Episode #090 - When to WALK AWAY From a Deal in Commercial Real Estate!

Today hosts Braden Cheek, Brian Duck and Joel Thompson discuss the times in which you should WALK AWAY from a Commercial Real Estate deal, providing real life examples from their own experiences.

All right welcome back to another episode of how to invest in commercial real estate. And we are here today with another cool topic. But before we begin we're just gonna talk about a little bit about what's going on and we're closing out the year strong. We're pushing pushing through the end of the year with two last minute closings one um jim deal. We just closed and we're gonna launch that out to investors here pretty soon. But more importantly, one that just launched is the criterion retail partner deal. It's a retail development in Owasso hard corner of oh so we're developing just over an acre of land. How hard is the corner? Super hard hardest corner in Tulsa. So but whatever, that's why I said Tulsa. Okay. Anyway so is it up on the website? Can people see it? It is up on the website, it launched already. Um So it might be full already. Not sure but it was a $1.2 million equity raise plus or minus a 20% Ir are depending on when we exit the deal. We typically always give the best case scenario most likely in a worst case scenario.

And and those are just based on exit cap rates on our ny right so around 20% I. R. R. Will be in and out in 18 months. We have to deliver a couple pads, wait for them to build the building and then we list it for sale. So super exciting opportunity and it's right next to a Chipotle. So it's got to be some good real estate development deal on the other side of Chipotle is the last retail development we did so great real estate anyway. So much of this show, I think we talked about reasons to get involved in real estate. You have to buy why we buy all of those things. But there's a lot of reasons not to buy real estate. There's a million reasons not to buy real estate. And sometimes you get into a deal and things just aren't what you thought they were. They aren't necessarily what was pitched. There's hiccups along the road. I mean, in the 1st 30 days of every contract, we have a free inspection period and that allows us to test the rent. They're bringing in the Ny, to make sure that number matches up. We're inspecting the property. We're making sure the tenants are opening for business.

And more often than not, there's a hiccup, you have to work through and they're not always reasons to walk away from a deal. But today we're just gonna go through some of the hiccups. Um, and scenarios we've encountered the most sometimes we've walked away from the deal. Sometimes were able to negotiate something and stay in it. But we're just gonna go through a list of, of things that you may need to raise a red flag for things that may raise a red flag and you may want to walk away from All right. So our first deal, we were under contract in our due diligence period in Wichita on the deal in Wichita. Right? And so we thought it looked like a great deal. We drove up there to inspect it and the property wasn't in great condition. I I you know, it's OK, we probably could have done some things to fix it up. But the main thing was we started looking in some of those uh spots and nobody was in there. Right? And when we started looking at the leases, the previous owner had given free lease for about six months to a bunch of people. And to us, it looked like no one was in there, no one planned on moving in. And at the end of their free lease period, they were, you know, they were just gonna give up.

It was it was odd that we were walking around in these units were supposed to be lease and it would have a business name. And then the space would look just like it's been vacant for three years. And and so we got the opinion or the impression that he was out there and then maybe convinced some tenants to sign their name on the lease uh with free rent indefinitely. Just to show that it was it was occupied to try to get a sale. And then after that free rent period. Yeah, of course, they can just decide whether six months from now they want to move in with that, that had a lot of risk for us. And so we ended up being on that deal, he probably went back and offered a lower price based on the fact that millions lower. Yeah it was millions lower and and and it it fell through. I'm glad it did. The interesting thing about that is right. We all have our own perspectives in real estate. That was one point you guys brought up. But one of the big points that stood out to me on that deal was the massive money pit of the center. It was hundreds of thousands of feet. The parking lot was garbage, the roofs were garbage. Some of the spaces looked like they hadn't built out been built out in decades. Um There was like an 18,000 square foot laser tag facility that looked like a laser, I mean it was still looked like a laser tag facility but it was vacant.

So I just saw millions of dollars even if all the tenants stayed who's fixing all of this stuff and I didn't see the rent supporting all of the Capex it needed. So obviously walked away from that deal. Yeah, site visit did it. So on the numbers looked okay. We had a good debt quote but when we showed up and actually inspected the deal, the walkthrough what cost us the deal And I guarantee that there's one person out there listening who we talked about walking every single apartment unit or walking the retail units. They probably think we're crazy. But we actually walk the units and this is why and this is why we backed out. And if we hadn't have gone there and we would have bought off the. Om we would've been screwed for sure. Alright. What's next? Okay. Uh We had another deal here in Tulsa and we couldn't get the owner to give us historical financial data. Right. Yeah. That was an interesting one. It was a good it was a good location, good center but we were trying to verify the income and he would not give us anything but the current rent roll and like the last six months financials and it just it just gave me pause.

