Investors have long looked to commercial real estate to build wealth. However, entering the CRE market can be confusing if you don’t know how to start. There are many factors to consider when searching for a CRE property that meets your needs. Where will you find a property? Is the commercial property in a prime location? What is the expected cash flow? And what will renovations or repairs cost?
Finding the ideal commercial real estate investment opportunity can be challenging. Here at CXRE, we want to help guide you towards a CRE investment that meets your needs. Below, you’ll find information to help you determine which commercial real estate property is best for you.
As always, we are here to help. If you want more information about investing, property management, or property valuation, please contact us. One of our commercial real estate professionals would be happy to answer any questions you might have.
- Why Choose Commercial Real Estate?
- Types of CRE Properties
- Multifamily Real Estate
- A Note About Mixed-Use Properties
- Financial Considerations for Commercial Real Estate
- Due Diligence: Choosing the Right CRE Property
- Deciding on a Commercial Property that Meets Your Needs
- The Downsides of Commercial Property Management (500)
- What properties are defined as commercial real estate?
- Can anyone buy CRE properties
- Why should I invest in commercial real estate?
- Are there risks associated with buying commercial real estate?
- How can I best manage the inherent risks and protect myself from a bad investment?
- Do I need a property management company?
- What type of commercial property should I invest in?
- How can I be sure my investment is going to produce positive cash flow?
- Are value-add properties a good investment?
- How can I learn more about commercial properties in my area?
Why Choose Commercial Real Estate?
Many investors choose commercial real estate to build wealth over time. Commercial properties are the perfect way to diversify an investment portfolio. When compared to other investments like stocks or bonds, ETFs, and even residential real estate, CRE tends to be a steady performer.
While there are some disadvantages and inherent risks in CRE investing – like there are in all investments – there are ways to mitigate those risks. By carefully selecting properties that will provide steady cash flow and gain in value over time, you can build a successful commercial real estate portfolio.
There are many advantages to investing in commercial real estate.
Commercial Real Estate is a Stable Investment
Even when the stock markets are volatile, commercial real estate remains steady. Many factors affect CRE returns over time, including location, property values, and other economic factors. However, the National Council of Real Estate Investment Fiduciaries (NCREIF) estimates privately-held commercial properties see an average 25-year return of 9.4%, according to a 2019 report.
By comparison, the S&P 500 reports a 9.8% average return over the past 20 years. Therefore, CRE properties perform just as well as the stock market, even considering the real estate crash in 2008.
Even during an economic downturn, real estate investments can continue to provide steady income.
Of course, real estate investing should be a part of your overall investment strategy. Consult your financial advisor to discuss how you might diversify your portfolio.
Monthly and Long-Term Income
Owning commercial real estate has economic benefits in both the short and long term.
First, commercial property owners receive rental income from existing tenants immediately upon taking ownership. Assuming the asset was purchased at a reasonable price, with a favorable interest rate, and it has high occupancy rates, the income generated should be substantially more than the debt payments. That is, you’ll be experiencing positive cash flow every month as long as tenants continue to rent your space.
Secondly, your CRE assets gain value over time. As we mentioned above, commercial real estate reports nearly a 10% historical return on average. Therefore, when you’re ready to sell your asset, you can expect significant returns on your initial investment.
No conversation about commercial real estate investing would be complete without mentioning the incredible tax advantages property owners enjoy.
The tax advantages are too numerous to discuss in detail here, but here are the basics:
Real estate owners (and property managers in some instances) can claim deductions on real estate-related expenses. These tax write-offs are the most significant money-saving tax advantage for commercial real estate investors. Real estate owners can deduct everything from interest paid on a loan to housing improvements and marketing costs.
Capital Gains Savings
When an owner sells a property, taxes apply to capital gains (the dollar amount over the initial cost). However, if an investor owns a property for more than one year, their tax burden is significantly less. And if you hold a property as an inheritance for your heirs, they won’t pay capital gains taxes at all.
Depreciation represents another significant tax advantage for real estate investors. The IRS allows deductions for normal wear and tear, and the expected expenses incurred to maintain the property. Even if the property sees positive cash flow, the owner can still claim depreciation deductions to decrease the overall tax burden.
