How to Invest in Commercial Real Estate

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Episode #067 - How to Spot RED FLAGS in Commercial Real Estate!

by Criterion, Braden Cheek, Brian Duck
June 20th 2022
00:00:00
Description

Today our hosts Braden Cheek, Brian Duck and Joel Thompson from The Criterion Fund discuss some red flags to look out for when purchasing a new multifamily or retail property!

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But if we hadn't done that done that, this deal would would have been a disaster, there might be further expenses, they might have to end up doing some sort of remediation and who knows how long this is gonna last. And if I knew three years ago that we would still be messing with it three years from now. I don't even know if I would have accepted uh the money in the escrow because I still feel like there is some amount of risk but you own the property and there's all these problems. Yeah, they're they're monitoring as Wells right now. And I like the state of Nevada says further monitoring acquired every quarter. They're telling us that escrow money runs out, then you've probably got to sue somebody. Well, luckily the agreement we had is that they had to pay out of pocket for the monitoring and they don't use the escrow for that. And so the escrow is sitting there and they want that money. So they're continuing to spend, there may be a point where they're just they throw up their hands and they say we're not going to spend any more money. That's when, you know, you're screwed. Yeah. Because then I gotta go take that money. That's an escrow and hope that it's enough to cover it. And it probably isn't. All right, welcome back to how to invest in commercial real estate.

Thanks for joining us. And this week we are back for an exciting topic and what we want to focus on today, took a little advice from Neil. Sometimes it's not about what we can teach you, but what to kind of stay away from. Right? So here's a few things that if you see, you should definitely throw up some red flags. It should definitely cause some concern. And you should definitely maybe take a moment say, okay, these guys told me to look out for these things. I need to, I need to make sure I know what's going on. So I don't get burned. Yeah, I think it's important because people are starting to hit us up. They listen to the podcast. They're, they're asking us questions. You know, I want to get into commercial real estate and most of the deals that they're looking at, as long as everything goes perfect and there's no hidden issues. The deals will work out fine for them. But the value, uh, and our experience comes from knowing, okay, where can I get burned on these deals? What am I missing? As a, as a beginner investor? And so today we're just going to be going over, hey, what are some red flags that you need to watch out for when you're looking at a deal that could burn you once you buy it. Yeah. So I think one of the first ones is we're obviously buying these properties based on the income they produced right?

If you've been watching the show at all, you know that we're buying real estate for, for the cash flow, right? Not the inherent value of the real estate. So one important thing is you would like to monitor and see how that cash flow is done over a period of time before you purchase it. Like say you're buying it January one of 2021. I would think it would be normal and nice to have the 2020 financials to have the 2019 financials to have 2018 financials, you know, as much historic data as you can give me to underwrite. You know, show me some historical past of, hey you say the N. Y. Is a million dollars? Have you ever hit that? What's the highest you've ever hit? Is it, is it 600,000? Now I'm supposed to get to a million. You know, what, what is this, what is the historic financial data look like? Yeah. Yeah. Well and what we've run into in the past is sometimes sellers when you try to get historical financial information, they kind of box they don't want to provide. It, it it becomes a little bit of a sketchy issue with them. And so that's red flag number one is a seller that doesn't have or doesn't want to provide accurate historical data for the last 2 to 3 years.

So you can analyze the Ny and see how that compares to the N. Y you're buying. And a couple of reasons for that first. Uh If if the property like you say was doing half a million in ny uh two or three years ago and now and then it did 600,000, and then this year you're buying it on a million dollar in a y you've got to understand that transition. What was the cause of that? Because if they just if they've had real problems filling the units and then they get a big lease and and now you're buying it, you're assuming some risk on today's higher in oi uh that the property hasn't supported for the last two or three years. Yeah. And you can see, you know, if it's, if it's multi family and you see this massive rent increase, right? You could be assuming, oh, they just normally get those rent increases. But when you look at the balance sheet, you realize, oh man, they were giving everyone with a renewal a brand new refrigerator, that's stainless steel Washing machine, that stainless steel, like that's a, you know, $2500-$3,000 per door cost. That you would have to underwrite for that rent pop for that rent increase.