Now I'm not saying it wasn't a good center but for me if I can't get the actual income and expenses for the last two or three years, even if they're not necessarily what the owner wants them to be. If he's not willing to turn them over, then I'm going to approach that with caution. And in this case uh It caused me to walk from the deal. We have that in our P. S. A. R. Purchase and sale agreement. Standard language that we asked for it. You know, it'd be weird if somebody tried to strike that in a contract And most importantly this is a big thing for the lender. The lender is lending 75 80% of the capital to buy the building and they want those financials just as bad if not more than us to make sure um they can cover the debt. That's, that's one that I would, I would put serious consideration in. Right, okay. Okay. The next one is, I haven't had to back off on one like this Joel. You've probably run into this some but um really bad environmental issues that you find out about the due diligence period. Yeah, I mean that that is one that doesn't seem like a big deal. You're like, oh the phase one recommended a Phase two, what does that mean?

Um It means that you could have a potentially huge liability on your hands. Now it could be that there's nothing there. But that's why they recommend the phase two, it's kind of a more extensive study. And one example I'll give you is a deal out in Vegas where we had a Phase two recommended and I had the broker. Uh well I'll skip ahead and say, okay, I did the phase to the Phase two recommended uh some remediation, hey you gotta, you dig some wells and there, there might be stuff down here and the brokers like this is a bunch of bullsh it, you know, this is gonna, they're not gonna find anything. They never find anything, this is just them covering their ass. Yeah. And I was like, you know, I'm not just gonna take your word for it. So we hired an environmental attorney and he helped us negotiate a huge amount of money set aside and the seller had to be responsible for any remediation found by that Phase two, we went ahead and closed the good news is that we got the seller to to pay for that. So they've, they've been paying for that now for three or four years.

Well, let's pause there. I think one of the biggest key indicators for me is that you ran into this problem and you found an environmental attorney and that environmental attorney sounds like they more than covered their fee. Seems like they negotiated you a massive win. So when you come into something like this reach. Yeah, For sure. And, and you know what could have been a disaster is if we, we had just gone ahead and closed or thought it wasn't a big deal and just just said, Hey, give us $100,000. But then we would have been responsible. We're still monitoring wells four years, 3 to 4 years later on that property and they're still finding contaminants. And so I, I don't know exactly when this is even gonna be cleared up, luckily the seller is still paying for it. But um, I hope that we get out of this deal with that being taken care of by the seller, but it just no environmental issues are not something to mess around with. And if you have One that, that have recommended the phase to do the Phase two before you buy it. If the Phase two has any recommendations don't buy it until you get a professional attorney involved. Just as a side note, how long does it take to get a phase two? Are you gonna be able to get that done within the 30 day due diligence period or you're gonna have to delay?

Uh, that's a great question. It is a good question. I don't know that I can answer it. I you might be able to get it done, but if you can't because let's say people in the area are busy or you're getting a three or four or five week lead time, get an extension. If the seller won't give you an extension for that Phase two and you can't get it done in time walk away. Alright, the next one is um, that we looked at is if you get to your earnest money, hard money time and you don't have a term sheet yet on a loan or loan tied up. So I think more importantly a commitment letter, right? You're gonna have tons of term sheets because you're smart investor and good steward of your money. So you're getting multiple offers, it's like buying a car like anything. So you're gonna multiple term sheet. But more importantly, you need to have a signed commitment letter before your earnest money goes hard Because once your earnest money goes hard, you lose a big piece of leverage, you lose, you know, whatever your earnest money, maybe, I would say our average earnest money amounts $50,000 at least roundabout. Sometimes it's a lot more, sometimes it's less.

So what does it mean to? And I'm gonna explain this. What does it mean to lose your leverage? Uh if you go past your due diligence and you don't have a commitment letter. Now, all it takes is for someone in that banks credit department to say, we're not gonna do it. It doesn't mean that you're not gonna be able to get debt. But if you can't get debt by the closing date, the seller can just say, you know what, I'm just gonna keep your $100,000 earnest money. And you may say, well, I still want to buy it and I got a lender that can do it. I just need another three weeks. He's gonna be like, great, I'm gonna take 100,000 and you can pay me the purchase price in another three weeks. You just lose your ability to uh to negotiate at all with the seller once your earnest money is hard. So if you do not have a commitment by from a bank, you have to get an extension. If you're not able to get an extension, you should most likely walk away. So I think this is an important point. Let's dive more into what a commitment letter from a bank is. How would how would you define a commitment letter, Joel? It would be a commitment by the bank to lend on this property based on the terms outlined in that letter.

