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Evaluating Commercial Real Estate Deals

Published: 09-12-21 Category: Investing

Specializes in providing actionable insights into the commercial real estate space for investors, brokers, lessors, and lessees. He covers quarterly market data reports, investment strategies, how-to guides, and top-down perspectives on market movements.

This article was updated on 8/10/2023.

Commercial real estate (CRE) deals require preparation and thorough evaluation before they're brought to closing. CRE investors who go it alone take the time to complete their due diligence and research; others acquire the help of experienced commercial real estate brokers who can navigate deals and win favorable terms when searching for commercial real estate for sale.

CRE offers higher payoff potential, additional cash flow, more reliable tenants, longer leases, and an abundant market of property managers. But with its great rewards come its risks; commercial real estate tends to falter in times of economic decline, require higher upfront investments, and demand professional, paid help.

You should not only be evaluating on paper the property you're looking at but also taking into account these risks and rewards when purchasing commercial real estate for sale.

With that said, here's what you should do to properly evaluate a commercial real estate deal.

#1 – Run Numerical Comparisons

Most residential real estate is valued on square footage based on the sales of other local, comparable properties. In other words, the value of a single-family home in Austin, Texas would be partially determined by the sale prices of other single-family homes in the neighborhood.

But commercial real estate deals are valued differently. When purchasing commercial real estate for sale, professionals often run comparisons that are not solely based on sales of similar properties in the area. For example, commercial real estate professionals often compare the property's capitalization rate (or cap rate) to those of other, similar properties.

You can calculate the capitalization rate of a property by dividing its sale price by its net operating income. If you're purchasing commercial real estate for sale in cash, calculating its capitalization rate would give you a good idea of your annual rate of return on the property.

Other Property Valuation Methods

It's certainly important to calculate a property's cap rate, but you shouldn't place all your eggs in one basket. It's a good idea to see how the commercial real estate property you're buying stacks up against others by using other valuation methods as well.

These include:

Cash flow: The net cash flow of the property and how much cash is going in versus going out. Ultimately, this determines how much money you have left over after property expenses and other bills are paid.
Gross income: The amount of money a property makes before expenses.
Cash-on-cash return: This is another way to measure your return on investment: Simply divide how much cash you put down on the property by its annual cash flow.
Net operating income: The primary amount of money that's used to calculate a property's capitalization rate. This is how much income the property rakes in after all operating expenses and before a mortgage is paid.

These valuation methods will give you a clearer picture of the deal when buying commercial real estate for sale.

#2 – Prepare for the Negotiation Table

The buck doesn't stop at running and comparing numbers for a commercial real estate property. There's plenty to consider and bring along before you even make the trip to the negotiation table.

Financing Commercial Real Estate for Sale

If you're seeking financing to buy commercial real estate for sale, the bank through which you obtain the money needs to feel good about the property's merits. This is unlike single-family homes and other types of residential real estate. The owner-operators of the commercial real estate property are the personal guarantors and are solely responsible for repaying credit.

If the property has four units or fewer, you can take advantage of owner-occupied financing and live in one of the units. Your property won't be able to generate as much cash flow as you'd probably like it to given that you yourself are occupying one of its units, but doing so makes it easier to manage the property, communicate with other tenants, and build commercial real estate experience for newer investors.

Acquiring the Help of a Broker

If enduring the process of buying commercial real estate for sale makes you uneasy or confuses you, you should acquire the help of a commercial real estate broker. A broker is a real estate professional with more hours of additional training and experience than your typical real estate agent as well as a state license.

Commercial real estate brokers usually specialize in a single geographic area and become extremely familiar with that area's market trends and data. A broker will understand how to use the aforementioned valuation methods to evaluate the deal and win you favorable terms.

If you choose to work with a broker, you should ask them any and all questions that come to mind. Questions surrounding local market trends, future market predictions, the broker's own professional experience, the broker's negotiation tactics, and so forth. Give yourself as clear a picture as possible of what's to come.

#3 – Ask the Seller for Important Documents

Some important documents you should request from the seller of the property include:

Rent roll of current tenants;
Maintenance records;
Service contracts;
Copies of leases;
Estoppel certificates; and
Income and expense statements.

You'll want to request these documents to give yourself as complete a picture as possible of the property's financial health, physical condition, and tenant quality. You may also want to ask the locals about the property and if any problems have recently risen.

Do your due diligence and cover your bases well.

#4 – Stay Current

If you're investing in commercial real estate for sale in either the retail or office space property types, you'll want to stay current and up to date with CRE news. Doing so will help you identify economic and industry trends that can assist you in evaluating commercial real estate deals.

Commercial real estate property types are affected by times of economic decline and are sensitive to price. As we recently saw with how the Coronavirus Pandemic affected the economy, if a bar or restaurant isn't getting customers in the door, it may struggle to pay its rent and may need to ultimately close down, resulting in a loss for you.

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