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4 Reasons Due Diligence is Critical for Commercial Real Estate Investors

Posted by Rocky Mackintosh on November 29, 2017 Leave a comment

Get insights into the importance of due diligence and various approaches (including a real-life example) that will help you mitigate risk.

Dreams can be dangerous things.

Ask any number of investors and owners that have been blinded by idealism and punched in the gut by reality. It happens to even the most savvy commercial real estate investors, building and land owners.

Investors see full buildings with tenants that always pay the rent and acres of raw land transformed into the next great Frederick residential community. On the flip side, sellers, who’ve invested so much time and money in their property, often times just can’t see why they are not getting what they believe is top dollar for their property.

But no matter how great a building might be, or how many beautiful vistas and rolling hills there are on a piece of land, everything comes down to the numbers.

“Over 25 years, I’ve sat at the table with many investors and owners—all smart and capable folks—that got waylaid trying to realize a dream that was unattainable,” said Rocky Mackintosh, owner of MacRo Commercial Real Estate, Ltd. “It’s our job as trusted brokers and advisors to really dig into the numbers and close the gap between the dream and reality. A thorough market study is how we map out a number, data-driven strategy that will yield the best possible rate-of-return given a particular scenario.”

Whether you’re in the commercial real estate market to invest, or getting ready to sell, you need the cold, hard facts before you get too deep into the process. The key is to seek expert advice early in the process and before too much sunk cost is incurred to recover.

Here are 4 reasons conducting a market study before you get too far is crucial to a successful investment or sale of a property:

  • Cash on hand can be a blessing and a curse

    Having available cash to purchase a property and then make improvements, or using these funds to enhance a property you’d like to sell, is an envious position to hold.

    However, cash-on-hand can be a curse if your vision is not anchored by a clear rate-of-return strategy and the realities of the market. In many cases, real estate investors and owners alike drive forward with what they think is the correct approach, sometimes enabled by a team of “yes” men and women. Before they know it, they incur large amounts of “sunk cost” in a project that could never work. A thorough market study that leads to a clear, realistic plan that roots real estate investment, land development and improvement expenditures within an overall profitability strategy, can really harness the power of cash-on-hand, in that it can be used more strategically to maximize rate-of-return.

  • You need an outside expert to take a cold, hard look at your asset.

    Emotions can sometimes blind us to the facts. And being too close to a project, or having a team that’s too close to a project, can lead to missed opportunities. The right, experienced commercial broker or land expert can see your asset objectively, and will use a market study to create a road map for success.

    Here are a few market study approaches that can determine the highest and best use of your asset:

    • Working backwards

      An experienced commercial real estate broker or land expert will begin with the end in mind. What does that mean? He or she will work with you to determine your ultimate goal for a given asset. Are you looking for long term appreciation and/or revenue? Or are you in a position for a quicker cash out? At the end of the day, an experienced broker will help you articulate what you want to get out of an asset, and then complete the research and analysis to place your asset goals in context. In other words, your broker will run your vision through the crucible of market analysis and see what comes out the other side. An experienced broker, and one that provides the greatest value, will help you adjust your expectations based on your timeline and how it relates to current market conditions.

    • Putting costs in context

      Let’s say you’re looking to develop a piece of land. If you’ve connected with an experienced broker he or she will provide you with an assessment of the land and a detailed rationale for the estimated value. Next, and as part of the market study process, he or she will explore the highest and best use of the land, meaning he or she will see if development costs exceed potential generated revenues or vice versa. He or she will then present a number of potential options, seeking the best possible approach to maximize returns. Here’s what this equation could look like:

      Max Potential Gross Return
      - Broker Fees & Taxes
      - Hard Costs (physical property improvements)
      - Soft Costs (engineering, architects, permitting, government approvals, etc.)
      =Net Return on Investment

      Then, the potential net return on investment needs to be weighed against the current market value of the “raw”, undeveloped land.

      The equation seems fairly simple, and it is. However, determining what gets poured into the equation takes thorough, unbiased research and a deep understanding of actual market conditions. And building an accurate risk-benefit picture upon which to make pragmatic decisions is not something to trifle with.

      Putting cost in context applies to every asset, including office and retail space. A seasoned land and commercial broker will examine various costs and revenue scenarios, and help you determine what type of tenant to target based on market demand and what risk particular tenants present to an owner. 

      If, for example, an owner has a shorter time horizon for maximizing revenue, they may consider seeking higher risk tenants and construct a lease that will generate stronger short term returns (not something a good broker will often advocate). Conversely, if the owner is in the long game, securing a more reliable and established tenant with a consistent, yet lower, rate of return could be ideal.

      The point is: you don’t know what you don’t know sometimes and finding a commercial real estate or land expert to conduct a market study early in the process will give you some clarity and a far better chance of getting the most from your asset. 

  • You need to break it down before building it up.

    Consider the example of Joe Doe who owns a raw 10 acre lot that is zoned such that it could be subdivided into a maximum of 15 residential lots. On the surface Mr. Doe may believe that the best way to maximize the value of the property is to sell it to a developer, who would then take advantage of this land development opportunity, which in the end would yield significantly higher returns than just selling it directly to a couple who want to build one house on the property and use the extra land for privacy or their personal recreational area.

    To learn more, and to take a look at a hypothetical market study/Pro Forma scenario that is based upon an actual analysis that the MacRo team conducted for a client, click below.

    Download Commentary

  • Who does the research matters.

    Your relationship with your expert team, and particularly your broker, is crucial to developing a strong investment and sales strategy. You don’t need a cadre of “yes” people pushing you down the road to losing your shirt on a deal.

    The quality of the relationship with your broker really matters.

    A seasoned, confident broker will tell it like it is, will keep an open mind, and will work with you—even if it means addressing unpleasant realities—to build a strategy grounded in objectivity and honesty. Your broker should never shoot from the hip, or make recommendations born from pressure or a desire to please. In many ways, an ideal broker is similar to a great doctor: they might tell you things you don’t want to hear in a way you don’t want to hear it, but at the end of the day, you know they’re the best at what they do and they’ll get the results you need.

    The sooner you and your broker build enough trust to tame “the dream” and agree to a common reality, the higher the likelihood you’ll reap the best possible benefits from your asset.

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Rocky Mackintosh, President, MacRo, Ltd., a Land and Commercial Real Estate firm based in Frederick, Maryland. He has been an active member of the Frederick, Maryland community for over four decades. He has served as chairman of the board of Frederick Memorial Hospital and as a member of the Frederick County Charter Board from 2010 to 2012.  He currently serves as chairman of the board of Frederick Mutual Insurance Company. Established in 1843, it is one of the longest enduring businesses in Frederick County.

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Topics: Commercial and Industrial Real Estate Ashleigh's Fields Notes