The right commercial real estate investment could serve as the one asset that puts your portfolio over the top.
There are several fundamental indicators to take into consideration when evaluating the viability of commercial real estate investments.
Not unlike flips and wholesales, investors should consider commercial real estate as an important exit strategy.
Investing in real estate is a great way to build wealth. Commercial real estate investing, in particular, is known to provide some of the highest income streams. If you’ve been investing in residential real estate for a few years and have been wondering how to invest in commercial real estate, this guide serves to break down everything you need to know to get started.
What Qualifies As “Commercial Real Estate?”
Commercial real estate is property that is typically leased out for business and retail purposes. Investing in commercial real estate involves the purchase or development of properties that have been designed with the intent of housing commercial tenants. Unlike a residential real estate investor, commercial real estate investors lease out and collect rent from the businesses that occupy space in their properties, rather than from residential tenants. It should also be noted that raw land purchased for the development of commercial property is also included in this definition. Commercial properties can generally be categorized into five main types. Keep reading to learn more about each one.
The 5 Types Of Commercial Real Estate
Before we get into the mechanics of how to invest in commercial real estate, it’s important to understand the various types of commercial properties. This way, you can start thinking about the commercial asset type in which you want to specialize. Commercial properties serve a broad range of purposes, but are generally grouped into the following types:
The most common commercial real estate type is office space. These buildings, which can range from single-tenant offices to skyscrapers, are defined by one of three categories: Class A, Class B, or Class C.
Class A commercial real estate properties are typically newly built or extensively renovated buildings located in excellent areas with easy access to major amenities. They are typically managed by professional real estate management companies.
Class B commercial real estate properties are often older buildings that require some type of capital investment. Although they are well-maintained and managed, these properties require minor repairs and upgrades—making them a popular target for investors.
Class C commercial real estate properties are typically used for redevelopment opportunities. They are generally poorly located, require some type of major capital investments to improve out-of-date infrastructure, and their high vacancy rates are much higher than higher-classed buildings.
Another popular commercial real estate type is retail buildings. These properties, which range from strip malls and community retail centers to banks and restaurants, are often located in urban areas. The size of these real estate properties can extend anywhere from 5,000 square feet to 350,000 square feet.
From warehouses to large manufacturing sites, industrial buildings are typically geared towards manufacturing industries, as they offer spaces with height specifications and docking availability. In addition, these commercial properties generally lend themselves more to investment opportunities.
Multifamily properties are comprised of apartment complexes, high-rise condominium units and smaller multifamily units. A property is qualified as multifamily real estate any time it has more than one unit, but can also be considered a commercial property if it has more than four units. Many residential investors get their start in commercial properties by expanding into larger multifamily properties. Residential tenants tend to have shorter lease terms than office and retail tenants, so tenant turnover is a factor that should be considered.
5. Special Purpose
In general, special purpose properties are designed for a specific use, so much so that it would be difficult to repurpose the property for another use. Car washes, self-storage facilities and schools are all examples of special purpose properties. The leisure and tourism industries represent a large proportion of special purpose real estate as well. Common examples within the industry include hotels, airports and sports stadiums, and amusement parks.
Mixed-use development properties are also prevalent in the commercial real estate sector, and continue to grow in demand. These properties represent a mix of different uses, such as residential, retail and even public sector. A mixed-use building could have shopping and services on the first floor with apartment units on the upper floors, for example. Read our guide to mixed-use developments to find out why they have become so popular in recent years.
What Is Owner Occupied Commercial Real Estate?
Owner occupied commercial real estate (OOCRE) is when investors purchase commercial real estate with the intent of utilizing the building for their own purposes. This strategy can be applied to any of the five commercial real estate types discussed above.
Having the option to occupy the commercial real estate in which you invest is just one of the many benefits associated with commercial investing. Keep reading to find out some of the other benefits that may pique your interest.
The Many Benefits Of Commercial Real Estate Investing
Investing in commercial real estate can be very rewarding, both personally and financially. For many, the objective of investing in commercial real estate is for future wealth and security; others utilize it for tax benefits and investment portfolio diversification.
A commercial redeveloper can also take advantage of the following benefits:
Higher Income: The hallmark benefit of investing in commercial real estate is a higher potential income. Generally speaking, commercial properties have a better return on investment, an average of six to twelve percent, while single-family properties fetch between one and four percent. Secondly, commercial real estate provides a lower vacancy risk, as properties tend to have more available units. (Consider this: one vacancy in an office building with 25 commercial spaces will negatively impact an investor’s bottom line more than one vacancy in a residential duplex.) In addition, commercial leases are generally longer than those you will find in residential real estate. This means that, commercial real estate owners have to deal with far less tenant turnover.
