I have a potential deal on my hands. I am trying to be detail oriented in my due diligence so that I can make a informed decision. I currently own a 3 and 4 family house but would like to make a transition to commercial real estate. Please take a look and provide, comments, suggestions, insults and recommendations. Any discussion and comments here will help me form my final decision. Also please let me know if I left out any important information.
The deal is as follows:
$410,000 purchase price with 5% down seller financing, (interest rate as yet undetermined)
Most current, supplied rent roll from the seller has a stated income of ~ $9,200 per month @ 80% vacancy. The boiler was converted to natural gas last year and the A/C is 5 years old.
It is a 5 story office building with about 25k sqft located in a depressed downtown district. The surrounding streets are nowhere near war zone but could be better. The going office space rate per my research appears to be in the $10/sqft/yr range. Several of the tenants are lawyers, marketing firms and real estate agents. Many of the units are small suites with some larger 3 room suites. The building has obviously been cared for as it has a full time janitor who cleans the bathrooms, halls and other common areas. The building is nearly 100 years old and has many unique features like granite entryway, brass railings, mahogany window sills and fireplaces in offices.
The elevator does NOT work. Seller supplied a quote to bring it into operation for $80K. The place has operated without an elevator for about 2 years. Other issues with the elevator is that it is a small, (old style) elevator that would not meet code today. I still need to talk to the city and understand if it would be grandfathered in.
Many tenants only pay $200 per month, especially on the upper floors. The bottom floor is a retail store. There is a cell phone tower on the roof who contributes $1000. The seller is a lawyer who has a office in the building and wishes to stay. He reason for selling is that he is older, (70s and is tired of managing the place)
Key metrics is how long have current tenants been there?? Is there an oversupply of office in the local area??
You mention market rates at 10 sq ft currently. What are the leases in place written at?? Are the pre-recession rent rates that are inflated and coming due or are they market or below market??
If inflated the income stream with current and historical books means nothing as the leases come up for renewal they will re-trade to current lower rates or they will leave to go to other buildings. That means cap rate is going down for purchase price due to lower NOI and gross rents.
The elevator thing is huge as generally an existing owner is grandfathered in but any change in ownership many times it goes away.
TALKING to the city doesn't do anything. If a city official for that department will not sign and notarize in writing what they are telling you verbally than you can't count on it.
Thanks for the speedy reply.
I am not familiar with the local office space market at all unfortunately. That is a real blind spot in this deal for me. To mitigate it I need to speak with at least 3 property managers/leasing agents to confirm the current atmosphere and bring myself up to speed. If I was a superior investor I would go a knocking, property to property, on the same street, and find out from those property managers/landlords/leasing agents.
Excellent point about the lease history. I need to ask this question and verify the documents as a part of the purchase agreement. My own personal thoughts are that the place is on a much shorter interval of lease up. Many of the top tenants are probably no more than fly by not operations.
I will hammer out the elevator issue and make sure to get it in writing and notarized. This needs to be an absolute certainty moving forward. Thanks for the reminder. If the elevator needed to be complete I don't think it would necessarily sink this deal. I would try to negotiate the price down and provide repair capital.
As far as elevators, we briefly looked at updating one and they can go well over $100k assuming you have a current shaft that can support it. They are not cheap. It would surprise me if the city doesn't make you update it. In our area we can get an exemption if it's an historic building and doesn't currently have one. I believe that's only for under 3 stories. With a current shaft, in their eyes they could easily force you to update. I would look up ADA requirements at the federal and state level. I did a while ago but can't remember where I found them.
1. How much term is left on the existing leases?
2. Are the leases NNN?
3. Are there any outstanding receivables?
4. What are the operating expenses?
5. How does the property compare to neighboring competitive properties in terms of occupancy and rental rates?
6. If the elevator needs $80k worth of repairs now, you are better off modernizing it. I am doing a mod project now for a 6 stop traction elevator now and the price tag is $120k, which doesn't include misc. machine room upgrades required by current code. When you modernize you will be required to update the cab, fixtures and machine rooms up to current code.
7. If the elevator has been in disrepair for the past 2 years what other building systems are potentially in poor shape or have gone long periods without regular preventative maintenance? Roof, boiler, HVAC, plumbing, electrical, etc.
Based on what you have told us so far about this deal, I would walk away.
