Whether you already own residential rental properties or you’re still deciding if real estate investing is how you want to build wealth, the idea of purchasing commercial real estate may have crossed your mind. Commercial real estate (also known as CRE) includes any non-residential property used solely for business purposes.
Investing in commercial real estate is very different from residential real estate investing so before you can start calculating potential profits of a CRE deal there are many things to do and know about this alternative type of investing.
It’s wise to spend time educating yourself early so you can make the smartest decision possible as you continue building and securing your financial house. Here we’ll dive into the following to help you begin (click on any bullet point item to jump to that topic):
- The different types and classifications of commercial properties
- Benefits of owning CRE
- Drawbacks to CRE investments
- Commercial real estate lingo
- Financing basics/options
- Tough questions to ask yourself
- Assembling a team of experts
- Research and inspection of properties
- Completing your due diligence
There are different types of commercial real estate investments, and each can be further classified based on characteristics including purpose, size, location, and kind of construction.
Here are some examples of CRE properties.
1.Retail/Restaurant. As a commercial real estate investor, you can focus on strip malls, regional malls, downtown storefronts, grocery stores, drug stores, and more. Have you thought about buying a restaurant, pub, or specialty retail store? Those are a few commercial businesses you might consider purchasing with a property.
2. Office Buildings. You can invest in a small office building, a high-rise office building, or in a multi-building office park. One of the benefits of this type of investment is that many have triple net (“NNN”) leases. In this type of contract, the tenants pay you a fixed rent, and they are also responsible for insurance on the property, real estate taxes, and all maintenance and repairs.
3. Industrial Properties. Commercial property investors can also consider manufacturing facilities or warehouses. Some of these properties have large customized buildings for special use, while others may have mixed uses and include office space.
4. Multifamily Housing. Whether you are looking at a 5-unit apartment building or an apartment complex with hundreds of units, these are popular properties with many CRE investors.
5. Land Investments. Farmland, vacant land, or land being re-purposed are examples of commercial real estate land investments you can consider investing in.
6. Miscellaneous. There are plenty of other CRE properties that people invest in including self-storage facilities, gas stations, ice skating rinks, golf courses, hotels, and ice cream stands.
Classifications for Commercial Office Buildings
A classification rating system helps investors, landlords, tenants, and real estate brokers identify and compare commercial office buildings. These classifications are subjective and may vary greatly between geographic locations, and between landlords and tenants.
These A, B, and C classes are based on parameters such as building age, technology, quality of mechanical systems, location, infrastructure, on-going maintenance, and building services and amenities. Possible amenities include restaurants, coffee shops, or food courts, fitness centers, copy, mail and shipping services, or childcare centers.
- Class A – Think latest and greatest. The newest, most modern spaces on the market, with top-notch amenities and state of the art technology. Highly sought after space in central business locations. Tenants typically include banks, law firms, advertising agencies, large accounting firms, etc.
- Class B – Think more sensible but still very nice and functional. Comfortable spaces, possibly former Class A buildings, at a more favorable price just slightly outdated.
- Class C – Think out-of-date, rough but useable space. Economical commercial space with no (or very few) amenities.
Note: The benefits of owning commercial real estate described below are generalizations. Every potential property has specific traits that need to be considered on its own merits.
CRE investors are in the business of making money, and commercial properties can have some advantages over residential real estate.
- The potential for greater cash flow and reduced levels of risk. If you purchase CRE with multiple units, you have more tenants paying rent. So, if you lose one tenant, you still collect rents from the other tenants – unlike renting out a single-family home. This can help to reduce your risk when you have vacancies.
- Tenants may take better care of your property. If you purchase a strip mall or a building with a retail store or a restaurant, the businesses renting from you want to attract customers to make a profit. This may benefit you because they will focus on keeping up your property.
- Longer leases can stabilize cash flow. Other than multi-family properties, CRE leases tend to be longer which helps with the stability of your cash flow. It may also be easier to remove non-paying tenants in CRE investments than to evict people in residential housing.
- Less competition. If you decide to invest in the commercial real estate market, you may face less competition from other investors. Higher upfront costs and a lack of experience and knowledge will keep many from investing in CRE.
Commercial real estate investing, when researched and planned well, can be a significant way to build financial wealth.
Note: The drawbacks of owning commercial real estate described below are generalizations. Every potential property has specific traits that need to be considered on its own merits.
Even though owning commercial real estate has many benefits over residential real estate investing, there are disadvantages you need to consider too.
- It will likely cost more money. If you need financing for your CRE purchase, you’ll need to find lenders offering commercial loans. You can also expect to put more down for the property – possibly 30% or more of the purchase price. With larger properties, your capital expenses are higher; there is more equipment to purchase and more to repair. With greater use, CRE property brings higher maintenance costs too.
