real estate investors make when buying commercial real estate.
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