Underwriting and Financial Analysis Questions for Commercial Real Estate Investments
One of the most crucial processes of purchasing investment property is the financial analysis and underwriting during your due diligence process plan. This process will not only determine what the property value is currently, but also, how much debt you can put on it and give you an idea of what value you can achieve upon execution of your exit strategy. In addition, you’ll be able to determine where some savings can be gained in the operating expenses and any increases in the rental rate structure of the leases, both of which affects the bottom line and adds value to the property.
The following is a list of questions you need to answer as you’re creating and underwriting the financial analysis of the property:
What is the current in-place net operating income? What does the NOI trend look like? Look over the trailing 12 months and forward 12 months to see if it drops, and if so, ask why this is happening. Perhaps a major tenant is downsizing or vacating.
What is the expected sale price?
What is the current occupancy? What is the historical occupancy for the past three years? Is it dropping? If so, you need to determine if this is a market that is continuing to lose tenancies or whatever other problems you may uncover.
How does the average rental rate in the building compare with its competitive set? Are they above market or below market? What are the rental rates of the most recent leases done in the building? Are they above or below market?
What is the rollover (leases expiring) for the current rent roll? Is the rollover rent above or below market?
Are there any termination options in the current leases? (You need to constantly update your financial analysis as you get feedback during your, initial investigation, due diligence and tenant interviews).
How are the expenses running compared to other buildings in the area? Are they higher? If so, what categories and why? What are the expense trends for the past three years? Make sure you come to a conclusion as to why a particular category is higher or lower for that matter.
Are the pass throughs of operating expenses going to continue or drop if expenses are lowered? If so, an adjustment should be determined that will more accurately reflect the change in future income.
What is the condition of the tenant improvements in the rollover space coming up as well as the vacant suites? Are they typically built out and need only minor improvements and modifications or are they built out for a specific use and most likely will require a “gut and re-do” on the entire space? A realistic budget should be assigned to each suite in order to come up with a good number for tenant improvements required.
What is the market leasing commission being paid for new leases and renewals? What is the average tenant improvement allowance in the market for new and renewal leases?
What are the current lease comparable for the competitive buildings in the area?
What kinds of rental concessions, if any, are being offered?
Are there broker incentives being offered by the competition? What are they and for which buildings?
Are there common area upgrades that are needed? If so, you need to budget them and place them in your underwriting.
What kinds of conditions are the building systems in, i.e. roof; mechanical and electrical systems; elevators need modernizing? Do they need replacing, repairing or upgrading?
Does the building need to be brought up to current code compliance for: ADA; elevators; fire sprinklers; fire/life safety; OSHA compliant window cleaning roof supports, etc.? You need to contact the local municipal building and safety department authority to make sure there are no existing code violations or pending requirements that need to be made.
Are there any environmental issues affecting the property? If so, you need to determine the cost or if you even want to move forward with the acquisition?
Is the debt coverage ratio acceptable for your respective lender(s)? What is the highest loan to value that the lender will provide? Is the NOI at least 25-30% higher than the debt service?
Do the operating expenses in the offering memorandum reflect the same expenses found in the reports provided by the seller? If not, where are the discrepancies?
Are there any association fees or dues required to be paid by the building’s ownership?
Are there any services required by an existing tenant in the building such as security or parking attendants?
Are there any additional HVAC hours provided at the building owners expense to any of the existing tenants?
Will the lender require any holdbacks of funds or reserves for upcoming building improvements or re-leasing and/or lease renewals? If so, how much?
How will the parking income be affected upon expiration or termination of leases?
Is your exit strategy reflecting a realistic cap rate upon the sale of the property?
Are there adequate reserves plugged into your underwriting to cover any immediate repairs and future replacement of necessary items such as cooling towers; chillers; roof, etc.?
Are there any amenities that could be added to the building such as a common conference room; a work out facility; bike racks; smoking and/or seating areas, etc., which would enhance the lease ability of the building? If so, what would be the cost? Is it justifiable?
This list is not conclusive; however, it gives you enough information gathering to cover a lot of ground in your underwriting process. Each property is unique in some way as well as each geographic location. There are some locales that have expenses to the property that are unique to that particular region, i.e. snow and ice removal; sinkhole problems; seismic concerns and retrofits on equipment, just to name a few.
You need to continually be on guard as to what information is being given to you and its validity, because the end result is once you own the property, it’s your problem to deal with. Make sure you’re verifying information and are comfortable with your findings. ASSUME NOTHING. Underwriting is an ongoing process during your due diligence and beyond, until closing. Even then, you’ll be looking back to see how accurate your analysis was during the time you own the property.
To learn more about how to purchase commercial real estate please purchase my book: “The Due Diligence Handbook For Commercial Real Estate”. It has many more tips on how to evaluate, create value, cut expenses and investigate properties so that you can make an intelligent and informed decision while looking to invest in income properties.