In any real estate portfolio, the goal is to be profitable. And while 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, don’t forget that expansions, cutbacks or relocations by major local employers can significantly affect property prices. This means you’ll need to regularly monitor local news and blogs for such developments.
Social and historical factors also play a large role. Knowledge of a historical event that took place on a property or a neighborhood’s reputation as a hotspot for the rich and famous, for example, may help drive real estate prices up. Value-lowering factors, on the other hand, include odors drifting from nearby landfills, factories or farms; a history of neighborhood tensions or violence; and recent flooding. Again, mine the local news and records for both good — and not so good — property information.
Understanding operating costs
Your investment decisions are only as good as your financial projections. This means it’s 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. And some landlords leave money on the table by forgetting to enforce escalation clauses or recoup expenses paid on a tenant’s behalf.
Finally, don’t assume that you can slash expenses — or boost revenue simply by raising the rent. It just doesn’t 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, for instance, 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. But 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 ― and, barring further congressional action on the issue, it couldn’t 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.