So it gives you some clarification, like you said, helps tell the story of what's going on. And when you start looking at enough of these financials, you understand what the normal story should look like, right? You understand kind of where the bodies are buried anyway, Well, in retail, if it's up and down, then that could indicate that uh they've had a bunch of vacancies or people are coming and going right. And so, and if that's historically what's going on, you need to understand that. Good point that leads us into red flag number two. I don't know if it's number two in the list, but let's go to it is historical vacancy is it can be a red flag either in multi family. It would be odd that you had a good a good manager that had historical vacancy because apartments should be least if they're in presentable condition and they're asking a market rent. So there there there would have to be an underlying reason why occupants you would ever dip below 85, if you're looking at a property and and there's a 70% 60% time period. What I think of is either either major renovation. You know, they had to kick some tenants out and they were upgrading the the units and they should be looking great or there's some inherent mechanical electrical utility problem that caused massive exit, like boiler chiller, hot water heater goes down and it's common for the whole property.

Something that caused, you know, a mass exodus where people were unhappy on retail, like you said, if the n y is varying year to year on a retail deal, then what that means is you you do have tenants coming and going, That's not necessarily a good sign for the location. It means that they're having tenants fail there most likely and then they're having to re 10et that is very, very expensive. So you provided an excellent example of that earlier, before the show and it was, you know, we we all know that restaurant in our town that's constantly going out of business and then a new rush pops up with a different concept and they're like Exactly, exactly. It could give insight into that location, not being ideal for whatever the uses a retail, if it's a retail deal, like maybe the retailers are struggling for some reason, maybe the ingress egress isn't good, maybe the traffic count isn't good. But what's really important is all the expenses that go into tenant turnover on a retail deal where you lose the income, you have to pay tenant improvement dollars to attract a new tenant and you've got to pay leasing commission to the broker.

All of those things are really expensive and they may not be on the income statement, they may cap ex those items. And so that's really important to dive into that. Once you see the occupants historical occupancy varying, you've gotta then dig in to see, okay, what were the Capex costs, What dollars did they give tenants to incentivize them to move in? And are they hiding that on the balance sheet? Uh and so let's say, I'll give you a very specific example, reach, I've got this tenant going in and as an owner, I want the highest rent possible. So I, I induce that high rent by offering high tenant improvement dollars for them to build out their space. Really nice and in exchange they're going to pay a higher rent. Really common in new development, new construction. That but it may not be that it's marketing now, maybe they're over market rent and they're only willing to pay over market rent because of all the ti I dollars that that they were given. And so you've got to then look at that and say okay I have risk here because because I'm not I now have a tenant that's over market rent because of what the seller did to induce that rent.

And when their renewal comes up I may have a hard time getting to renew at that high rate. Great example. We're getting a new tenant in at that high rate or Yeah. Or they bail. Can I replace it? And now I have a hit to my you know, I because I can't replace the high rent. Yeah, we've talked about this before but a starbucks perfect example guys, you got to buy Starbucks, they're paying $27 a square foot and they build a new one right across the street. The odds of somebody coming in with a coffee shop right across from a brand new Starbucks. I can tell you they're not going to pay the same rent guaranteed. Yeah. Well and and more likely it's like $40 of rent per foot for a starbucks. Yeah and and you know, there's there's another point, right? Like we tried to buy this retail deal and we offered you know 99 times out of 10, we're trying to figure out a cap rate that we can put on this net operating income. And this guy says, hey net operating income is 500,000 just using a clean round number I take and a cap on it. But you know, I think Uh you know the vacancies worth something, so you should pay me $30 a foot for the vacancy. Do you remember this deal Tulsa? Anyway, our argument was if the vacancy is worth something to anybody then go lease it to them and get it to produce any income whatsoever and then I'll be happy to have you pay for it.

