This chapter is all about getting the best price and adding value when selling your commercial property. Discussed are why and how commercial properties increase and decrease in value, a power real estate broker's method of determining the highest sales price, 12 mistakes to avoid when selling, doing value-adding before selling, whether you should do a for sale by owner, whether you should owner-carry, and doing a master lease purchase.
Let's start out by looking at six reasons why commercial property values go up.
First, there is an expectation that they will increase. From the moment an investor decides to buy a property, whether they intend a short- or long-term hold, they have likely been burning with desire for the property to skyrocket in value. You cannot underestimate the power of intention. Unfortunately, whether the property's value goes up or not has more to do with your ability to raise rents over time than pure intention.
The second reason is the innate drive of the investor to raise rents. However, the ability to raise rents is dependent on what the market can bear. Raising rents raises NOI, which raises appraised value.
Third, commercial real estate brokers add fuel to this fire. They know that if they want to get a listing that they have to drive the price up as high as possible. The best of them know they'll have to temper an attractive price with sales comparables in the market and cap rates. But if the property is an office or retail property, the limitations in the leases on raising rents and the quality of your tenants can put this fire out fast.
Fourth, the law of supply and demand affects property values. The more demand there is for a commercial property type during the expansion phase of the real estate market cycle and the scarcer new listings become, the higher the price will be. In many metros there are few, if any, new commercial lots left to build on. This intensifies the scarcity factor.
Fifth, interest rates are a factor. When rates are low, the net operating income (NOI) of the property will support a larger loan amount for the buyer and a higher sales price for the seller. Of course, the opposite is true if rates are high.
Sixth, today's replacement cost of building a property similar to an existing property is a factor. In an environment in which commercial land and construction costs are going up, existing properties will be worth more.
Now let's look at six reasons why commercial property values go down.
First, a recession occurs as a result of high unemployment and the purchasing of fewer goods and services, resulting in lower demand for rental units, which results in lower rents and occupancy. This lowers NOI, which raises cap rates which lowers property value.
Second, the recession has an immediate affect on financing as underwriting guidelines become stringent, resulting in fewer buyers that qualify. Often lenders lower loan to value and raise DSCR. This creates smaller loans, which results in larger down payment requirements, which creates a smaller pool of eligible buyers. This creates more supply than qualified buyers, forcing prices down.
Third, there are too many construction starts and units for rent during the hyper-supply phase of the real estate market cycle. This is when there are more units available for rent than the market can absorb. This lowers rents and encourages rental concessions, both of which lower net operating income which lowers property values.
Fourth is a decrease in economic occupancy during a recession. The property might have good physical occupancy but many multifamily tenants have lost their jobs and office and retail tenants have lost customers, resulting in poor rent collections. This mostly hits Class C properties during a recession.
Fifth, appraisers are pressured to lower valuations during a recession. Lenders no longer trust values from comparable properties that sold before the recession. They know values are coming down and this terrifies them. As the recession progresses, distressed commercial property owners need to sell fast and lower their prices to avoid foreclosure. Appraisers are pushed toward using recent higher-cap-rate comparables that lower property values.
Sixth, whenever interest rates skyrocket, commercial real estate prices come down accordingly, as the NOI of the property now supports a smaller loan amount. This brings prices down, as there is a smaller pool of investors that can put a larger amount down to support the higher prices.
Surprisingly, most sellers of investment commercial property do not dwell much on the likelihood of their property value's coming down someday. The moment they take title, most know that when they sell they are going to make a killing. If they do get caught in a recession, and cannot get their price, as long as they have the cash to ride it out most will wait until the real estate market goes up again to sell. From a nuts-and-bolts standpoint, commercial properties should go up in value because they have been physically improved, repositioned, or repurposed, resulting in higher rents over time. But if the real estate market takes a nosedive, lower rents, collection losses, and poor occupancy can bring those values down again. The good news is that history has shown that the bust periods are temporary. Going back to the 1865 recession, real estate prices have always recovered and gone up over time.