A 1031 Exchange allows investors to defer tax payments on capital gains indefinitely in some cases. By using a 1031 Exchange, owners can defer capital gains taxes on one property by investing the profits from that sale into another real estate property. The owner will not owe the capital gains taxes until the final property sells.
Some investors use this strategy as an inheritance plan for their heirs. When the owner dies, the investment property passes to the beneficiaries, who will not owe any taxes on the property.
You can learn more about 1031 Exchanges here.
Of course, to learn more about the potential tax benefits of commercial property ownership, contact your real estate attorney.
Knowing and understanding the advantages of each can help you better choose an investment type that meets your need.
Types of CRE Properties
Before choosing a CRE property, it’s essential to understand the various types of commercial real estate. While there are many types of commercial real estate investments, we are focusing on the four most common types: Office, Industrial, Retail, and Multifamily.
As with all investment options, there are benefits and drawbacks to each type. Knowing and understanding the advantages of each can help you better choose an investment type that meets your need.
Office commercial properties vary widely in size and scope. This category includes everything from the small 400-foot, single-story building in a small Texas town to towering skyscrapers in downtown Houston.
Any property where a business owner conducts daily operations – and often meets with clients, patients, or customers – is considered an office space.
Office Space Classification
Office space is categorized by “class:” Class A, Class B, and Class C.
Class A is the most desirable office space, with high-end finishes, prime location, updated infrastructure, and professional property management services. Because of the desirability of these properties, they often attract higher-end tenants and demand higher rents. Of course, they also come with a heftier price tag for investors.
Class B is the “middle ground.” These buildings are older, in need of a little TLC and some updating or minor renovations. In most cases, these properties are still perfectly functional. Many business owners and clients seek out Class B properties because of their value. Tenants can still get plenty of amenities, in a suitable location, for a reasonable rate. And with some renovations, many Class B buildings can step up to the Class A category.
Class B offices tend to attract high-quality tenants who can produce reliable income for the property owner. And these assets are more affordable to investors. Think of them as the “just right” in the Goldilocks and the Three Bears scenario.
Class C offices are the lowest rung of the office commercial real estate category. These buildings are old, perhaps in less desirable locations, and need significant renovations and updates. As a result, these properties tend to see fewer tenants, lease for lower rates, and produce less cash flow than other office class properties.
However, for investors, Class C properties represent opportunity. If the building is in a decent location but needs some infrastructure overhaul or significant repair work, it’s an ideal chance for an investor to make money. The investor can purchase the property at a low price and re-develop the asset into something much more profitable.
Types of Office Space
Office commercial real estate covers a wide variety of buildings. Office buildings include:
- Executive offices, often with parking, a central lobby, and a reception desk
- Co-working offices with open flooring concepts
- Private offices
- Flexible office space in a refurbished residential building
- Medical or dental offices
Of course, each office building and each tenant are unique, so the needs of each will vary. When investing in commercial office buildings, consider the ideal tenant, how you’ll attract them, and how you will manage that property effectively.
Why Investors Choose Office Commercial Real Estate
Office commercial real estate can represent a significant financial investment. Multi-office buildings in a prime location require substantial capital. However, qualified investors still take the gamble.
Because office space is a reliable cash flow source.
Unlike residential real estate, office tenants tend to sign longer-term leases and stay for many years. If you can find a high-quality tenant, you could have a steady stream of income for years to come.
Industrial real estate refers to properties used for manufacturing, warehouses, or large-scale storage. Examples of industrial real estate include:
- Manufacturing facilities
- Distribution warehouses
- Refrigeration and cold storage centers
- Telecom or data storage centers
- Biotech Laboratories
The industrial sector continues to expand, even as the economy shrinks. Investors are purchasing industrial properties at record rates, and even a pandemic and a trade war don’t seem to be stopping its momentum.
Why Investors Choose Industrial Real Estate
Let’s face it: industrial real estate isn’t the most glamorous. They’re not skyscrapers or quaint office complexes. They’re warehouses, shipping centers, and no-frills manufacturing locations.
But that’s precisely why they’re a solid investment.
First, industrial real estate is consistently leased. The manufacturing industry is booming in the US, and businesses need space to create their products, store them, and ship them to consumers. Therefore, this real estate sector is projected to see continued growth and historically low vacancy rates across the country.
As internet retail continues to grow, more businesses are turning to industrial centers as the core of their operations rather than traditional retail space.
