Top 10 mistakes in commercial real estate (CRE) transactions
Published on March 11, 2022 by Naveen Patel
Introduction: Investing in commercial land may be a good way to make money. Making mistakes is understandable when trying something new, but we see common and expensive mistakes being made even by seasoned CRE owners only too often. These mistakes often result in buyers walking away and deals falling through. In this article, we discuss some of the most common mistakes made and how they could be avoided, to ensure a smooth transaction.
The most common mistakes that result in higher costs and more time spent on a sale or purchase:
Using low-quality photos: Not only are buyers likely to forget poor photos, but they are also likely not to take the property/proposal seriously. It is imperative that high-quality photos, taken by a professional photographer, be used. The way a property is advertised makes a significant difference.
Getting stuck on the current use of a property: A buyer could use a property in a number of interesting ways. Confining one’s view of a property to its current use would result in selling it short and cost the seller.
Failing to respond in time: Responding quickly is an easy way to establish yourself as a trustworthy seller. Provide buyers with all the information they require.
Not instilling confidence in your buyers: Buyers are more inclined to trust a business that provides information that is beneficial to them. Another strategy is to show a buyer that you understand all there is to know about the property and that you are prepared to walk away if their offer is not satisfactory in terms of the valuation of the property. While this may appear to be the opposite of what you need to accomplish, indicating that you are prepared to accept a lower offer would give a buyer confidence in your valuation.
Overestimating purchasing power: This can be divided into three parts: First, the buyer needs to be ready to present proof of funds if the offer is to be taken seriously. This proof of funds should be for the amount being deposited if you are obtaining financing, or for the full amount if you are making an all-cash offer. Do not submit proof of funds for part of the deal value and then say your offer is all-cash. Even if the buyer does not have the full amount in cash, it is possible to document a proposal that does not include contingent financing, but that is a different view. Second, you need to have realistic expectations about how you are going to finance the remainder of the deal if this is not an all-cash purchase. For example: 80% of the loan to value (LTV) is virtually impossible to obtain on most net lease deals. Therefore, if that is your requirement, you would need to adjust your price point to be in line with a more reasonable LTV, such as 65%. Third, if you intend to invest with partners, determine the partnership structure before you pursue your first investment. Who will be the point person, how much will each partner realistically contribute and what reserves do you all have to meet transaction costs? It is important to understand all this and your target properties.
Not hiring the right deal team: Your accountant should be the first person you contact before embarking on a new real estate strategy, followed by an experienced and qualified CRE attorney and a successful broker. Research, interview and select your counsel before you write your first letter of intent. The most experienced net lease attorneys are comfortable representing clients purchasing properties out of state, but the specific location of the property or properties you select should not hinder finalising counsel. Waiting to select your attorney until after you have an accepted letter of intent could slow the contract negotiation process and put you at risk of losing the deal. When selecting a CRE broker, specialisation and experience are key. This is especially true if you are contemplating a 1031 exchange (a swap of one investment property for another that allows capital gains taxes to be deferred) and have limited time to find a suitable property. In most cases, accomplished brokers have deep relationships in the market and can provide you with the much-needed credibility as a new buyer, increasing the likelihood of your offer being selected. Brokers can also help you assemble the rest of your deal team if you are new to the industry; they can refer you to qualified attorneys, title companies, environmental consultants and surveyors. Remember that brokers do not get paid until a deal closes, so they will be motivated to do everything possible to make sure your exchange or acquisition goes smoothly.
Thinking an accepted offer equals deal control: An accepted offer is very different from an executed contract. Letters of intent are typically non-binding on either side, and unless you have very specific exclusivity language in your offer, you have no control over an opportunity as a buyer until you have a signed contract in hand. Move through your review of the contract with your attorney as efficiently as possible to minimise the chance of losing the deal along the way.
Glossing overdue diligence: This is a common mistake among cash buyers. Without a lender dictating the necessary inspections, it could be easy to skip updating third-party reports or skim over matters that may seem tedious. Do not try to save a few thousand dollars by skipping the ALTA land title survey or the phase 1 environmental report. The only exception may be if reports are available and are less than a year old. However, even then, you would want to review them carefully and have them re-certified. A comprehensive due diligence effort includes many tasks, such as title reviews, understanding zoning and lease reviews.