How do rents affect appraised values? If your property's rents have gone up, an appraiser will choose sold properties with a correspondingly higher rent per square foot as comparables. This will raise your property's value. Conversely, if the property has become more derelict over time and rents have been stagnant and expenses have risen, then the property will be compared with lower-quality properties, which will lower the valuation. It's strange, but in an up market, the momentum from property values going up and the scarcity of properties for sale will likely pull these fixer-upper properties up too.
One of the greatest factors in raising commercial property values is something I call “the power broker force.” Top-producing commercial realtors consider it sport to raise property values in their communities. I have seen them do this in many of the markets I lend in nationally, and they do it with relish. They use their arsenal of tested recipes to push prices up and cap rates down.
Nancy Lemas is a power broker in Boise, Idaho. She reminded me recently about all the fun we had together closing $44 million in commercial properties in 2016. She was the listing broker on each deal. I'm not sure I would quite call it fun. For me it was very much like skydiving—exhilaration at the beginning followed by worrying about whether the chute would open.
My job was to create loans for four of her properties that carried record-breaking prices, and although it had been an up seller's market for close to seven years, I was worried that there were just not enough comparables that had sold at comparably low cap rates for them to appraise at their purchase price. We did close on all four purchases, which resulted in sales comparables that lowered cap rates and increased property values on future sales in this market.
I have personally witnessed Nancy push the envelope by increasing commercial property values above what they are logically worth. She does this with her intellect and her bold personality. She has the most thorough, and I think the most accurate, method of determining maximum sales price that I've seen. Here it is:
In conclusion, your commercial property is worth what a buyer is willing to pay for it. Many properties are priced too high simply because the seller is not able to connect the dots on what the buyer's expectations will be or what outside drivers are (e.g., recession, market absorption rates, and sales comparables). These properties tend to stay on the market for a long time and experience many price reductions. Buyers can easily check to see how long a property has been for sale, and if it has been over six months, they are going to expect a discount. There are exceptions to this. For deals of $10 million and above and for newer properties that are in excellent condition, institutional investors and real estate investment trusts are often willing to pay more than the property is worth because they have a lot of cash just sitting. They are willing to accept lower returns on their investment, but the properties have to be turnkey with very low risk, a strong operating history, great tenants, excellent collections, and an outstanding location.
Although this practice is not illegal (the IRS does not go after property investors that do this) it can be thought of as misleading to the borrower and their lender. Lenders and astute buyers quite often request Schedule Es from the seller's tax returns to verify income and expenses. If there is a discrepancy between the income and expense statements and your tax returns, don't be surprised if the buyer asks you to lower the sales price.
The remedy for this is to point a finger at it. Just tell the buyer and the lender that this is what you have done. Most lenders don't care since the IRS doesn't care. And since you were honest about it, the buyer can't really ask you to lower the sales price. Be sure to give the buyer a separate list of capital improvements and their costs for three years.
YES, you should tell them! And yes, the buyer will find out. Your real estate broker and the buyer will assume that everyone on the rent roll is in good standing unless you tell them otherwise.
If you have late-paying or no-paying tenants and do not disclose this, I assure you that at a minimum, the buyer's lender will find out. And they will think you misled them and that your financials might be fraudulent. Underwriters are trained to look for discrepancies between rent rolls and income statements for rent collection problems. If they don't find out from these documents, they will find out for sure at least for the commercial properties where lenders require tenants to sign an estoppel certificate. These certify the lease terms, that there are no defaults, and when the rent was last paid. The tenant is committing a federal crime if they lie on a lender's estoppel certificate.
I've worked on hundreds of real estate deals and I have never seen a property inspector find that nothing needs repair—even on newer properties. They do need to earn their fee. For the majority of purchases I have worked on, the buyer will request a reduction in the sales price for a variety of reasons just prior to the due diligence period being up. From the seller's perspective, it makes sense to negotiate repairs along with other price-reduction requests at the same time. Major repairs, such as the need to replace the roof, should be disclosed to the buyer at the beginning.