Cash Flow: Commercial real estate has one very distinct advantage: a relatively consistent stream of income due to longer lease periods. In addition, commercial properties often have more units than residential properties, which means you can achieve economies of scale and multiply your income streams much more quickly. Known in the industry as a triple net lease, many commercial tenants also pay the building’s real estate taxes, property insurance and maintenance costs, thus increasing your owner benefits.
Less Competition: Another advantage associated with commercial real estate is relatively less competition. Because of the perceived difficulty of commercial investing, the commercial space tends to be less saturated with other investors.
Longer Leases: Perhaps one of the biggest perks of commercial real estate is the attractive leasing contracts. Commercial buildings generally have longer lease agreements with tenants compared to residential properties, which, as previously stated, offers investors impressive returns and significant monthly cash flow. In many cases, lease agreements for commercial properties are signed for multiple years.
Commercial real estate investing offers investors an array of opportunities and advantages that other investment strategies do not. Once the benefits of commercial real estate investing are recognized, the next step is dive in. Read the following to receive tips on how to get started in commercial real estate.
How To Get Started In Commercial Real Estate
The question of ‘how to invest in commercial real estate’ has only one answer: with due diligence. Regardless of what sector or niche you’re in, doing your homework and minding your due diligence is a critical element in ensuring your success in real estate. In addition to learning the ins and outs of commercial investing, make sure you understand the commercial real estate market and how it can differ from the residential real estate market. If you’re ready to embark on your first commercial endeavor, be sure to abide by the following tips:
1. Understand How Commercial Real Estate Is Different
The first step as a commercial investor is understanding that commercial real estate is valued differently from residential properties. Unlike residential real estate, the income from commercial real estate is typically related to usable square footage. In addition, commercial property leases typically last longer than those of residential leases. These two factors help illustrate why a commercial real estate investor has a better potential to earn a higher income.
Location is an important factor regardless of your investing niche, with commercial investing as no exception. However, commercial investors also need to pay close attention to their tenant type. The location and intended tenant type are two factors that intersect closely when determining demand. For example, a space intended for corporate offices will likely have better performance in an urban center compared to a primarily residential neighborhood. Analyzing recent comparables can provide you with a better clue as to how your property of interest might perform.
2. Analyze Comparables
The next step is to analyze comparables in the area and research future developments. Otherwise known as “comps,” these assets refer to prices paid for recently sold properties that are similar in location, size and style. Analyzing comps will help you determine the current market value of a property. A general rule of thumb when determining comps is to choose a property where the square footage does not go beyond 10 percent higher or lower than that of the property being evaluated. This will allow for the most accurate comparables possible. Read more on tips for pulling the most accurate comparable sales.
3. Use The Right Success Metric
Commercial real estate investing involves a wide array of calculations, as well as an understanding of real estate finance. To be a player in commercial real estate, there are several formulas you should know.
Net Operating Income: This is a calculation that equals all revenue and costs from a particular property. Configured before taxes, this number provides investors with an idea of how much they’ll make from an investment minus all necessary operating expenses. Operating costs typically consist of insurance, property management fees, utilities, repairs and janitorial fees, utilities and property tax.
Cap Rate: Used to calculate the value of income producing properties, the “cap rate” — short for capitalization rate — will provide investors with an estimate of future profits or cash flow. This is essentially the ratio of net operating income to property asset value.
Cash On Cash: Cash on cash is a metric that provides investors with a rate of return on their commercial real estate transactions. It’s typically used by investors who rely on financing to purchase their properties. Cash on cash measures the return on out-of-pocket cash invested relative to the portion that was financed. This will provide an accurate analysis of an investment’s performance.
The above formulas serve as an introduction to complement our complete guide to real estate calculators that every investor should know.
In this next section, we will discuss how to obtain different types of commercial investment loans. Being well-versed in the above formulas and calculations is critical when presenting your case to commercial lenders.
Understanding Commercial Investment Loans
Now that you’ve received an overview of commercial real estate investing, including its benefits and ideas on how to get started, you’ll need to start thinking about an important aspect: How will you go about financing these investments?