But that that's been sitting vacant for five years, it's worth nothing to nobody. Yeah. So the final point on historical occupancy or historical vacancy is you have to ask yourself, you know, if they've been 90% occupied or 100% then they lose a tenant, No big deal. But if they have uh historical occupancy lower it. Maybe it looks like a good deal, high cap rate, low price per foot, but there's gotta be a reason, no owner's gonna own a property and not fill it. And so if they couldn't fill it, you have to ask yourself, well why couldn't they fill it? And yeah it's a low vacancy and you think, oh I'm just going to lease that space up but maybe you're not and that's a risk that you're taking on. So you've got to get a real good premium for that because once again it would have been leased on some level if if it was easy. Yeah. Alright. Next point. So the next one, I mean just tying this back into the first one getting historic financials. You know, it's becoming a theme here is big problems that potentially come up. So we talked about historic historic vacancy right? You walk into this massive, you know 5000 square foot.

It used to be a Mexican restaurant to get that least to anyone but a Mexican restaurant is going to cost a ton of money. You're gonna have to demo all of that. You're gonna have to get ready for the new concept. Like you said you're gonna have to pay leasing commission and And um 10 improvement obviously. So there's a massive risk for some big dollars being shed? You know, some big dollars? Another thing we look at immediately is roof repairs and those financials, are they having to patch this roof every single month? Are they having a roof for come out all the time. Do they have 10.20? Yeah, there's probably a roofing problem. Right. That's another thing that we're constantly talking about is when you get a deal under contract inspect the roof. But specifically what we're talking about on this point is big potential Capex problems. And do you have the cash budgeted? And what happens if it fails and you need to replace it? Where is the money coming from? What does that do to your model? It's that's a good point. So that what we do and we look at analyzing those deals is we take all the big ticket items which is in retail. It's parking lot, it's roof, it's H.

V. A. C. And its uh T. I. Dollars for vacant space T. I. And commission dollars for vacant space in multi family. It could be, you know boiler chiller, its roof, it's parking and it's down units? Uh So you know if you're buying a multi family that one of the big expense you'll have is uh if they're not full is they'll have a bunch of what we call down units and their their units where people have moved out and they're not rentable and so not rentable unit, Not rentable unit. And so it may be that you got to spend $5,000 to get that ready? It also may mean you have to Spending $30,000. I mean does it have cabinets, does it have appliances? Does it have flooring? Are there issues with the plumbing or the electrical? So I want to put a big asterisk on this point because for the longest time when we were looking at multi family deals, we were looking for those sorts of opportunities. So I'm calling him a red flag in this episode because you need to be weary. This is by every means an opportunity, right? Because if you can go in and fix those down units and you have enough cash to make your model work and you can get them principle and generate an extra $1,000 a unit, let's call it.

And the other guy didn't want to mess with that. That's a massive opportunity. You can make, you can make some cash there, right? Yeah. And I'll make a distinction between retail and multi family on this point. Multi family is one of those things where if you provide a clean made ready unit at market rent, you're gonna rent that unit. When I first started into real estate. I was always worried when I bought a house, am I gonna find a renter who's gonna rent this? But what I, what I found over the years is once again, if you understand what the market rate is for that three bedroom house or for the apartment building, as long as you have, you know, new carpet and nice paint and appliances and everything is in working order and you offer it at about a market rate, you're going to lease that space. Uh And so on retail though, that's not necessarily the case because you know, location is so much more important with retail and it's so much, it's such a bigger deal for a business to decide to open a location, you know, to run their business than it is for somebody just to sign a 12 month lease on a temporary apartment.

And the location is less important for the apartment, you know, because it doesn't need frontage, it doesn't need good traffic counts. Uh and so it's, it's just easier to think about being able to rent uh, the apartment than it is the retail space. So treat vacancy a little bit, a little bit more seriously on multi tenant retail than you do on apartments. Yeah, I mean, we've bought, we bought a center here in Tulsa um, awesome location and they had this um, the horseshoe of, of retail space and it had been rented in a decade. Pretty easy. Your offices there now, right? But when you look at it, there was, there was horrible visibility, there was no parking, it was this massive green space area. And, and we just immediately thought, what if you just make that parking, you could see it, you could get it, get to it. And since you didn't really have to have a high rent in there, it historically hadn't been least in decades, we didn't give it much weight, weight. So you can get a tenant in there at almost almost anything like what are you willing to pay come occupy my center and pay you triple net and, and you know, slowly increase with time and now your office.