Can it be an email that says they will or you need a signed letter or I would want, I would want something that says, you know, addressed on bank letterhead saying that this is a, it can even be a conditional loan commitment, but it needs to say loan commitment and then it'll have these, these deals and it, it may say that uh, you know, we don't find anything, Uh, you know, nefarious that the property that we haven't been told, uh, it may be based on 80% of the appraisal whatever that is, you may still have some risk moving ahead after receiving the commitment letter, but it's gonna be pretty minimal and it's gonna outline those risks and then you can decide are these risks Okay for me to take. Yeah, I think the key difference point between a term sheet and a commitment letter is a term sheet is saying, hey, we could lend these terms based on the underwriting of the property and the underwriting of your personal credit, which is a limited amount of questions from a bank limited amount. And then a commitment letter is saying, we've reviewed the underwriting for the property and you personally and we will issue this loan if all of these conditions on the term sheet are met and that may be an appraisal that maybe a number of things, right?

But you need that commitment letter because then that puts leverage back in your hands because the lender can't walk away from a commitment letter scotch free. You know, they open themselves up to litigation if they're issuing commitment letters and they're not honoring them and the buyers are taking real damages because they're losing their $100,000 earnest money. So they know the impact of a commitment letter. And you need to have that commitment letter before the end of your due diligence period. And if you don't have it, don't be afraid to extend your due diligence period. Alright, next one is um okay, let's say you find some problems with the property, whatever it might be rough or whatever and that wasn't disclosed in the O. M. You made your offer based on the information, the Om and then the seller won't negotiate with you on those those problems. We've run into that before. I mean, I guess you need to decide whether you're gonna do it or not. But then it becomes a tough decision. But That may be a time to walk away because if let's say your equity raised on a $4 million $1 million. And then you find, you know, 700,000 worth of Capex that's going to be needed in the first year or two.

My wedding ring just ran away from me. Uh but so that that may blow your cash on, cash returns out of the water, you know, may reduce them so much that it's not even the same deal. And so if the sellers like no take it or leave it well, then you may have to leave it and and let him deal with that issue with the next buyer because he's not gonna get out of addressing that every buyer, if they're legitimate, are gonna go through those same exercises and find out the roof needs replacing the parking lot needs repairs. And so I would roll my, roll the dice and, and take my chances that he isn't gonna find somebody else. And he may even come back to you Every time. I mean every single time it's your job as a buyer to find problems with this and I know you love it and you want to buy it and it's gonna make you all this money. But for the 1st 30 days you need to poke as many holes in it as you can because you're testing it and you're spending millions of dollars, you want to know every possible thing that could go wrong and budget accordingly.

Right? So the roof is a big one. A roof could be $10 a square foot if you're buying a 40,000 square foot center, that's almost half a million dollars in roof exposure. If the roof needs replacing a few years and your down payment, a million bucks, you just cut your returns but substantially by having to replace that roof. If the seller's owned the property for the majority of the usable life, let's just say he put the roof on the roof last 20 years and he's selling in year 19. How do you not have a reasonable logical case to take to the seller and say, Hey, you used 19 of the 20 years of the usable life of this. How can you not credit me for a new roof? And to Joel's point, the next guy's gonna find it. The next buyer is gonna find it. At what point are you going to credit for this? It's only gonna be a matter of time. Your price could be dropping the entire time. Interest rates could be rising the entire time. The timing of this stuff is just as important. Yeah. And if you have an underwrite underwritten that uh, you're just putting yourself at unnecessary risk. So I think let's just decide to move on. If if the seller isn't gonna compensate in some way and again, just clarify all of these points are done within your inspection period because that's your free window to walk right?

We, we may have a specific clause in the contract that says, if we can't get a clean phase one, then we get our earnest money back. But that maybe, you know, one of the only exceptions on that's not under the general inspection cancelation clause or whatever we wanna call it. Right, okay. Next one. I'd be interested to hear what you guys would do in this case. Uh, if you can't get an estoppel on, let's say your largest income producing tenant, uh, what your reaction would be, maybe tell us what an estoppel does exactly and why that's a problem. Yeah. So I can talk about the estoppel and start us off. So a estoppel is the tenant and the new landlord where it's, it's a tenant filled out form and it is the tenant re ratifying the lease. They're confirming all the major points. When did rent start? When does your lease expired? Do you have any rent increases? Maybe this form is created by your attorney or the broker. You can add or edit to this form. It's not like a one size fits all. It verifies the security deposit they have on file.

It says the rent is paid up to date. It says they're not in default. It says they have no intention of being in default. They're not under bankruptcy. It just ratifies, hey, I'm intended in this building. I pay this amount of rent and I'm not planning on closing and we need that. Why? Because it's a, it's a security deal. You're buying all these leases. You want to make sure those leases are real people. And a letter saying, yeah, I paid rent this month and I plan on paying rent next month brings me a lot of comfort. You can't get that, then that's a big red flag, is that right? It can be a red flag. Sometimes it's hard, especially with large tenants or national tenants to get the right person that's willing to sign off on it and it can take time and you may not have enough time. And so the alternative there is to walk because you can't verify the validity of the lease or what's owed or I've had sellers say, hey, I'll sign it, I'll sign an estoppel basically, I'll put my name on it guaranteeing that they don't, you know, they don't own any free rent that we don't know about that their current with their rent. And so at least you have a document signed by the seller at least go back to them and sue them if if things aren't quite right.

