In any real estate portfolio, the goal is to be profitable. Although the commercial real estate market has improved significantly since the lows seen during the Great Recession, investing still involves understanding the market. Let’s take a look at steps you can take to help bolster your investment portfolio.
Researching the local market
While national real estate trends are of some value, remember that the best market indicators are right in your backyard — those in your local market. Do everything you can to learn about and understand local rental rates, occupancy levels, competitive space supply and demographic trends. Moreover, do not forget that expansions, cutbacks or relocations by major local employers can significantly affect property prices. This means you will need to regularly monitor local news and blogs for such developments.
Social and historical factors also play a large role. For example, knowledge of a historical event that took place on a property or a neighborhood’s reputation as a hotspot for the rich and famous may help drive real estate prices up. On the other hand, value-lowering factors may include a history of neighborhood violence, odors drifting from nearby factories and recent flooding. Again, monitor the local news and records for both positive and negative property information.
Understanding operating costs
Your investment decisions are only as good as your financial projections. This means that it is crucial to look at real operating figures when purchasing an established rental property.
Evaluate existing leases to find out when they expire. Do they include escalation clauses? Can you renegotiate any soon-to-expire leases at higher rates? Or, will you need to renegotiate them at lower rates to retain the tenant?
Historic rental and vacancy rates may not be realistic going forward. Additionally, some landlords leave money on the table by forgetting to enforce escalation clauses or recoup expenses paid on a tenant’s behalf.
Finally, do not assume that you can slash expenses or boost revenue simply by raising the rent. It does not work that way.
Heeding warning signs
Performing due diligence on a prospective property is the most important thing you can do as an investor. Be sure to look for deteriorating bottom lines, as well as aggressive revenue recognition policies or deferred expenses.
A comparison of the property’s cash flow against its earnings statement can be revealing. If the former owner shows net income increasing while cash flow is in the red, be wary. A change in accounting methods or accountants midstream should also raise a red flag. Both of the situations should prompt you to question the reasoning behind such moves.
Using leverage sparingly
If used properly, leverage can be a powerful tool for increasing your return on investment. Debt allows you to use other people’s money to boost your return, as long as you can earn a higher rate of return than you are paying in interest.
In past years, interest expense was fully tax-deductible, making leverage extra appealing. However, the Tax Cuts and Jobs Act introduced a significant new restriction on the interest expense deduction for businesses with more than $25 million of average annual gross receipts, generally limiting the deduction to 30% of adjusted taxable income. However, it allows real estate businesses to elect out of the interest limitation rules. Loan interest would then remain fully deductible, but the business would be required to use the alternative depreciation system for real property used in the business. Barring further congressional action on the issue, it could not deduct bonus depreciation on those assets.
Do the homework
No one can predict the future with absolute certainty. Even with thorough research, most investors will have some investments in their portfolios that exceed expectations, along with some that underperform. However, you can tip the odds in your favor by evaluating every aspect of a proposed real estate investment and having your accountant double-check your findings.
For more information, contact Jeff Newman at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.