Summary: All commercial real estate investors should grasp the objectives, risks, and rewards of each stage in a property’s life cycle. This summary of the main phases of a CRE property’s life cycle can help you decide on an exit strategy.
No matter how actively or passively you want to participate in your investment, all commercial real estate investors should have a solid understanding of the goals, risks, and potential returns associated with each stage of the life cycle of a property.
Let’s look at the four primary stages of a CRE investment and the crucial information to have at each stage.
Note that your process may not always follow this formula. Some examples of when it might not include this formula include buying a property that has already been stabilized or a previously stabilized property that has become unstabilized and now requires value-adding or redevelopment efforts.
1 – Acquisition
Either you are planning to start from scratch with the development of your property and want to purchase the land for your future property, or you are looking for an opportunity to purchase an existing building, but either way, you need to assess all aspects of the prospective acquisition carefully. However, before embarking on these significant undertakings, be sure you have spent sufficient time picking the appropriate essential actors who will work as your guides during the transaction. This will include, but is not limited to, a broker, a financial analyst, legal advice, a developer, and financial partners, including both stock and loan investors (lender).
The component of this stage devoted to site selection (if developing), which includes a target market strategy and a full market analysis, is considered a part of this stage. If it is an already existing building or property, you will need to perform an underwriting on the asset by conducting a comprehensive financial analysis of current and future assumptions regarding the property’s occupancy, rental income stream, net operating income (NOI), return on investment (ROI), taxes, common area maintenance (CAM), utilities, and other costs. Read the article entitled “Tips for Buying a Commercial Real Estate Property” for further information and specifics.
After you have established that you are interested in purchasing this property, the next step is to begin the process of filing, negotiating, and then executing the letter of intent (LOI). It is crucial to keep in mind that this procedure can take anywhere from a few weeks to a few months before the prospective buyer and seller can agree on the terms of the transaction. The executed LOI details the major parameters that will be included in the purchase and sale agreement, even though, in most cases, the parties do not consider the LOI to be legally enforceable (PSA). The process of negotiating the PSA will start after the Letter of Intent (LOI) has been signed by both parties.
If and when the purchase contract is signed, then the amount of time allotted for due diligence will begin. During this extremely important and time-sensitive process, the goal is to work toward exposing both unknown or reported issues related to title, surveys, encumbrances, easements, liens, or restrictions that might affect the use of the property or its development. This could have an impact on how the property is developed or how it is used. It is essential to check for any issues with leases and tenants, such as physical issues (for example, a roof leak in the suite) and financial issues. It is vital to look for any issues with leases and tenants (i.e. a rent reduction that was not disclosed in the offering materials). Check out this post for a checklist of items that should not be skipped over when conducting due diligence.
2 – Value-Add
You have successfully completed the acquisition of the property and are now the owner of it; nevertheless, if you want to boost your NOI potential, your work is not yet finished. Think about adding value to the property by making some improvements to it. As a result of the physical upgrades, I the leasing of any unoccupied spaces will be promoted, (ii) the quality of tenants will increase, and (iii) rental rates will increase. For more particular examples, check out the Tips for Adding Value to a Retail Property article on our website.
Remember that at this stage of adding value, you will also be analyzing different ways to reduce operating expenses to boost revenue (the cash flow of the property), and, eventually, the worth of the asset. Since this demands the appropriate level of experience, you might think about forming a partnership with a developer with a portfolio demonstrating success in circumstances analogous to yours.
3 – Stabilization
When you have reached the stage of stabilization, you should congratulate yourself on the decreased risk and more predictable cash flow that you will now be able to enjoy. The attention should now be directed toward more restricted use of capital and strategies for continuing to maximize cash flow (NOI). Keeping your records up to date with continuing assessments and adjustments to the asset’s value should be a priority throughout the cycle. Make sure that your predicted cash flows are kept up to date at all times (including their marked value). In this stage, the primary focus is on stabilization; for the sake of taxation, you should also account for the depreciation of the property yearly.
You should consider conducting an exit analysis now that we’ve reached this late stage in the cycle. This will help determine the most profitable moment to sell the property, which, depending on the market state at the time, could be before the property hits the occupancy or income levels outlined in your original business plan. This leads to our following point, which is…
4 – Disposition
Determine the optimal moment to sell by taking into account the present status of the market, the investment value (determined using the calculations from the phase before this one), and comparable sales in the area. This step was alluded to in the stage before it. However, the core financials, investment timing, and where we are in the CRE cycle overall (that is, boom or bust) speak far louder for commercial properties than residential properties, which may be more reliant on the time of year.
The following aspects of the timing of investments need to be analyzed: I the maturation of existing debt and loans; (ii) anticipated future capital expenditures such as replacement of the roof, elevators, and parking lot; and (iii) anticipated future tenancy lease terminations and vacancies. Market timing based on sub-index characteristics such as geography and product type needs to be taken into account as well, despite the fact that interest rates and liquidity are essential factors.
Research the recent trends in the capitalization rates of previously sold properties comparable to the one you are selling. Are rental rates rising and where do they stand? What are the current trends for vacancy rates? Additionally, examine the demand from investors for that particular type of property and the desirability of that particular tenant mix (if applicable).
This summary of the primary stages in the life cycle of a commercial real estate (CRE) property should give you a high-level but clear understanding of each phase of your property and assist you in deciding on your exit plan.
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