This is the fourth in an 11-part series of understanding the key ingredients in all successful real estate transactions.
Picture yourself flipping a coin and for twenty consecutive flips it comes up heads. Exciting perhaps, but assuming it is not a trick coin, what are your chances that on the next flip it will be heads?
In fact there is exactly a 50-50 chance that it will be heads on the next flip. The past twenty flips had no causation or correlation that the twenty first flip will also be heads. This is an important concept to keep in mind when thinking about making investments. Your investment is about the future income stream after you own it and not about past performance. We’ve all heard and read that line many times, but it is true. Investing is about the future.
Are there times when researching historical data and performance is important? Yes, always. But how the data is used needs careful thought. Historical financial performance should not automatically be assumed to continue or that the rate of growth is a linear projection into the future. If a buyer happens to be making a great purchase with wonderful upside potential, the past financial history of the income stream becomes less important due to the buyer’s insight that the future income stream will be improving.
In commercial real estate the past is important to understand. Professional brokers analyze data like rent rolls, expenses, lease termination dates and the like—all standard procedures to making a decision to buy or sell. Everyone understands that analysis of this type is important, routine and necessary. However, the informed investor knows there are additional pieces of information or knowledge necessary to make an outstanding investment. Assuming the seller knows the best timing and way to exit the property, investors should ask, What are the more hidden pieces of historical data, current knowledge, and future trends that might reduce the risk of future ownership?
Let’s take a look at several research steps to enhancing value for real estate investors.
Legal – Make sure you have the right legal team in place. Prior to committing to purchase, getting a clear understanding of the property easements, restrictions, covenants, etc., that are recorded in the deed or other documents filed at the courthouse is one of the first steps in a due diligence process. Your attorney will assist with multiple items, but two important ones are making sure your agreement of sale provides for a due diligence period and searching the title regarding the aspects of the deed.
Zoning – When researching the title at the courthouse, you may find that the results likely will not provide an in depth understanding of the ramifications of the type of zoning affecting the property. This research should be completed by discussing your use with the authorized governmental official under whose jurisdiction the property falls. Purchasing a property without knowing whether your change of use of the property from past historical uses is acceptable to the governmental authorities can result in serious financial consequences. Additionally, meeting with governmental authorities can provide insight into other issues affecting the property that the previous owner may not have satisfied. These items could be building code violations, zoning violations, invalid certificates of occupancy, etc. All of these could affect the fair market value of the property.
Property Inspections – Touring the property with a discerning eye and keen sense of how the property was maintained is very important. Completing an environmental audit is vital to understanding previous uses of the property and how those uses may affect your decision to purchase. These audits can be completed during your due diligence period and prior to final commitment to purchase. There may be occasions when structural engineers are needed to advise as to the structural integrity of the facility for current and future uses. Perhaps a past use or age caused the physical structure to deteriorate so that it may be unsafe or of insufficient strength for your use.
There are other areas of historical records whose disclosure may benefit the buyer or seller prior to a sale. However, the real benefit of owning commercial real estate is about the future. What value-add or unseen or undeveloped opportunity can a property be turned into that makes the future income stream grow exponentially? Knowing historical records is important, but being able to see the future potential is key to success.
Don’t just flip a coin to make your decision. Do the historical research and, although there is always risk, look to the future.