Secondly, the operating expenses for industrial properties are much lower than standard office buildings, retail centers, or multifamily. That’s because many tenants operate on a triple net basis, where the renter pays their share of operating and maintenance costs. Therefore, property management costs, maintenance costs, and janitorial expenses are lower as well.
Retail commercial real estate is any property out of which a business sells goods to consumers. These properties can be single-story, one-room locations, or multi-story retail centers housing many businesses.
The following are all considered retail properties:
- Shopping malls
- Shopping centers, like “strip malls” and other outdoor shopping complexes
- Fitness centers
- Pet stores
- And many more
Is Retail CRE Still a Good Investment?
The retail market has seen a decline in recent years. As more and more businesses move their operations online, retail centers – like shopping malls, strip malls, and even small retail complexes – are seeing fewer tenants.
The property’s location, age, local demographics, and economic stability all play an important role is an investment’s returns.
However, there are still plenty of businesses selling goods that can’t be purchased online. These include things like pet stores, spas and salons, fitness centers, and restaurants. These retailers are well-positioned to survive an economic downturn because they offer goods and services that can’t be purchased online. Therefore, these types of retail businesses are still seen as a good investment.
Of course, every investment comes with inherent risks. The property’s location, age, local demographics, and economic stability all play an important role is an investment’s returns.
The Retail Market in a Post-COVID World
In the age of Coronavirus, retail centers have seen dramatic losses in the first quarter of 2020. While the future is still uncertain, experts predict the effects will be long-lasting for the retail and office sectors. To that end, some retail centers are repurposing their spaces. Restaurants have transformed into markets where residents can buy groceries. Stores offer online orders with curbside pick-ups. And as states begin to reopen, many retailers are offering deep cuts in prices to get consumers in the door.
Retailers that are opening up are taking the health of employees and customers seriously. Social distancing regulations remain in place, and businesses are providing hand sanitizer and masks for consumers.
The sharp downturn in business could be good news for property investors. As current owners fail to pay mortgages, they may choose to sell their properties at prices below market value. Investors can jump on these opportunities, purchase the retail real estate, and hold that property until the market bounces back. It could be an excellent time to invest in commercial real estate.
Why Investors Choose Retail Real Estate
Just as with industrial real estate, many retail tenants sign a triple net lease. These leases place some of the operating costs, taxes, and building insurance onto the tenant, allowing the property owner a much more “hands-off” approach. That’s an attractive option for many investors.
Investors also choose retail properties because of their longer leases. Many businesses want to be in one location for the long haul. Therefore, they’re willing to make necessary improvements to the property (be sure to determine who will pay for these renovations). When a business invests in improvements, they’re more likely to stay in one location for many years. That’s good news for building owners, who won’t have to consistently chase after new tenants.
Multifamily Real Estate
Even during tough economic times, people still need housing. That’s why many investors find multifamily real estate to be a lucrative and reliable investment.
Multifamily properties include any housing where two or more individual families are living at a time. This includes:
- Row townhomes
- Apartment buildings
In most cases, the investor owns the property and receives monthly income from the tenant’s rent. Depending on the size of the property, the owner’s skill set, and other determining factors, owners may choose to manage the properties themselves or hire a property management company.
Property Management and Multifamily Properties
Multifamily properties represent the most time-consuming investment because they require more upkeep and maintenance than other property types.
Think of your own housing. Toilets run, appliances break, the exterior needs painting, the yard needs to be mowed. Now apply those same maintenance needs to multiple households, and you get some idea of what managing a multifamily property is like.
Many investors choose a hands-off approach to multifamily properties. Instead, they hire a high-quality property management company that can take care of maintenance requests, tenant relations, and leasing. Maintaining a multifamily property can be a full-time job
Why Investors Choose Multifamily Real Estate
From 1992 to 2017, multifamily real estate provided the best returns of any commercial property type (9.75%). Furthermore, millennials aren’t buying homes like the generations before them. Instead, they’re choosing to rent. And because millennials represent the largest generation in history, that’s good news for multifamily investors.
Likewise, Baby Boomers are increasingly choosing to rent rather than buy retirement homes. A 2017 report from the National Multifamily Housing Council and National Apartment Association found that renters ages 55 and older account for about 30% of the nation’s total renters. Older Americans are drawn to rentals, not because of the cost, but because the maintenance-free living is an attractive option.
