Commercial Property Due Diligence

9 Replies

Hi everyone! Glad to be part of Bigger Pockets community and I am looking for some help on my first potential commercial real estate deal.

I am looking to acquire a shopping center that is profitable but not in best of shape with some differed maintenance in the common areas (parking lot and landscaping primarily). The center does not currently have any major chains in it and have a couple larger spaces 10-20K sq ft) with potential to have some medium sized retail chain possibly (drug stores, dollar stores, or even auto parts stores). It is only about half rented now and brings in about just north of six figure NOI so I believe it has a lot of potential by increasing the occupancy rate and taking care of the maintenance items which will allow for rent increases down the road. I have the following questions I would appreciate some feedback on:

What is the typical due diligence process you would need to do?

Does the property command a lesser cap rate if it does not have a big name chain?

How much of a discount should I expect due to the deferred maintenance needed which is significant ?

What is the process of getting a big chain to come to a property and how long should I expect it potentially could take?

The owner is willing to do owner financing but with about 30% down. I think this would be about the same as a commercial loan. What are the advantages of taking the owner financing vs. getting my own loan?

What is the typical cap rate for retail shopping centers that you are seeing in the market place now?

Thank you in advance for your help! And Of course any other advice would be appreciated!

John

@John Pu

I'll try to answer some of your questions here.

1) Due diligence should involve verifying all the numbers as on any deal, structural inspections, environmental study, etc. You should also be looking at demographics, traffic patterns, and of course getting bids on the cost of rehab. Visit the city and ask about what sorts of uses the zoning allows and if there are any current known violations or "grandfathering". If you are using a broker, they should be able to help you through all of this.

2) NNN property typically is offered at a lesser cap rate because it's considered a more stable long term investment than a residential multi family. Leases are usually 5+ years and have built in rate hikes of 3-5%/year and expenses get passed direct to the tenants via NNN. There are pluses and minuses to having a big chain anchor.

3) This is not something I have experience with so I will leave it to an expert in that space.

4) There are some great advantages to owner financing IMO. First off, there are no loan points or closing costs associated with the loan. There's also no appraisal required. The owner might be more flexible on rates and terms than a typical commercial lender will be. The owner financed deal can also close far quicker than with bank financing. If the property needs work, this makes even more sense since the bank might take a look at the project and either decide they don't want to do the loan at all or they will only give you a 65% LTV because of the perceived risk. Use the owner as the bank, then get the property rehabbed and fully stabilized. Then refi back up to a 70-75% LTV based on the new value you have created.

Quick note about the drawbacks of a big name chain... They will typically come in and try to take control away from you. I don't mean they will come in and want to run your property for you. But they will come in and try to grind you on many, many aspects of your deal. They will dictate your tenant mix by putting language in your lease restricting other tenants you can rent to. They will want a better rate on their lease because they know that they add value to your property just by being there. Also, these sorts of tenants can take a LONG time to make decisions and sign leases. 

@John Pu Discounts due to deferred maintenance are negotiable and many times is factored into the offering price. It also depends on how motivated the seller is and how bad of condition the property is in. It all boils down to how much you are willing to pay. A good place to start would be to determine The value of the property as is based on income and subtract the improvement costs. 

CAP rates for these types of properties vary greatly depending on location, type of building, type of construction, class (age), tenant mix, leases, and overall demand in the market.

Talk to a retail property management in the area that works on turning around centers. They often have some good insight.

You are asking a lot of questions. Basically wanting to do a value add retail deal without the experience or it appears that way by the post. Typically in those situations you have to PAY for that knowledge. Whether that is getting a company hired on as  consultant, giving some equity to the property management company coming in to turn it around, etc. 

There is a lot of work to stabilizing a center.  A regular loan is usually not available on un-stabilized ( typically under 85% occupied) centers. Owner finance, bridge debt,etc. can be options.

It's not just the 30% down the seller wants. You will have tenant improvement costs, typically free first few months rent on occupancy, attorney legal fees to negotiate the lease ( property management company usually just does LOI), tenant rep broker commissions for bringing the tenant to your center,etc.

Thank you all for your responses. As I said, I am new to commercial real estate even though I have several residential real estate properties that are cash flowing. I was out of pocket last week so am just getting caught up now.

@Geordy Rostad

Thanks again for your insights. This is a direct to owner deal so no brokers are involved yet. I am in process of getting some of the preliminary information and have also reached out to the city as you suggested. Some of the tenants have been there for 7+ years (1 almost 20 yrs) so some of the tenants are stable. The cap rate he has it at is about 6.8% with the property about half rented so there is some upside. However, due to a highway that was built in the last ten years or so, the road it is on is now a secondary road used for local access now so traffic count is lower. The area has seen some money flow into as evidenced by some renovated and new built homes nearby. As far as the the environmental study, what is involved and how do I go about it. If the previous owner had one done when he purchased, is that sufficient?

@Greg Dickerson

Yes, I agree. I am having a difficult time getting comps even with currently available listings. however, some with the bigger named stores/chains are in the 4-6 cap rate and they look like they have minimal deferred maintenance. That's why I posed the question. So I guess the best is to determine value and then subtract out expected repair costs as a starting point. Any suggestions on getting information on sold comps?

@Joel Owens

Thanks for the facts. I know it is a difficult task for someone without experience. I am trying to bring on a partner that has done other commercial deals and hoping he can help me through the process of not only the purchase but also managing it going forward so I can learn the ropes as we go. Any suggestions on how to properly vetting a potential partner that has such experience - what key questions may provide the necessary insight on their ability to add value?

@Ronald Rohde

That is true. The escalators are all in the 2-4 with majority at 3% range. The tenants all have at least 3-5 years left with renewal clauses. Several of them have been with the plaza for over 7+ years so there is a stable core. I will revisit the projections with the escalators added in on future years and see how it looks. Thanks again.