The Commercial Real estate investment process is intricate and involves a number of stakeholders and lengthy steps. Although it may seem intimidating for new investors, it is noteworthy that the investment process in a commercial real estate deal essentially involves four distinct stages. These are Acquisition, Value-add, Stabilization, and Disposition. Together they form the life cycle of a commercial real estate asset. Hence, proper knowledge of these stages to acquire the best deals and evaluate the accurate valuation of asset benefits both new as well as seasoned investors. Let’s have a look at how the life cycle of a commercial real estate asset unfurls.
Stages in the life cycle of a commercial real estate asset deal
Stage One: Acquisition
The first stage of any commercial real estate investment is acquisition. This stage begins by identifying the right asset to fit the desired returns. Since identifying and acquiring the right asset is a risky decision, due diligence on one’s real estate purchase is the required course of action. Through a comprehensive understanding of the market dynamics, determining the property’s value in the future and its historical performance, and offering price of the asset, one can decide to acquire an asset without facing any potential risk down the road.
1.1 Business Plan
The Acquisition stage usually begins with the formulation of a business plan which acts as a roadmap for the investors. Typically, a business plan includes steps to assess future market demand and evaluation of property improvement opportunities. Further, it also enables estimating the return on investments and managing expenses. In addition to this, a plan establishes budgeting for asset acquisition and purchase price. Hence, it is safe to say that a business plan increases the value of a property and generates stable cash flow for investors. Generally, a business plan for a commercial real estate investment consists of the following elements:
- Determining the investment niche and diversification strategy: the investors should identify their niche among the various commercial asset classes such as multifamily, industrial, offices, etc.
- Picking the location: It is crucial to select a few target markets for their commercial real estate business. For instance, multifamily investments may not fare well in areas with high crime rates. But it may have demand in areas where there are schools, transportation connectivity, etc. Hence, the right location directly influences the demand and supply of a property.
- Setting a target holding period: Investors should think through the timelines of holding periods in their plans. This helps guide the business primarily if the properties are located in developing areas.
- Establishing realistic return on investment (ROI) goals: By studying net operating income (NOI), capitalization rate, internal rate of return, and other financial metrics of the property, the investor should establish achievable ROI goals.
- Developing a growth strategy: A growth strategy helps investors in guiding their purchase and sale decisions. Further, it majorly helps in maximizing the gains and ROI on a property.
- Networking: Investor should establish their networks with other investors and professionals in order to grow their real estate investment business. Engaging with real estate attorneys, brokers, private and bank lenders, etc helps in seizing an opportunity as soon as it arises.
- Creating a sub-business plan for each property: The investor should strategize individual business plans for each property. These mini-plans should address all the approaches mentioned above.
Next, the business plan enables the investors or his/her team of experts to make offers on those assets where they can make risk-adjusted returns. If the offer is accepted, the investors enter into a contract with the seller, open escrow, and conduct due diligence on the property.
This step includes hiring seasoned experts and executing a proper business plan to identify the potential of an asset. Moreover, the business plan helps in executing the need for property movements or management changes. Further, this step also analyzes how the upgrades will maximize risk-adjusted returns.
- Hiring professionals: To be able to identify the asset’s value and future potential, it is crucial to hire an experienced team of experts. Their knowledge of the asset, local market competence, and rapport with the tenants eases the evaluation process to a great extent. By leveraging their professional networks and outbound marketing skills, one can identify the ideal opportunities that fit the specific investment criteria.
- Market research: After identifying the high-opportunity properties, the next step is to conduct proper market research on each of the assets. These include inspection of the physical, environmental and ecological condition of the asset. Further, it also constructs the valuation model of the asset based on the analysis of historical operating costs, leases, and property taxes. Lastly, market research also includes the legal due diligence of a property.
- Physical due-diligence:
A thorough examination of the physical condition of a commercial asset helps to better understand its future potential. It also helps in negotiating the sale price based on its condition and risk factor. There are generally three types of properties. Class A properties are generally new and high quality and represent the lowest risk. Class B properties are older than Class A properties and require some maintenance. They are slightly more at risk and hence available at lower prices. Lastly, Class C properties are often 20+ years old, with the need for heavy maintenance. Hence they retail for much lower rates than their other counterparts and are the riskiest assets.
- Environmental Due-diligence:
This involves the assessment of past and potential environmental liabilities and obligations associated with the property. This includes the assessment of risks of soil or groundwater contamination, presence of hazardous building materials, risk of hazardous soil vapors, etc. Further, environmental due diligence ensures the compliance of the property with environmental regulations. This is done for uncovering any costly non-complying conditions that will limit the potential of the property in the future.
- Financial due-diligence:
To mitigate future financial risks, financial due diligence is crucial before any real estate transaction. Financial audits allow an investor to determine a property’s cash flow. Further, it also ensures that the income and expenses match the seller’s representations. Financial due diligence includes:
- Lease audit: The legal team compares actual hard-copy leases to the rent roll to measure accuracy.
- Contract audits: This file audit reviews existing service contracts. This includes agreements with internet and cable providers, landscaping/snow removal services, office equipment services/technicians, and third-party maintenance providers.
- Cost Analysis: This audit studies historical operations to gain insight into expected expenses. Further, this helps in removing the buyer’s bias and developing a realistic budget.
- Market analysis: This audit helps to estimate future rents. This is done by evaluating similar property locations, amenities, and other variables. Moreover, it helps in estimating the property’s value after its upgradation.
- Rent-roll analysis: The legal team analyzes the timing of expiration/rollover schedules, terminations, renewals, relocation options, and existing lease schedules.
- Legal due-diligence:
The legal team determines the entitlements and obligations of a property. This includes:
- Title transfer: this verifies the ownership of title over the property. This ensures that no pre-existing claims over the property can affect the prospective owners.
- Land use and zoning audit: This survey helps in evaluating any rights of site access by adjacent landowners. Further, this audits local and prior zoning ordinances of the property. As a result, zoning audits help in confirming that all of the intended uses of the purchasers are permitted in the particular zone. In the case of ground-up developments, land audits determine whether the purchaser’s intentions for future developments comply with the zoning requirements.
Once the due-diligence checklist is completed and it confirms that the business plan is viable, the investment is funded. This leads to the closing of the acquisition phase in the life cycle of a commercial real estate asset.
Stage two: Value-add
In some cases, properties in excellent locations and fundamentals hold issues for physical, operational, or financial stress. Hence, these are called “value-add properties” that require upgrading.
The investors acquire these properties at a discount to their innate value and then make improvements to these over the course of the investment period. As a result, the purchasers can command higher rents from leasing the spaces to high-quality tenants. Moreover, as refurbishing increases revenue and lowers operating expenses, it can improve the overall management and operation of the building. Typically, value-adding includes one or more of the following approaches:
- Renovations: lack of proper maintenance deteriorates a property’s structure, architecture, and landscaping. As a result, such properties’ demand and rent rates fall below market rates. However, opportunistic investors can acquire these properties at discounts and then invest some capital in remodeling the property. Hence, this increases the market value of the property. Therefore, the purchasers can increase the property’s rental rates and which improves its income.
- Additional upgrades: In the cases where the property does not require renovations and is at a favorable location, additional amenities may help in increasing its demand from its competitors. For instance, updating the central heating system and improving the curb appeal could raise rent and improve the value of the asset. Moreover, updating the old wiring and plumbing system and expanding the storage space is also particularly helpful in enhancing the value of the asset and increasing the property’s cash flow.
- Market Adjustments: In some cases where the property is in overall good shape, there may exist issues with negotiating leases and lease renewals. As a result, the property’s current rent rates may differ significantly from the market rents. In such cases, the purchaser can negotiate higher rates when existing leases are up for renewal. Hence, this increases the Net Operating Income.
- Expense Management: Value-adding can also mean purchasers managing the existing expense and altering them to match the market standards and maximize their potential. A detailed review of each expense can help purchasers to determine whether they are unnecessary and can be eliminated. As a result, there is a decrease in such additional expenses while the overall operation of the property remains unaffected. Further, the property may be re-assessed for a lower value, which lowers taxes and increases Net Operating Income.
- Tenant Mix: In some commercial properties, there are tenants running their business in a particular building. They co-exist near each other and leverage the traffic of the main building to boost their individual businesses. However, new owners of the building may evaluate the tenant base and replace them with new tenants to increase the Net Operating Income in the process. Moreover, they can lease the spaces to high-quality tenants for the long term, which increases the occupancy rates, lowers risks and maximizes returns.
Hence, it is evident that value-adding can be expensive and time-consuming. Moreover, on the part of the investors, it requires innovation and experience for identifying an asset’s potential. However, it is a crucial stage in the life cycle of a commercial real estate asset.
Stage three: Stabilization
Once major value-adding is completed, the investors begin to understand how the improvements might impact the property’s value and attract tenants. At this stage in the life cycle of a commercial real estate asset, the purchasers focus majorly on maximizing returns and the property’s cash flow. Moreover, at this stage, there occurs a shift in the dynamics of the risk profile of the asset. Hence, in the low-risk environment, investors enjoy a more predictable cash flow and slightly reduced return expectations.
In addition to this, stabilization also includes Asset Management. Through Asset Management, the investors can monitor all aspects of the property’s performance to ensure it has reached its fullest potential. The management procedure is conducted through the analysis of revenue performance versus proforma and reducing further expenses. Further, asset management also includes following the industry and broader economic trends to maximize investment returns. Moreover, at this stage, preparing quarterly sponsor reports and analyzing the financials and balance sheets enable the investors to track the property-level performance.
Stage four: Disposition
Typically the final stage in the life cycle of a commercial real estate asset is an exit strategy or disposition timeframe. Investors constantly evaluate the changes in the asset’s value to maximize their returns before exiting the business plan. Therefore, the disposition of the asset allows new investors to enter the investment domain.
An investor’s disposition (selling or liquidation) of a property depends mainly on the intended use. For instance, if cash flow was the sole intention of the investor for purchasing a property, it is likely that he/she will lock the property in for a long time or until its maximum depreciation. However, some investors purchase a property for appreciation and raise rents by value-adding. In such cases, it is likely that they will sell the property after it has reached stabilization according to the market performance. After stabilization, investors negotiate higher rents from the tenants and may want to continue collecting the cash flows. However, in some cases, investors may choose to exit just after the closing of the acquisition. This is because, after the purchase, the building value has already appreciated and it provides desired returns. Therefore, typically, investors focus on maximizing property value and returns before their disposition.
However, potential investors generally seek properties that are well into their execution stage rather than newly acquired ones. This is because a stabilized property has already started to produce higher rents from high-quality tenants. Hence, potential investors can acquire these assets in the secondary market, without losing time in value-add.
The above steps are generally the life cycle of a commercial real estate asset. These serve as a road map for investors when evaluating a commercial property for purchasing and maximizing returns. Just as comprehensive due diligence is the key element in the acquisition stage, value add and stabilization depends largely on operations and asset management. Lastly, the disposition strategy is mainly driven by the focus on generating cash flow and increasing returns on investment. However, the insight and experience of investors over time and prevalent market conditions make the investment process more intuitive.