In addition, investors often find better financing terms on multifamily properties than in any other commercial real estate market. The IRS also gives tax incentives to investors who purchase property in underserved areas, where rental housing is abundant.
A Note About Mixed-Use Properties
While this is not a comprehensive list of every commercial real estate property type, the four mentioned above are the “four main food groups” of CRE.
However, there has been a resurgence in demand for mixed-use properties. These properties, as the name indicates, have multiple uses. They might be shops on the ground level, with multifamily living space above. Or office space on one end of a complex, with shops and restaurants on the other.
They are gaining in popularity because many younger workers – the same millennials that are renting in record numbers – want walkable communities where all amenities are close by. Instead of spending hours commuting to and from the office, these mixed-use areas allow people to live, work, and play all in the same area. Many of these mixed-use properties are in a prime location, demanding higher rents and increasing owner cash flow.
Because mixed-use properties are gaining in popularity, they’ve also become popular with commercial real estate investors. The versatile tenant base also means investors have multiple streams of income, from different bases, with many opportunities to attract new renters if necessary.
Financial Considerations for Commercial Real Estate
Commercial real estate investing is a long-term financial strategy. Selecting a CRE property that meets your needs is the best way to make sure your asset continues to produce income long into the future.
Before purchasing a commercial real estate property, you will need to assess your current financial standing. Then, work with a lender or a commercial property expert who can help you determine which property type and investing method best fit your financial goals.
Ways to Invest in Commercial Real Estate
There are multiple ways to invest in commercial real estate, from buying a property outright to crowdfunding. Even individuals with very little capital can still own a piece of the commercial real estate pie.
Buying an investment property outright can be an expensive venture. Many lenders require investors to put at least 25% down. Furthermore, owners should have several months rent set aside in case tenants can’t pay or break a lease. And then there are renovation expenses, maintenance costs, and operating costs.
However, investors who have significant capital often choose to purchase commercial real estate outright. If an investor can front the cost of purchasing CRE property, he or she will also benefit the most from monthly income and long-term gains.
This article assumes the investor purchased a property directly and is therefore responsible for all leasing, management, maintenance, and operating expenses.
A Real Estate Investment Trust, or REIT, allows investors to purchase shares of an investment property rather than the entire property itself. In essence, a corporation or company acquires income-producing properties, then sells shares of those properties to investors.
Investors then receive payments, either as dividends based on monthly rental income (Equity REIT) or on the interest of a mortgage (Mortgage REITs).
Investing in a REIT has potential drawbacks and risks, but they’re also an easy way to invest in real estate without assuming the responsibility. REIT shareholders aren’t responsible for leasing, property management, or any other daily operations of a property. And investors can buy into a REIT without fronting large sums of money.
Just as game developers, filmmakers, and other entrepreneurs use crowdfunding platforms like GoFundMe, Kickstarter, or Patreon, real estate investors can also use crowdfunding to pool funds and buy commercial property.
The idea of real estate crowdfunding is relatively new – a product of the 2012 JOBS Act – but it’s gaining in popularity. Crowdfunding allows everyday people to invest in huge real estate projects, sometimes with as little as $500. But it can be a risky proposition and should be considered with caution.
ETFs and Other Traded Stocks
The most hands-off way to invest in real estate is to purchase shares of an Exchange Traded Fund (ETF) or other stock or mutual fund. These portfolios, sold and traded through a licensed stockbroker, contain a variety of securities, including commercial real estate.
Investors in ETFs and other funds do not have any oversight of the commercial real estate properties in that portfolio.
Fix and Flips
Some investors choose to purchase a property well below market value, the “fix and flip” the property for a profit. While this strategy is popular on network television, it’s difficult to successfully fix and flip commercial real estate. The financial and tax considerations are also substantially different than traditional real estate investing, so consult your tax advisor before investing in a renovation and resale project.
Due Diligence: Choosing the Right CRE Property
Now that you know which type of commercial real estate you want to buy, it’s time to find the best property, with the highest value, that will produce the best return on your investment.
All investments have inherent risks. However, investors can manage those risks by carefully performing due diligence before purchasing a commercial property.
For the purpose of this article, we will assume you, the investor, are buying a property directly, without crowdfunding, REITs, or other stock-linked financial backing.
All investments have inherent risks. However, investors can manage those risks by carefully performing due diligence before purchasing a commercial property.
