This chapter is all about making smart decisions when buying a commercial investment property. First we look at the importance of having your down payment and financing together. Then we examine the benefits of leveraging done responsibly. Defining your property search objectives is covered next, followed by how to do a quick determination of value and how to choose a property that can be recession-proofed. Lastly, we discuss choosing the professional team members who will advise you, and some great tips on making and negotiating offers.

1. HAVE YOUR DOWN PAYMENT, PROFESSIONAL TEAM, AND FINANCING TOGETHER BEFORE YOU GO SHOPPING

Often beginners shop for financing with no experience and before they have a down payment or a team. Worse yet, they make offers first and then shop for their team and financing, after a seller is interested. Both of these methods are totally backwards and may waste your time along with everyone else's. If you do find the right property, do you really want to sabotage your chances for landing it with the listing agent and lender by conveying that you don't have the wherewithal to pull it off? Yes, first impressions really do matter. Here are some great steps to follow before you make your first offer:

1. Get prequalified for financing at the beginning by an experienced commercial mortgage broker who is affiliated with many lenders. If you want to just use your bank, make sure that whoever is going to approve the loan reviews the submission package at the beginning. Get deeply involved with the lending process and find out what the qualifications are for the property and the borrower. (Prequalifying yourself for the loan programs you are interested in is gone over in detail in Chapter 11.) You need to know the maximum you can borrow for the property type, based on the property location, your experience, your down payment, and the property financials. You also need to know the closing costs and post-closing liquidity requirement ahead of time. Yes, lenders will not allow you to be broke right after closing—and this way you will know in advance if you need investors to raise additional equity. Lenders hate it when you tell them, “Oh, I know I don't have enough down, but I will raise the money.” You will also be finding out what the rate and terms look like, which you will need for filling out the purchase agreement.
2. Get your team together at the beginning: this includes your investors, your lender or mortgage broker, your buyer's real estate broker, your property manager, and your real estate attorney. You want to inform your lender and the listing real estate broker about these people. If you do not have the down payment and closing costs needed, lenders will not waste their time with you. Read Chapter 3 on raising investors: it discusses bringing in a high-net-worth investor who could just act as a proxy. Offer to give them a very small percentage of ownership in the property (like 2%) for taking on this role. You can use their personal financial statement to prequalify for loans, and if needed switch them out for another high-net-worth investor down the road. The listing realtor will also likely want to see a strong personal financial statement plus verification of liquidity before signing a purchase contract with you.
3. Get a letter of preapproval from a lender or commercial mortgage broker that you can attach to your letter of intent to purchase. This will give the listing broker and seller confidence that you will be able to close. Be prepared to also share with them a copy of your bank and/or security accounts to show proof of your down payment. You can have them sign a confidentiality agreement that prohibits them from sharing this information with anyone. If you do not have a strong enough personal financial statement or proof of down payment, read Chapter 4 for some great tips on how to get around this step and how to fake it until you make it.

2. USE LEVERAGE RESPONSIBLY

Who wouldn't want to get rich using other people's money? This is the best definition of leveraging. There is simply no better method of growing your net worth over time than buying commercial real estate and financing the majority of the purchase price. I work for many wealthy people. About a quarter of them did it the easy way—they inherited money. The rest used leverage to buy commercial property and get rich. But before we get started on the amazing benefits of leveraging, I'm going to put a damper on the discussion.

There are many get-rich gurus out there who will tell you that they can teach you to buy commercial real estate with 10% down—or better yet, no money down. Most of the programs these people run make money by selling books or coaching programs. At least twice a week our firm gets an inquiry call from someone who does not have any money and thinks that this is okay.

Here's the reality: the best of these mentoring programs work with investors who have a realistic amount of money to put down on a property and are moving from residential to commercial property investment. My friend and colleague Peter Harris is the author of Commercial Real Estate Investing For Dummies. He is also a principal at Commercial Real Estate Advisors, a mentoring/coaching firm. He will tell you that trying to buy with little or no money down is a waste of everybody's time. Nevertheless, if you have at least half of the down payment and are tenacious you can pull off getting into commercial real estate investing. He states that putting 20% down and getting the seller to carry the mortgage is the best way to get started if you do not have the experience to qualify for a conventional loan.

The majority of my highly leveraged clients did not make it through the Great Recession, and many in this group are struggling today to hang on to their properties during the coronavirus recession. They were doing what they thought was smart—putting every dime they could muster into buying another property. They would brag, “I have all my money making money for me. I'm not dumb enough to just let it sit there in the bank.” Many lost everything. But just about all of my borrowers who hung on to some cash for a rainy day and put 25% or more down made it through. In fact, many were able to pick up bargain properties that investors in the overleveraged group lost.