But if if you can't get the estoppel from the tenant and the seller isn't willing to guarantee the estoppel. Now you have a red flag that may be worth walking away from. And just just another point on estoppel because there's been properties early on that I did not get them. And some problems arose is what you're trying to avoid is after the fact a tenant has a signed document by the seller that's a side agreement that says, well he says here, I don't have to pay the first month's rent in 2025. You know, and yeah their country. Uh and so you're you're you're looking at this and you're like, okay, the store didn't tell me about that, but if I don't have uh something in the contract that specifically obligates them to disclose or to, you know, tell me about that stuff, then that can be out there. But what gets rid of it is the gestapo, the gestapo will say, hey, there's no outs standing rent, oh there's no outstanding free rent or other perks promised. And so when you get the the tenant to sign that, then it doesn't matter what other agreement he has because you have that estoppel that said there's nothing out there.

And so then that gives you something to battle against whatever other document the tenant has. So that's the important part about the Istanbul. Okay, that that kind of ties in, you're still stuck on the accident. It was an Atwood's apparently, yeah. Um so um it was or tractor tractor supply maybe. Um So that ties into the last point. I think everybody in new york thinks we have those kind of accents here, I think California, like oh he's just doing an Oklahoma accent as well. We don't have sushi here ride a horse now, they need to watch Tulsa King, see how big we are. I don't know if that helps. I watched episode two, it was it was really pretty slow and pandering a little bit. But anyway, last point. Okay, that does tie into the last point. What other information might you find out about one of your largest income producers, uh, tenants that would keep you from closing on the deal bankruptcy. Chapter 11 bankruptcy. Really, Maybe even a rumor of bankruptcy, possibly a rumor of bankruptcy can, can cost you your earnest money as I know all too well.

We were in a deal and I allowed myself to go non refundable. And then the day that day or the day after a story came out about the potential of one of the tenants to file bankruptcy. Just the rumor of it bank cancel the contract. I didn't have the right clauses in my contract. Lost. My earnest money is very, very painful. But I would say when you have a big tent, we're not in the business of taking huge risks. I know people think that we do because we're commercial real estate investors. I can't believe you said that, but but we don't, we try not to take huge risk. And and the bigger you have, the one tenant is of your center and the lab Sure you are of their business operations or how long they're gonna be there, the more risk there is. And so, you know, I would be very careful if you have a tenant that's over 50% of your income and they have two years left on the lease and you don't have confirmation that they're renewing. That's a big risk. And that might be one that you want to walk away from. So keep that in mind. Yeah, I mean, you can find out a million bad things about a big tenant or even a small tenant. I mean, even your local credit mom and pop stores, there was a story about us, You know, it was a small deal was like 20,000 ft.

This tenant was maybe four or 5000 ft. So not a massive tenant in proportion to the center or at all. And we were walking through a shop and it was just empty. It was a liquor store and it was relatively empty. It wasn't empty, but it just didn't have a feel of a thriving liquor store and he had been late on his payment the month we were purchasing the property. So the red flag went up and we're like, okay, we still like the center, let's go talk to this guy and just see he's late on his rent. The store was a little light. What's he have to say? Guess who's store closed down within first. The meeting was, I love this store, This is all I ever want to do. I'm never closing this liquor store. This is, this is, this is what I'm gonna do for my dad has tons of money and he's got me set up and this is going nowhere. And as soon as we close, he never made a rent payment, never open for business closed down, totally lied to us. And so, but overall, we, what we did is we because of our uncertainty, we negotiated a full year's rent up front from the seller.

And so for that that year, that that he was out, we were getting rent and we could reposition the space and we ended up releasing it to another tenant. So let's end on that, because I think that's the theme here, right? It's your job in the 1st 30 days, once you get a property and contract to go and find all the things wrong with it. But that gives you an opportunity as the buyer and that opportunity is the ability to renegotiate with the seller. And hopefully the seller is willing to renegotiate based on what you found. And the best way to do that is with a logical explanation that they can they can reasonably understand and then be willing to walk away from it if they don't accept it, because at the end of the day, if you have to put a new half a million dollar roof on the property and the seller is not willing to pay for it or whatever going back to that example, It just doesn't make sense. So stop wasting your time on things that don't make sense and propose things that do make sense anyway, we will catch you next week on how to invest in commercial real estate