Commercial Real Estate for Buyers & the Legal Process
There are a handful of reasons to buy commercial real estate. Perhaps you are a business owner looking to establish a new brick-and-mortar location, or an investor hoping to generate another source of income. Regardless of the reasons for buying commercial real estate, a buyer should consider the transaction carefully and should not shy away from professional guidance. The process is not exactly the same as buying a home.
Finding a Commercial Property
Unless there is a reason a buyer must purchase one specific property, it is probably a good idea to shop around and evaluate different options before buying commercial real estate. Similar to buying a home, a list of must-haves, nice-to-haves, and absolutely-nots can be a good starting point, although the factors in those lists and their importance will differ. For example, a buyer looking to use the property for their salon business might be focused on how many stylist stations they can fit in a space, while a buyer who wants to purchase property as an investment may be more interested in the market rental rate.
Buyers often employ commercial real estate brokers to help find and purchase property. Not only do brokers usually have considerable and up-to-date knowledge about a specific market, but also their fees are typically paid by sellers, not buyers. Buyers may also work with mortgage brokers, accountants, and lawyers, among others.
The total cost of the property will likely be a considerable factor. Buyers should remember that the purchase price of the property itself will not be the only expense. They might also pay property management expenses, maintenance expenses, utilities, property taxes, insurance, loan interest and fees, closing costs, professional fees, and more.
Calculating a Property’s Capitalization Rate
Buyers purchasing commercial real estate for investment purposes might find it helpful to calculate a property’s capitalization rate. A basic way to calculate a property’s capitalization rate is to divide its net operating income by its current fair market value. The capitalization rate will give a buyer an idea of the property’s potential annual rate of return. The higher the capitalization rate, the better the annual return the property may produce.
To calculate net operating income, a buyer will either multiply by 12 the current monthly rental income for the property or estimate it based on the market rate for similar properties, and subtract total estimated operating expenses, including maintenance, utilities, taxes, and insurance. When calculating a property’s capitalization rate, a buyer should take into account that the property might not be fully occupied and could remain that way for a while. In that case, the monthly rental income estimate should be adjusted accordingly.
The Letter of Intent
Once a buyer finds a commercial property they are seriously interested in, they will negotiate a letter of intent (LOI) with the seller. The letter of intent contains the basic terms of the proposed contract, including things like the purchase price and the closing timeline. It will also include the names of the parties involved, a detailed description of the property, and disclaimers. While a letter of intent does not bind a buyer to purchase the property (or a seller to sell it), disclaimers can be useful in explicitly stating why a party might back out. Finally, a letter of intent might include some binding components, such as a non-disclosure agreement (NDA).
The benefit of the letter of intent is that a buyer can express their commitment to buying the property without undergoing the expensive and time-consuming process of negotiating and drafting a binding sales contract if there is no chance that a deal can be reached. A commercial real estate broker can help a buyer draft a letter of intent.
Once they reach an agreement, both the buyer and seller will sign the purchase and sale agreement, and the due diligence period will begin.
Exercising Due Diligence
The due diligence period is the period during which a buyer will evaluate and inspect the property to determine whether it will meet their needs and whether there is any damage or potentially dangerous conditions on the property. Due diligence also usually entails acquiring and reviewing documents and records related to the property, such as surveys, public records, third-party contracts, and balance sheets.
The conditions a buyer discovers while conducting due diligence might inspire further negotiations between the buyer and seller. For example, a buyer who discovers a broken window on the property may be able to convince the seller to replace the window immediately and at their own expense. A buyer who realizes that they will need to renovate a portion of the property in order to fit their business equipment might be able to negotiate a reduction in the purchase price if they can offer something more to the seller, like speeding up the transaction.
Before and during the buying process, the buyer should be cognizant of their “exit strategy.” A buyer may plan to sell the property eventually and can map exactly how they will ensure that the property’s value will appreciate over time. But all buyers should also plan for the unexpected. A buyer may buy a property thinking they have a great chance of having it rezoned, only to realize that the administrative process will take much longer than they thought. Or they may have a dispute with their business partner that would be best addressed by selling the property. Not only should a buyer be sure that they have extra funds on hand for the unexpected, but also they should plan a strategy far in advance to mitigate their losses.
Closing
Once the due diligence period ends, the closing process will begin. At this point, the parties cannot back out of the agreement for any reason beyond those specified in the purchase and sale agreement or very specific circumstances, like the destruction of the property. The closing essentially involves reviewing and signing a handful of documents. Closing documents may include deeds, transferred leases, transferred service contracts, environmental reports, zoning reports, disclosures and warranties, loan documents, and other documents the parties find appropriate.
Before closing, a buyer will usually be able to remove certain items from the title by objecting in the required period of time. At the closing, the title company will issue a final title insurance policy. Often, the seller will pay the premium of this policy, though this may vary based on local custom.
After everything is in order according to the escrow agreement, the escrow agent will release the funds to the seller. Any accrued charges will often be prorated as of the closing date. The seller will generally pay the current taxes and credit the buyer for future taxes. If there are tenants, the seller will give the buyer a credit for prepaid rent and transfer any security deposits. Utility bills may also be prorated.
