Investing in commercial real estate can be financially rewarding, but it also comes with risks. To improve your chances of success, it’s important to learn from the experience of others and know which commercial real estate investing mistakes to avoid. We asked experts to share the most common pitfalls in commercial real estate investing.
The top 24 mistakes when investing in commercial real estate include:
1. Failing to Understand the Terms of Balloon Financing
Benjamin Mizes, CEO, Clever Real Estate
A common type of loan used in commercial real estate investment is a balloon mortgage. Many investors don’t fully understand the terms of these loans before utilizing them for their properties. Balloon mortgages are relatively high-risk products for credit issuers, as they require the borrower to fulfill repayment in one lump sum at the end of the term.
Usually, the borrower is only required to make interest-only payments or it’s payment free. Where investors make a mistake is not thinking about what needs to happen at the end of a balloon mortgage—they may need to refinance (which can be at an even higher rate) if they don’t have the cash on hand to make the lump sum payment.
2. Incorrectly Assessing the Value of a Property
Kenneth Ameduri, Wealth Management Expert & Co-founder, Crush The Street
Real estate isn’t a commodity the way one ounce of gold is the same in California as it is in Argentina. Commercial buildings are not all created equal; they are nuanced starting with location, local economy, quality of construction, desirability of layout, and more. Not correctly assessing these variances and not capturing equity from day one can lead to financial pain. The best thing a person looking for commercial real estate can do is get a pulse for where the sweet spots are in the market to best gauge what a fair market price is and ideally, attempt to purchase within or under market.
3. Focusing Too Much on Gross Income
Jennifer Okhovat, Real Estate Agent, Compass
One of the most typical mistakes that investors make when purchasing real estate is looking at gross income instead of net income after expenses. Many sellers and brokers advertise properties as having certain returns, but only a savvy investor will look to see if those returns are actual or projected, and if they take into account actual expenses and potential expenses the property may have.
For example, even if a property is currently making a good sum of money for the owner, will the numbers still pencil out for the next investor after property taxes and other expenses? Will the property potentially need new improvements (e.g., HVAC, roof) in the coming years? The best way to avoid such mistakes is to work with a trusted real estate adviser who has experience in the field. That way, they can assist with educating the client regarding inspections, leases, and other matters related to the sale of commercial properties.
4. Relying on Information in Public Listings
Russ Moroz, Associate Director, Marcus & Millichap
One common mistake in buying a commercial property is relying solely on publicly available listings as your source of information. This limits your options, and chances are you won’t find the best fit for your business. It’s best to work with a knowledgeable broker who knows about many other available properties not listed on public websites that you’ll never find yourself.
5. Not Knowing Your LTV & DSCR
John Matheson, Real Estate Developer, Co-founder & CEO, Commercial Loan Success
Lack of preparation for commercial real estate financing is a leading cause of acquisition failure. Spending time to organize before speaking to a lender will significantly improve your chances for success. Speak to any successful commercial real estate owner and they’ll tell you to make sure you are confident in your numbers before going in. The vast majority of banks will look at your loan-to-value (LTV) or debt service coverage ratio (DSCR) to determine if they’re interested in discussing further. Today, there’s new software and education available to quickly help you prepare a presentation that lenders will appreciate—use them and increase your chances for success.
6. Failing to Do Due Diligence
David Reischer, Esq., Attorney & CEO, LMP Corp.
Failing to do legal due diligence is a common mistake when investing in commercial real estate. A serious and costly legal mistake can wreak havoc when trying to obtain financing for a commercial property or create financial problems once in possession of the property.
As such, always make sure that no commercial space is being utilized as an illegal residential apartment. Check the title report and make sure there are no open violations, but also make sure to physically check that there is a commercial fire alarm and sprinkler system installed regardless of whether there are no open violations on the title report. Ensure that the water treatment system is functioning. When it comes to tenants, make sure that they have been paying their rent on time, that they are using the space legally, and that the tenants are all properly licensed and up to code and have the correct Certificate of Occupancy for their businesses.
7. Not Working With a Team of Professionals
Lee Kiser, Principal & Managing Broker, Kiser Group
Make sure to hire a broker, attorney, and lender when evaluating commercial properties. These professionals can guide you through local practices and customs and help you determine the most important items to review during due diligence. Items you will need to look into are physical aspects of the building and the financials, especially the cash flow of the building.