Here is my take. Sorry for the disjointed info but just wanted to give as much as I can in limited time.
I think you need to do a lot more due dilligence. Commercial property is a whole another animal. You need to really think like a company that is looking for office space, not a tenant looking to live somewhere.
Even if the rent is $10/sq ft, that doesn't mean you can get it. Parking is a key thing for offices and only a few offices probably have it. And, they probably gobble up the few companies that need to be in the area. For example, lawyers or agencies that deal with the city. Additionally, the space needs to have a minimum level of quality. There is a reason there is an 80% vacancy.
I disagree with the one person who says you need to get something written or notarized for the elevator. No city official is going to give you that even if you are allowed to grandfather the elevator. I'm not saying that you should assume you can grandfather it in (actually I doubt is since if an elevator is taken formally offline, some states mandate you need to bring it up to modern code which may require you to replace many of the elevator components) but you need to do a lot of investigation. For example, you might try to put the elevator back online during the due dilligence period under the name of the current owner.
There are a ton of things you'll need to investigate. For example, look into the taxes and the status of tax appeals for the last few years. the seller might be facing a huge tax increase because an abatement is expiring. Talk to the tax collection department and talk to them on expected tax rate increases. Although they wont comment in anything longer than 1 year, they can tell you if rates are going to increase the coming year. Inspect rent deposits by requesting all bank statements to see if tenants actually pay rent. Make sure that the seller isn't hiding utility bills. Basically, you've gotta question every single line item in a income and expense statement. In my experience, all sellers hide something. Some sellers hide A LOT.
I can tell you that you'll probably make a lot of mistakes so go in with little money on your first acquisition. You'll probably lose money but commercial properties are very lucrative.
"I disagree with the one person who says you need to get something written or notarized for the elevator. No city official is going to give you that even if you are allowed to grandfather the elevator."
Roger that's my whole point. I used to be in commercial land development working for large developers assembling land. It's all political and what the city or county officials tell you verbally is worthless. It means absolutely nothing at all. One day they can be working there and the next so and so is no longer with us. We are sorry they told you that but it doesn't change you will have this 100k expense. So if you can't get a commitment from them there is a reason for it.
You can't stick the county or city legally for something unless it's in writing. Each states laws are different. Here where I am in Georgia a verbal agreement IS LEGAL but generally held to UNENFORCABLE in a court of law.
So if you can't get something in writing from the city or county then plan for the WORST and I mean the most expensive solution to get the property fixed. If the numbers still work at your offer price then great. If they don't then reduce the price or walk. Tell the seller if you can't get commitments in writing from the county or city then you have to plan for worst case which is why you can't go a cent over a certain price.
You could also have seller proceeds from a higher price held in escrow by a neutral third party title or attorney. So say 100k of sellers proceeds can be held in escrow after closing. If it turns out you are allowed to be grandfathered or costs not to exceed XX then the remaining proceeds will be released to the seller. If not then proceeds get credited back to the buyer up to 100k for fixing the issue etc.
This is just a very general example I am giving. The point is with legal counsel you can get creative to solve the issues. No legal advice.
I'd need a lot more information to be able to make a recommendation, just as others have asked for. The major question you have to answer, through due diligence, is what is it going to take, from both a time and dollar standpoint to get the property leased and stabilized. You really need to know the occupancy rate of comp properties and to get a real understanding of why this property is 80% vacant. Also, the price of $16.40/sf sounds awfully inexpensive, but have you pulled comps in the area?
If the deferred maintenance doesn't kill you, and you have a reasonable and executable plan to get it leased up, it could be a good opportunity. But you'd better dot every i and cross every t. Anything you miss in due diligence could turn a good opportunity into a disaster.
Thank you for all the responses. As you can imagine I have been scrambling to gather information. Hopefully tonight I will have some time to sit down and answer everyone who was kind enough to leave a reply.
@Greg V. The elevator situation is most likely the keystone of this entire deal. I spent considerable time contacting every firm who is licensed by my state to repair/service/install elevators. A few of them have responded and plan on visiting the building and helping me asses the situation. I am looking to get some coding guidance and cost options from them.
1) I am requesting the existing leases at my next meeting with the seller.
2) I don't think so and that if fine.
3) Excellent question. Joel also brought this up and the seller mentioned that some of the tenants are in arrears. In addition to requesting the bank statements to confirm occupancy I need to request how many of them are late.
