Guide to Commercial Real Estate Investing
Investing in real estate is commonly viewed as a solid choice. But while residential investments are generally thought of as ‘routine’, commercial real estate opportunities are often shrouded in mystery.
Yet, commercial properties can provide some of the highest income streams out of all real estate investment avenues. There is a reason why the big money plays here. But that doesn’t mean you can’t take a slice of the pie too.
So whether a first-time real estate investor or an experienced property developer, a guide to commercial real estate investing can often be useful.
What is commercial real estate?
Commercial real estate is a grouped term to cover all buildings that are used for business purposes.
Another useful way to categorize commercial real estate is any property that generates an income for the tenant. If the property is being used to generate income through business services, the property is likely commercial. A commercial real estate investor generally collects rent from a business.
Types of commercial real estate
Commercial real estate is a broad term. While residential property is clearly for residents – a place to call home – commercial properties come in all shapes and sizes. So let’s take a look at what type of property qualifies as commercial real estate.
- Offices. These are buildings primarily used for office space. They can come in many forms varying from skyscrapers down to smaller mid-rises in suburban areas. Offices are rented out by any company or organization that needs them. Lease terms can be high (5-10 years).
- Multifamily units. Multifamily units are a collection of four or more residential units. Due to the capacity to cater for multiple families, they are classified as commercial real estate. Apartment buildings are a good example. Lease terms for multifamily properties can vary considerably, ranging from months to several years.
- Retail spaces. Retail commercial real estate covers all premises that retail businesses use to sell goods and services to the public. This includes small independent shops and larger shopping malls. Similar to offices, rental terms can be much higher (3-5 years).
- Industrial units. Heavy manufacturing, warehouses, data centers, and distribution centers all fall within industrial commercial real estate. These properties are usually grouped together in areas that are not suitable for residential housing.
- Special purpose buildings. The final category covers the remaining commercial real estate that does not fall into one of the previous categories. Special purpose buildings include properties such as childcare centers, healthcare centers, elderly care homes, arcades, or hotels.
Investing pros & cons:
Although an ominous investment option for many, commercial real estate offers a host of advantages for those willing to give it a try. That being said, it’s not all sunshine and roses, so like any investment, it is important to weigh up the pros and cons.
- Cash flow. Renting commercial premises can generate a consistent monthly income for investors. The extended lease terms that often accompany commercial property mean that sometimes this can last for a prolonged period of time. Free cash flow can then be used for other investments or a rainy day fund.
Many commercial leases also require businesses to pay associated taxes, property insurance, and maintenance costs. This decreases costs for the investor. Deals such as these are often referred to as triple net leases.
- Property appreciation. While cash flow could be rolling into your pocket, the property itself may also be appreciating. Like residential properties, commercial units generally appreciate over long periods of time. While short-term market impacts cannot be foreseen, history has shown that prices tend to rise due to commercial property scarcity.
- Higher returns. One of the biggest draws for commercial real estate is the potential for high returns. While upfront costs are often higher, returns can be double or triple that of residential property.
- Less competition. As commercial real estate is perceived as a more complicated path for investors, the competition to acquire properties is less fierce. Deal terms can often be forged with sellers early in the process to remove other competitors.
- Maintenance of the property. Many commercial tenants have a vested interest to maintain and take care of the property. An unmaintained property could lead to customers turning away from businesses. This means, usually, both the tenant and owner are aligned with how the property should be maintained.
- High capital requirements. For higher returns, usually, higher upfront costs are required, and commercial real estate investing is no different. Due to the income-generating potential, commercial properties are usually far more expensive than residential properties within the same area.
On top of the initial investment, significant maintenance costs can occur at any time, which will eat into your bottom line. Rent needs to be high enough to cover these costs per year.
- Illiquid asset. Like a residential property, funds invested within a commercial property are extremely illiquid. The process to sell a house can take several months. Commercial properties can take even longer.
If funds are needed for an emergency, the chances of pulling money out of commercial property investment are low.