8. Not Having a Cost Segregation Study
Logan Allec, CPA, MBT, Tax Expert, MoneyDoneRight
From a tax perspective, one mistake commercial property investors often make is not having a cost segregation study done on their recently purchased property. A cost segregation study can result in massive tax benefits for commercial real estate investors because it can significantly increase their depreciation deduction in the early years of owning a piece of commercial real estate.
When you buy a piece of commercial property, you have to split up your basis in it between land and building. You can take a depreciation deduction on that building portion, but you have to spread out that depreciation deduction over 39 years, which is quite a long time. So if you purchase a $1,000,000 building, you would get a $25,000 deduction (approximately) per year on the building. However, if you do a cost segregation on that building, you can carve out a portion of the building as property with shorter depreciable lives.
For example, in a $1,000,000 building, you may be able to carve out $100,000 of shorter-lived assets. You can either take accelerated depreciation on these assets (say over five, seven, or 15 years depending on what the assets are), or you can take bonus depreciation on them and expense them all in the year you purchased the property (or did the cost segregation). The immediate tax savings can then be deployed to fund further acquisitions. Since you can enjoy massive tax benefits by doing a cost segregation study, it’s a huge mistake for any commercial property investor to not at least consider having one done on each of their assets.
9. Neglecting to Hire a Good Property Manager
Than Merrill, CEO & Founder, Fortune Builders
Whether you own a single commercial asset or an entire portfolio, nothing can take your investments further than a good property manager. A qualified property management company can simultaneously reduce stress, mitigate risk, and increase profit margins. From finding tenants and avoiding vacancies to collecting rent and maintaining the status quo, a truly qualified property manager will give investors the most valuable asset of them all: time. Aligning your services with the right management company can free up your time to pursue more important things, like scaling your portfolio.
10. Failing to Structure a Holding Entity Correctly
David Roberson, Esq., Principal, Silicon Valley Property Management Group
One of the most difficult aspects of starting a real estate investment business, regardless of whether it is a partnership or a solo venture, is how to structure it. It’s important to protect yourself from personal liability, separating your personal finances from your business life. In most cases, it’s best to work with a real estate attorney to go over the different options and determine which one best suits your situation.
For instance, in California, an S corporation or an LLC may be best suited for your enterprise as they are “pass-through” tax entities, where the individual shareholders pay individual income tax on their income from the entity. A C corporation, which is a separate taxable entity, may be required for more complex organizations. In either case, a competent real estate attorney can help you through this decision process.
11. Miscalculating Cash Flow
Jake Plotkin, CCIM, Senior Director, Lee & Associates
As much as possible, refrain from making the mistake of miscalculating your cash flow. Many successful real estate investors buy, hold, and rent out properties for the long term, ensuring they have enough cash flow for maintenance and other expenses. Savvy real estate investors allocate their budgets so there is sufficient coverage for expenses like the mortgage, taxes, insurance, and advertising costs. When you don’t have enough cash flow, your property becomes a liability, when it should instead be an asset.
12. Skimping on Due Diligence
Wally Conway, President, HomePro Inspections
A common mistake made by commercial real estate investors is attempting to save money on their due diligence. It is interesting that lenders are often more engaged in due diligence to protect the loan than cash buyers are to protect their cash investment. Too many investors limit their due diligence to what is required by the lender. The lender’s key interest is in protecting their investment should they need to foreclose. That is a far lower threshold than having sufficient information to maintain and or upgrade the building.
13. Underestimating Vacancy & Tenant Improvement Costs
Mike Hills, Property Manager & Real Estate Broker, Atlas Real Estate Group
Vacancy and tenant improvements can be long and extremely expensive, especially in commercial real estate. For example, if an owner buys a commercial building that needs a lot of repairs and doesn’t have respectable tenants, the time that it takes to make money from that investment can take a really long time. And if the business owner is underfunded, they can lose a lot of money in a building until it becomes profitable.
14. Failing to Understand the Lender’s Underwriting Requirements
Michael Blank, Founder, Syndicated Deal Analyzer
One common mistake most property buyers commit is not understanding the requirements of lenders before they spend a lot of time, money, and energy looking for a property. It’s essential to conduct a preliminary discussion with some lenders to know the amount of loan they can lend you and the requirements that you need to comply with it.
