With the real estate industry’s steady growth over the past several years and property values holding reasonably constant, investors are eager to jump on a perceived bargain. While securing the lowest price is not a bad idea, investors need to be careful about doing their research before closing on an apparent deal. That so-called “bargain” can quickly turn into a problem if you fail to consider more than just the purchase price. Before taking the plunge and buying a seemingly good parcel, here are five other factors to consider.
- Zoning Ordinances
Zoning ordinances are regulations that determine how owners and tenants can use the property purchased in specific geographic zones. Before buying a property, check local zoning authority records to determine if there are any restrictions for the intended use. It is also good practice to review the current limitations and if any changes to the permitted uses will occur in the foreseeable future. Verify if existing approvals are transferable under the potential new restrictions. If not, it could be challenging to obtain any required variances or permits, which may result in timely and costly delays to developers and builders. Securing a loan may also depend on the proper zoning for the property in question.
If you are purchasing a property located in special public financing or qualified opportunity zones, there may be additional land-use restrictions to consider. However, these types of properties present tax benefits and credits if eligible. It is important to speak to your tax advisor about these opportunities to determine the best recommendation for your situation.
- Added Improvement and Carrying Costs
Some bargain-priced properties can require additional maintenance and repairs to bring the building up to rentable standards. These repairs and improvements may require additional capital to ensure the building is up to code and habitable. The necessary capital investments may be as much as the original cost of the building. This expense is something to consider before putting in an offer.
In addition to increased capital investment, the rehabilitation can leave your property with vacancies for some time. The longer a building is off the market due to maintenance and building upgrades, the more the burden of the cost falls on the shoulders of the investors. Until work on the building is complete, these associated costs are unable to be offset by rental income. These costs include property taxes, mortgage payments, insurance and so forth.
- Occupancy Rate and Tenants
When it comes to occupancy rates, the higher, the better. Spending time finding new tenants can cost you both time and money. Having regular tenants means a steady inflow of rental income. When purchasing a rental property, either residential or commercial, it is essential to evaluate whether the location and rental fee are appealing to potential tenants and can command the demand to keep vacancy rates low. A high vacancy rate can doom a bargain property, especially in the first couple years of service.
In the real estate market, it is all about the supply and demand of properties determined by many factors. To maintain the desirability of rental locations and keep vacancy rates relatively low, evaluate your existing leases for any unfavorable terms and assess the financial standing of every tenant. It is imperative to research the area you want to invest in to better understand the market and neighborhood dynamics. Before purchasing a multi-tenant property, compile a current rent roll summarizing key details for every tenant, including:
- Move-in date;
- Security deposit;
- Escalation clause;
- Expiration date;
- Outstanding rent balance; and
- Options to extend or purchase.
Review and note which tenants are behind on their payments, which leases are nearing expiration and any rent rolls that differ significantly from the seller’s income statement. Consider how long tenants lease and which rentals are likely to be renewed in the future.
- Associated Legal Issues
Just because a property looks like a good deal, it may have additional expenses that will cost you more than previously expected. Like potential maintenance and improvement costs, you should also take into consideration any legal responsibilities incurred by the seller. For example, sellers may have fallen behind on obligations to contractors and other third parties. If so, you, the purchaser, may incur costs to locate lienholders and obtain releases.
Review any current contractual obligations to third parties. Find out if the warranties, guarantees, indemnities and rights under the original construction agreements are assignable to you, the new buyer. Some contracts and warranties only apply to the original purchaser and, therefore, will need to be renegotiated or repurchased to be valid. Another cost to look out for are fines related to building codes and permits that were not correctly applied for or have currently lapsed. You may become responsible for any code enforcement fines the original owners incurred.
- Unknown Environmental Concerns
Before acquiring a loan, your lenders will most likely require a Phase I Environmental Site Assessment. The assessment evaluates the environmental conditions of the property to identify any potential liability for the buyer by analyzing the property’s past and current uses. When determining potential risks, both the underlying land and physical improvements to the property are considered.
Identifying these risks can save you time and money before purchasing a property. Depending on the results of the assessment, the clean-up costs and liability for lurking environmental issues can accumulate quickly. Even as the new buyer, you may be liable for the clean-up jointly with past owners of the land. Review any environmental reports, notices of violations and any pending litigation related to the property and surrounding area. Several laws and regulations are put in place to protect the environment and can vary from state to state. Have your real estate advisors and attorneys review applicable federal, state and local environmental regulations, including any that could limit future uses.
LOOK AT THE BIGGER PICTURE
In addition to the five factors listed above, other outside threats and risks can affect the long-term profitability of the property. A bargain-priced property is more than just its low price. To better assess future earnings, you should consider the neighborhood’s future property values, research crime rates, median income of tenants and comparative rental rates with surrounding buildings. Consider the potential economic growth of the neighborhood and the surrounding area.
Before rushing into a deal, take the time to perform your thorough due diligence. Some bargain-priced properties may not be a bargain after all.