Investing in Commercial Property (Commercial Real Estate)

Broadly speaking real – estate can be classified as commercial, industrial and residential. Commercial Real Estate  is property used solely for business purpose.  It is any property used to produce income. Examples of commercial real estate include malls, restaurants, convenience stores  and office spaces.  Industrial real estate is used for manufacturing and production. Businesses that occupy commercial or industrial real estate usually lease space. Commercial and industrial real-estate is usually owned by investors who own the building and collect rent from each business (tenants). Similar to buying a business, investors should complete due-diligence before investing in commercial property. Key element of due-diligence include Location,  Property Type, Budgets and several other factors listed below.

Location

Location is a critical element of commercial property investing. Investors must understand the soundness of the location, demand / supply dynamics and vacancy  rates. Additionally, investors should ensure that job market, economy and population growth in the area is favorable. Without sufficient research they may land up buying  property in micro markets with high vacancies.

Property Type

There are different types of commercial property available  including retail, office space, industrial, multi-family and land .The most popular being retail and office space.   Investors looking for retail space have several options including free-standing street outlets and shops in malls.  These outlets can be as small as 500 – 1000 square feet. Shop in malls belong to a strata and are pre-sold to individual investors.

Industrial and commercial properties may have capital appreciation and rental yield.  Rental yield is the annual rent divided by the value of the property. Rental yield is critical element for valuing a property. A low yield implies the property is overvalued. Rental yield varies by country and market. For example, commercial properties with rental yield of 11 %to 12% is considered correctly valued in major Indian cities like Mumbai and Bangalore. Commercial property with yield less than that is considered overvalued.

Due – Diligence

In addition to the above factors Investors should check the credentials of the developer, potential infrastructure development in the area, access to public transport and quality of property management. In case of a retail store front -age and visibility are critical.

The buyer usually provides the seller a due diligence checklist.  The checklist includes request for information related to tenant information, building information, operating information, financial information and other miscellaneous items. Tenant information include rent roll showing the rents paid. Rent information must include tenant’s name, suite number, size of premises and several other attributes. Operating information should include financial statements of the property for the  past three years, current operating and capital expense budgets for the property, utility bills for the last three years, tax bills and more. Financial information includes understanding the break-up of cash flows. This includes collecting data on vacancy factor, maintenance expenses, property tax, building insurance, lease term, lock-in period and expiry dates for leases, long-term capital appreciation potential, cost of refurbishment and potential for refinancing. Additionally, the buyer should obtain new third party inspection report and title report.

Whatever information is provided by the seller, they usually include a provision in the purchase agreement stating the information contained in the documents must be verified by the buyer. It does not constitute a representation of warranty of the seller as to their accuracy.

 

Negotiating a Term Sheet

The term sheet is not a legal document. It is used to negotiate the broad parameters of an investment. The actual agreement is set in several other documents including the stock purchase agreement and investor rights agreement.

Term sheets are non-binding agreement between parties involved except for certain terms that include confidentiality and no-shop provision. Most deals that get negotiated using a term sheet are finalized. Term sheets have an exit date and agreements must be signed before the expiry date.

Term sheets can be for a debt offering or equity offering. Terms common to debt offering and equity offerings include pre-money valuation, amount to be invested, post-money valuation and cap-tables. Debt-offering terms include convertible offering, fixed or indeterminate conversion price, automatic or optional conversion, assets used for security and interest rate. Interest rates are not usually negotiated if it is in a reasonable range. Anything between 3% and 8% is considered reasonable.

Equity offering terms include shares (common or preferred), liquidation preference, conversion price and valuation, automatic conversion, anti-dilution, pre-emptive rights, protective provisions, voting rights and shareholder rights.

Additional common terms in a term sheet include full legal name, type of security (debenture, common shares, and preferred shares), size of round, price per security, number of closings, number of tranches and milestones, targeted closing date, use of proceeds and expiration date.

A term sheet can be for a note deal (debt) or for an equity deal. Usually it is cheaper and quicker to do a convertible note deal because there are a lot fewer terms to negotiate and draft as compared to an equity deal. Additionally, a convertible note term sheet kicks the valuation can down the road to when the note matures. For example, in case of a convertible note deal if the investor invests in 100 thousand when the deal matures (say after 1 year) the investor will get $106 thousand worth equity at the negotiated equity price.

The convertible note puts a stop in the valuation discussion and frees up the business to go and get work done. In effect the valuation discussion is pushed to a later point in time when the business is more established. Convertible notes are only useful if it includes terms that protect the investor from runaway valuation. For example, the investor may invest $100,000 in a business at an early stage, but then if the company gets an investment in millions of dollars the original investor is completely diluted. Suddenly the investor who took the biggest risk has the lowest percentage in the company and correctly compensated for the risk. Convertible debt makes sense only if the term sheet has terms to protect the original investor investing through convertible debt.

The most negotiated terms in a term sheet are valuation, type of security, board of directors, significant financing threshold, IPO threshold, drag along threshold, anti-dilution provisions, pay-to-play and management carve-out.

The term sheet is usually served up by the investor to the entrepreneur. However, in case of a seed round or party round it may fall up to the entrepreneur to create and serve up term sheet and serve it to the investor. Both investors and entrepreneurs should take the opportunity to get legal advice before signing a term sheet.

Ideally, all inside rounds of financing should be shopped around using term sheets. Doing so facilitates a market check that helps determine the correct valuation for the business, which is the correct outcome for everyone involved. That said a term sheet may include a no-shop provision.  During due-diligence investors should be mindful of this provision because can affect the valuation of the company long-term.

Exploding terms sheets are term sheets that must be signed in a very short time. Ideally, investors should avoid exploding term sheets because it does not give them sufficient time to complete due-diligence on the company.