Due Diligence and Analysis of Commercial Real Estate
Due diligence is the process of inspecting all aspects of a property before the sale is finalized. During this process, the seller supplies all tax documentation, lease agreements, government permits, financial statements, and surveys or building inspection reports to the purchaser.
The purchaser also has the right to access the property to conduct inspections.
Due diligence is an essential step in the commercial real estate process. Purchasers should consult with CRE professionals who can conduct due diligence evaluations and determine whether or not the purchase price is fair.
The property valuation is a crucial factor in determining whether a commercial property is a good investment. However, unlike residential appraisals, a commercial property valuation isn’t based solely on comparable sales.
There are several approaches to CRE appraisals, but most of them take into account the following:
- Estimated property value based on comparable properties in the area.
- The amount of anticipated income the property will generate.
- The estimated cost to completely replace a property.
- Current infrastructure.
- Age of the property, location, structural integrity, and physical aesthetic.
Knowing a property’s value can help you determine whether the asset will be a profitable investment.
Prime Location Means Higher Profits
A property’s value also depends on its location. Properties in a prime location, like a city center in a bustling metropolitan area, are worth significantly more than a building located on the outskirts of a small town.
Buying a property in a prime location comes at a premium cost, too. Because these buildings demand higher rent, they’re often much more valuable and will be priced accordingly.
The key is to determine whether the prime location is worth the cost of purchasing the property, or if you would make a higher profit with a building is a less desirable location.
Another important consideration when assessing a commercial investment property is the cost-benefit analysis. The Cost-Benefit Analysis (CBA) should be performed by an experienced project manager or analyst.
The CBA looks at the complete financial picture of the property to determine whether or not it’s a sound investment. The costs are things like:
- Potential renovations or repairs
- Updating infrastructure, technology, or security
- Operating costs such as utilities or property management
The benefits in the cost-benefit analysis include things like:
- Potential earnings due to rent, percentages or sales, or other revenue streams
- Potential for growth, both in the short term (increased rents after renovations, for instance) and long-term (equity and value growth over time)
Once the analyst considers the potential costs of purchasing the property and compares those to the potential benefits, you will have a clearer picture of your potential earnings. Ideally, you can compare the potential benefits against your financial goals and determine whether or not this property will help you achieve those goals.
Determine the Return on Investment
As part of due diligence, the seller must provide updated financial records to the investor. These records can help the investor determine if the property will be profitable.
First, determine the estimated return on investment, or the amount you will receive after all bills have been paid. To find your estimated ROI, follow the cap rate formula:
Divide net operating income (NOI) by the property’s value
The product is the estimated annual return percentage.
Of course, calculating cap rates and ROI are much more complicated. You can learn more about it here. However, your best bet is to consult an experienced and knowledgeable commercial real estate firm that can help you analyze the property’s potential ROI and determine if it’s a good fit for you. The brokers and staff here at CXRE have vast knowledge in commercial real estate investing and can help you decide which property best meets your needs.
Occupancy and vacancy rates affect both the property’s value and the potential return on investment. During due diligence, the seller will disclose all lease agreements and occupancy/vacancy rates. Knowing these rates can help you determine whether the property has the potential to create cash flow.
There are two ways to look at occupancy and vacancy rates. First, if occupancy is high (vacancy is low), the investor can purchase a property knowing monthly cash flow is secure. Because the property already has tenants, the value is higher. However, that also means the price is likely to be higher than properties with a lower occupancy rate.
On the other hand, properties that are struggling to find tenants will be valued lower. For investors, this means purchasing the property at a lower price. But it also means a lower monthly income.
Balancing the occupancy/vacancy rates can help you determine if the property will be a valuable asset.
Determine Cash Flow
Cash flow is the term used to describe the amount of money left over after all the bills have been paid each month. For instance, if you purchase a 100-room apartment complex where each unit pays $1000 rent each month, the total income for the property is $100,000.
From that, you must deduct operating expenses, property management costs, and the amount saved out for reserves. What’s left over is the cash flow.
So, if we have $65,000 per month in total expenses and reserves, the cash flow for the investor is $35,000 per month. If there are multiple investors (as with a Crowdfunding commercial real estate venture or a REIT), that cash flow is divided among all investors.