I met Laurence in 2000 when he applied for a loan to buy his first motel in Bakersfield, California. An elderly couple had turned it over to their kids, who ran it into the ground. It was a mom-and-pop business located on Interstate 5. Laurence had a good business plan to turn it into a flagged hotel using the Travelodge brand. I was able to get him an 80% SBA (Small Business Administration) loan and the sellers carried 10% in second position. It was a roaring success. A little over a year later he repeated this recipe and bought a second motel in Sacramento. By February of 2009 he no cash left, but he did have five motels all purchased with 10–15% down that were hanging on by the skin of their teeth. By 2011, he was working as a car salesman. To keep this from happening to you, keep your down payment to 20–25% or above and keep a minimum of 15% of your net worth in cash.

Now, let's get back to the amazing benefits of leveraging responsibly. Some might think that paying all cash for a smaller property and not having a mortgage is the way to go. But there is really no way this approach can compete with putting 20% down, taking out an 80% mortgage, and buying a larger property that will produce more income from operations and appreciation combined, plus more savings on taxes from higher depreciation. To illustrate this we will compare two income property investors, each of whom has $200,000 to invest in real estate. One buys residential—a duplex for $200,000 cash—and is proud to not have a mortgage payment. The other buys a 12-unit apartment building for $1,000,000 and puts 20% down (also $200,000). The vacancy rate and the expense ratio are the same for both investors. Both properties have net income that goes up 8% per year and appreciation that averages 6% per year.

It seems impressive that in five years the duplex buyer will have earned $174,057 in net cash flow and appreciation on their $200,000 investment, which is an annual internal rate of return of 17.4%. But it is much more remarkable that the apartment buyer earned $515,202 in net cash flow (after loan payments) and appreciation. That comes to a 51.5% annual internal rate of return and is $341,145 more than the duplex buyer earned in five years. The duplex owner's equity has grown by $72,097, which is a 36% increase. The apartment owner's equity has grown by $425,370, which is a whopping 213% increase. To top this off, the apartment building produces an annual tax shelter in depreciation of $29,090, compared with $5,818 for the duplex (see Table 2.1).

3. DEFINE YOUR PROPERTY SEARCH OBJECTIVES

Can you imagine how great it would feel to look for a property to buy knowing exactly what you want, what you qualify for, and what the parameters are? Being a proactive investor means you know from the beginning what you are looking for and have experienced team members to help you sort through a large stack of deals to find it. We're talking about not only knowing from the start what the property type will be, but also where you want to buy. What you want to achieve financially from the investment and what size and type of loan you need to get you there. What price range you can afford and your minimum acceptable cap rate. How to estimate the value and what your value-add objectives are. Who your team members will be and what strategies you will employ as a team to win the best deals.

The following sections describe eight objectives you should define at the beginning of your property search.

4. FOUR 15-MINUTE METHODS OF DETERMINING PROPERTY VALUE

Now that you know what type of commercial property you are most interested in and your objectives for the property, it's time to go shopping. When sorting through properties that fit your profile, how will you know which ones are a good buy? Many, or even most, will be overpriced. Most sellers know that they need to start out high so that they can come down a bit and end up at the price they really want. You'll need to determine what the property is actually worth. During the beginning of a recession this can be tricky, as comparable sales will likely be overpriced. You can use my Apartment Quick Analysis Spreadsheet or Commercial Property Quick Analysis Spreadsheet for each property you are seriously interested in to estimate a property's value based on cap rate and GRM (see Appendix A). You can find a downloadable Excel version of these spreadsheets on my website: https://apartmentloanstore.com.

For the four 15-minute methods of determining value, we are going to use a 16-unit apartment complex that catches your eye. It is priced at $2,200,000. Before you start, you need to find three similar properties that are currently for sale or have sold in the past year. If you are buying during a recession, use properties for sale through LoopNet or your real estate broker that are the same type and a size and quality similar to the targeted property. If you are not buying during a recession you will need to find three properties that have sold in the past year. You need to know the purchase price, cap rate, number of units or square feet, gross rents, and NOI for each property. Here are the four quick methods to determine value:

1. Price per door or square foot quick valuation method. This method is really fast. Use the price per door for multifamily properties and price per square foot for all other commercial property types. Calculate the average price per unit or price per square foot for the three comparable properties and the subject property.

   Let's say that the average price per door is $144,400:

   

   Your property is priced on the low side at $2,200,000.

