For an investor who invests in commercial real estate, they can find it a good option, depending on their financial goals, risk tolerance, time horizon, and investment strategy. However, every investor’s situation is unique, so it’s important to carefully consider all the benefits and risks involved to determine if a commercial real estate investment aligns with your needs. Understanding key terms and concepts will help investors as they consider this strategy.
Commercial real estate refers to properties used for business purposes, not residential living. This type of investment involves acquiring and owning these properties to generate profit through rent, property value appreciation, or both.
Commercial properties are generally much larger than residential ones, sometimes by a significant margin. The average US home is around 2,400 square feet, whereas commercial properties can be as large as 1 million square feet or more. As a result, commercial properties are typically more expensive to buy and maintain.
Commercial properties are leased to businesses, not individuals (with the exception of commercial apartments). This makes them more susceptible to fluctuations in the local economy and the financial health of the tenants. Residential properties, on the other hand, are typically leased to individuals, leading to more stable rental income.
Financing a commercial real estate purchase can be far more complex than financing residential property. Commercial properties are more expensive, and loan terms are more flexible. Residential mortgages are very similar: 30-year terms, fixed interest rates, and monthly principal and interest payments. Commercial loans have a wider variety of terms and conditions, typically customized for each transaction.
A defining factor of a commercial investment is the lease agreement. Here’s a look at some key differences between commercial and residential leases:
– Length: Commercial leases are typically much longer than residential leases, with terms ranging from a few years to several decades. This is because business owners generally require more stability and predictability in their lease agreements compared to individuals.
– Lease Terms and Conditions: Commercial leases are generally more complex than residential leases, with more detailed terms and conditions. These can include provisions for rent increases, property maintenance responsibilities, and tenant improvements.
– Operating Expenses: In a commercial lease, the tenant is typically responsible for paying a larger portion of the operating expenses for the property, such as property taxes, insurance, and maintenance. In a residential lease, these expenses are usually the responsibility of the property owner.
– Lease Termination: Commercial leases typically have stricter provisions for early lease termination compared to residential leases. This is because businesses rely on the stability and predictability of the lease to plan their operations and finances.
– Property Use: Commercial leases may also have more specific provisions regarding the use of the property, including limitations on the type of business that can operate on the property. In many cases, this is done for competitive reasons. For example, a coffee shop lease might have a provision that prohibits other coffee shops in the same shopping center.
It’s important to note that every lease is unique and written for the specific needs of the property and the tenant. From a due diligence perspective, investors should
Commercial real estate investing can be riskier than residential real estate investing due to the factors mentioned above. However, the potential returns can also be higher. Commercial properties are more sensitive to economic and market conditions, while residential properties are more stable because renters prioritize housing throughout economic cycles.
Commercial real estate encompasses a diverse range of properties that cater to various business needs. Here’s a breakdown of some of the most common types:
– Office Buildings: Office buildings are commercial properties designed for businesses to lease space and use as a workplace. These can range from single-story structures to high-rise towers in major metropolitan areas. Office buildings are typically categorized into Class A, Class B, and Class C, based on factors like location, age, and overall quality. Class A buildings are the newest, most prestigious, and expensive, while Class C buildings are older and more basic.
– Industrial Property: Industrial properties are facilities used for manufacturing, warehousing, and distribution purposes. These buildings are typically located outside of urban areas, often in industrial parks with easy access to transportation routes. Industrial properties can be further categorized into: Heavy Manufacturing: These buildings are designed for heavy industrial uses with specialized features to accommodate large machinery and equipment.
-Light Assembly: These buildings are suitable for a wider range of industrial uses, including product assembly, storage, and light manufacturing.
-Bulk Warehouse: These large-scale facilities are typically used for distribution and storage purposes.
– Retail Space: Retail space encompasses properties used for selling products directly to consumers. This category includes a wide variety of formats, such as:
-Shopping Malls: Enclosed shopping centers with multiple stores and common areas.
-Shopping Centers: Open-air shopping centers with multiple stores, often anchored by a large big-box retailer.
