If you’re looking to purchase an investment property, whether it be a residential single-family home or a commercial building, the purchasing process is very similar. While there are some differences between the two processes, I thought they are close enough that I thought we should take a quick run through to get a discussion in place for future articles.
For discussion purposes, residential properties are single family homes, duplexes, triplexes, and quadplexes. Commercial properties encompass everything else including retail, office and industrial buildings as well as multi-family projects of five units or more.
The investment purchase process for both residential and commercial properties looks like this:
2. Locate a property
4. Due Diligence
a. Physical Inspection
b. Records Inspection
c. Tenant Inspection
5. Contingency Removal
1. Locate a property
3. Due Diligence
a. Physical Inspection
b. Records Inspection
c. Tenant Inspection
4. Contingency Removal
5. Financing (begins during due diligence)
As you can see, the processes are very similar except the financing component. I’ll deal with the financing section later as described in the commercial process.
Locate a Property
This is the exciting time. You’ve decided you want to buy an investment property and you’re ready to get to work. This is where you need to think about some of the following items …
1. What type of property do you want to purchase? If residential, is it a single-family home or is it a duplex? If commercial do you want to purchase a retail strip center or is an industrial building more to your liking?
2. Do you want to self-manage or will you hire a property management company?
3. Will you purchase the building yourself or do you plan on purchasing the property alone?
4. Do you want to buy local or are you open to buying in other markets across the country? How about outside the country?
There’s a fair amount of effort that goes into this stage. You can tour a lot of properties to find the right one for you. Sometimes, you can find the perfect property immediately, but that doesn’t happen often. Instead, you’ll tour quite a few properties and run a lot of numbers before you finally decide, “this is the one.”
That’s okay. It’s the process and it should be embraced.
Don’t fight the process. If you try to rush through the progression, in a hurry to buy a property, you will miss something. You could jam yourself up. It’s better to take your time and possibly lose a property to another buyer than to be in a hurry and buy a dud.
During this time, you should decide whether to use a broker. In full disclosure, I’m a commercial real estate broker. My investing partner or I act on our behalf when we invest in a commercial building. When purchasing a residential property, however, I am represented by a residential real estate broker. I don’t try to represent myself in this arena. My broker filters out the properties I would never look at and then actually checks out the ones I might have interest on. We have a series of questions that are asked beyond what the MLS will show. He does some extra legwork before sending a prospective property to me.
I don’t know the residential neighborhoods as well as he does nor the potential rental rates I could achieve. Once he’s given me his take on the property, I do my own homework. If we jibe on the information, we’ll get together for a tour.
Once you’ve found the property, the negotiation starts.
You make your initial offer on a Purchase and Sale Agreement (PSA). This will detail the major points such as sale price, due diligence period, who will conduct the closing, and when closing will actually occur.
The PSA will also have little details like what happens in the event of non-performance. For example, you’ve said you’re ready to purchase and you show up to the day of closing only to back out. What happens? Well, the PSA will have information on how to handle that moment.
The negotiation period is often the shortest of the various periods, but it’s the most emotionally heightened because everyone is talking about money.
A Due Diligence period is the time when you examine the property, its books and (in the case of investment property) speak with the existing tenants. You are buying the property so you will want to know as much about it as possible.
This is where you need to become a contractor, an electrician, a lawyer, an HVAC technician, etc. Or you need to know who to call.
As I detailed in the article, In an Emergency, Who's Your Guy?, having a list of go to people at this time is a must. If you enter your due diligence period without a clue of people to help you, you’re going to be behind the curve.
Having a “go to” team is invaluable in this process. You want to be able to make a quick call, ask for an inspection and then trust they will get back to you with an honest assessment.
This is the part that I’ve always loved. This is where you examine the numbers.
During the due diligence period, the seller is required to turn over records such as Profit and Loss Statements, previous year’s operating statements as well as tenant leases. They may have done this prior to the offer you made, but this is where you really need to spend the time doing some research and asking deeper, probing questions.
Numbers will point you to the truth. Study them. Pull them apart and put them into your own spreadsheet. I’ve done this before and gotten a different result than the selling broker. I once discovered an error on a seller’s proforma which affected the value of the asking price. The seller didn’t move off the price and I didn’t move forward with the purchase. However, if I would have accepted what was shown on the original spreadsheet, I would have been stuck.
The same goes with the lease(s). Read them and take your time. If there are things you don’t understand, consult an expert. Just a reminder, though, your broker is not an attorney. They can give you guidance with a lease but understanding nuances of legal language isn’t their expertise. If you’re starting to get into the minutiae of a lease, spend a few minutes with an actual attorney. It will be worth it in the long run.
