Purchasing commercial real estate is a lucrative business for investors and a great way to increase their portfolio of investments while making a sizable profit. The only problem with investing in this type of real estate is it’s risky. Analyzing the deal is critical to a successful investment, but how do you analyze a commercial real estate deal?
Investors need to consider many factors to analyze a commercial real estate deal. These include evaluating market trends, conducting a property analysis, and calculating the cap rate. But, the most crucial aspect to consider is the risks of buying commercial properties.
Investors can choose from many different properties, including office spaces, retail properties, and industrial buildings. While some prefer to purchase existing properties, others buy and develop land. Getting into this type of real estate can be complex, and determining what you can afford is one of the biggest questions you’ll need to ask yourself when sealing the deal.
How To Analyze A Commercial Real Estate Deal
When buying property, you must evaluate market trends and conduct a property analysis to determine its viability. As an investor, you’ll also need to compare a few properties to see which is the best investment.
Here are a few other factors to take into account before committing to buying a commercial building:
Evaluate Market Trends
Evaluating market trends is the first step in determining what is a good deal. With a market trend analysis, investors will look at market cycles, which peak and dip, and while it’s impossible to precisely predict what will happen in the market, it gives investors an idea about whether it’s safe to invest or not.
Other market trends to look at may include:
- Growing or shrinking population
- Economic growth
- Median household income
- Unemployment
- Need for affordable housing
- Hybrid work environments
- Increases in e-commerce and a drop in occupancy of retail spaces
- Increasing demand for hotels and hospitality properties
Conduct A Property Analysis
This type of analysis provides valuable information on a building. It considers factors like the purchase price, cost of renovations, operating costs, potential revenue, and how it compares to the others in the market. It also gives you a comprehensive report and helps determine if it’s worthwhile.
Capitalization Rate
The capitalization rate is the calculation used to determine the return on investment an investor will make on their purchase. This rate is calculated by dividing the property’s net income by the market value. This rate is usually between 3% and 20%.
Cap rates are not always easy to calculate, especially with this type of real estate. In some instances, there aren’t comparable properties, and it’s more of a tool used to evaluate a potential purchase.
It’s important to note that this should not be the determining factor of whether to go ahead with an investment or not. The cap rate is, however, one of the most popular methods used to measure the profitability of an investment.
Assess The Risks
Investments always come with a certain amount of risk, and investing in commercial properties is no different. Some of the most important risks you’ll want to analyze before going ahead with a real estate deal include:
- Liquidity risks. Real estate is considered an illiquid asset. This type of asset cannot be converted into cash quickly. If an investor needs to sell immediately, it will likely be undervalued based on its current market value.
- Inflation. Inflation is roughly 2%, and investors can use this to determine lease rates. But if the rate of inflation increases and the investor doesn’t plan for this within a long-term lease, the investor carries the additional cost.
- Interest rates. When interest rates rise, mortgage payments do, too. If there is a loan used to finance an investment, it negatively impacts the lender and may cause cash flow problems.
- Environmental risks. Environmental risks include impacting wildlife, contaminated water sources, waste, and sewage or hazardous materials used to construct or renovate buildings.
- Location risks. Location is one of the most important factors to consider when buying property. You could buy it today, and in a couple of years, the neighborhood could go down, and people could move away, leaving you with an investment that is no longer with its original value.
How To Calculate Depreciation On Commercial Real Estate?
While depreciation may be considered a bad thing, for investors in real estate, it’s often a good thing and one of the biggest reasons why people invest in it. The IRS permits depreciation on these assets over 39 years, which gives you a tax break by reducing the investor’s taxable income.
There are various ways to calculate depreciating assets, but the straight-line method is used to calculate depreciation on commercial real estate. To calculate this, you need to take the cost of the property and subtract the land value. Once you have this value, you divide it by 39 years, and you’ll get the annual depreciation.
Here’s an example:
| An office building costs $1,500,000. The land value is $500,000. Cost of the property – land value = basis Basis / 39 years = annual allowable depreciation expense deduction $2,500,000 – $500,000 = $2, 000,000 $2,000,000 / 39 = $51, 282 |
The only time you can start to use depreciation on the building is once it is in use and can generate income. Depreciation will continue until it is sold or it has been depreciated (after 39 years). This deduction is based on each property and not the investor. So, if the investor has many of these investments, they will likely have a better depreciation expense deduction.
There are a few benefits to depreciation. First, it allows investors to create thousands of dollars in tax savings and will enable them to reduce their taxable income every year. Smart investors use this method to alleviate the tax burden on their investments.
How To Calculate ROI On Commercial Real Estate?
A return on investment is the profit you have earned from that investment. The out-of-pocket and cost methods are two ways to measure your ROI. These methods are basic and don’t consider rental income and maintenance factors.
The Out Of Pocket Method
The out-of-pocket method generally results in a higher ROI. It is calculated by taking the total amount of cash you invested in the building and subtract money generated from renting or selling it. This value is then evaluated against the current market value to determine the ROI.
Example:
You purchased real estate for $1,800,000 and put $800,000 as a downpayment. After renovations, repairs, and construction costs, the total put into the investment is $1,000,000. So if you then sold it for $2,600,000, the net cash investment would equal 61%
Formula:
Return on investment = selling price – total cash investment/selling price x 100
ROI= 2,600,000 – 1,000,000 / 2,600,000 x 100 = 61%
ROI= 61%
*This method does not consider the cost incurred when you sell a property.
The Cost Method
The cost method is calculated by dividing the investment gained by the initial costs and considers the increased market value of your purchase by doing renovations and repairs.
Example:
You purchase a building for $200,000 in cash. You renovate and make improvements to it, which cost $80,000, and the value increases to $320,000. This means that the property gain is $40,000.
Formula:
$80,000 / $280,000 = 28%
ROI= 28%
*The cost method does not take into account any debt.
Conclusion
Analyzing your real estate deal is crucial for making a good investment and for creating a successful portfolio. These deals always come with risks, and the only way to mitigate these is to conduct thorough research and compare the property you want to purchase to others on the market.
When you have all the tools and information you need, you can easily invest in commercial real estate and be successful in the real estate market.