The market is down, the banks won't lend. Your business isn't what it was and your expenses are getting higher. So what do you do? Go buy some commercial real estate! Sounds crazy but what's even worse is to buy it when you are standing in a line of potential buyers with bags of money to throw at a property.

 

Just a few years ago, people would brush off the five percent Certificate of Deposit the bank was offering and look for real estate to own. Dreams of a steady stream of rental income paying the bill were too much to pass on and who really needed an FDIC-backed investment when, you know, real estate never goes down in value!

 

The times have changed and investment fundamentals have returned to the commercial real estate market. Now is the time to look at a property and determine what the Internal Rate of Return (IRR) is before making the investment.

 

Many factors need to be considered with any investment, and commercial real estate has specific considerations in addition to just the IRR. Owning a property has tax considerations, and connecting it to your business as an owner/occupant impacts your business model as well. Buildings depreciate differently than equipment, rent payments are an expense. Mortgage interest is a deduction. When making this decision careful attention needs to be paid so the comparison of investment options are considered on an equal basis.

 

Using the IRR of an investment is a useful way to determine which investment will benefit you the most. Simply put, it is the return produced by each dollar for the amount of time that dollar is in the investment. The bank CD paying five percent has an IRR of five percent. For a real estate investment, there is more risk, so the rate an investor should expect will be higher to accommodate that risk. Promises of 30, 40 or 50 percent returns on short-term investments should scream risk, but a well managed commercial property with good fundamentals in place can and does have IRR's in the 10 percent to 20 percent range. Conversely, a property with a low IRR can be a poor choice with alternative "safe money" investments available.

 

The IRR is also specific to each investor. One may require a 12 percent return while another will be satisfied with 10 percent for the same property. An owner/user will have control and the expectation of steady rent payments while an investor/non-user needs to factor in management, vacancy and collection considerations. Again, the higher the perceived risk, the greater the return needs to be.

 

In the current market, potential buyers should educate themselves on sale prices and replacement costs. Evaluate the Net Operating Income (NOI) for a property and determine the value of that property based on the numbers, not what the owner wants to sell it for. There are probably a few properties in the market that are considered bargains at the moment but without knowing the projected IRR based on reasonable assumptions, you will not know that for sure.

 

On occasion, real estate marketing material will promote great returns for a property only to find out that property is vacant and the "projected income" is based on the perceived market rates. Careful examination needs to be made and a determination of why the building is vacant before making any IRR assumptions. A medical building that is not conveniently located or has functional obsolescence issues will not command a market rate for medical space. If it can be leased for two-thirds the rate of other medical space, the adjustment needs to be considered when determining the IRR. A building with historical vacancy issues needs to be examined with detail and a determination made to adjust the projected rent or increase the vacancy factor. Also, a fully leased investment property with submarket rents should not command the same per-square-foot price as a measure of value, when compared to properties leased at market rents. The solution here is to evaluate the net income of the investment and determine the IRR for each property and decide which investment meets your objectives.

 

Consider using a real estate professional for evaluating a potential property for investment or owner use. A commercial real estate specialist such as a Certified Commercial Investment Member (CCIM) will have the expertise needed to properly evaluate a property. When the numbers make sense, the property is more than just a good looking building.