-Freestanding Retail Properties: Stand-alone buildings housing a single store or business.
– Multi-Family Housing: Multi-family housing refers to residential properties with more than one dwelling unit. This category includes apartment buildings, duplexes, triplexes, and fourplexes. Multi-family properties can be further categorized by class (A, B, and C) based on factors like location, amenities, and overall quality.
– Hospitality: Hospitality properties provide temporary accommodations for travelers. This category includes hotels, motels, resorts, extended-stay hotels, and vacation rentals.
– Special-Purpose Properties: This category encompasses a wide range of properties that don’t neatly fit into the other categories. Examples include restaurants, gas stations, car washes, theaters, bowling alleys, and healthcare facilities.
The amount of capital required for commercial real estate investment depends on various factors, including the property type, location, and current market conditions. Generally, commercial properties are more expensive than residential properties, so a larger amount of capital is likely needed to start.
Depending on the investment method, investors can start with as little as $100 or as much as $1,000,000 or more (refer to the next section for details).
There are a number of ways to invest in commercial rental properties, depending on your risk tolerance, time horizon, desire for property management involvement, and return goals:
– Direct Ownership: This method involves purchasing a commercial property outright and becoming the sole owner or partnering with others. Once acquired, the property generates income through rental payments and potential capital gains from appreciation. The benefit is complete control over the property selection, financing, due diligence, and closing processes. Additionally, you earn 100% of the cash flow and profits. The downside is that these tasks can be very time-consuming and require significant operational expertise, according to Casey Development. For direct ownership, investors typically need 20-30% of the property’s purchase price to get started.
– Commercial Real Estate Investment Trusts (REITs): REITs are companies that own, manage, or finance various commercial properties. Investors can purchase shares in a REIT, entitling them to a proportionate share of the rental income and appreciation generated by the underlying commercial properties. The benefit is that investors don’t have to manage the properties themselves. Additionally, shares in publicly traded REITs are highly liquid and can be purchased by anyone with a brokerage account and sufficient funds to buy a single share. The downside is that REIT investors relinquish control over major property management decisions and may be charged fees by the REIT operator, reducing profits.
– Partnerships: A partnership is a legal structure where multiple investors join forces to purchase and manage a commercial property. The benefit of a partnership is spreading risk and ownership costs among multiple parties. It can also allow individual investors to access properties they couldn’t afford alone. The downside is that partnerships can be challenging when the investment doesn’t go as planned and additional funds are required for the property. Partnership capital requirements vary depending on the property cost and the number of partners. For example, if the total down payment is 20-30% and there are five partners, then each individual would need to come up with 4-6% of the total capital required.
– Commercial Mortgage-Backed Securities (CMBS): CMBS are not direct investments in commercial real estate properties. Instead, they are securities backed by commercial mortgages. Investors can purchase CMBS as a way to indirectly invest in commercial real estate. The benefit of a CMBS investment is that it generates passive income in the form of steady monthly payments. The downside is that CMBS investors don’t participate in the upside of a property’s value appreciation. The amount of capital required for a CMBS investment can vary widely. On the lower end, commercial real estate investors can purchase shares in a publicly traded CMBS lender for a few hundred dollars. On the higher end, they may need tens of thousands of dollars for a private investment.
– Private Equity Deals or Funds: Private equity deals and funds are investment vehicles that pool capital from multiple investors to purchase and manage commercial properties like office buildings, apartment complexes or shopping centers. For investors, the benefit is passive income and exposure to institutional-grade assets that they likely couldn’t afford on their own. Additionally, they benefit from the expertise of the private equity firm in finding, selecting, financing, and managing commercial investments. The downside is that private equity investments can be illiquid and subject to fees imposed by the private equity firm. Private equity investments are typically only available to investors who meet minimum net worth or income criteria and often require high amounts of capital, often with a minimum of $25,000 or $50,000.
It’s important to carefully consider which investment method best suits your investable assets, risk tolerance, and investment goals. Consulting with a financial advisor or professional can be helpful to determine the best course of action for your specific situation.
