The life cycle of a commercial real estate asset deal
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The Commercial Real estate investment process is intricate and involves a number of stakeholders and lengthy steps. Although it may seem intimidating for new investors, it is noteworthy that the investment process in a commercial real estate deal essentially involves four distinct stages. These are Acquisition, Value-add, Stabilization and Disposition. Together they form the life cycle of a commercial real estate asset. Hence, proper knowledge of these stages to acquire the best deals and evaluate the accurate valuation of an asset benefits both new as well as seasoned investors. Let’s have a look at how the life cycle of a commercial real estate asset unfurls.

Stages in the life cycle of a commercial real estate asset deal

Stage One: Acquisition

The first stage of any commercial real estate investment is acquisition. This stage begins by identifying the right asset to fit the desired returns. Since identifying and acquiring the right asset is a risky decision, due-diligence on one’s real estate purchase is the required course of action. Through a comprehensive understanding of the market dynamics, determining the property’s value in the future and its historical performance and offer price of the asset, one can decide to acquire an asset without facing any potential risk down the road.

1.1 Business Plan

The Acquisition stage usually begins with the formulation of a business plan which acts as a roadmap for the investors. Typically, a business plan includes steps to assess future market demand and evaluation of property improvement oppportunities. Further it also enables estimating return on investments and managing expenses. In addition to this, a plan establishes budgeting for asset acquisition and purchase price. Hence, it is safe to say that a business plan increases the value of a property and generates stable cash flow for the investors. Generally, a business plan for a commercial real estate investment consists of the following elements:

Next, the business plan enables the investors or his/her team of experts to make offers on those assets where they can make risk-adjusted returns. If the offer is accepted, the investors enter into contract with the seller, open escrow and conduct due-diligence on the property.

1.2 Due-diligence

This step includes hiring seasoned experts and executing a proper business plan to identify the potential of an asset. Moreover, the business plan helps in executing the need for property movements or management changes. Further, this step also analyzes how the upgrades will maximize risk-adjusted returns.

  1. Hiring professionals: To be able to identify the asset’s value and future potential, it is crucial to hire an experienced team of experts. Their knowledge of the asset, local market competence and rapport with the tenants eases the evaluation process to a great extent. By leveraging their professional networks and outbound marketing skills, one can identify the ideal opportunities that fit the specific investment criteria. 
  1. Market research: After identifying the high-opportunity properties, the next step is to conduct proper market research on each of the assets. These include inspection of the physical, environmental and ecological condition of the asset. Further, it also constructs the valuation model of the asset based on the analysis of historical operating costs, leases and property taxes. Lastly, market research also includes the legal due-diligence of a property.

 A thorough examination of the physical condition of a commercial asset helps to better understand its future potential. It also helps in negotiating the sale price based on its condition and risk factor. There are generally three types of properties. Class A properties are generally new and high quality and represent the lowest risk. Class B properties are older than Class A properties and require some amount of maintenance. They are slightly more at risk and hence available at lower prices. Lastly, Class C properties are often 20+ years old, with the need for heavy maintenance. Hence they retail for much lower rates than their other counterparts and are the riskiest assets.

This involves the assessment of past, and potential environmental liabilities and obligations associated with the property. This includes the assessment of risks of soil or groundwater contamination, presence of hazardous building materials, risk of hazardous soil vapours etc. Further, environmental due diligence ensures the compliance of the property with environmental regulations. This is done for uncovering any costly non-complying conditions that will limit the potential of the property in the future.

To mitigate future financial risks, financial due-diligence is crucial before any real estate transaction. Financial audits allow an investor to determine a property’s cash flow. Further, it also ensures that the income and expenses match the seller’s representations. FInancial due-diligence includes:

The legal team determines the entitlements and obligations of a property. This includes: 

Once the due-diligence checklist is completed and it confirms that the business plan is viable, the investment is funded. This leads to the closing of the acquisition phase in the life cycle of a commercial real estate asset.

Stage two: Value-add

In some cases properties in excellent locations and fundamentals, holds issue for physical, operational or financial stress. Hence, these are called “value-add properties” that require upgrading.

The investors acquire these properties at a discount to their innate value and then make improvements to these over the course of the investment period. As a result, the purchasers can command higher rents from leasing the spaces to high-quality tenants. Moreover, as refurbishing increases revenue and lowers operating expenses, it can improve the overall management and operation of the building. Typically, value-adding includes the one or more of the following approaches:

Hence, it is evident that value-adding can be expensive and time-consuming. Moreover, on the part of the investors, it requires innovation and experience for identifying an asset’s potential. However, it is a crucial stage in the life cycle of a commercial real estate asset.

Stage three: Stabilization

Once major value-adding is completed, the investors begin to understand how the improvements might impact the property’s value anf attract tenants. At this stage in the life cycle of a commercial real estate asset, the purchasers focus majorly on maximizing returns and the property’s cash flow. Moreover, at this stage, there occurs a shift in the dynamics of the risk profile of the asset. Hence, in the low-risk environment, investors enjoy a more predictable cashflow and slightly reduced return expectations.

In addition to this, stabilization also includes Asset Management. Through Asset Management, the investors can monitor all aspects of the property’s performance to ensure it has reached it’s fullest potential. The management procedure is conducted through the analysis of revenue performance versus proforma and reducing further expenses. Further, asset management also includes following the industry and broader economic trends to maximize investment returns. Moreover, at this stage, preparing quarterly sponsor reports and analyzing the financials and balance sheets enable the investors to track the property-level performance.

Stage four: Disposition

Typicallly the final stage in the life cycle of a commercial real estate asset is an exit strategy or disposition timeframe. Investors constantly evaluate the changes in the asset’s value to maximize their returns before exiting the business plan. Therefore, through disposition of the asset allows new investors to enter the investment domain.

An investor’s disposition (selling or liquidation) of a property depends mainly on the intended use. For instance, if cash flow was the sole intention of the investor for purchasing a property, it is likely that he/she will lock the property in for a long time or until its maximum depreciation. However, some investors purchase a property for appreciation and raising rents by value-adding. In such cases, it is likely that they will sell the property after it has reached its stabilization according to the market performance. After stabiilization, investors negotiate higher rents from the tenants and may want to continue collecting the cash flows. However, in some cases investors may choose to exit just after the closing of the acquisition. This is because, after the acquisition the building value has already appreciated and it provides desired returns. Therefore, typically, investors focus on maximizing property value and  returns before its disposition.

However, potential investors generally seek properties that are well into their execution stage rather than the newly acquired ones. This is because, a stablized property has already started to produce higher rents from high-quality tenants. Hence, potential investors can acquire these assets in the secondary market, without losing time in value-add.

Conclusion

The above steps are generally the life cycle of a commercial real estate asset. These serve as a road map for the investors when evaluating a commercial property for purchasing and maximizing returns.  Just as comprehensive due-diligence is the key element in the acquisition stage, value add and stabilization depends largely on operations and asset management. Lastly, the disposition strategy is mainly driven by the focus on generating cash flow and increasing returns on investment. However,  the insight and experience of investors over time and prevalent market conditions make the investment process more intuitive.