Twelve Questions To Ask When Making A Real Estate Investment
1. What is your overall investment strategy?
An investment strategy is a plan developed to accomplish specific investment objectives. It ties into an overall goal for developing personal net worth. It relates to the amount of discretionary income one needs to maintain a certain lifestyle. A good investment strategy will assess how much capital is available to invest and the types of investments, i.e., stocks, bonds, real estate, mutual funds, needed to accomplish those investment objectives. An investment strategy also determines how much capital is allocated to each type of investment.
2. Do you want to hold the property long-term or short-term?
The investment objectives of a long-term investor are very different from those of a short-term investor. A long-term real estate investor will focus on the quality of the asset, its location, and the quality of the income stream over a long period of time. A short-term investor will focus on maximizing short-term gain. They may fix up the property but will likely make only cosmetic changes in an effort to recoup the capital invested and to make a profit.
3. Are you more interested in cash flow or appreciation?
Some property types lend themselves to cash flow while others have more potential for long-term appreciation. Retail and office properties leased to national credit tenants offer better cash flow than apartments or other investments that are more highly leveraged. However, retail and office properties leased to long-term tenants generally have less appreciation potential because of the length of the leases. Income on retail and office properties are directly tied to the length of the leases. Since appreciation is tied directly to income, the fact that the income stream is stable for several years means that the level of appreciation on those properties is also stable for several years. On the other hand, apartments, which generally experience high turnover, allows the owner to constantly increase rents, which means that income is constantly going up over time. As income increases so does appreciation.
4. What type of real estate property do you focus on and where do you want it to be located?
Location in real estate is paramount. The better the location, the more likely the property will maintain and increase in value. Every real estate market is comprised of a mix of different types of real estate investments. It will be important to determine which type of real estate investment you want to focus on. As you focus on a particular property type, you will get better and better at analyzing those types of properties as you learn what key metrics to focus on.
5. Do you own other commercial properties?
The type of commercial property you invest in will be determined, in part, by whether or not you have invested in commercial properties before. If you are a seasoned owner, you will likely be more comfortable taking certain risks because you have experience in managing the risk. If you are not a seasoned investor, it’s better to play it safe your first time or two. There’s nothing worse than making a mistake on your first investment and then being strapped for cash over the next several years because all of your money is going to bail you out of your mistake. It’s always good to start out cautiously and work your way up to more aggressive investments as you gain experience.
6. Do you have other property you want to sell or trade to purchase the new property?
If you have other property to sell or trade, it will make a difference the capital you have available to invest. Having other property makes it a little more difficult because you either have to sell the other investment or trade it. If you intend to trade up, it’s likely you’ll be involved in a 1031 Tax-deferred Exchange. That requires that you identify the replacement property within 45 days and close on it within 180 days of the date you close on the relinquished property. Having a property to sell or trade complicates the process but doesn’t make it impossible.
7. What are your management skills and temperament and do you want to personally manage the property?
Some properties are easy to manage while others are difficult. A triple-net (NNN) retail property is easy to manage because the tenant does all the work and pays for all repairs and maintenance. An apartment complex is difficult to manage because the turnover of tenants is high and the quality of the tenants is usually less credit worthy, which means collection of rent may be an issue. Plus the fact that maintaining an apartment is much more difficult than maintaining a retail building.
8. How much equity capital do you have to invest?
If you don’t have much equity capital, your best bet might be to pool your money with other investors and purchase a larger, higher quality investment property. For some people, it takes years to accumulate sufficient capital to invest in even a small commercial property. Sometimes they start with a small residential property and work their way up to a commercial property. Obviously, your investment choices are limited if your investment resources are minimal. However, you may be able to tap into some investment resources you don’t think you can use for real estate investing, such as retirement account savings.
9. How much debt can you qualify for and are you comfortable personally guaranteeing a loan?
There are very few commercial properties you can purchase without obtaining a loan. Almost all commercial loans require the borrower to personally guarantee the loan. Generally, the only time you don’t have to personally guarantee the loan is if you own less than 20 percent of the ownership interest in the property. Then it’s likely that the lender will not require your personal guarantee. Some apartment properties where the loan is insured by the federal government through the Department of Housing and Urban Development (HUD) as part of the Federal Housing Administration (FHA) do not require personal guarantees. For instance, a HUD FHA 221(d)(4) loan, which is what many apartment developers obtain, is a nonrecourse loan, meaning it doesn’t require a personal guarantee.
10. How is your personal credit worthiness and credit score?
Although many lenders look more to the quality of the asset and the tenants than they do to the credit quality of the borrower, it is still difficult to obtain a commercial loan if your personal credit score is not above 600. The better the credit score, the more likely you are to qualify for the loan. A score in the 700+ range is advisable. In addition to a good credit score, it’s difficult to obtain a loan if there are other questionable situations in your credit history that could cause the lender to question your ability to pay back the loan. For instance, job history, length of employment history, and any judgments you may have against you, could impair your ability to get a loan.
11. Where is your investment capital coming from?
If you have to borrow most of your investment capital from a friend, relative or hard money lender, it may be difficult to purchase a property that has sufficient cash flow to service all your debt obligations, even if they don’t show up on your credit report. It’s better to not buy a property than to get too over-leveraged.
12. What is your expected return on investment?
If someone offers you a return on your investment that is unreasonably high be very wary of that investment. Safe investments have cash-on-cash returns that run in the range of 6-8 percent with an overall return on investment that runs around 12-15 percent. If you achieve a return higher than these numbers, consider yourself fortunate. If someone’s touting a 20-30 percent return or higher, be very cautious. Those returns are achieved occasionally, but only when the leverage, meaning the amount of debt to equity, is excessive. If the property is too highly leveraged, that means any hiccup in the market and you lose your investment. Remember Warren Buffet’s investment philosophy, “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”
ABOUT THE AUTHOR
Ken has been in the real estate business for over 40 years and has personally overseen the development and management of over $350 million worth of assets. Ken holds a B.S. degree in Accounting from Brigham Young University, a MBA from the University of Utah. Licensed real estate broker since 1976. He holds the following designations: CCIM, CPM, CRS,CCA. Served as the president of the Utah Apartment Association.