5. Have a contingency and capital reserve fund
There is always uncertainty with any investment. Regardless of how much you researched, verified, or prepared, there will always be unknown factors that can positively or negatively affect your overall yield. One way to hedge this uncertainty is to account for cost contingencies.
- Cost contingencies are additional funds you set aside as a part of your initial acquisition costs to help with unexpected expenses that arise as you sign leases, raise rents, change management, renovate, rezone, or build.
- Cost contingencies can also help cover your debt service until the property is stabilized.
- Cost contingencies are especially helpful if there will be negative cash flow while you improve the property's overall performance.
- In commercial real estate, the standard contingency budget is 5% to 15%, but it varies depending on the asset and whether it is underperforming.
Additionally, a best practice in real estate is to create a capital reserve or replacement reserves fund. A capital reserve is a fund or account that has money set aside for long-term improvements or unexpected expenses beyond your initial capital improvements.
This is money you set aside before netting any positive cash flow, typically anywhere from 3% to 5% of gross rents. Budgeting for both of these factors will increase the chances of profitability and ensure funds are available when unexpected events arise.
6. Be prepared for setbacks and extended timelines
Just as there are uncertainties with costs, there are also uncertainties with the timeline. Most people set unrealistic timelines for building, renovating, fully leasing, or reaching market rents for their CRE investment.
New construction, renovations, rent increases, management changes, and the introduction of new systems all take time. There will almost always be setbacks and challenges that stall progress.
- Try to identify the potential obstacles in your due diligence period.
- Prepare for these obstacles as part of your contingency costs or with a plan of action to implement if delays occur.
- If you are investing in commercial real estate through a more passive vehicle, such as a REIT, crowdfunding, a partnership, or a fund, be flexible with your return expectations and timelines.
Asset performance can fluctuate due to economic factors, market cycles, or challenges that arise after acquisition. It's ultimately the fund manager's job to properly inform you of this risk, but it's also good to be conscious of it on your own.
