The true cost of purchasing an existing building or project not only includes the purchase price, but the cost of rehabbing and repairing the building and most importantly making the building suitable and attractive for the intended tenant and users.
Attracting rent paying tenants remains the most important aspect of any commercial real estate development whether it’s a new building or existing commercial structure. Moreover once the developer has tenants interested in leasing space finding the financing to purchase and rehab the building will be much easier.
Simply said; location attracts tenants, tenants pay rent and rent paying tenants attract financing. So how does a developer reasonably assess and analyze the overall cost of purchasing an existing commercial building or project?
Three Major Cost to Rehab an Existing Building
There are three major cost related issues that the developer must assess to understand the total potential investment in a project (not including project financing cost). These are 1) the Sellers asking price, 2) the cost of basic rehabilitation and repair and 3) the cost to make the space suitable for the intended tenants and users, including tenant improvement cost.
Understanding these three costs will help guide the developer in evaluating the major issues and if the investment makes good economic sense. Ultimately, the overall investment must make good economic sense by translating to competitive lease terms for the intended tenants and an attractive return for the developer.
- Rehab and Repair Cost
Since it is likely the developer knows the Sellers asking price it is important to focus on the estimated cost of rehab/repair and making the project suitable for the intended tenant and users. To adequately evaluate the rehab and repair issue the developer must make an initial inspection of the project.
Assuming the developer does not have this expertize it is common to utilize an architect or general contractor to do the initial inspection. Many architects/contractors will do an initial inspection for little or no cost realizing that the ultimate goal is to contract for the actual work when the developer purchases the project.
The initial inspection should include all aspects of the building including structural, systems (mechanical, electrical and plumbing), common area and exterior work. The goal of the initial inspection should be to identify any major issues that will make the rehab very expensive or extremely difficult.
Of course there are other issues that the develop needs to review such as; zoning, permitting, regulatory, utilities and of course financing-the developer should never lost sight of how he plans to pay for the project. To complete the assessment the developer must still consider two other major cost issues; making the space suitable for the tenant and tenant improvement cost.
- Making the Lease Space Suitable for Tenant and Users
As mentioned earlier rent paying tenants remain the most important item in any real estate development effort. With this in mind, there remain two very important additional costs that the developer must know to understand the overall investment in the project.
First, the cost of making the building or project suitable for the targeted tenants and second, the tenant improvement costs. Although these two costs can be similar there is a difference. Making the project suitable for tenants represents costs that the developer may need to occur to attract tenants but may not be investments that are not tied to any specific tenant or user.
Benefits and features that are required or important to attract tenants can typically be determined by knowing the regulatory requirements and exploring comparable projects and buildings in the area. If you are looking to purchase and rehab a building for medical use it is important to understand requirement of the intended user.
Medical buildings require larger elevators, larger doors and hallways, handicap accessible bathrooms, windows in patient rooms and other unique features.
- Tenant Improvement Cost
The developer must also consider tenant improvement cost. Tenant improvement costs are costs that the developer will pay to entice the tenant user to the building. Tenant Improvement cost or “TI” allowance can be very expensive and add substantial investment to a project.
It is important that the developer adequately research the TI allowance made available by other landlords in the surrounding market so the project lease terms are competitive with nearby buildings. The developer should be able to learn the typical TI allowance from a local commercial real estate broker.
Evaluating the project and intended use with a local real estate broker can be extremely valuable. There are certain product types such as apartment projects were TI is not a typical expense to attract tenants. However product types like multi family will typically require a greater investment by the developer in competitive features and benefits.
Now that we have assessed the major rehab and repair issues, evaluated the cost associated with making the property suitable for the tenants, including TI allowance the developer must determine if the project is still feasible.
The total cost of the project must still translate to terms that will be attractive to the potential tenants and result in a good return for the developer and investors. This evaluation will often result in a negotiation with the seller to reduce the purchase price.
Having the results of the initial inspection, understanding desired benefits and features and market TI allowance can go a long way in convincing the seller that a reduced price is justified. With the estimated total cost in hand, revised financial plan and possibly a reduced asking price the developer can now decide whether or not to move forward with the purchase of the project.
By John Hester