Is there any way it's just nice beautifully space now. But there's probably something like you said, there's something wrong with it that prevented it from being leased. And another thing in retail especially is On, on multi family. You change your rates weekly. You can change them faster. You know what I mean? Based on your occupancy and based on, you know, supply and demand. Hey, we have five vacancies. They're expensive now versus we have 25, you know, we'll take $40 last month. If you just get in right retail, you can't really do that. I mean you can't just lower your price every month until you get a tenant. It's, it's not really helping you that much. Yeah, the dynamic is different because once again people that are deciding to start a business, they're choosing to be at that location for a host of factors. Population density, traffic council talked about it next to a home depot. Let's say if they, if that helps them for a long time. Yeah. And so it's, it's just, they don't make the decision based on a dollar or $2 less in rent. So for me, you have to wait a lot longer to fill retail vacancy.

But you don't need to like fire, sell it and negotiate, you know, down on it because once again, people really aren't making a decision, oh what's $10 a foot instead of 11 or $12 a foot. So I'm gonna decide to put my business there, they're not making that big of a decision based on that small of an increment, I would agree. All right, what else we got? Alright, um every deal we buy, we get we get an environmental inspection. Every single deal because environmental issues are, I'm not gonna say that joke, environmental issues are the gift that keeps on giving right. It is very hard to get away from them. It is very hard to get a um no further action letter is what you're looking for. It seems like it comes up a lot more often than I thought it would. Either there was a gas station on the corner. There used to be one or there was a dry cleaner in the dry cleaners, a big one. It comes up quite a bit. Yeah. And if they just, if they knew about a dry cleaner there, it may throw a flag like, oh, there's a dry cleaner there 10 years ago, Joke's on you. Well, so, so guys listening girls, guys who are people listening, here's the deal is you're going to get a phase one and that's just an initial low look to see if there was ever any potential issues.

It doesn't tell you whether there are issues or not. It just tells you if there are potential issues at the property, A Couple $1,000. Yeah, a couple $1000 you know, 23, whatever And as long as you get a clean phase one, you can proceed because even if later down the road, they find a problem. As long as you have a clean phase one, the law says that you won't be held liable. That maybe state specific. I think that maybe in Oklahoma law may be varying. So just consult with your environmental or attorney expert. I think there's a, I'm going to speak out of turn, but some national, we should google this before I say it. But a national fund that's been set up to handle environmental issues. And, and once again, as long as you're taking the appropriate steps to do your due diligence to ensure there isn't one. Uh, and you get a clean phase one, uh, then I think you're protected from being on the hook because there was effectively no way you could have known that there was a pre existing environmental issue. Now, what happens a lot if you have a dry cleaner, uh, you know, gas station or something like that, is that you'll get a phase one that says further investigation needed.

And so that's the red flag. Okay? And the broker, the broker will say, oh, you don't have to worry, this is no big deal, but it is. And you need to get a Phase two. And Phase two is a more extensive study into What raised the red flag on the Phase one. Is it more expensive? It's more expensive shocker there. Yeah. And so the phase two will dig a little deeper and they'll, they'll see, okay, are there any potential issues here? And the phase two, we either say no, you're good or here's the testing you need to do. Uh, and so if you get into a situation where they find that there needs to be testing, it may be that you need to move on from that deal because it can be the gift that keeps on giving. Uh, and I'll give an example just so you know that we've been through this process. We have a deal in Vegas and we, we ran into a phase one. Uh, there was some, they noted a dry cleaner than we did the phase two. They noted some elevated levels. Uh, in some of the boring testing they did.