As the seller, if you do not provide the property financials quickly, the due diligence period will take longer. If the buyer is not preapproved for financing correctly at the beginning, they will likely not get their loan approved. They will then have to start the loan process all over again with another lender. This will add an additional 45–60 days to the closing or even kill the deal. Check in with your real estate broker often and make sure they are time-managing these 10 critical dates:
Also be aware that delays caused by legal counsel for the buyers, lenders, or sellers are one of the top reasons closings are pushed past the drop-dead date. Property insurance that doesn't meet the buyer's lender requirements is another. These items need to be time-managed too.
If you do not already have a broker that you have worked with before, how do you choose one? Unfortunately, usually the real estate broker who says they can get the highest price is going to win your business. If they don't show you the market analysis that proves that price is attainable, be wary.
What is much more important is finding a broker who is actually working diligently to sell properties and not just to land deals. These brokers will be experts in their field and will likely already know someone who is interested in buying your property. They will also know many of the other major commercial realtors in the area and be willing to share their fee with them. They will have many methods of marketing, including various online platforms. They will have a long referral list of satisfied customers who you can talk to. Their marketing flyers and online property brochures will be outstanding and based on facts. They will screen every buyer carefully for verification of down payment, experience, and financing. These realtors have enough experience to know if the buyer's financing has holes in it, and they get involved in plugging those holes. And they likely know where the best sources of financing for your property are and are bold enough to get involved with the buyer on this. They will answer the phone most times you call and make you feel like you are their only customer. Most of all they will tell you what they really think and not just what you want to hear.
Lastly, do not use a residential real estate broker who does not have commercial real estate experience. This is like going to a veterinarian to have your gallbladder removed. They could probably wing it, but you're not going to do that. Commercial really is a different animal than residential real estate. A commercial property is income based and has a different due diligence list.
Most buyers are trying to find a commercial property with an upside. So as the seller, why not create this upside and increase the property value for yourself? If your property is currently worth a million dollars at an 8% cap rate and has an annual NOI of $80,000, increasing the bottom line by 15% can increase the value of the property by $150,000. The best way to achieve this is to tackle it from both ends by increasing rents and decreasing expenses.
Major value-adding is called repositioning. Go to Chapter 7 for a lot more on this subject. Repositioning value-adds can be divided into three categories:
Try to stick with low-cost and low-risk operational value-adds. If cosmetic work is needed, try to confine it to light cosmetic work: paint the ugly cabinets instead of replacing them.
Compare your rents with your competitors to determine if they can be raised.
Have an experienced property manager review your expenses for where there can be decreases. Often decreasing expenses can be as simple as shopping for cheaper insurance or lowering your property tax bill. Going through all your expenses and trimming a percent here and there can really add up.
Any leases coming due? For office, retail, and industrial properties negotiate longer-term leases before you put the property on the market. This represents a minimal expense and can make your property worth more simply because it lowers the buyer's risk, which means they can qualify for much better financing. For multifamily properties, raise rents to the max whenever you can. It is unlikely that a tenant will move out for a $50 increase given the cost of moving.
Ultimately you are going to have to carefully weigh the cost and time involved with value-adding to determine if it is going to be cost effective. And if you are doing some rehab, be sure to include your loss of income due to the lost rents when you have to vacate spaces while improving them.
With the exception of multifamily and hospitality properties, costly cosmetic changes that just make the property look better do not necessarily raise rents and increase the property value. Take a look at your competition. If they are getting higher rents than you because they have better interior finishes, floor coverings, and fixtures, then maybe you should follow suit. But it could be they are doing better just because they have a better location. For an apartment property in a low-income neighborhood, there is a limit to what your tenants can afford to pay. So be careful to not overimprove the property. If you have an apartment or office building built between the 1960s and the 1980s, it will always be a Class C property that won't command the higher rents of a Class B property, no matter how much you improve it. Keep in mind that appraisers will always constrain the value by comparing it to other Class C properties.
