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256 Part V:Kicking Your Investing into High Gear
Does your prospective commercial fixer-upper favorably satisfy these fac-tors? If so, you’re ready to move on to the next level: due diligence. If not, consider finding another deal for now.
Perform due diligence
Due diligence is the process of doing your homework on a potential invest-ment. You’re looking to find out whether it’s a good buy, an average buy, or a bad buy. Because we have dedicated Chapter 6 to the subject of due dili-gence, we recommend that you review it again.
Due diligence is not only a fact-gathering mission, but it is also a mind-set. You must think like an investigator on one of those detective television shows. Leave no stone unturned. Expect the unexpected. Expect drama. Expect the twist in the story. The one thing you want to avoid is a surprise ending, right?
A proper mind-set also means being “present” with what’s going on around you. You need to be as distraction free as possible when going through the due diligence process. What are the consequences of being distracted during due diligence? Not good, that’s for sure. Not being present may cause you to overlook important property expenses or not follow up on a severe physical defect in the property’s structure.
The due diligence process usually has three areas of focus: physical inspec-tion, financial investigation, and legal inquiries. In the following sections, we touch on these topics as they pertain to commercial fixer-uppers, but we add another area: sales and marketing strategies, which are often overlooked.
Physical inspection
Hire a professional property inspector to do the physical inspection. These professionals are trained to spot apparent and potential problems. They’ll get on the roof, check out the building’s foundation, walk through every unit of occupyable space, including storage and garage areas and laundry facilities, check for building code violations, and see if the electrical and plumbing sys-tems are up-to-date.
Keep in mind that during a physical inspection, your goal is to take note of every broken piece of the property that’s going to need fixing. For example, jot down if there is evidence of a roof leak or if a section of the sidewalk is a safety hazard and needs replacing. Remember, your goal is to buy at a good price, fix it up, lease up, and sell. Knowing how much the fix-up is going to cost is a major piece of the puzzle. After you have your list of items that need fixing, you’re in a position to add everything up to see if the costs outweigh the benefits of buying.
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During the inspection, it’s a good idea to have your roofer and general con-tractor there, walking around with the property inspector. An inspector will give his best guess on what it will cost to have a roof replaced or what it will cost to have siding replaced. With the roofer and general contractor there, you can get more accurate costs immediately.
Although a professional property inspector can give you the overall picture of the property’s condition, you should consider bringing in a specialist if the inspector’s report turns up a potential problem that’s beyond his experience.
Financial investigation
You’ll run into different financial scenarios with a fixer-upper than you would if you were buying a normal, ready-to-take-over commercial property. First of all, because the property is distressed, the financial records will show it. Typically, the income is much lower than its potential, and the expenses are higher than normal, proportionally. Don’t be surprised. Second, expect the financial records to be incomplete, nonexistent, and maybe really unprofes-sional looking. This is why it’s a fixer-upper. This is where you make your profits.
When you do your financial investigation, crunch the numbers as-is by evalu-ating the cash flow of the property in its current condition. Of course, you’ll see a horrible, negative cash-flow condition. Make a note of that negative cash-flow number. Now crunch the numbers as if the property is fixed up and 90 percent occupied or at market occupancy with great tenants. What does the cash flow look like? Hopefully it’s great. Make a note of that positive cash-flow number. See the big difference between the two? Now, you have to ask yourself these questions:
U How do I go from that huge negative number to that great positive number?
U How do I bridge the gap? Is it attainable?
U How long will it take and how much will it cost?
All of these issues are discussed later in the chapter.
Legal inquiries
Everything that you read about “legal” due diligence in Chapter 6 applies here. However, with fixer-uppers, you need to look at a few things a little more closely. First, because the property is distressed, we would be concerned about liens from contractors, subcontractors, workers, and materials suppli-ers. Make sure that your purchase contract agreement states that the seller is responsible for clearing up all liens placed against the property before closing occurs. Also pay close attention to building code violations. Because
258 Part V:Kicking Your Investing into High Gear
the property is distressed, what corners did the owner or management cut? Last, but not least, pay extra attention to the insurance policy, and obtain a claims history report. You’ll find out about things such as past fires, past water-damage claims, and prior tenant claims.
Sales and marketing strategy
Part of your due diligence is to come up with a sales and marketing plan to lease your spiffy new property with great tenants and great leases as quickly as possible. Just as any new forward-looking, successful business has a busi-ness plan, your project needs one too. This part of due diligence is often overlooked because the person managing the update has his hands full with those challenges. And most great project managers don’t have a salesperson’s mentality. They’re usually very analytical, but not the salesperson you need to have on the team.
If you’re creating a plan for a retail center, start off by asking these questions:
U How are other retail centers doing in this area?
U Is the population trend upward or downward?
U Is there job growth in the city?