4) They are definitely high for the current income.
5) I am not sure how to get this information with the exception of knocking on every office building door. I am trying to work with local property managers who hopefully have better insights into the local office market.
6) As stated above I have a number of licensed elevator firms who I will work with to understand the best course of action.
7) The rest of the building looks great in my humble opinion. I am a mechanical engineer myself and I viewed the boiler, AC and roof and all were in great shape. The building has been cared for and is nearly immaculate. The elevator seems to have gotten old and the owner was tired of making small fixes to keep it running.
@Roger Doe I agree! I am up to my eyes in due diligence action items and lacking time. I am slowly trying to close the loop on all of my concerns and using this forum to make sure that I do not miss anything major.
I am going to rely heavily on the consultation of property managers who have better insights into the local office market. There is a city owned parking garage directly adjacent to the building. A large turn off to prospective tenants is the area is somewhat depressed and the non working elevator.
I am not using the 80% occupancy as a large of an indicator that I usually would. The owner,while a lawyer, is not very savvy in my humble opinion. His law office is in this building and it does not contain a single computer, (stacks of manila folders). I evaluating this deal based on my own aggressive style and the knowledge that I would employ a professional property manager to run and lease up the place.
I need more information regarding the elevator. As mentioned above I am working with a few elevator firms and need to supplement it with my own research into ADA codes. Good point about the taxes. I looked into this and saw no issues to cause concern. I will request the bank deposits. I have a feeling that the seller may balk at this or want a formal offer first before giving all this information. I would have to verify them before purchasing the building.
Your last words resonate with me well. That is exactly my attitude. I have the money to invest and my goals are to move into larger commercial investments. I want to hurry up and get the bad decisions out of the way so I can start making the good ones.
@Joel Owens We have beaten the elevator to death and hopefully I will have some more information to share soon. Thanks for the creative mitigation strategy. Once I have a handle on the costs of the elevator I can start to consider how I might structure it into the deal to still make it work.
To everyone who has commented thank you very much for your time. I really appreciate the discussion.
@Account Closed The way you mention comps makes it sound like this information could be readily obtained from local brokers. Is that what you are implying? I apologize I am not familiar with commercial real estate.
You can use a local SIOR broker.
Be careful by underestimating the seller's attempts at leasing up. People are not dumb. They can be lazy but people usually aren't dumb. There is a reason why the vacancy is 80%. You don't need a computer to lease up space. Check the surrounding office vacancy and I'll bet that the vacancy is similar. You won't be able to fix the units up, re-rent them, and make a profit if the rental rate is $10/sq ft.
On the other hand, look at the Class A property in the neighborhood. I bet you the rent is at $15-20/sq ft. You want to aim for that. But, you'll need minimum finishes and big thing is parking and safety.
@Roger Doe @Joel Owens @Mike Giudici @Greg V. @Account Closed I wanted to follow up to this post and let everyone know what happened. I followed the advice of many posters here and really dug into the elevator modernization costs, office comps in the area and cost of property management.
As the information came in this deal quickly became a no go.
Elevator modernization costs: $80-300K
Type B office space in the area is around 80% occupancy with low $/sqft
Property managers were quoting 8-10% of gross plus labor
So I am will definitely not be purchasing this property but I enjoyed the due diligence process and I will keep my eyes open for the next opportunity.
Thanks again everyone
Just curious but did you mean that the occupancy is 80% or the vacancy is 80%? I have a feeling you meant 80% vacancy.
Just a flip side in buying in these areas is that the cap rate on properties in these types of areas are usually very good. I hate using cash on cash return as a measure of performance because it doesn't factor in the risk of the property (eg you can leverage at 100% and get a phenomenal return but you can easily go bankrupt) but when the cash on cash return is over 20%, it's a pretty tempting buy.
Interesting to read the "post mortem" on this deal. I agree the elevator issues can kill a deal. My suggestion would always be to keep an eye on the property and see the trends in the neighborhood. Sometimes a bad deal this year may turn into a better deal next year when a clearer neighborhood trend emerges.
Also there are some newer elevator solutions. Sometimes abandoning the existing unit and replacing it in another part of the building is a better solution. I would love to see your analysis sheet revised in a year or so.
Thanks for sharing!
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