Buying Foreclosed Multi-Family and Retail Property

by Brent Wilson, Reochronicle.com/blog

A lot of the same sloppy lending that went on with residential property also
went on with commercial property.

In some cases loans were made for over 100% of appraisal, loans were made
assuming that rents would increase perpetually, loans were made to weak
borrowers who didn't know how to manage properties correctly, etc.

The bottom line is that commercial properties will be foreclosed on just like
residential. One main difference, however, is that most of the commercial
lending in many areas was done by local banks, who still hold the loans. With
residential,  most of the loans were done by larger mortgage companies and/or
the loans were sold upstream to companies like Fannie Mae. 


Dealing With Local Banks

Many local banks don't even have an REO department, since until recently they
haven't had much foreclosed property. Normally they just assign someone in the
bank to handle their REO inventory, someone who also has other duties.

It's fairly likely that whoever is handling a particular bank's REO inventory
is not an expert in managing apartment complexes, strip malls, or whatever it
is that they might be holding. Consequently their cash flow is often poor, even
with existing tenants.

Commercial property foreclosures are actually far more likely to bring down
local banks than residential real estate foreclosures. Commercial property
hasn't cratered yet to the extent that residential has, but it's on it's way.
If the FDIC starts sniffing around some of the weak banks, some banks will have
even more incentive to dump some of their problem assets at fire sale prices,
before the FDIC forces them to raise capital. 

If you decide to invest in foreclosed multi-family or commercial property, you
first need to find out about the inventory of local banks.

Some banks will list their inventory with local commercial brokers. In many
places commercial brokers don't share listings, so you just have to go around
to various brokers and inquire.

Other banks will try to market their properties themselves, for various
reasons. In this case you just have to go to each local bank and inquire about
any properties they may have, and ask to be put on a "please call" list, so
they will call you whenever they get something in inventory. If you become one
of their favored customers, it's possible that you may not have to compete
against anybody else in bidding on a property.

For commercial properties the pool of buyers is generally small anyway, and for
foreclosed properties it's usually microscopic. 

Lots of commercial properties are priced on a percentage net basis-- "yields 8%
cash on cash" or something like that. Banks may trot out some percentage figure
of that sort. 

In practical terms this percentage net isn't very useful when buying a
foreclosed property. For starters there's probably some deferred maintenance.
Maybe the rents are already too high. Obviously the property didn't work out
for the last owner, so you have to get it cheap enough to be sure it works out
for you.  A return of only 7% or 9% or whatever on rents isn't enough when
you're taking a chance on a problem property with a lot of issues to be worked
out.

Another advantage of dealing with local banks is that the bank may not only
sell you the property, but they may finance it for you as well, particularly if
you have 15-25% to put down and a strong balance sheet. You may not be able to
chisel them down on the price as much if the bank is offering financing, but if
the terms are good that can be worth more than a lower price.


To Buy or Not to Buy the Dogs

Some investors make a lot of money buying doggy properties, and others lose
their shirts.

A doggy commercial property might be a strip mall in a really bad area, Class C
office space in a so-so area, an apartment complex in a low income area, etc.  

Some people are very good at making money on problem properties, but it's not
for everybody. Many of these places look good on paper, but end up eating your
lunch. Not everybody is prepared for the much higher management effort that is
normally required.

If you are interested in marginal or doggy properties, do your homework. Some
of these places end up making a mint if you know what you are doing--and others
could drive you into bankruptcy. Just do your homework and be very conservative
on estimates of rents, expenses, etc.


Foreclosed Multi-Family

Fannie Mae and some of the other large lenders have an inventory of
multi-family, usually duplexes, fourplexes and so on. They normally list their
smaller properties with local real estate brokers, so you can usually find
these in the local multi-list.

Local banks are normally a good bed for larger properties. A few phone calls
should put you in touch with banks in your area that do multi-family lending. 

Some insurance companies and pension funds do lending on really large
properties as well. If you find a complex that you suspect is foreclosed and it
isn't listed with any local brokers, you can also check ownership at the county
assessor's web site in your area, if they have an on-line search function. 

Once you find an apartment complex or property that you are interested in, you
need to start doing your homework. Lots of foreclosed multi-family places have
had lousy management (one of the reasons for foreclosure in the first place).
When a property starts going downhill, normally maintenance starts to suffer,
and you need to make an estimate of all costs to get the maintenance up to
snuff. 

A lot of foreclosed multi-family properties also have trouble with their tenant
base. As maintenance gets worse, there is a tendency to rent to lower quality
tenants. In some properties which have gone downhill for a period of time,  you
have to go in and "clean house" with your tenant base, getting bad tenants to
move as their leases expire, or even consider paying them to move, so that you
can keep good tenants in the property. One bad tenant can drive away many good
tenants--a single bad tenant can cost you literally tens of thousands of
dollars a year, something few investors can afford.

Normally a bank will hire a management company, and while there are good
management companies, it's likely that you could keep a better watch on
expenses by overseeing things more directly yourself. Even if you hire a
management company after you take over, it's wise to keep them on a short
leash, at least at first. 

When forecasting cash flow on a multi-family property, don't just take the
bank's figures at face value, better to verify every expense and income item.
Don't automatically assume that you can get the cash flow up right away. Above
all, be a pessimist rather than an optimist when forecasting the cash flow. If
you don't know construction and remodeling extremely well, get someone who does
to go over ever inch of the property and give you estimates for all items that
need to be taken care of. Take a very close look at the roof, and if you have
any doubts as to the age and condition, at least get an estimate to replace it. 

One special thing to watch out for is the property with a boiler-chiller
system. With high utility costs, it can cost you a fortune to run a
boiler-chiller system, and a bigger fortune to put in individual heat and air
units. If rents are high in your area, it's possible that you could still come
out, but with lower rents a boiler-chiller system can be the kiss of death.


Buying Foreclosed Retail Properties

One issue with foreclosed retail and office properties is the vacancy rate, and
the likelihood of current tenants staying. With some properties, the property
would be close to worthless if the current tenant(s) moved out, since the
property may have been designed for their special needs, would need extensive
remodeling for another tenant, is in an area or building where other businesses
would be reluctant to locate in, etc. 

Commercial properties can be vacant for many months or even years in some
areas, so you have to be sure your finances can withstand extended vacancies.
Retail especially seems to be on a downtrend with the recession that's
starting, so it would be wise to be very conservative with any estimates of
income on retail properties.

Retail has become grossly overbuilt in many parts of the country. Total square
footage of retail space has more than doubled since 1990, and in a recession
there is often a reduction in retail square footage. It could be a long, long
time before retail space needs grow in some areas.

The flip side is that some good properties with stable long term tenants may be
coming up for sale after their previous owners borrowed too much. The right
property in the right place at the right price (90% or more of all foreclosed
properties won't fit these criteria) could be a great deal.

In retail properties, the success of your tenants is basically your success, so
it would be wise to seek out properties with strong tenants and long leases,
even if the property itself is in some trouble.

Traffic counts, local area incomes and so on are very important in retail
businesses, so it would be wise to take a look at these figures for any
property you're interested in. When in doubt, weed it out. As with any
property, you have to ask yourself whether the area the property is in is on
it's way up, or on it's way down. 

Some suburban retail properties may tend to struggle more than other areas,
since so much recent retail development has taken place in the suburbs. The
residential bust has concentrated more in suburban areas, and retail is
probably not that far behind. Suburban residents also generally spend more on
gas, and thus their incomes are that much more constricted.