- Correlated with the economy. The success of commercial real estate and the economy can be heavily correlated. If the economy suffers, the demands for goods and services can fluctuate dramatically, which can quickly have an impact on the demand for commercial premises. Residential properties are not as greatly affected because people always need a place to rest their heads.
- Complexity of lease agreements. Most residential lease agreements are carbon copies of one another. They vary very little. On the other hand, commercial lease agreements can vary considerably. Every aspect of the tenancy is up for discussion, including maintenance coverage, insurance, and tax.
As a result of the complexities, often expert commercial lawyers are required to ensure an agreement is logical for both parties.
- Longer vacancies. Depending on the commercial property, lease terms can be extremely long. However, this also means a property can stand empty for longer periods. If a business has to commit to a 5+ year tenancy, they will need to be 110% sure that your commercial premises are right for them. You need to have a cash buffer to cover any costs that arise during any vacancies.
How to get started
You should now hold enough knowledge to hold a conversation with a commercial real estate professional – well, you should at least be able to tell your friends what it is.
But to get involved and start making money, which is what this is all about, there are still several steps to be aware of. So to help you make the process as efficient as possible we have broken each step down for you.
Step 1: Do Your Own Research (DYOR)
Success experienced in commercial real estate investing is strongly correlated with the amount of research that goes upfront. It is where profits are truly forged.
You need to begin asking yourself a few questions. Do you want to invest nearby where you live or in a different location? Will you focus on one particular niche of commercial real estate, for example, offices? Or will you be open to every opportunity?
Once you have determined the type of property you are looking for and location, now it is time to research the market. Gather as much information on prices, footfall, rental income, availability, and state-specific taxes as you can. As knowledge builds, you should begin to grasp which commercial property will be suitable for your level of investment.
For some useful tips on selecting the right location check out points 2 & 3 of our rental guide below.
Read the guide: How to buy a rental property
Step 2: Organise your finances
With such high upfront investment costs involved with commercial property, it is crucial to become comfortable with your finances. Do you know how much deposit you can afford to put down? Have you got a plan for funding the remainder?
Funding may be coming from a conventional loan, a government-backed loan, a syndicate of interested parties, or financing offered by the seller. If you require a loan, make sure to have an investment plan and top credit score in place. It won’t just be the commercial property that a bank will be looking at.
Usually to gain the funding you also need to understand the potential for returns. As a result, the return on investment will be a crucial deciding factor when choosing a property. Luckily, there are some key metrics that can help you sort the commercial property diamonds from the rough.
- Net operating income (NOI). The NOI represents the annual income generated by commercial premises. It is calculated by subtracting the annual expenses for keeping the property fully maintained away from the annual rental income. You want this number to be as high as possible.
- Capitalization rate. The capitalization rate, sometimes called the cap rate or rate of return for short, is commonly used by investors to assess the potential of one property against another. It is calculated by comparing the gross annual income against the total price of the property.
If a commercial unit is purchased for $800,000, and annual rental income is $80,000, the gross cap rate would be 10% (the math- ($80,000/$800,000) x 100). To calculate the net cap rate, you use the same calculation but instead of using the annual rental income, you use the net operating income (NOI). This cap rate will take into account any costs for the year.
The idea of cap rate is to get the percentage as high as possible, therefore, increasing your returns. The calculation of cap rate does not take into account any debt that may have been used to purchase the property.
- Internal rate of return (IRR). The IRR is a forward-looking calculation for determining how quickly an investment will return money. It’s commonly used by commercial real estate investors to compare different-sized projects that are competing for the same funding.
A commercial property may generate a rate of return of 10% one year but may only generate 8% during the following year. IRR is used to account for these changes.
The higher the IRR, the quicker that money is being returned to your pocket. If money comes in quickly, it can then be used for other opportunities. Return of money sooner is more valuable, than the return of money at a later stage. Although a useful calculation, due to its complexities it is a calculation that is best calculated through software, rather than on paper.
After maneuvering your way through finances, the last port of call is tax. It is an investor’s responsibility to deal with all tax filings for the total earned on commercial real estate investments. However, this can sometimes be intimidating. Finding a decent accountant could pay dividends when dealing with this process.