2. Gross rent multiplier (GRM) quick valuation method. GRM is the purchase price divided by gross annual rent if the property is 100% occupied. The lower the GRM, the more rent you will be getting for the purchase price.

   Start out by calculating the GRM for the property you are interested in:

   

   Next calculate the GRM for each of the three comparable properties and the average GRM for all four properties. Let's say the average GRM is 8.95%:

   

   This confirms again that the subject property is priced on the low side.

3. Cap rate quick valuation method. Capitalization rate, or cap rate, is annual net operating income (NOI) divided by the purchase price.

   Here is the cap rate for the subject property:

   

   Now calculate an average cap rate for the four properties.

   Subject Property NOI: $166,960/$2,200,000 purchase price = 7.6% cap rate

   Comparable Property 1: NOI $152,800/2,175,000 purchase price = 7.0% cap rate.

   Comparable Property 2: NOI $176,950/2,425,000 purchase price = 7.3% cap rate

   Comparable Property 3: NOI $140,600/1,995,000 purchase price = 7.0% cap rate

   To do this calculation even faster, you just average all the cap rates.

   Average of all four properties = 7.20% cap rate which would put the value of the subject property at $2,318,000. $166,960/$2,318,000 = 7.2%. Again, the subject property at $2,200,000 at a 7.6% cap rate is priced below market.

4. Valuation average method. This only takes a few minutes. To get the most accurate indication of value for the subject property using a method that you can compute yourself, average the property value yielded from each of three approaches above:
   

5. CHOOSE A PROPERTY THAT CAN BE RECESSION-PROOFED

Sorry to start with a disclaimer, but with the exception of buying a commercial property occupied by a credit tenant like Walmart or the federal government that has an insanely high credit rating and 20 years or more remaining on the lease, nothing is truly recession-proof. The Gap, which had a fair credit rating of BB+ in March of 2019, was downgraded toward junk territory with a BB– a year later as a result of stiff competition from online sales and the start of the coronavirus recession. Then they stopped paying rent in April of 2020 after furloughing 80,000 employees and their credit rating tumbled further. The same month, Staples, Mattress Firm, and Subway stopped paying rent. These were all considered good tenants.

Does this mean that commercial property is just too risky to invest in? No. What it means is that just like in all recessions, the coronavirus recession—which was the worst economic tsunami to hit global financial markets since the Great Depression—nearly wiped out hospitality and wounded office and retail properties. Apartments, flex-industrial, self-storage, and mobile home parks seem to always make it through with much less pain.

Many of my clients are just sitting on the edge of their seats waiting for the next recession to hit. They have cash ready to grab good properties at great prices. For their existing properties, they put cash aside to protect them for the next recession, along with other recession-proofing strategies. They did this in the same way someone buying property in a storm surge area in Florida prepares for the inevitability of a hurricane. In a moment I share with you the 10 best recession-proofing strategies.

In most markets, a recession causes commercial real estate values to go down. This is because there is lower demand, and financing becomes more stringent, resulting in fewer buyers being able to qualify. Even though interest rates are usually low during recessions, lenders lend less by lowering their LTVs, raising vacancy, and raising their underwriting interest rate (Encyclopedia Topic H, Financing). Appraisers get pressured by lenders to lower valuations by having appraisals reflect lower occupancy, higher credit loss, and rent concessions.

According to Wikipedia, during the 60-year period between 1960 and 2020 there were 10 recessions in the United States, or an average of one every 6 years. If you are buying a commercial property and are planning on a long-term hold it would be smart to pick a strategy that will recession-proof you and your property. What you really want to know is this: If your occupancy takes a dive, how low can it go and still allow you to pay all expenses and your mortgage payment? Can you hang in there until things get better? What resources will you have to enable you to survive?

Which commercial property investors do the best during a recession? During the Great Recession that started in December 2007, my clients who had bought commercial properties with a long-term hold strategy weathered the storm better than those who planned on a short-term hold. The latter group intended to make a bundle in the future and pulled cash out to buy more properties. Although property values went down and occupancies dropped for properties held by many of the long-term hold borrowers, most made it through until occupancy and property values went up again. How did they pull this off? Most had chosen a more recession-friendly property and had enough cash or other sources of income to ride it out. In contrast, some short-term investors who had bought properties to rehab and flip got hurt because once they had completed the renovations the lease-up period was too long because the recession had already started. They just did not have enough capital left to make the mortgage payments, and many in this group lost their properties.