Part of this occurs in both the physical inspection as well as the records inspection. During the physical inspection did you walk into their unit? How was it maintained? If it’s a residential tenant, was the unit kept in a clean and orderly way or was it dirty and smelly? If the tenant isn’t keeping the unit clean, that impacts the property. Carpet generally has a life span of 7 years if it’s maintained (i.e. vacuumed). However, that life span is shortened greatly by tenants who don’t keep a clean apartment. Cleanliness is not a protected class (i.e. race, gender, familial status) and is often defined within a lease. This is something that should have been addressed by the seller and wasn’t. It’s going to be your problem upon closing. That’s okay, just be aware of it.
What if the tenant was a commercial retailer? How was their store presented? Was it clean and orderly? Were the shelves stocked fully or were they sparsely inventoried? A partially inventoried store could indicate a problem with cash flow. This is something to make a note on while you continue your inspection.
During the records inspection, you would check the tenant’s payment history and for any previous rental issues. Did they have a history of late payments? Were previous notices given for noise violations or other lease infractions?
So, you’ve seen their space and you’ve reviewed their files. What else can you do? Talk to them. Ask how their tenancy has been in the building. You can find out surprising information from a tenant. I once found out about an ignored roof issue from a tenant that turned out to be large enough that we killed the deal. You can also find out if the tenant is planning to renew their lease. This is valuable in the case of commercial buildings where leases typically run 5-7 years. If a tenant is nearing the end of their lease and they indicate to you that they have no plans to stay this will create a different type of issue for you. Perhaps it could be an opportunity, but it will become your issue to deal with after closing. If you didn’t talk with them, you’d have bought the property and walked into the issue unaware.
Once you’re satisfied that the property meets your requirements, you’ll remove contingencies. This will be different for all markets. In my market, residential properties automatically go live if you fail to remove contingency. On commercial deals, the deal will automatically die if you fail to remove contingencies. There are arguments to be made for both scenarios, but I prefer the automatic death of deal if you fail to remove contingencies. If you can negotiate that into your deal, do it.
At this point, you’re moving to closing in a residential deal. Congratulations.
In a commercial deal, we still have one more hurdle.
So this is where residential and commercial buying scenarios really differ.
In a residential buying scenario, you must get pre-approved for your loan up front. Typically, a lender will provide a letter stating how much of a loan they’ve approved to lend you. This letter is submitted along with your Purchase and Sale Agreement to prove that you have the funds available to buy the property your considering. It speeds up the process and weeds out the tire-kickers. Even if you’re buying an investment residential property, the sellers will want to see this letter, especially if they are working with a broker. This is because it is the norm.
In commercial, the financing happens after the offer is agreed upon due to the various scenarios that could affect pricing. For example, perhaps I know of a retailer who wants to open a new restaurant. I make an offer on a property that is currently used as a small office building. If the new retailer and I can come to a lease agreement, I may be able to double the value of the property the office building sits on. The bank doesn’t care what the property was worth yesterday. It cares what the property will be worth with the lease after closing.
Or the bank realizes I may bring in various partners to close the deal. Often this isn’t done until the deal is structured, and the due diligence is far enough along to know that the property is viable to submit to potential partners.
We put a $1.5Million building under contract and, to complete the transaction, we needed to raise slightly over $375,000. When the due diligence process was done, it was easy to show potential partners and the bank how the project would work. They willingly wrote the loan.
Having a relationship with your banker is of paramount importance, though. Constantly shopping around for a slightly better interest rate means re-introducing yourself every time. Sometimes you will get a better rate, sometimes not. However, having an existing relationship will speed the process up every time.
The deal was negotiated, the due diligence was done, and the financing was approved. Now it’s time to get to the closing table.
You can either use an attorney or a title company for your closing agent. There are arguments for both ways. We’ve typically used an attorney to handle our closings, however, as the market has heated up our attorney has become very busy and it has been hard to get time with him. In situations like this, we realize this is where a title company excels. They have additional staff to handle problems like this.
Regardless of which direction you go, attorney or title company, both should be professional. If you haven’t used someone before, ask around for a referral. Most folks in the industry would be happy to recommend someone who has given them great service.
That’s it for the basic outline of the investment purchase process. Broken down like that, hopefully, it’s less intimidating if you’ve never done it before.
If there are items you’d like to see further explained, please let me know.