Step 3: Hire expertise
Once you have a clear appreciation for the type of investment you’re looking for, have a budget in mind, and have clued yourself up on as much information you can drag from the internet, it is likely time to contact an expert.
A commercial property expert, or broker, will be able to help you in your search for your first property. Before choosing, make sure to look at their background. Have they sold properties that are similar to what you are looking for? How long have they worked in the area? Do they have any useful local contacts? Their market knowledge should be razor-sharp.
When talking with suitable candidates, outline what you are looking for clearly, and assess their reactions. It doesn’t take a long conversation to determine if a person is the right fit for you. Look for someone that is engaged, enthusiastic, and experienced.
Step 4: Find a suitable property
You have done your homework and you can now begin searching for your suitable commercial property (or properties). Luckily, commercial properties are not as abundant as residential properties, which means the task of choosing is reduced. But as nice as it is to have fewer options, fewer options means good opportunities are harder to come by.
There are several ways that commercial investment properties can be found. Chatting with your commercial real estate agent or broker should be first on the list. Situated at the forefront of the market, they should already know the details of potential local properties. Alongside your agent, join any local wholesaler networks. Wholesalers work in both the residential and commercial sectors and can notify you of upcoming deals.
Another popular method for finding commercial investment leads is by direct mail. This can involve emails or letters. Through your own direct mail campaign, you can specify exactly what you are looking for in an investment property and potentially what you are willing to offer.
While searching, remember to keep checking the numbers. Have you calculated the NOI and cap rate? What about the IRR? Make sure those dollars are working as hard as they can for you.
Step 5: View the property
Never buy a commercial property at face value – any property for that matter. Always arrange a booking prior, potentially several if required. This can be completed before or after an offer has been made.
If you viewed the property on your own initially, when things get serious, remember to take your commercial real estate broker back to take a look. He or she may spot things that you have not accounted for. You need to be fully aware of everything before signing on that dotted line.
Step 6: Make contact
So you’ve now got a property in mind and you have made sure that it aligns with the capital you have secured & the numbers of a profitable venture. Next, it is time to make contact with the seller.
Unlike residential property, commercial property usually requires a letter of intent (LOI). A LOI is a simple document that outlines what you are looking to purchase and the basic terms of the purchase. Basic information to include would be things like purchase price, deposit amount, evaluation period, and any other clauses you wish to enact.
A letter of intent is not a legally binding document. Its purpose is so that you and the seller can start to discuss the outcomes of a future deal.
Step 7: Submit competitive offer
If the deal continues to look promising then, as the saying goes, there is no time like the present – it is time to make a formal offer.
A formal offer will be made in the form of a contract. All contracts should be reviewed thoroughly by a qualified lawyer. Make sure the contract outlines all of the necessary details of the deal and contains enough clauses and conditions that it protects you and the seller.
Once a contract is agreed upon, check that your funding is in place ready to go.
Step 8: Conduct an inspection
Just like residential properties, you need to be sure there are no underlying problems with a commercial build. Are there any hidden structural issues that you are simply not aware of? The time between making a formal offer and closing the deal should be taken to check for such issues – formally known as the inspection period.
A variety of checks can be completed by a buyer including a building surveyor’s report, an environmental survey, and an inspection of the boundary. Details regarding the income generated by the property can also be established at this stage. What is the current rent? Is the building vacant? If so, how long has it been vacant? Is the tax on the property up to date?
Step 9: Profit
If all inspections go well and you remain happy with your commercial property choice, the deal can close. The closure of the deal is effective from the date funds are transferred which is usually handled either by a lawyer or by a title company.
From here on in, your focus should be on maximizing the profit of your investment.
The management of the property now rests on your shoulders. Are you going to run it yourself? Or are you going to have a management company run it for you?
Commercial property investing does not have to be a place where only the ‘titans’ of the real estate industry dominate. It is an investment avenue open to anyone willing to put in the time and hard work. The steps do not have to be intimidating and you certainly don’t need millions of dollars to participate.
Like most investments, a commercial real estate deal is made or broken by the numbers. Focus on them. Collect the research, account for as many variables as possible and you will come out ahead.
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