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Investment in commercial real estate can provide cash flow, appreciation, or both. When assessing the likelihood of consistent cash flow or appreciation there are a variety of considerations.
Today’s article focuses on property improvements. Age, condition and appropriateness of the improvement to the property’s current and future use can impact both cash flow and potential appreciation.
When stable cash flow is the goal, tenant quality and lease terms are fundamental factors. In addition, a good understanding of the improvements as they relate to future capital expenditures and required maintenance are important. In the short term these factors may or may not impact cash flows.
For example, if capital improvements and maintenance expenses are paid for by a national credit tenant on a long term lease, the likelihood of reduced cash flow to the investor due to maintenance on the property is low. If, on the other hand, the tenant is weak and/or these expenses must be paid by the owner the predictably of consistent cash flow can become problematic.
The appropriateness of the improvement can impact both the current tenant and the ease or difficulty of re-tenanting in the future. Of particular concern are specialty buildings used for a specific use (i.e. a fast food store). If the current tenant moves out, the cost to remodel or demolish and rebuild can have a significant negative impact on the property value.
Functional obsolescence and the cost to cure the obsolescence are also important considerations. An example would be warehouse properties with low ceilings and short clear spans that no longer are suitable for a given market.
Future demand for the type of improvement can be evaluated by reviewing employment, economics and demographic trends. For example, many call centers are now being outsourced overseas because of labor costs, thus reducing the demand for office space designed as a call center.
Environmental contamination of improvements and the land need to be carefully reviewed. What environmental issues exist and who pays for remediation and when is a serious consideration. A “Phase I” and possibly a “Phase II” inspection can reveal potential contamination, the cost of which should be factored into the value and risk of the property.
Analysis of existing electrical, plumbing and HVAC systems could reveal potential for cash flow and appreciation increases. Some leases contain a clause requiring that tenants pay for upgrading the improvements if the upgrade decreases expenses. Along the same lines; an investor could shelter income from taxes by installing more efficient systems, i.e. use less of our natural resources.
Sometimes properties can be bought for “less than replacement value.” What this means is that it would cost more to build a new building on the site than what is being paid for the existing improvement. This type of investment can provide good appreciation potential and cash flow if situated in a strong market, providing the improvement doesn’t suffer from excessive need for capital expenditures, functional obsolescence or high maintenance costs.
While there are many things to consider in investing in real estate it is important to evaluate the nature of the improvements. The improvements can either positively or negatively impact both the quality and consistency of the cash flows and the potential for appreciation.
Contact Christina Porter at 1 877 4 TM 1031 or email her at Christina@www.tm1031exchange.com for further assistance. TM 1031 Exchange specializes in assisting investors in planning and executing successful real estate investment strategies. Visit www.tm1031exchange.com for a complete list of investment properties and to download a Free 1031 Exchange Tool Kit.
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