Traps To Avoid When Investing In Commercial Real Estate, Part I

Clark Perry

Retail centers are a healthy addition to any investor’s portfolio. Yet buyers beware, the market is speckled with brokers trying to pull the wool over your eyes. Protect yourself by knowing this one simple trick.

Beware the Pro-Forma

The Latin phrase “pro forma” once meant “for the sake of form or appearance.” Today, these eight letters can make eight digits or more disappear from your bottom line. When making a pitch, brokers are quick to boast of their property’s income. They’ll provide thick reports to back up their claims. These numbers, however, can be rendered meaningless by the word “pro forma” perching to the side. This dreaded term means that numbers apply to an imaginary situation. Any part of them may be a lie… and many statistics were probably included to distract you from noticing. Once you’ve spotted that little Latin phase, the next step will be to find out exactly what’s being imagined.

Good Pro-Forma

Once you’ve discovered the term “pro forma” haunting your income statement, act swiftly to determine which type it is. The best-case scenario is that a new tenant has been added to the property, the lease has been signed, and their rent payments are guaranteed in the future. Since a year of rent payments doesn’t yet exist, the pro forma creates a fictional year’s worth of data to compare to your other year-based numbers. Since the money is actually going to arrive, this is fine to take into consideration. This pro forma simply makes it easier to quantify what your property will produce.

Bad Pro-Forma

This scenario is the most likely. When a seller has a property with vacant units, a slick broker will estimate how much this unit WOULD produce IF a tenant were occupying it. However accurate the estimate may be, there is no tenant and the empty unit is not producing rent. To get this potential income, you’ll need to advertise, court, and woo a new tenant from the surrounding area – a scenario that will require hours of time and monetary investment. Many times, a seller is putting his property on the market because no new tenants can be found.

Buying properties with vacancies can be a great opportunity, but don’t be tricked into paying for empty units as if they were leased. Ask the broker to explain exactly how the pro forma was used, and to send records of the actual in-place numbers. A good frame of reference is to ask to see the financial records for the previous calendar year. If “good” pro forma is being used, you can add that income into the equation, but make sure that vacant properties are not counted as rent-paying tenants on the bottom line.

Where To Go From Here

The market is full of potential pitfalls, but an investment firm like River Oak Capital can help you navigate the waters. If you’d like investment help from seasoned investors who understand, or are interested in a no-stress sale of your commercial property, contact the acquisitions department of River Oak Capital.

By Clark Perry, Vice President of Acquisitions, River Oak Capital