And so the broker, the seller, they're all like, no, this is no big deal. I've seen this 1000 times. You got nothing to worry about. And we like, I don't know, we, this is a big deal is like $13 million deal And we're like, I don't think we should take the risk on this. We got an uh, an environmental attorney on, on the hook and he was, he was great. And what we had to do was, we wanted to go ahead and close, but we had to negotiate that the seller was gonna put up money uh, in an escrow account and that they had to pay for all of the testing and the monitoring Wasn't this like $1 million bucks or something. It was several 100,000 they put up and they had to pay and once and and not until the issue was taken care of. Could they could they get that money out of that escrow? Well we thought okay they're gonna do some well testing and it'll all be taken care of. We are here three years later and I still get quarterly monitoring reports on these wells and there still is elevated levels of P. C. E. Or uh some of these other chemicals. I never thought we would be in this position. The only saving grace is that the seller is still paying for the well monitoring and they still have that that money put up in escrow.

But if we hadn't done that done that this deal would would have there might be further expenses. They might have to end up doing some sort of remediation and who knows how long this is gonna last. And if I knew three years ago that we would still be messing with it. Three years from now. I don't even know if I would have accepted uh the money in the escrow because I still feel like there is some amount of risk but you own the property and there's all of these problems. Yeah they're monitoring as well as right now and I like the state of Nevada says further monitoring required every quarter. They're telling us that escrow money runs out then you probably gonna sue somebody. Well luckily the agreement we had is that they had to pay out of pocket for the monitoring and they don't use the escrow for that. And so the escrow is sitting there and they want that money. So they're continuing to spend, there may be a point where they're just they throw up their hands and they say we're not going to spend any more money. That's when you know you're screwed. Yeah, because then I gotta go take that money that's in escrow and hope that it's enough to cover it and it probably isn't knowing that they walked away from it thinking it wasn't enough to cover it.

What about multi Family any environmental issues with multi family? Do you have to do a phase 1? That's a great question You can do. In fact we were in the process of selling some multi family now and there was a phase one and uh there was a dry a gas station right next to the property line. And so they recommended a phase two. Phase two. We did it came back clean. So that's great. But but multi family, there's going to be less environmental issues like you said it was a gas station close by close by where a lot of commercial it it was a dry cleaner. A gas station, a business that was on on the commercial site. Yeah. So I mean, let's encompass that example just super quick. I mean you have to not only get a phase one, a few $1000 you have to get a phase two, which is, you know 57 $10,000. You have to engage this environmental attorney, you have to spend more time on legal fees negotiating it. You have to spend time now even though it's not your money, it's somebody else's. You still feel like you have potential risk, you know, a lot of money there for a potential problem.

And and guys deals or deals are everywhere. I mean deals are everywhere. You don't have to pitch and it's so easy. I do this all the time. We all do it. We love the deal. We have to get this done no matter what we have to get it done and you try to talk yourself into it. But what we're saying is that's a red flag that you may, especially as a beginner. I want to move on from because there's too many other deals that don't have the red flag that don't have environmental issues that you can buy at a decent cap rate, yep. All right. What else we got? Um, we've touched on this briefly, but y changes, you know, it goes back to getting the historic financials when when you have a massive discrepancy in what the NY is, you're buying it on a million dollar Ny. And then last year the seller's Ny on their statements was 500,000. That should cause you some serious concern. And and we bought deals and and we're even looking at deals now that have, that happened where the trailing 12 month financials aren't exactly what the contracted income is and what that tells me is I need to go read my leases more and make sure this income is solid. I need to do some tenant interviews and make sure this income is solid because again when you've got the historic financials that it's a burden off a little bit it's like okay these people have paid rent for the past two years.

The probability of them just stopping as soon as I buy the building is a little less than Hey these tenants maybe haven't even opened for business. Maybe they're about to open soon. Maybe they have free rent for six or 12 months all of these things. So the. No I could be what they're projecting but it hasn't ever been that way. Again that's a little red flag. Yeah I agree. And part of part of what we do is evaluating that and finding it out, we we have purchased properties where the Ny was lower in the past and to go forward in a y we were happy with but there needs to be a really really good story on exactly why that is. And what happened, you know one of the properties we've done really well on um it's also in Vegas, it had lower historical in a y but it, you know was kind of over, it was built kind of out a little bit away from the city, the city had Henderson hadn't caught up with the property yet and then the recession hit and it got foreclosed and and so there was all these problems with with the deal and then another owner came, bought it out of foreclosure and was filling it up.

