When you purchase a piece of commercial real estate, the selling broker will spend a lot of time trying to convince you that you are buying a property that will magically generate huge sums of cash for you.
While some properties are better than others, there are some hidden expenses that exist for all commercial real estate properties that you ought to be aware of. So next time you are considering a property purchase be sure to ask for details about the following items:
A pro forma sure looks fat if you never put any money back into the building. Unfortunately, the reality is that parking lots needs to be resurfaced, roofs need to be replaced, HVAC systems need to be updated, and much more. So, when you are looking into purchasing a property be sure to check out what capital items have been repaired or replaced recently. In addition, get an update on the age of all the main building systems especially the HVAC and/or boiler system. These are big ticket items that can make or break an investment.
Vacancy and Credit Loss
You may be looking at purchasing a property that is 100% occupied. Even still, be sure to model into your pro forma a vacancy of at least 5 to 10%. Tenants often re-locate or go out of business. Even in the best building in the hottest market it takes time to replace a tenant. That precious time is money to you. So be sure to give yourself a discount on the purchase price by adding in a vacancy.
Credit loss is a similar concept. Check the credit of all current tenants and their payment history. In all likelihood you will have tenants that either pay slowly or don't pay at all. You need to give yourself a buffer knowing that this will happen. Even the most credit-worthy tenants often have glitches that result in late payment which hurts your bottom line.
When you do have tenants that re-locate and you need to backfill, don't forget to budget for tenant improvements. In an office building these improvements can be very costly. In essence, you will need to provide an allowance to a new tenant to fix up his space before leasing. In urban high rises this can be in excess of $30 per square foot.
Obviously you would like to encourage tenants to take space as-is, but in all likelihood you will have to get a tenant improvement allowance. Be sure to budget and have some cash available for this in the event that you need to replace a tenant.
Broker's Fees As the property owner you get to pay all brokers fees for any tenant that leases in your building. Even if you represent yourself, a broker who brings a tenant to you will get a fee. In most cases the broker will get about 5% of the NNN value of the lease that is being signed. For a quality long term lease this can be a lot of cash. In addition, brokers are paid up-front (half at lease signing and half at occupancy typically) – so be sure to have the cash on hand.