Purchasing commercial real estate is huge decision that has far reaching impacts on your business’ cash flow, balance sheet, and funding options. So it is really important that entrepreneurs take their time and carefully consider when and why it might make sense to stop renting and invest in commercial property.
A recent report on Small Business Financial Health released earlier this month by FundWell, in partnership with the Federal Reserve Banks of San Francisco and Chicago as well as Pepperdine University, found that only 22% of businesses with excellent financial health had cash available from operations to invest in commercial real estate. In other words, even businesses that are top performers require some third party financing to buy commercial property. That being said, most lender and/or equity investors that a business owner approaches for funding to invest in commercial real estate will want to see that the following five conditions are met:
1) Set Long Term Space Needs – Before you lock yourself into one retail, office, or industrial property, you should have a firm handle on how much physical space your business will need to operate over the next three to five years. Given the time, energy, and costs associated with making this type of investment and building out the space to meet your needs, the last thing you want is to outgrow it after just a year. So if your company is still expanding – staff, customers, and/or products/services – and you cannot confidently project how much space your business will need to operate within the next two to three years, then you should consider waiting until you have a better handle on your future size and build out requirements before you buy.
2) Show Historical Profits – A commercial property is a long term business asset. Entrepreneurs that are in the best position to make investments of this type are those that have a proven business model and a track record of profitability. A business that is profitable typically pays business taxes and has excess cash at the end of each year that can be used to reinvest in the business. Typically businesses that have only been profitable for one or two years focus on reinvesting in business operations to ensure the company has the marketing and business development talent and other staff, inventory, and furniture/fixtures/equipment to support growth. However, by year three and four of profitability, business owners are in a strong position to begin investing in longer term assets like commercial property.
3) Build Cash Reserves – Buying commercial real estate takes “cold hard” cash. When you make an offer to acquire a commercial building, you typically need to provide a cash deposit to demonstrate to the seller that you are serious about completing the transaction. Deposits can run anywhere from 1 to 10% of the total negotiated purchase price of the property. For example: In the case of a retail café that you get under contract for $500,000, the “out of pocket” deposit that you will need to pay is anywhere from $5,000 to $50,000. And even after you get the property under contract, in order to get a loan to complete the purchase an entrepreneur typically needs to show that you have between 10% and 40% of the purchase price available in your bank, money market, and/or investment account to satisfy a prospective lender’s down payment requirements.
4) Evaluate Relative Affordability – It should come as no surprise that any decision to purchase property should include a “rent versus buy” financial analysis. This type of analysis typically involves at minimum a comparison of the monthly rent and estimated mortgage payment, including interest, principal, and taxes. In this comparison, you are not just looking to evaluate which expense is higher; you are looking to determine the relative affordability of each option. Ideally, your space related expenses should be roughly 10% or less of your total revenues. So if you are currently renting office space that represents 5% of your total sales and you now have an opportunity to purchase an office condo at a price and with a mortgage payment that represents 25% of your annual revenues, you need to either hold off on buying property until commercial real estate market values settle down or find another acquisition target that is more affordable.
5) Target Stable or Emergent Communities – Last but not least, you must consider the golden rule of real estate investing “location, location, location”. It is really important that you do your homework an identify neighborhoods, commercial districts, geographic areas that have relatively flat and/or upward trending market values (limited volatility in real estate prices). Some leading indicators of strong/high potential community areas are those with: increasing real estate development activity, major public infrastructure investments (i.e., roads, schools, public transit, and police station), expanding high quality commercial base (i.e., new grocery/retail, cafes/restaurants, etc.). If you choose the wrong area and market values in your chosen location drop, you run the risk of losing valuable customer traffic as well as eroding your equity interest in the property.
There you have it! There is a time to rent and a time to buy. However, before you purchase commercial property, review your business plan; consult with your accountant and an experienced commercial real estate broker to ensure you are really ready and able to make this investment. If you are, that’s great; you are well on your way to building long term assets for your business. If not, congratulations for taking this important step and remember to use the five criteria outlined above as a reference to better position your company to buy commercial real estate in the future.