You can also advertise to commercial real estate groups on Facebook or list the property for sale on Craigslist.
No matter how great your property is or how organized you are, selling a commercial property is a very complex and technical endeavor. If you have sold a home yourself successfully, you might be tempted to do it with commercial real estate. Even if you are selling a simple single-office property zoned commercial, it might appear to be as easy as selling a residence, but it is not as easy. The difference is that with commercial property, you are selling an income stream with the brick-and-mortar attached. Unless you have done it many times before, selling your commercial property yourself, in my opinion, is like an elementary school teacher trying to teach a graduate level university business course.
An experienced commercial real estate broker can help a seller through:
In commercial real estate, owner-carry mortgages are sometimes a marriage between a buyer who doesn't have much money or experience and a seller who owns a distressed property. Yes, this can get worse if the buyer has weak or bad credit and cannot qualify for a loan elsewhere. Now, does that sound like a match for a good long-term relationship? As the seller, do you really want to be legally tied to someone who needs something from you—like a handout? Maybe that seems harsh, but I'm calling it the way I see it.
The flip side is that if you are willing to prequalify the buyer as a bank does, this can be a good marriage. Also, you are almost certainly going to get a higher sales price.
As the seller, you usually need something too. The property is often underperforming, having too many vacancies or some tenants not paying rent. It might even be 100% vacant. Sometimes it is just in a very isolated small town, which makes it difficult for a buyer to get conventional financing. The property often will have a long list of neglected repairs due to lack of money, poor management, or both. These properties often do need new blood. At a minimum they need new management. Most often they need to be repositioned. In most cases the owners just do not have the energy or funds to tackle this.
Don't get me wrong, there are some good, decent people out there that need an owner-carry, and have the experience, drive, and commitment to make this a success for both parties. Some of them just do not have the net worth or experience required by a conventional lender. If their credit score is 640 and above and they can put at least 20% down, this might be a good fit. Be sure to verify that the buyer will not be broke after closing (that they will have some post-closing cash). The most important thing to owner-carry borrowers is a smaller down payment than required by the bank and monthly payments that the property can afford. Interest rate and loan maturity doesn't seem to be a major issue for them.
If your property is distressed, or just having difficulty selling right now and you just need to get away from running it, consider selling it using a master lease purchase. A master lease is most often used when a seller/lessor wants to lock in a higher price today than the property is worth based on its occupancy, net income, and/or condition. In most cases, the seller does not have the financial means or motivation to improve the property. In exchange, the buyer—who likely does not have the down payment for traditional financing—has an abundance of motivation and energy to improve the property. There is no loan involved, so both parties need not worry about that.
The buyer/lessee can take from two to four years to reposition the property—remodel it, re-tenant it, lower expenses, and raise rents. The lessee makes monthly payments to the lessor. At some specified future date, the lessee has the right to purchase the property for the amount agreed upon when the master lease was signed. When the lease is up the property will usually qualify for quality permanent financing, and the buyer will have raised the down payment from the property value increasing. The buyer/lessor gets the benefit of appreciation. The seller/lessor has the benefit of getting more for the property than it was worth today and the disadvantage of having sold the property for less than it will be worth when the lease expires.
It is standard for the lessee to put as little as 10–15% down when signing the master lease. These funds are credited toward the purchase price for the buyer as long as the future sale goes through. The buyer/lessee loses these funds if they choose not to buy the property. One great benefit of a master lease for the seller/lessor is that you keep legal title to the property. If the buyer/lessee defaults on the lease, it is easy and fairly quick to take the property back since you still own it. The lessee has equitable title, not legal title, which allows the lessee complete authority to run the property and benefit from the property's income, appreciation, and depreciation.
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