One of the most common investments used to gain and increase wealth is the purchase of commercial real estate. When performing due diligence to determine which properties are most suitable for investment, a buyer should use the same approach that will be used by the bank providing the financing. A long-time standard of commercial lending has been adherence to the rule of the 5 C's of credit to make sure the borrower and property meet each one. These 5 measures are capacity, capital, character, collateral and conditions.
While all of these are important the one most commonly emphasized by the lender is capacity, meaning does the borrower have the capacity to repay the commercial real estate loan. This capacity is measured by the cash flow of the project. This measure will show not only can the loan be repaid, but whether the investor will make any return on their investment. These two are critical to the success and continued life of a project, thus the often heard statement "Cash flow is King".
Although similar, cash flow is measured differently depending on whether the commercial real estate is to be owner occupied (rented to a business owned by the investor) or non-owner occupied (rented to a non-affiliated tenant).
- Owner occupied - when measuring the ability of the investor to repay the loan the cash flow of the renting business is analyzed to determine if it has the ability to generate sufficient cash to pay the bills, the loan payment, and the owner. Traditional cash flow of a business is defined as net income (revenue minus cost of products and all expenses) divided by debt service ( the total of loan payments). An acceptable ratio in this case is generally considered to be anything above 1.25. The 0.25 extra not only provides a cushion in the event of decreased revenue or increased expenses, but is also the source of the investors return.
- Non-owner occupied - although the 1.25 ratio is still used, the calculation in this case is the total of all rent payments minus expenses associated with the management and maintenance of the property divided by the debt service. In this case, the cushion is important to cover any periods of vacancy between tenants.
By using these measurements when looking at potential investments, the real estate buyer can form a good opinion about the potential profitability and long-term sustainability of a project. All the bills paid, a little cash in the pocket and a good night's sleep are all worth the due diligence required in commercial real estate investing.
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