# **A Five-Part Guide for Commercial Real Estate Investors Seeking Passive Income (Part 1)** ## _Part 1: Key Elements of a Business Plan that Impact Investment Decisions_ Welcome to the first of our five-part series, _A Guide for Commercial Real Estate Investors Seeking Passive Income_. In this article, we’ll explore several specific aspects of a project that you should consider when evaluating an investment opportunity. When considering an investment in real estate, the proposed business plan is one of the key documents that informs and impacts investment decisions. You should scrutinize several business plan elements when assessing a property’s potential for success and corresponding risk factors. Understanding how these elements can affect returns on your investment is critical for any investor looking to earn passive income by investing in institutional quality real estate projects and diversified real estate investment vehicles like non-traded REITs and funds. ### Executive Summary A business plan is a formal document that provides an overview of a commercial real estate investment project. It spells out the sponsor’s goals, timeline, and budget, and details the contemplated strategy that will be used to achieve them. A well-written business plan can help attract financing and partners and keep operators on track as the project unfolds. Key components of a business plan include: - **Property:** The physical characteristics of the property, including location, age, and condition, can have a significant impact on its value and the challenges associated with certain strategies. - **CapEx budget:** A well-managed property will have a solid capital expenditure budget in place to maintain and potentially improve the property over time. - **Rent growth:** A property’s ability to generate consistent rent growth is often a key component of its investment potential. - **Reserves:** A prudent investor will always set aside funds to cover unexpected repairs or vacancies. - **Financials:** A thorough understanding of the property’s historical and projected financials is essential to making sound investment decisions. - **Holding period:** The length of time a business plan contemplates holding a property can impact the overall return and execution risk. - **Taxes:** A business plan should take into consideration the potential tax implications of various decisions on investors. Individual tax implications in connection with owning a property should be considered when making investment decisions. - **IRR:** The projected internal rate of return is a key metric for evaluating forecast investment performance. - **Tenant quality:** The quality of a property’s current and projected future tenant(s) can have a significant impact on its value and profitability and should be incorporated into any business plan. - **Underwriting quality:** A business plan’s underwriting assumptions should be reasonable and well-supported with the goal of minimizing investment risk. ### Property The first step in evaluating a business plan is evaluating the property or properties underlying the investment. There are many factors that you should take into account when doing so, as they can have a significant impact on the overall potential value and underlying risk of the investment: - **Age of the property:** Older properties may require more maintenance and repairs, which can affect profits. - **Type of property:** Different types of commercial real estate (e.g., multifamily, office buildings, retail, industrial) come with their own unique set of risks and rewards. - **Property class:** Properties are classified into A, B, C and D with Class A properties being the highest quality (and usually the most expensive). - **Occupancy rates:** Lower occupancy rates can indicate that a property is not in high demand, making it more difficult to fill vacancies and generate rental income. - **Types of tenants:** Tenants with strong credit ratings and stable finances are typically less risky than those with poor credit or unstable financial profiles. - **Condition of the building(s) and improvements:** A well-maintained property is more likely to attract and retain tenants than one in disrepair. - **Potential entitlement or construction issues:** If a property requires significant renovations or has zoning issues that limit its current development or operating potential, it may be less attractive to investors. ### CapEx Budget It’s important to understand the project’s capital budget clearly. This will help you assess whether the project is feasible and the degree of risk associated with generating projected cash flows. In addition, you should analyze the CapEx budget in conjunction with the overall business plan to see if the two are aligned. If the CapEx budget seems out of line with the rest of the business plan, it may be a red flag that the project is not a prudent investment. It is also important for you to review the CapEx budget for both identified and future unidentified capital expenses. Some examples of identified capital expenses include the need for exterior paint, enhanced signage or refreshed interiors. Unidentified capital expenses might include future repairs or renovations that are not currently specifically budgeted for but would be reasonably anticipated during the projected hold period. ### Rent Growth Potential When projecting future rent growth, it’s important to understand the local market conditions. This includes understanding the current vacancy rate as well as the average rental rates for similar properties in the area. Additionally, it’s important to be aware of any planned competitive developments or changes to the appeal of the local area that could impact the longer-term potential of the investment. Another important factor to consider when projecting future rent growth is the quality of the property itself and the related characteristics for that type of property. For example, for a multifamily building, you will want to know whether it is well-maintained, whether it is located in a desirable area, does it have amenities that tenants are looking for. ### Property Reserves You should look closely at the projected level of reserves for a commercial property when reviewing a business plan. Reserves provide a margin of safety and are set aside upfront or over time to cover unexpected repairs, renovations, or other costs associated with the property. ### Acquisition Price It’s important that you carefully review the acquisition price to ensure that it is in line with similar properties in the area. You’ll also want to take a close look at relevant metrics such as the price per square foot or price per unit. ### Hold Period A hold period is the length of time a sponsor’s business plan projects keeping a property before selling it. Hold periods can vary depending on the type of investment, the market conditions, and your goals. ### IRR IRR is the annualized rate of return on an investment over a hold period, expressed as a percentage. The internal rate of return (IRR) measures an investment’s performance that considers the time value of money. ### Tax Implications The use of depreciation is one of the key benefits of investing in commercial real estate. ### Tenant Quality Tenant quality is a term used in commercial real estate to describe a tenant’s creditworthiness and financial stability. ### Underwriting Quality Underwriting is the process of evaluating a potential investment and assessing the risks involved. On the surface, evaluating a business plan might seem complicated. But, as with any investment, careful consideration and knowing the key elements to look for can make it much easier.