15. Not Planning Ahead
Richard Lorenzen, CEO, Fifth Avenue Brands
Failing to make ground-level planning is one of the common mistakes business owners make when buying a property. Before you make any move, outline your expectations and plans thoroughly. Proper financial planning should also be included in this plan, especially the upfront costs, ongoing expenses, mortgage payments, and how much income you need to be able to afford them.
16. Buying Too Small a Property
Kyle Tobin, Owner, LawnSavers Plant Health Care Inc.
One of the most common mistakes most business owners make when buying a commercial property is failing to consider their business’ growth in the future. Most of these business owners look back and say they wish they had bought something with bigger space to accommodate their growth and expansion. If you have the ability to do so, buy something larger than what your company needs now, and sublet excess space until you need it. You’ll thank yourself later.
17. Timing Your Move Incorrectly
Jamie Barati, Senior Vice President, JLL
If your company is currently leasing space, you need to consider the timing of the move to the property you’re buying. The purchasing process can take 60 to 90 days, depending on the building and any complex issues that might arise. The property may also need improvements before you can take occupancy, which can take another three to six months. It’s best to consider this to time your purchase strategically so you’re not pressured because you’re squeezed for time.
18. Choosing the Wrong Location
Jonas Sickler, Marketing Director, ReputationManagement.com
Choosing a commercial property for a new business goes beyond analyzing traffic patterns and neighborhood demographics. There are many things that you need to consider when choosing a location, such as your target market, the neighborhood community, your and your employees’ residences, and the safety and security of the place, among others. Choosing the wrong location may cause the business to fail.
19. Not Checking Local Zoning Ordinances
Jason Rittie, Zoning Attorney &d Partner, Einhorn, Harris, Ascher, Barbarito & Frost, PC
Before buying a property, you should first evaluate and investigate the current land use and zoning ordinances. This is to determine whether your intended use of the property is permitted under current zoning ordinances. Failure to check the zoning ordinances may result in certain violations or you may not able to use the property as intended.
20. Forgetting About Occupancy Licenses
James Timothy White, Founder & Broker, WeSaySold.com
Just because a building seems physically ready to be occupied doesn’t necessarily mean it really is. A business owner needs to obtain all necessary licenses for the building to be utilized and occupied. Forgetting to obtain such licenses can be very costly. Make sure to call your city or county to secure the required occupancy licenses.
21. Relying Too Much on Your Broker
Brian Good, CEO, iBorrow
A big mistake business owners make is relying too much on the broker. Buyers need to independently and objectively verify the information provided to them, especially by brokers. As a business owner, you should do your own due diligence and be prudent and cautious when dealing with brokers.
22. Buying the Property in a Rush
Chad Bermingham, Vice President, Avison Young
One of the biggest mistakes is buying a property in a hurry. Some business owners set their hearts on the first property they see and don’t give themselves leverage to negotiate by considering other locations. It’s best to take your time when buying a property. Consider all angles, such as the location of competitors, talent pool, transportation, parking, local community, taxes, proximity of neighbors, and budget.
23. Being Moved Solely by the Asset, Not the Market
Leonte Benton, Senior Vice President, T. Dallas Smith & Company
Your commercial real estate purchase should not be driven solely by the type of real estate you think may be a good investment because of past successful ventures by you or others. Your decision should be inclusive of the current state of the market as well as supply and demand. Whether you are investing for the short term or long term, know which type of commercial real estate product (office, land, industrial, or retail) will offer you the best return based on the demand in the marketplace and location. Buy it when it’s ugly, below replacement cost, in the path of growth, and where the market says there is demand so that you can reap the greatest benefit.
24. Underestimating the Process Involved in Obtaining Mortgage
Angat Saini, Principle Lawyer & Founder, Accord Law
One of the most common mistakes we see novice commercial property investors make is underestimating the rigorous process involved in obtaining mortgage financing on commercial properties. Clients often assume that the commercial lending process is similar to residential lending. Unfortunately, the process is much more time-consuming, and often involves significant upfront costs such as property appraisals, site inspections, and commitment fees. When clients underestimate the time and costs involved in the financing process, it can jeopardize the transaction or cause unnecessary delays with respect to the closing date.
Investing in commercial real estate for beginners can be a great breakthrough for your business. However, it’s important to spend time making strategic decisions when purchasing a property, as this is both your business asset and investment. Also, make sure to minimize your risks by avoiding these common commercial real estate investing mistakes.