subject: The Seven Leading Financial Indicators Of A Great Real Estate Investment [print this page] The idea fairy often drives the decision to make a commercial real estate investment. A company can improve its earnings, valuation and industry standing through effective real estate investment activities. But the dream is only the beginning point. A solid fundamental analysis of the real estate investment opportunity must be completed to ensure it adds tangible financial value. The business executive needs to be reasonably sure based on sound financial calculations that a minimum acceptable return on invested capital will be realized. Most great real estate investments have seven leading financial indicators to guide capital decision making. There are other non-financial indicators such as physical location that are not the focus of this article.
First, be clear that the office building, manufacturing plant or retail store front that you own and occupy is not PRIMARILY an investment. Rather it should be viewed first as the consumption of necessary physical space to generate your primary source of business revenue. You might realize a savings over market rent for similar space which aids your cash flow by reducing expenses. Your company might sell the property for a capital gain in the future but the axiom that real estate prices always go up is false. Many homeowners made critical financial mistakes by believing their primary residence is an investment instead of the consumption of shelter. The misplaced investment mindset can lead to over-consumption of space whether it be residential or commercial square feet.
The most important financial consideration when evaluating a real estate investment is the amount and quality of gross rental revenue generated by in-place tenants. A successful real estate investment will have a substantial history of lease payments from credit worthy tenants. Take a look at the individual lease terms to identify below market rent conditions and evaluate the opportunity to add value with new leases or renewals at higher rents. Review a lease expiration schedule to identify years of substantial tenant rollover and the probability of replacing expiring leases with new or renewal leases. Study the accounts receivable aging report to see if your management team can extract efficiencies and incremental income through better rent collection processes.
Look for sources of ancillary income that can quickly add revenue and value to the property. A shopping center might add promotional income from a major sponsor and an office building might install billboards. Lease terms, zoning ordinances and architectural design might limit the possibilities for additional revenue so be sure to do your due diligence in this area.
Closely evaluate the operating expenses and look for cost management inefficiencies. There may be opportunities to reduce expenses through large volume vendor relationships if you own several properties. Open existing maintenance contracts for new bids to gauge current market conditions. There may be opportunities to reduce costs through environmentally friendly improvements such as efficient lighting and recycling programs. Some of these improvements will require their own financial analysis to determine the return on the capital expenditure.
The real estate should generate substantial net operating income after deducting operating and non-operating or management expenses. There should be sufficient cash flow before debt service to fund anticipated capital expenditures and to fund reserves. Be mindful of a situation where ownership will likely make additional capital calls. Do you have the investment funds to comfortably make those capital contributions?
The cash flow available for debt service is the net number after subtracting operating, non-operating and capital expenditures. This is the amount of money available to pay monthly principal and interest on any loans used to finance the investment. Over-leveraging an investment can result in negative cash flow, foreclosure and or bankruptcy so this calculation is extremely important. The amount of debt that can be used to leverage an investment is directly dependent on NOI among other factors. However, real estate should be evaluated on an un-leveraged basis first, that is without debt, when making a capital investment decision.
The owners get paid last with any remaining cash flow that can be distributed or reinvested. Some investors choose to hold distributions in favor of establishing reserves as a cushion against future expected and unexpected expenses. Your capital investment analysis should show a net profit and distribution to ownership. After all, that is the most compelling reason to write the investment check in the first place.