And so by the time we got it, the historical, you know, I didn't match what we were buying but we felt like the area was was really coming into its own and improving. So the story was good enough for us to buy and it's been a great property and we haven't had any issues because the growth has continued in that direction. Well, the allies continue to grow, has it not? Yeah, and so we're not saying you can't buy a deal that has an N. Y. Discrepancy, but you just have to understand the story and how it applies to you and what you're doing with the property. So that brings me to the last point I think is what you just mentioned right there, It had a massive discrepancy but the location was phenomenal, right? In a bad location or or bad demographics around your location or bad traffic counts around your location or you know, if it's multi family, there's no jobs around your location, there's no reason for anybody to be over here. It's away from everything. It's in a sub market that's too small. It's in a city that doesn't have or it's very hard to get to. Or, or some of these demographics, you need to pay attention to the location. And I know it's talked about a lot, you know, location, location, location, you know, whatever, especially in residential real estate or, or you know, almost everything, but it's really important.

You know, you see these major national brands and they pay a lot of money for that dirt. They pay a lot of money for that location. You think, oh, chick fil a just kills it because they have good chicken sandwiches like, okay, it's mediocre chicken sandwich. They have the best locations every single time. Starbucks, best locations. Every single time you see New Dutch brothers, new scooters coming in, they get amazing locations right? And there's something to be said about that totally agree location, it can save you, uh, you know, a bad property and a good location, given enough time can become a good property, but the location can also eat your lunch. If you are in a bad location, it does not matter how nice the property is, especially retail. If you're in a bad location, you won't be able to lease that space. Uh, and multi family, same thing, multi family that the location is less relevant. But if it's in a rough area, what you have to know about the location of multi family is like I said, you will always rent uh your apartment if you have a market rate asking rent and you have a really clean unit.

But the market rate and a bad location is capped where in a good location, a hot area. The market rate can go up and up and up with inflation with demand. But but at some point in the workforce housing C Class location, your upside is capped on what those people can afford because you're never gonna get uh Not you're not. I won't say never. Ok over the timing could gentrify but getting, getting tenants that can pay 1000 1215 $100 in rent on an apartment. Getting them to a workforce housing where there's a lot of section eight or government housing, it's not gonna happen. And so you have to plan on, hey, my upside is capped here doesn't mean you can't buy their, we've made a ton of money buying in those locations, but you just gotta know that location delivers this kind of top end rent. And on retail. Once again, I would take location and a crappy looking building every day over a nice looking building in a bad location because retail is just so specific businesses aren't gonna open in areas that they don't feel like they can be successful.

Yeah. Speaking from personal experience, if you're trying to buy retail properties by the, you know, stop looking at good properties, the good ones don't make any money. It's very hard to make a good looking retail property, make money because the dirt was so expensive. The cost of construction is so expensive. The rent is ridiculously expensive. So you're nervous about backfilling it. If you have a vacancy, it hurts way worse and your property taxes are way more and your triple nets or more and it's just everything about. Uh, anyway, I'll get off my high horse. Well, I mean, I, I don't want to say you can't make money on nice, nice retail. You can and it may be that you take an initial lower return on your money. And, and, but it's in such a good location, the appreciation takes over and it and it goes up in value that way. We are high cash flow buyers, We are high cap rate buyers and we want high rates of return for our investors. And so it's hard to get those types of returns on the best looking real estate in the city because everybody wants that, it's less risky. So people pay up for it, which makes the returns come down. So, well that is a handful of red flags.

There's tons of stuff to look out for their um, if you're watching, make sure to get on our investor list. Super, super. Important to how to invest in CRE dot tv or the criterion fund dot com or precision equity dot com. Make sure to sign up for the investor list, name, email. And if you're a credit or not, then you will get all of our investment opportunities. And if you're looking at deals and you want to know if there are any red flags hit us up. Let us take a look at it for you and and we'll give it a quick overview and hopefully we can help you find red flags and make sure we save money on your deal. Love it. Alright. Thanks guys.

Episode #067 - How to Spot RED FLAGS in Commercial Real Estate!
Episode #067 - How to Spot RED FLAGS in Commercial Real Estate!
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