Thomas Stilp, JD, MBA/MM, LLM, MSC
There is no prescribed list of disclosures required for real estate transactions. You must undertake your own due diligence to analyze risks before moving forward with any purchase.
There are three areas where you can focus your efforts to get the most benefit. Below is a brief overview –
Location, Location, Location
One of the most fundamental risks of real estate is whether the underlying property will maintain its value over the course of the investment. Although you don’t necessarily have to select investment property in a neighborhood where you would live for residential real estate, it is important to buy property where someone wants to live.
To assess the current and prospective desirability of a property, you should understand the demographics of location – the population in the immediate and broader vicinity of your property, local income levels, and other socioeconomic indicators. Is the population in the area growing or declining?
Does the neighborhood have young families, seniors, and a robust mixture? Are land and housing prices trending upward or downward? Zoning, parking, public transportation? Today, all types of information can be gotten, often for free, on the internet.
If you have reservations about what the neighborhood may look like in five to 10 years, it is not worth the investment risk.
Tenant
Investment properties with leases have risks associated with the tenants’ ability to pay rent and perform other lease obligations.
Single-tenant properties rely on the creditworthiness of one tenant, and perhaps a guarantor. You must assess whether the tenant will renew or extend the lease at the expiration of the term.
If the property has two or more tenants, there is likely some degree of common area expense and management. This could be limited to exterior areas like parking lots and landscaping, or it could be more extensive, including reception, meeting or fitness facilities. Your lease agreements should address not only payment of common area expenses and taxes, but also the use of parking and other common areas, hours of operation and the like.
An experienced attorney will know the hot-button issues and how to help.
Financing
Many real estate investors use financing to improve cash flow and to acquire more expensive properties for the same equity outlay.
Whether “pulling yourself up with your bootstraps” moving from one property to investing in the next, or playing off the “positive arbitrage” where the cost of funds is less than the money you make with the fund in the property, there is risk.
The largest risk of any prospective loan is whether there is recourse, meaning whether the borrower is held personally liable if the loan cannot be repaid in full when due. Most lenders will require individual borrowers to provide a personal guaranty for all loan payments, and any deficiency if the property is sold. Non-recourse loans (loans with limited or no personal liability) are generally only available to business borrowers and parties with strong relationships with their lender.
A commonly measure is the loan-to-value ratio (LTV), the outstanding loan amount divided by the current market price of the property, reflected as a percentage; the higher the LTV, the more risky the loan (e.g., 80% LTV is riskier than 60% LTV). The lower the LTV, the greater equity cushion you have to protect you if you need to sell the property and pay off your loan.
Another measure of loan risk is the debt service coverage ratio (DSCR). This metric compares the amount of your loan payments with the amount of income your property generates (DSCR = net operating income/debt service). Lenders commonly offer more competitive rates and terms for properties with a lower LTV and a higher DSCR. However, failure to maintain the agreed-upon LTV or DSCR may trigger a loan default.
The above risks are a very short sampling. For those who are interested, the role of capitalization rates, determining value, net operating income, and other details, all appear in my book, Making Money Going Into the Deal: The Art & Science of Real Estate, now available on Amazon.
Understanding and evaluating risks before buying a property is critical. Work with someone who has not only done deals, syndications, loans, but has drafted agreements and tried cases in court will know what is important and what works in the real world.
