The 8 Questions Every Real Estate Investor Should Ask to Assess the Risk of a Property
(Recent Article I wrote and republished here)
In 2021 with inflation on the rise, real estate investments have quickly become one of the most popular ways for individuals to build wealth and earn passive income.
Not only are investors putting money into residential properties, but they’re also getting into commercial real estate investing because it allows them to invest passively in cash flowing properties.
Because passive investing is ultimately what high net worth investors want, there are more ‘syndicators’ raising capital to for their commercial deals. However, not everyone with money knows what questions to ask to help assess the risk of a property.
One professional real estate investor, developer, and cash flow specialist, Shane Melanson, shares his expertise to help newcomers understand the risks and questions they need to ask to perform proper risk assessments of different commercial properties before putting money into them.
1. Are You Following the Smart Money?
“Follow the smart money”.
If Starbucks or Wholefoods is in the neighborhood, or you see cranes and new development, that is generally a good sign”. Developers and smart, multinational tenants do a lot of homework before they enter a market.
According to Shane Melanson, this is one of the first questions to ask. “Before you ask any other questions, look at the location and ask yourself if you like the property enough to visit it often over the next several years. If so, you have your answer,” he said.
You can make money in tough areas, but it’s not how I prefer to do business. I never rely on a property manager to do the heavy lifting. Be prepared to take control of a property.
2. Is the Deal Large Enough to Justify Your Time?
One reason people invest in cash flowing real estate is to stop trading time for money. But new investors typically focus on small deals that require just as much energy and effort as larger properties.
A gut check question, ‘Are you just buying a 2nd low paying job, or are you acquiring an asset that is going to allow you to find professionals to manage, so you can stop trading time for money?
“My mentor, with 40+ years investing in commercial real estate and eventually became my father-in-law, helped me develop a systematic approach to investing, which is how I’ve managed to have such success.
Each property I invest in has the potential to earn seven figures. So, it’s something to think about when you’re investing in any property,” shared Melanson.
How Much Debt Will You Put on the Property?
Be realistic when determining how much debt or leverage you will put on a property.
One of the key metrics professional investors uses is called the DCR or Debt Coverage Ratio.
It’s a simple formula.
Divide the Net Income (after expenses) by the debt payment. Most commercial lenders like to see a minimum 1.25 DCR. For every $100 of debt, you require $125 of income. It’s a good idea to stay above a 125 DCR, in case a tenant leaves, you have sufficient income to cover your expenses and mortgage.
4. Does the Property Fit Your Core Competency?
Think about who your tenants are? If you’re investing in retail, industrial or office buildings, do you understand what these tenants look for when renting space?
Focusing on properties that you have some background in is important. Maybe you were a tenant at one time, leasing space and you understand the characteristics of properties that you liked and didn’t like.
For example, how much parking did the property have? Did you have good street frontage? Was there public transit and how close are amenities? What is the ceiling height? Does a tenant need dock or grade level loading?
It’s an integral part of real estate investing that not everyone considers in the beginning.
5. Does it Cash Flow Today?
Gather details on the income and expenses of the property. What is the value of the property today, given the in-place net operating income (NOI).
For new investors, Shane does not recommend paying for the upside in value-add properties. When you understand the income of a property today, it’s much easier to determine what you’ll pay for the stream of cash flow.
6. Are You Buying Below Replacement?
One of the best ways to protect against the downside, is to buy below replacement.
Meaning, what would it cost if you had to rebuild the property today? With inflation climbing, supply chain disrupting the ability to get building materials, the cost of labor and land rising, new properties are becoming increasingly difficult to bring to market.
This is one key reason the wealthy are moving their money into hard assets like commercial real estate.
7. Is the Property Functionally Obsolete?
Buying a property that is under parked, has poor access, or low ceiling height, in many cases is a non-starter. Shane explains this is one of the biggest mistakes new investors make when investing in commercial real estate.
“In a hot market, where it’s hard to find good, safe properties to invest in, new investors, fall victim to the Bigger Fool. Buying properties that no seasoned investor wants.’ Do your research. Talk to the tenants and look at what has happened with the property over the past decade.
This can provide you with valuable insight on whether it’s worth investing in or not.
8. Who Has Control Over the Property?
Having control over a property is one advantage real estate offers over, say the stock market or crypto currencies.
But some investors unknowingly think they have control, when they are limited in what they can do. An example would be buying on leased land or having restrictive covenants on title. Each of these situations, someone else is exerting influence and thereby limited the decisions you can make on your property. Typically, in these situations it reduces your control, and raises the risk.
More risk equals generally means higher ROI expectations.
As an experienced and established real estate investor, Shane Melanson wants to help new investors succeed by getting on the right track and avoid these common mistakes. He’s released a new book titled, Club Syndication, How the Wealthy Raise Capital, and Invest in Commercial Real Estate.
In the book, he provides his personal action plan that consists of the five steps investors can follow before putting money into commercial properties. Such as finding the right properties in the right location at the right time in the market, where to find investors to raise capital, how to secure the right debt and how to build a team around you to help execute your deal and more.
Shane has invested in commercial real estate since 2008 and personally completed multiple 8 figure deals. He’s currently a developer in Calgary AB, with multiple retail, industrial and multifamily/townhouse projects underway.
One of his favorite deals, was acquiring an 1,152-acre resort property just north of Toronto for $8.5M and turning it around and selling three and half years later for $17,000,000. It was not a smooth deal and things didn’t always go as planned. It worked out in the end, and it was this experience that gave him a real-world MBA in investing.
Commercial Real Estate Investing Scorecard
My 8 Non-Negotiables to Investing and the checklist for how I analyze every property