The cap rate is a metric used to gauge the potential return on investment for a commercial property. It’s calculated by dividing the property’s net operating income (NOI) by its purchase price or current market value. A higher cap rate indicates a potentially higher return on investment, but also signifies higher risk. Conversely, lower cap rates are typically associated with higher-quality properties with more stable cash flow.
NOI is a metric that represents the income generated by a commercial property, minus operating expenses such as property taxes, insurance, and maintenance. It’s used to assess a property’s profitability and is a crucial factor in calculating the cap rate and ultimately, the property’s value.
The GRM is a metric used to assess the value of a commercial property relative to its rental income. It’s calculated by dividing the property’s price by the annual gross rental income. A lower GRM suggests a potentially better investment as it indicates that the property is being sold at a lower price relative to its rental income.
A lease is a legal agreement between a property owner and a business tenant, outlining the terms and conditions under which the tenant can use the property. Commercial leases are generally longer and more complex than residential leases, and they can include provisions for rent increases, property maintenance, and tenant improvements.
Tenant improvements are modifications or additions made to a commercial property by the tenant to customize the space for their business needs. These improvements may be paid for by the tenant or the property owner, depending on the terms of the lease. For instance, office space may necessitate significant tenant improvements like individual offices, communication equipment, conference rooms, and break areas.
A triple net lease is a type of commercial lease where the tenant is responsible for paying all of the operating expenses for the property, including property taxes, insurance, and maintenance. This type of lease is generally considered to be more favorable to the property owner as it transfers the burden of these expenses to the tenant. NNN leases are particularly common in retail properties like grocery store-anchored centers.
For investors who decide that commercial real estate is a good fit for their goals, they may experience some or all of the following benefits:
– Potential for Higher Returns: Commercial real estate can offer the potential for higher returns compared to other investment options like stocks or bonds. This is partly due to the fact that commercial properties generate income through rent payments, which can provide a steady stream of income over time, and can increase in value, which can be particularly advantageous in a strong real estate market.
– Diversification: Commercial property prices generally have a low correlation to price movements in other asset classes like stocks and bonds. As a result, incorporating commercial real estate into an investment portfolio can help diversify holdings and potentially reduce overall risk.
– Professional Management: Many commercial real estate investment opportunities are overseen by professional property management companies. This can generate passive income for investors through periodic dividends and distributions.
– Tax Advantages: There are potential tax benefits of real estate investing, such as the ability to deduct certain expenses and depreciation on the property. Additionally, investors can potentially defer capital gains taxes from the profitable sale of a property by reinvesting the proceeds into another property through a tax-deferred exchange known as a 1031 Exchange.
– Income Stream: Similar to a bond investment, commercial properties can provide regular distributions of income derived from their rental income.
Overall, investing in commercial real estate has the potential to deliver strong returns and a variety of other benefits while providing diversification for an investment portfolio. However, it’s important to weigh these benefits against potential risks.
Capitalization Rate (Cap Rate): As described previously, the cap rate is a metric used to gauge the potential return on investment for a commercial property. It’s calculated by dividing the property’s net operating income (NOI) by its purchase price or current market value. Generally, a higher cap rate indicates a potentially higher return on investment.
– Internal Rate of Return (IRR): The IRR is a metric that represents the rate of return on an investment over time, considering the time value of money. For most commercial investments, it’s the primary metric used to measure return.
– Gross Rent Multiplier (GRM): The GRM is a metric used to assess the value of a commercial property relative to its rental income. It’s calculated by dividing the property’s price by the annual gross rental income. A lower GRM suggests a potentially better investment as it indicates that the property is being sold at a lower price relative to its rental income.
– Cash on Cash Return: The cash on cash return is a metric that represents the annual return on an investment, calculated by dividing the annual cash flow from the property by the initial cash investment. This metric is useful for evaluating the short-term profitability of a commercial real estate investment.
From an investment due diligence standpoint, it’s important for investors to consider multiple return metrics because they provide information about different aspects of the investment opportunity.