The 10 Best Recession-Proofing Strategies

1. Have working capital and other sources of income. Yes, cash is king! There is absolutely nothing that can make you and your commercial property more recession-proof than a nice chunk of cash. Having additional sources of income is a lifesaver too. Working capital is a rainy day fund used to pay unplanned-for repairs, or in the event of a recession to help with expenses and even mortgage payments. Do a quick pro forma on your property to determine what the expenses and mortgage payment will average each month. Then for a multitenant property bring occupancy down to 65% and calculate the monthly shortage you have after paying all expenses and the mortgage. Your working capital fund should be 12 to 18 months of this shortage.
2. Find a property with a break-even ratio that is 75% or lower. The break-even ratio tells you the minimum occupancy you need to pay all of your expenses and the mortgage on the property. Keeping this at 75% or lower is the next best recession safety strategy after having a stash of cash.
3. Don't overleverage. Plan to reduce your personal debts and make sure that all your investment properties are purchased with at least 25% down. It's a lack of positive cash flow that ruins commercial property investors during a recession. One of my clients owned a beautiful historic eight-unit apartment building in San Francisco that was thriving through the Great Recession. But it was the four distressed apartment buildings in Sacramento purchased with 15% down seller financing that took him down. He lost the San Francisco property because he drained it of cash to cover the shortages on the Sacramento properties, which he ended up losing, too.
4. Refinance with lower payments. Having lower payments on all the properties you own, including your home, will give you extra positive cash flow during a recession that can be used on investment properties that are not able to make it on their own.
5. Buy a property at below its value. There is nothing better that you can do than to buy a property for an even lower price than what it is worth. Let's say that you brilliantly take $125,000 off a $1.5 million purchase price. Well, first of all, think about how long it would take for you to raise rents and lower expenses to earn an additional $125,000 from the property. Most importantly, this windfall will enable you to take out a smaller loan, thus lowering your monthly payments.
6. Keep your rents below market. I know, this sounds like leaving a lot of money on the table. But think about it. During a recession, rents get lowered and some tenants move to less expensive properties. If you already have lower-than-market rents, your tenants won't be leaving and you will be attracting renters from more expensive properties. My client who owns a shopping center in Louisville, Kentucky, keeps his rents about 15% under market. I have scolded him for this. But his intention is to keep his property full during both good and bad times and he has. I have a client in Eugene, Oregon, who owns two apartment complexes, a 36 and a 61 unit. He made it through the Great Recession unharmed and is collecting 96% of his rents during the coronavirus recession. He says this is because his rents are lower than his competitors' in his submarket. He always stays full for the same reason. And during bad economic times his tenants don't want to risk losing their homes.
7. Choose a recession-friendly property type. Multifamily, medical office, self-storage, and flex industrial properties, as well as mobile home parks and senior housing, have a much better chance of making it through a recession unscathed. In 2008, multifamily occupancy grew as more people lost their homes and moved into apartments. Many of the same people rented self-storage units to hold the stuff that did not fit in the apartment. Mobile home park occupancy stayed strong during the Great Recession. Flex industrial complexes weathered the recession too, with small spaces having reasonable rents occupied by a large variety of businesses.
8. Don't buy at the top of the market. This is hard to do if you are buying during a seller's market. As mentioned in Chapter 1, little adds value to a property like not overpaying for it. In an up market you will have to work harder to find decent deals. If there are no good deals, just wait until the market comes down.
9. Choose a multitenant property with many smaller units. If you buy a four-unit office or retail building and two tenants fail during a recession, you could be left with 50% occupancy and be underwater.

   Also, stay away from retail and office properties where one tenant occupies 20% or more of the total space. The exception to this rule is anchored retail.

10. Find a property that has many value-add opportunities. Buy a property where you can do two or more of these lower-cost value adds: make cosmetic changes and raise rents, increase occupancy, lower general expenses, lower taxes and insurance, optimize lease potential, and attract higher paying tenants. Put together a buyer's pro forma that shows the financial gains from your value adds and that you will obtain a lower break-even ratio in the near future. Boy, does this make your property recession-proof!

6. CHOOSE THE BEST TEAM MEMBERS

Experienced successful commercial property investors have a team of professionals that they usually work with over and over. Consider yourself the president and these people your cabinet. They will advise you and help resolve problems, but the final decision is yours.

7. WINNING THE NUMBERS GAME——MAKING AND NEGOTIATING OFFERS

You really want this property. If you can just get the price down a bit it could pencil out. What's the most you can afford to pay for it based on your value adds, the break-even ratio, and your minimum acceptable cash on cash return and internal rate of return (Encyclopedia Topic A, Buying)? Putting together a buyer's pro forma will help you determine this.