During due diligence, the seller will disclose income statements, helping you determine the expenses, and your potential cash flow.
Value Add: Will the Property Need Renovations?
A value-add property is any commercial real estate property with the potential to add value. That is, the property needs improvements, renovations, or repairs, but has significant potential to increase in value once completed.
Some investors choose to purchase value-add properties because they are affordable. The property is often underperforming, which leads to a lower property valuation. Therefore, investors can buy the property at a reasonable price, make the necessary repairs, and see both short and long-term gains.
In the short term, value-add property can see drastic increases in occupancy rates soon after improvements are made. The property valuation will also increase as occupancy rises.
In the long term, value-add properties see better returns than properties purchased above market value. As occupancy increases, the property valuation also increases. When the investor is ready to sell, the property will be worth significantly more than the initial investment.
Who Pays for Renovations?
You will also need to consider who will pay for renovations to your property. If you purchase multifamily properties, you, the investor, will likely be paying for any renovations.
However, industrial, office, and retail properties often split the cost of renovations with the tenant. Many new tenants will want a build-out – construction or projects that make the space more personalized to the tenant. Often, the lease agreement establishes both the owner and tenant responsibility for build-out costs.
It’s important to know upfront what the owner pays, what the tenant pays, and who will oversee and manage the project. For more information about commercial build-outs, read our article here.
Deciding on a Commercial Property that Meets Your Needs
We have now discussed the types of commercial real estate, reviewed how to invest in these properties, and looked at ways to determine whether a commercial property is a financially sound investment.
Before you sign a sales contract and start due diligence, however, it’s important to set some guidelines. Following these rules of thumb can help you find a property that meets your personal and financial goals.
Know Your Goals
Before you start looking for investment opportunities, establish your financial goals. Are you hoping to generate monthly income? Are you more interested in long-term wealth-building opportunities? Or would you like to invest in something that both makes modest monthly income but also offers financial stability in the future?
Secondly, know your risk threshold. Investments come with inherent risk. While you can mitigate these risks by performing careful research and due diligence, there will still be risks involved. Understanding these risks is key.
Some real estate investments are safer than others. Typically, safe investments provide more modest returns, while higher-risk investments have the potential for more significant gains. Of course, safer investments also tend to see fewer dramatic downturns, while higher-risk investments could be costly if something doesn’t go as planned.
Before investing in any commercial real estate, talk to a trusted accountant or tax professional to discuss your short and long-term financial goals. They can help you determine which investing strategy is right for you.
Know Your Limits
Setting goals is always a good place to start but set realistic expectations. Take a hard look at your financial situation before you start investing, and don’t bite off more than you can chew. Markets change. If you finance more than you can realistically afford, you could be setting yourself up for financial hardship.
You should always have enough cash on hand to cover several months of unpaid rent. If a tenant defaults on a payment, their business goes under, or you have several months with a vacant unit, will you be able to cover those expenses without going broke?
Consult the Professionals
Commercial real estate investing can be complicated and confusing. CRE professionals like those at CXRE know the business and can help you navigate the investing maze.
Get the experts involved in the process. Tax attorneys, real estate attorneys, brokers, and property managers are all willing to help you find a CRE property that matches your needs. They are all specialists in their field, they’ve seen what works and what doesn’t, and they want to share their experience with you.
CRE professionals like those at CXRE know the business and can help you navigate the investing maze.
Similarly, before taking ownership of a commercial property, consult a property management firm. Property managers take care of everything, from finding tenants to leasing paperwork to scheduling inspections and managing construction. A high-quality property management team can substantially increase your occupancy rate, therefore increasing your property’s value and increasing your cash flow.
If you don’t know where to begin, start by contacting one of our real estate professionals. We will identify your financial goals, listen to your concerns, answer your questions, and help you find the right property.
The Downsides of Commercial Property Management (500)
While we have talked about several ways to mitigate your risks, you can’t ever eliminate risks altogether. Investing is inherently risky. As a buyer, you should seek professional advice, perform due diligence, and thoroughly research property types to make sure you’re assuming only as much risk as you are comfortable with.
However, even the most well-versed investors can run into problems from time to time. Before you invest, it’s essential to understand the potential downsides of CRE investing.
CRE Investing Requires Significant Capital
Most real estate investments require a great deal of cash upfront. While some real estate investing methods – like CRE crowdfunding, ETFs, or REITs – need less money initially, they’re not going to see the same returns as a traditional real estate purchase.
