Most investors know that commercial real estate (CRE) is an investment option, but fewer know how to take advantage of the opportunity. CRE is a vehicle that offers passive income, high returns, and growth potential, but it also has its risks. People who are considering CRE should do as much research as possible before buying in. Keep reading to learn about the seven most important things to know before investing in commercial real estate.
Commercial Investing Is Different from Residential Real Estate
The investments are different because the properties are different. Residential real estate consists of single-family homes and multifamily buildings of four units or fewer. Commercial real estate includes apartment buildings of five or more units plus any buildings used by a business, such as shopping malls, hotels, office buildings, and factories.
A residential property's value is based largely on location, while CRE's value is determined by how much revenue it can generate. CRE is more likely to be a long-term investment. Property leases run for years, often 5 to 10 years, while most residential leases are 6 to 12 months. Commercial lease turnover is lower.
A residential property landlord is frequently hands-on and closely involved with home repair and tenant relationships. Commercial property is more likely to be professionally managed with the investor at a distance.
It generally requires more money to get started in CRE. Perhaps most significantly, commercial properties offer higher potential returns and greater risk. Residential real estate investment is simpler. It requires less knowledge to buy and rent out a home than to evaluate a commercial property and put together a deal.
There Are Different Types of Commerical Real Estate Investments
The main types of CRE are industrial, office, retail, multifamily, and special purpose or other. The "other" classification includes hotels, storage units, medical facilities, and eldercare units. Each has its own characteristics of supply, demand, and profitability. For example, hotels and retail are more volatile and subject to downturn. Investors need to understand the particulars of the types of CRE they plan to buy.
Commercial Real Estate Market Conditions Are Local Market Conditions
Even if apartment rentals are booming nationwide, that doesn't mean they're doing well everywhere. Every CRE investment is specific to its geographical area. Its value is affected by local oversupply or undersupply. For example, anyone investing in office space needs to know how much square footage is available, the occupancy rate, and how much new construction is planned or underway.
Even within a region, location is key. Proximity to airports, freeways, and seaports is an asset for manufacturing facilities and hotels but may be less desirable for other commercial building types. Office buildings should do well in an urban core, while apartment buildings are popular in quiet suburbs.
How to Understand Commercial Real Estate Numbers and Metrics
A residential real estate investor looks at mortgages and other expenses and charges enough rent to cover them. A CRE investor must understand an expanded set of metrics. Here are a few:
- Net operating income measures all the revenues and costs from a property.
- Capitalization rate is the ratio of operating income to the value of the property.
- Cash-on-cash measures the return on cash out of pocket and considers the impact of financing.
- Loan-to-value compares the mortgage with the appraised property value.
- The debt-service coverage ratio measures the ability to cover the debt with the cash flow.
Investors must research CRE metrics such as these.
Due Diligence Is Critical with Commercial Real Estate Investments
Due diligence is important for any investment, but a failure of due diligence can be more costly with CRE. There's more to pore through. Investors need to look at financial statements, tax returns, property surveys, and property inspections. They're well advised to write a business plan. There are issues that a residential landlord doesn't have to think about.
For example, do zoning ordinances permit the building's intended use? If the investment involves new construction, is there local demand for the units? What permits might be required? Are permits up to date?
Some investors let the excitement over a property cloud their judgment. They will need legal support to guide them through the complexity of the paperwork. They need to look at comparable properties to assess whether the price is reasonable. It's not a bad idea to engage an expert or team of experts to checklist them through the process.
Initial and Contingency Funds Are Required to Invest in Commercial Property
Funding needs aren't limited to obtaining and covering the mortgage. Additional expenses will arise. There will be long-term building improvements. There will almost certainly be unexpected costs, such as major repairs. One CRE best practice is to maintain a reserve fund for these contingencies. This could be three to five percent of rental revenue set aside before counting the profits depending on the property.
Many investors have an unrealistic idea of how quickly and easily things will go. Preparations, renovations, and filling a unit with tenants often take longer than expected.
Indirect Commercial Real Estate Investment Is an Option
There are other investments options for people interested in commercial real estate but hesitant about the financial commitment, the knowledge needed, and the risks. Instruments such as real estate investment trusts (REITs) allow you to buy into a basket of properties purchased and managed by the REIT. There are other types of fractional ownership, such as partnerships, private funds, and even crowdfunding.
Just because the risk is spread out and there's less money out-of-pocket, that doesn't mean the investment is a good one. Investors still need to do due diligence on the instruments, looking at past performance and prospectuses. They need to understand how the REIT or other investment selects and vets properties.
Knowledge Is Key to Successful Real Estate Investments
There's a lot to understand about commercial real estate. Still, the basic practices are the same ones a residential investor should be using: know the market, understand the financials, do due diligence, have a plan. No investment is without risk, and wise investors arm themselves to minimize risk.
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