There are a wide range of commercial investment loan types, and it is up to the investor to decide which financing option best fits their needs. Each type of loan has unique eligibility requirements, such as a minimum credit score, experience level and down payment requirement. These loans also have varying terms including the loan term, interest rate, and loan-to-value (LTV) ratio. For example, one investor may be in search of a loan that offers lower interest rates over a longer loan term, while another investor’s priority might be finding a short-term loan as a means of bridging a financial gap. Be sure to visit our comprehensive guide to the different types of commercial real estate loans shown below:
Small Business Administration (SBA) 7(a) Loan
Certified Development Company (CDC) / SBA 504 Loan
Commercial Bridge Loan
Hard Money Loan
How To Get A Commercial Real Estate Loan
The idea of obtaining commercial real estate financing may seem intimidating at first, but investors who spend the time learning about the process and the different types of commercial real estate loans will find that they are completely attainable. Below are the main steps involved in obtaining a commercial investment property loan:
Individual Vs Entity: Step one is to determine whether to finance a commercial property as an individual, or as an entity. Although the majority of commercial real estate is purchased by business entities such as corporations, developers and business partnerships, it can easily be completed as an individual investor. The lender essentially wants to make certain the borrower can repay the loan, thus requiring borrowers to provide financial track records in order to secure a loan. For newer businesses with no credit history, the lender will typically require the investor(s) to guarantee the loan.
Mortgage Options: It is important for investors to recognize that residential and commercial mortgages are not the same. First, unlike residential mortgages, commercial loans are not backed by government agencies such as Freddie Mac and Fannie Mae. Secondly, commercial loans terms differ from those of residential properties. Commercial loans range from five to 20 years, whereas residential loans will typically range from 15, to 30 years. Lenders will typically make their decisions based on an investor’s financial and credit history.
Loan To Value Ratio: An important metric lenders consider when financing commercial real estate is a property’s loan-to-value ratio (LTV). This figure measures the value of a loan against the value of the property, and is calculated by dividing the amount of the loan by the property’s appraisal value or purchase price. For commercial loans, the LTV will range from 65 to 80 percent, with lower LTVs qualifying for more favorable financing rates.
Debt Service Coverage Ratio: Lenders also look at debt-service coverage ratio (DSCR). This metric measures a property’s ability to service a debt. It compares a property’s annual net operating income to its annual mortgage debt service, including principal and interest. A DSCR of less than one percent reveals a negative cash flow. Commercial lenders generally look for DSCRs of at least 1.25 to ensure proper cash flow.
Once you’ve secured your financing, you are ready to start searching through listings. However, this is a lot of information to process at once. Keep reading to have some of your most burning questions answered.
Commercial Real Estate For Beginners
A successful commercial real estate investor has the potential to have a very lucrative career. Many beginner investors use multifamily properties as a gateway to get into commercial real estate investing. Regardless, it is imperative that you have a proper business plan before getting started. Here are the answers to a few commonly asked commercial real estate questions every beginner investor should know:
How Do I Know If I’m Ready For A Career In Commercial Real Estate Investing?
Are you interested in commercial real estate investing but still feeling a little hesitant to take the leap? The following three questions were designed to help you gain more clarity on whether or not commercial real estate is for you:
Do you have the ability to think big?
Investing in commercial real estate requires individuals to think big and have an open mind. When investing in residential real estate, the properties under consideration are much smaller in scale. With a commercial property, you must be able to visualize a finished product even in the beginning stages of redevelopment. If you are debating whether to purchase a five unit apartment versus a property with ten or more units, it is probably more beneficial to choose the 10. If the five unit complex requires nearly the same commercial financing as the 10, it makes sense to think big and do what it takes to boost your bottom line.
Are you an expert relationship builder?
Networking and building relationships as a residential real estate investor is important, but it is an absolute must for commercial investors. The biggest reason to build relationships with other commercial investors and private lenders is for financing purposes. When facing a one million dollar or more purchase price, it is likely that you will be in need of funding, and what better way to find capital than to contact one of your personal private lenders with whom you’ve already built a relationship. Once you’ve built a network, you can rely on other individuals who have made and learned from their mistakes.
Can you successfully execute your due diligence?
Arguably the most important task beginner investors can do before jumping into commercial real estate investing is to perform their due diligence. After you’ve chosen your niche, you must research everything you can regarding that specific sector. Ask questions from like-minded individuals at your local REI club, find information about different types of financing options online, reach out to private lenders in advance so you know exactly what information to present them with when the time comes. Once you’ve carried out thorough due diligence, you will be ready to successfully embark on your first commercial real estate deal.
Commercial real estate investing may seem intimidating at first, but you should understand that the core skills and competencies required are the same as residential property investing. They include minding due diligence, having a proper business plan that includes an understanding of financing options, and being being able to build a strong network. Any type of investing is associated with some level of risk, and it’s up to you to find ways to mitigate that risk. If you use have the systems that brought you success with residential real estate and seamlessly implement them into your commercial strategy, and you will surely find success.
If you got into commercial real estate investing, which property category would you like to specialize in? Let us know in the comments below: