Certain criteria must be analyzed to effectively assess the value, potential risks, and rewards of different real estate investment opportunities. Simply utilizing the old adage “location, location, location” is often too simplistic in evaluating income-producing real estate, and strictly relying on capitalization rates to measure real estate value fails to contemplate potential future risks. In today’s investment marketplace, a prudent and disciplined real estate professional needs to consider many factors — both internal and external — when analyzing a real estate opportunity.
Financial Factors to Consider Before Investing in Commercial Real Estate
The multitude of items worth considering before electing to pursue and consummate an acquisition include:
- Tenant number, quality, creditworthiness, and renewal probabilities
- In-place rental rates versus market rates
- Lease rollover risks (expirations)
- Property use, condition, and average suite size
- Environmental risks
- Potential for future capital expenditures, (i.e., tenant improvements, leasing commissions, base building, and rent growth)
- Future operating expense growth
- Market economic drivers and current conditions of debt markets
- Cost of capital and various capital market sources (bank loans, insurance companies, and commercial mortgage-backed securities)
- Rent roll diversity
A thorough study of all of these elements is necessary to ascertain the potential risks and opportunities affecting a property. Once risks are well-determined, then the potential rewards can be understood and evaluated in context. The goal is to determine whether the potential rewards justify the risks. Begin every potential acquisition by applying various economic models to determine value. Effective property investment analyses include, at minimum:
- Forecasting the future cash flow projections and discounting them to determine an investment’s internal rate of return.
- Determining the current price per square foot compared to replacement cost and historical market peaks and valleys.
- Comparing the property’s price to its comparable set.
- Calculating the capitalization rate.
- Estimating the cash-on-cash returns.
When these various models are considered collectively, a well-informed decision can be made concerning where an investment sits on the risk/reward spectrum.
Once financial analyses have been performed and it is determined that price and value correspond and that minimum baseline investment expectations can be met, the next most critical criteria to evaluate are the number of tenants, their average suite size (square footage), and the property’s rent roll diversity (various business industries). Though it may seem like a lot to consider, each factor has an impact on the potential financial outcome of your investment — should you choose to move forward.
At Kenwood Management Company, we possess the systems and processes to effectively assess these financial factors during property analysis. We also offer an extensive wealth of knowledge and understanding about the local real estate markets and how to greatly reduce investment risks for owners and investors. Whether you’re looking to expand your portfolio or lease the right commercial property for your business, we can help. Contact us today to learn more.
Learn more about commercial investing by downloading our guide: "How to Invest in Commercial Real Estate: A Comprehensive Guide"