Do enough research to solidly quantify any trends that you discover. Next research and find out if there will be a strong market for your fixer-upper after you finish. Will your finished product be in demand? Do this work upfront. Then figure out the most effective ways of marketing your completed fixer-upper. Implementing a strong plan with the right salespeople on the front lines makes all the difference. For more help on this topic, check out Marketing For Dummies, 2nd Edition, by Alexander Haim (Wiley).
Before fix-up and after: Bridging the gap to payday
After your due diligence is complete, you have to make a decision. Do I pull the trigger on this deal? Your due diligence holds the answers to some key questions: Can I take this property in its “before” condition and transform it into its desired “after” condition? Can I do it profitably and within a reason-able time frame? In other words, do I have the skill, know-how, and resources to take this mess of a property, this great opportunity, and cross the bridge to a property that attracts the best tenants, gets good lease rates, improves the area, and makes me money? Here are tips for bridging that gap:
U Know your break-even point. Know how much income you need to bring in to break even after paying operating expenses and the mortgage. Get to this point as quickly as possible. (We discuss breaking even in detail later in the chapter.)
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U Find out the cause of the distress. Find the root causes of how the prop-erty got into trouble. Property problems go two to three levels deep. For example, if the property’s distress is blamed on a weak rental market (level 1), it’s probably because the owner is marketing to the wrong type of tenants (level 2). The owner may be misdirecting her marketing because she’s out of tune with what’s happening in the market today (level 3). As you can see, each level has a root cause (as well as a solution).
U Rate the seriousness of each problem. After examining the causes of the distress, prioritize each one on a scale from one to five, with five being very serious. Immediately address the fives first, and then work your way down.
U Total your financial needs. You need to figure out as best you can how much money you need to purchase and fix up the property. Your total should include any long- and short-term loans, including construction loans, rehab loans, bridge loans, hard money loans, or lines of credit. And as a safeguard, add a cash reserve.
U Figure out how long it will take to complete your game plan. Although this may be difficult to pinpoint, sketch out as best as you can how long it will take to acquire, fix up, and sell the property. Don’t just throw out a number of months or years. Instead, make an educated guess. For instance, if the purchase process takes 3 months, the fix-up takes 12
months, and positioning and selling takes 6 months, you’re talking almost 2 years for the project completion. The months can really add up quickly. It’s best to be on the conservative side.
U Decide who’s going to do the work. Who’s on your team? You’ll have to develop your team of professionals — general contractors, attorneys, property managers, leasing agents, maintenance personnel, project man-agers, accountants/bookkeepers, and various other folks.
Determining your break-even point
One of the first things we like to know before jumping into a deal is how much income we need to bring in each month to at least break even in cash flow. It’s stressful owning and managing negative cash-flow properties, so the question is, where do you need to be occupancy-wise to at least break even? You want to get to this condition as soon as possible. Getting to the break-even point allows you to predictably turn the corner to positive cash flow and profitability.
Here’s a quick and easy formula to use to figure out your break-even point:
260 Part V:Kicking Your Investing into High Gear
1. Calculate your potential gross income.
Potential gross income is defined as the most income the property can make when it’s 100 percent occupied. For example, if you have 60 apart-ment units renting at $555 per month each, your potential gross income is 60 ´ $555 or $33,300 per month. Now, multiply by 12 to get the annual total, which is approximately $400,000.
2. Calculate your total operating expenses.
Add up all of your monthly expenses, including taxes, insurance, mainte-nance, repairs, utilities, landscaping, accounting, management fees, salaries, and so on. Then multiply that number by 12 to get your annual total.
3. Calculate your total mortgage payments for 12 months.
This is called this your annual debt service.
You can use this formula to find your break-even point:
Break-even occupancy % point = (operating expenses + annual debt ser-vice) ÷ potential gross income ´ 100
Here’s a quick example: Suppose the fixer-upper is currently 50 percent occu-pied. Say at 100 percent occupancy, the property brings in $400,000, and the operating expenses run you $185,000. The annual debt service is $95,000. See the break-even point calculation below:
Break-even occupancy % point = ($185,000 + $95,000) ÷ $400,000 ´ 100 = 70%
This means that when the property reaches 70 percent occupancy, it will break even. Below 70 percent occupancy, the property will operate in negative cash flow. Any occupancy above 70 percent will produce positive cash flow.
In this example, the property is currently 50 percent occupied. After it reaches 70 percent occupancy, it will have a positive cash flow. Given these numbers, you need to ask yourself these questions: How long will it take to reach a 70 percent occupancy break-even point? And can I support the property finan-cially until it reaches 70 percent occupancy?
Creating checkpoints for the renovation process
It’s a given that when you purchase a fixer-upper you’ll have to do some work on it, and for that, it’s best to have timely checkpoints. Start your checkpoints by identifying the main pieces of the fix-up puzzle: financial, rehabilitation, property management, and lease-up.
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