Not having an exit strategy: Not having an exit strategy at the time of acquisition can impact the investment negatively. Obviously, market conditions change and personal situations may change, but knowing the answers to the following questions is important: How long do you plan to hold this property? Do you have an estimate of the selling value? What are your best- and worst-case scenarios, and could you live with both? There is so much to gain from investing wisely, but in an ultra-competitive market, being prepared would make the process efficient.
The following are some key considerations to ensure a smooth transaction and better understand the CRE market:
- Understand the tax implications: First, before you even go to market, you need to be prepared for a sale of the property from a tax and exchange perspective. Understand expected capital gains obligations on the front end and decide whether a 1031 exchange should be pursued before listing. For an exchange programme, a qualified intermediary needs to be in place before closing the deal, along with a general idea of what type of property has to be purchased. The very last choice in a sale is between paying taxes or finishing an exchange.
- The deal team matters: Focus should be on getting the right team on board. This includes a CRE attorney, a broker and third-party service providers such as environmental engineers, title companies and surveyors. Transactions are complex and a number of factors could make a deal fall apart. A high-quality broker could get the highest price in the market while ensuring your interests are protected at all stages of the deal. As new problems arise, as they would in every transaction, an experienced broker can navigate them to keep the deal moving forward. Similarly, hiring the right CRE attorney — an expert in the particular type of property — is crucial.
For example, a client hired a general attorney who had helped him with matters in the past. Unfortunately, the transaction they were trying to close had a very complex debt structure, one beyond the attorney’s scope. The client ended up changing counsel mid-transaction, significantly slowing the process and adding to costs.
- Competition yields the highest price: Avoid over-pricing the property. There may be factors unique to your particular investment that theoretically allow it to command above-market pricing. If you list a property significantly above the market value, provide room for negotiation. No activity helps no one. As a seller, you would want multiple offers, creating competition to push up the price. Be realistic when setting your list price if you want to sell for the highest price.
- Compile due diligence material early: All due diligence material should be compiled and reviewed by the deal team before going to market. This includes the full lease and all amendments. Do not rush to market — get all due diligence material together and make sure your deal team has reviewed it thoroughly and all marketing clearly reflects all elements of the deal.
- Disclose material facts upfront: Ensure you disclose any property-specific issues upfront, so there is no conflict later. These issues could include late rent payments, disputes with townships, deferred maintenance and unexpected Reciprocal Easement Agreement (REA) obligations. Waiting to disclose such issues until well into due diligence would almost always cause a buyer to re-trade the pricing or cancel the deal. Most issues could be worked through if disclosed in a timely manner and presented properly. It may be a seller’s market at present, but this does not mean you should ignore the abovementioned points. Give yourself the optimal opportunity to achieve maximum pricing from a buyer by being prepared for your sale, hiring the right deal team and disclosing all material facts in a timely manner.
Get ready to negotiate. Each property is unique. Each buyer and seller has different needs. And each CRE sale contract will be different in nature. However, with an understanding of the common and essential points mentioned above, you would definitely have an advantage at the negotiating table.
How Acuity Knowledge Partners can help:
We have multi-sector expertise in the areas of financial analytics, valuation and advisory services. The CRE sector is one of our main focus areas, and we have a large team of CRE analysts and subject-matter experts who support global financial institutions, brokers, investment firms and service providers. We provide support across the CRE deal lifecycle — from loan origination, lease analysis, loan underwriting and valuation, guarantor analysis, covenant monitoring and testing, post-closing and portfolio monitoring to asset management. Our proprietary suite of Business Excellence and Automation Tools (BEAT) gives you leverage, and we provide you with bespoke products and services tailor-made to your requirements.
About the Author
Naveen is experienced with a demonstrated history of working in the commercial real estate industry. Skilled in Microsoft Excel, Microsoft Word, Business Development, Strategic Planning, and Public Speaking. Strong business development professional with a Bachelor of Commerce (B.Com.) focused in Post Graduate Diploma in Management(PGDM) specialized in the field of Finance from Holy Mary business school.
He previously worked for Berkadia Financial Services as “Senior Credit Analyst II” for about 6 years and then joined Acuity Knowledge Partners as “Delivery Lead” in August 2021
Currently, he has over 6.5 years of experience in working with leading global organizations in commercial real estate lending domains.
His expertise spans a broad range of analyses, including CRE loan underwriting, loan servicing, due diligence, portfolio monitoring, market research reports, and cash flow modelling.
At Acuity Knowledge Partners, he is a part of global insurance firm, providing supporting in the CRE portfolio.
Originally published at https://www.acuitykp.com.