Most lenders require borrowers to put down at least 25% of the total purchase price. Depending on the property type, location, and value, 25% could represent a significant portion of your available cash.
Economic Downturns Could Mean High Vacancy Rates
An economic downturn (just as the one we see with the fallout from COVID-19) can severely impact business solvency. If a business closes or downsizes, your property could sit empty for months or even years before a new tenant moves in.
Therefore, investors should strongly consider how they will pay their mortgage if the property isn’t making any profit.
As for multifamily properties, tenants come and go often. It’s not uncommon for a unit to turn over once every year or two as leases end. Therefore, consider the costs associated with re-leasing rental units regularly.
More Regulations and Liability
Commercial real estate is subject to stricter government regulations than residential real estate. As the property owner, you could be held responsible even if your tenant breaks those rules.
For instance, if a tenant manufactures a chemical that is ultimately proven harmful to the environment, the EPA and local governments could take action, filing claims and imposing fines on both the tenant and the property owner.
In addition, if a business tenant gets sued by a client or customer, but doesn’t pay the fine, the complainant can ultimately file a lien against both the business and the property. If an enterprise conducts illegal activity on the premises, the property owner could get into legal trouble as well.
Finally, all commercial real estate is subject to strict disability and non-discrimination policies. Multifamily properties have to pay particularly close attention to these laws. Non-discrimination laws and disability laws keep tenants safe and give equal access to housing for all. However, property owners and property managers could face steep fines and legal penalties if they don’t adhere strictly to these laws.
As with all investments, make sure you know and understand the rules and regulations for your local area before purchasing a property. Consider how you might handle a legal issue with your tenant should it arise.
We’ve already discussed the significant financial investment needed to purchase a commercial property. While CRE has the potential to create great wealth – both in cash flow and in long-term gains – there are risks as well.
As with all investments, there is a risk that you could experience a significant financial loss. Knowing and understanding these risks can help you make a more informed investment decision.
How to Protect Yourself and Your Investment
Commercial real estate represents a significant investment. To protect yourself and your asset, you might consider some of the following strategies:
- Establish a limited liability company (LLC). This will protect your personal property and assets should your CRE investment run into trouble.
- Hold enough insurance. As your portfolio grows, you’ll need more coverage to protect your business interests.
- Hire a property management team. An experienced property manager can keep your property running smoothly, thus increasing the building’s value and generating more monthly income.
- Avoid unnecessary risks. While every investment can be risky, some risks aren’t worth taking. Consult your financial advisor, real estate attorney, or tax attorney if you have questions about your portfolio.
- Diversify your portfolio. While CRE investing has historically generated good returns, it’s wise to spread out your investments. Real estate should be one piece of your wealth-building puzzle.
What properties are defined as commercial real estate?
Commercial real estate is any property purchased with the sole intent of leasing it to generate income. There are four main types of commercial real estate: Office, Retail, Industrial, and Multifamily. Each of these has different risks and benefits. The best CRE investment is the one that matches your personal and financial goals.
Can anyone buy CRE properties
Commercial investing was once reserved for only the ultra-wealthy. However, new laws and guidelines have opened CRE investing to almost anyone. While we talk mostly about traditional real estate investing in this article, there are many ways to invest in commercial real estate.
For instance, investors with as few as $500 can invest in a real estate crowdfunding campaign, where each investor gets a share of the profits. Or, investors can choose a hands-off approach and invest in real estate investment trusts, or REITs, in which the investor purchases shares of a property. Other tradeable funds also allow investors to purchase shares of commercial real estate.
Today, the commercial real estate market is more accessible than ever to the average American.
Why should I invest in commercial real estate?
There are many reasons!
First, commercial real estate has performed well historically. The average annual rate of return for commercial properties over 20 years is about 9.5%. In comparison, the S&P 500 reported a rerun of 8.6% during that same timeframe. Even when the stock market is volatile, commercial real estate tends to remain a steady performer.
Secondly, commercial real estate provides both short-term monthly and quarterly cash flow and long-term growth.
And finally, the tax breaks are reason enough to consider commercial real estate. Many investors choose CRE for the tax write-offs alone!
Are there risks associated with buying commercial real estate?
