How do you get the real numbers on a commercial deal? How do you get the correct data? Even worse, what if you think you have the real world information and it turns out to be false? A common problem for beginner commercial real estate investors is getting the REAL numbers. And if you don’t have the income and expenses on a property, how can you make an accurate offer? The answer is not as complicated as you might think.
3 Perspectives in a Commercial Deal
Every commercial deal has 3 perspectives:
- The Investor
- The Seller
- The Agent
All three of these individuals have different goals. As an investor you need to understand the other two perspectives so that you can get the real numbers and negotiate the best deal.
No Consumer Protection Laws
Consumer protection laws for residential real estate are different than for commercial. In a residential real estate deal (single-family up to a fourplex), the seller is legally obligated to provide accurate income and expense information. If the information provided is false, as a buyer you have legal recourse. Not so with commercial real estate. A commercial property owner has no legal obligation to provide real numbers on a deal. They can lie through their teeth, and there’s nothing you can do about it. There are no consumer protection laws for the commercial investor, which is why it’s important to get the real numbers on every deal.
Remove Emotion
As a rule, the more alluring the agent’s brochure, the worse the deal is. The brochure is a marketing tool designed to draw you in emotionally. Therefore, you must learn to remove your emotions from the deal. Don’t let beautiful pictures and to good to be true numbers on paper sway you. You must understand how the numbers work and determine for yourself what is accurate.
To get the real number on a deal you need 3 things:
- Price
- Income
- Expenses
You need this information in order to do the initial evaluation of calculating the cash flow, the cash-on-cash return and the cap rate. However, often one of these three things is missing. So how do you calculate accurate numbers with missing information? Let’s look at three common scenarios and and get the REAL numbers for each deal.
Deal #1
Problem: No Property Expenses
For this deal the seller provided the price and rental income, but the property expense information is sketchy and definitely incomplete. With any commercial deal, the seller or agent should provide a full table of the expenses. At minimum, you should expect:
- Property Management Costs
- Repairs
- Insurance
- Supplies
- Utilities
- Contract services- landscaping, snow removal etc.
- Taxes
But what do you do if you’re able to get the rental income but very little expense information is provided?
Solution:
The solution is to use 35% of the rental income given as expenses. This is the industry standard that lenders use as a starting point. Simply use the formula:
Rental Income x 35% = Expenses
For example, if you have a rental income of $100,000, you multiply it by 35%, and estimate your expenses to be $35,000 a year. Now that you have the price, rental income, and expenses you can do your initial evaluation and calculate the cashflow, cash-on-cash return and cap rate.
Warning: Do not believe a seller or agent who tries to convince you that the expenses are less than 35%. It just isn’t true. It may mean that your cashflow is eliminated and you have to walk away from the deal. If you use a figure of 25% for expenses, you won’t get the real numbers for the deal and end up with a property that doesn’t cashflow. The industry standard for expenses is a minimum of 35%, anything less is fantasy.
Deal #2
Problem: No Price
In the second deal, the rental income and property expenses have been provided by the seller, but they refuse to name their price. Believe it or not, this scenario is quite common.
If you initiated contact with the seller directly to propose a deal, they often ask you to make an offer. Even when dealing with an agent, they will sometimes give you the location and property details, income and expenses, and then require you to come up with a market offer. This is a negotiating strategy and is a great way for the agent to get a high price.
Don’t let this strategy throw you off because it filters out the people who are not serious or educated. They can’t play the game because they don’t know what to do. But that’s not you because I’m going to offer you a solution.
Solution:
You need to determine the value of a property based on the comparable sales of other apartments or commercial properties in the area and using the NOI method. These two methods are what an appraiser would use to come up with the appraised value. To learn how to calculate an offer by gathering sales comparables and using the NOI method, watch my video called How to Make an Offer on Commercial Real Estate. It will show you precisely how to do that.
Warning: Do not give a low-ball offer. If you do, you will lose instant credibility with the seller or the agent. To gain credibility you need to share your sales comparables with the seller to justify your offer.
Deal #3
Problem: No Income or Expenses
There are two types of sellers: property investors who have complete financial records and manage their properties professionally, and property owners who own one property, collect rents in cash, and keep all their records and receipts in a shoe box.
In this deal, the seller is a property owner and doesn’t keep financial records at all. They give you the price, but that’s all they have. This is a common scenario in commercial real estate, so it’s important you know how to deal with it. The solution is simple, you don’t need to overcomplicate it.
Solution:
As I already mentioned, to do an initial evaluation on a commercial property you need three things: the price, the income, and the expenses. In this situation, you have the price, but you have no income and expenses.
Step 1: Calculate the Income
To solve the problem of having no rental income, have the seller go over how much rent he collects on each unit. Once you’ve tallied them all up you have the income.
Step 2: Calculate Expenses
You do a similar thing to get the expenses, going over each expense with the seller. But what if all he has is taxes and insurance. Again, just as in deal number one, you now have the income but little information on the expenses. You use the formula and multiply the income by 35% to estimate the initial expenses. Now that you have the price, the income, and the expenses you can do your initial evaluation.