There are risks involved with any investment, including commercial real estate. It’s important to take the proper steps to make sure the property you’re purchasing is a good investment. Of course, as we’ve seen in the past, there are always unforeseen circumstances, which can dramatically impact the CRE sector.
However, if we look back at the historical data for commercial real estate, the sector still outperforms many other investment types. So while there are risks, there is also the potential for incredible rewards.
How can I best manage the inherent risks and protect myself from a bad investment?
You can’t even eliminate all the risks that come along with investing. However, you can take steps to minimize these risks:
- Know your financial situation to avoid borrowing more than you can safely afford.
- Consult with professional financial advisors and CRE professionals and listen to their guidance and suggestions.
- Do your research. Know which property types, geographic areas, and management strategies work best with your financial goals and your lifestyle.
- Perform detailed due diligence. Have a knowledgeable analyst evaluate financial statements. Check all county and state zoning laws. Conduct environmental surveys. Thoroughly inspect a property before taking ownership to ensure you won’t have any surprises after closing.
Do I need a property management company?
While property management isn’t required for CRE investments, it is a good idea. Managing a CRE property can be a full-time job. Depending on the size and type of property you own, you may not need a property management company.
For instance, if you have a multifamily property with only three or four units, you might be able to handle the leasing paperwork, rent collection, and maintenance yourself. However, if you have multiple tenants, a specialized property, or other needs that you aren’t comfortable handling, property management is a smart investment.
Experienced, professional property management teams add significant value to your investment. Property managers can:
- Consult on potential value-adding projects, like renovations, additions, or other projects.
- Find high-quality tenants that will pay on time and sign long-term leases.
- Communicate closely with tenants, addressing any concerns that might arise.
- Schedule regular maintenance and address tenant maintenance requests.
- Ensure compliance with federal, state, and local regulations, protecting you (the owner) from costly fines.
- Compile financial reports for owners and other shareholders.
Commercial property management is almost always worth the cost for building owners.
What type of commercial property should I invest in?
That all depends on your financial, personal, and professional goals. Each commercial property type represents different risks, benefits, and potential for growth.
First, understand your financial goals. Are you looking for an investment that provides monthly income? Or a property that will produce significant long-term gains? Do you want to purchase a property that needs renovation, requiring substantial upfront costs? Or would you rather pay a higher purchase price to get a turnkey-ready property?
Next, research the risks and benefits of all CRE property types. Some investors choose to stick with one investment type, while others purchase properties from multiple sectors.
You can clarify your goals and understand more about CRE investing by connecting with a real estate broker, financial advisor, or real estate attorney.
How can I be sure my investment is going to produce positive cash flow?
No investment is ever 100% certain. However, you can take steps to make sure the property you purchase is more likely to turn a profit and produce positive cash flow.
Consulting with real estate professionals can help. These experts can give you a strong sense of which areas, property types, and investment strategies have the highest return potential.
It’s also essential to do due diligence before taking ownership of a property. Have an experienced analyst look over past financial reports, lease agreements, expense sheets, and other documents. This will give you a clear picture of the earning potential.
In addition, conduct a thorough physical inspection. Will the property need costly repairs? Are those repairs likely to add significant value and bring in higher-paying tenants? Performing a complete cost-benefit analysis will help you understand whether the property will yield considerable profits.
Are value-add properties a good investment?
Value-add properties can be a good investment! Typically, these properties are in less-than-stellar condition and may be underperforming. Therefore, investors can usually purchase these properties well below market value.
However, investors should expect significant construction and renovation costs when purchasing a value-add property. Major renovations, like updating electrical or sewer systems, could be extremely expensive.
Investors should conduct a thorough cost-benefit analysis of the property to determine whether the asking price can offset the potential repair costs. Moreover, will expensive repairs draw in higher-end tenants, resulting in rent increases? If so – and if the potential earnings and increase in property valuation outweigh the purchase price – it could be a good investment.
The best way to determine whether or not to purchase a value-add property is to consult with a commercial real estate professional.
How can I learn more about commercial properties in my area?
It’s always a good idea to consult with CRE professionals who know the business inside and out. Real estate attorneys, licensed CRE brokers, and commercial property managers can help you find the right property. They’ll help you clarify your goals and establish an investment strategy to meet those goals.
Our brokerage and property management teams here at CXRE would be honored to help you find your ideal commercial real estate property.