- It will likely take longer. When comparing CRE investing to residential RE investing, most things take longer to complete. Researching and inspecting properties is months long versus a few days or weeks. Finding and approving tenants will usually take longer. Any repairs, build-outs, or renovations will typically take longer as well. However, the typical commercial lease is longer too. Staying patient is key.
- There’s a greater chance of legal issues. Along with higher costs from more traffic comes a greater chance of legal problems too. It will be essential to have adequate insurance and to have a lawyer who understands CRE to advise you.
- So many rules and regulations. This is another reason to surround yourself with a team experienced with CRE’s if you choose to invest in one. In addition to your attorney, using a realtor with commercial property experience and an experienced accountant can make owning the property much easier.
Many who purchase commercial real estate also use professional property management services rather than managing the property themselves. You’ll want to consider this in your financial planning for the property.
Commercial real estate investing is also more vulnerable to downturns in the economy, and the sale of CRE can also take a long period of time because the properties appeal to a smaller investor demographic.
There are many commercial real estate terms you’ll benefit from knowing if you decide to invest in CRE. Here are a few to start with:
- Build-Out: Construction or improvements to the interior of a space; may include flooring, walls, finished plumbing, electrical work, painting, etc.
- Capital Improvement: Significant physical development or redevelopment of a property to extend the life of the property; may include upgrading of building mechanicals, replacement of the roof, renovations of common areas, or refacing of building exterior.
- Capitalization Rate (Cap Rate): Income of the property divided by the total value of the property. Cap rates can be used to roughly estimate how quickly an investment will pay for itself. A higher cap rate is better when you’re the buyer.
- Cash on Cash Return (CoC): Annual income over how much you actually invested. The amount invested may be no more than the amount of your down payment
- Common Area Maintenance (CAM): Additional rent charged to tenants, in addition to base rent, for maintaining any common areas of a property shared by building tenants; may include outdoor lighting, sidewalks, snow removal, parking areas, insurance, property taxes, etc.
- Debt Service Coverage Ratio (DSC) or Debt coverage ratio (DCR): Operating income over total debt. Basically how much debt you’ll cover each year with income received.
- Gross Lease: Property lease whereby the landlord (i.e., lessor) pays for all property charges usually included in ownership; may include utilities, taxes, and maintenance, among others.
- Loan-To-Value (LTV): A ratio of how much money you’re asking to borrow versus the total value of the property you want to purchase.
- Loss Factor: The percentage of gross space area lost due to walls, elevators, escalators, etc.
- Net Lease or Triple Net Lease (NNN): When a lessee pays additional expenses on top of their fixed rent it is considered a net lease. A single net lease typically includes property taxes in addition to rent. A double net lease usually involves paying property taxes and insurance premiums plus rent. And with a triple net lease (NNN), the tenant pays taxes, insurance, and maintenance expenses in addition to fixed rent and utilities.
- Net Operating Income: Net operating income (NOI) is a calculation of all property revenue minus any reasonable and necessary operating expenses, excluding loan principal and interest payments, capital expenditures, depreciation, and amortization.
- Percentage Lease: This type of lease may be used in retail settings where the rent is based on a percentage of sales volume made on the property premises. Often there is a clause for a minimum rental amount to be paid.
- Real Estate Investment Trust (REIT): A specified company that allows individual investors to buy shares in commercial real estate portfolios. These CRE portfolios receive rental income from a variety of property types such as apartment complexes, retail shopping centers, and office buildings. The REIT owns the property, leases the space, collects the rents from tenants, and then distributes income as dividends to portfolio shareholders.
- Return on Investment (ROI): ROI is a term used in accounting to indicate the percentage of invested money recouped after deductions for associated costs. For further explanation as to how it’s used in real estate investing see this article from Investopedia.
- Tenant Improvements: Interior work done within a rented space. Depending on terms of the lease, these improvements may be paid for by the landlord, tenant, or some combination of both.
- Usable vs. Rentable Square Feet: Usable square feet is the wall to wall area you occupy for your business. If you were to lease an entire floor of a building, it would include the hallways, restrooms, lobby area, etc.. But, if you do not occupy an entire floor, it does not include the common area hallways, lobbies, restrooms, storage rooms, etc. Rentable square feet is the usable square feet plus a percentage of the building’s shared space or common areas.
- Vacancy Rate: Percentage of properties that are vacant in a specified time period in a given area.
Commercial property loans are not generally made out to individuals but instead to business entities – corporations, S-corps, LLCs, developers, limited partnerships, funds, trusts, etc. For newer businesses who may not have a lengthy financial record or credit rating, the lender will likely require a guarantee of the loan by the entity owners or principals.
There are several types of commercial real estate loans available, but here are some options you might consider.
Traditional Commercial Mortgage
Most CRE loans are typically made by banks, to entities with strong credit scores and histories. Similar to residential mortgages, the commercial loan is secured by the purchased property.
These loans offer competitive interest rates, while terms may vary widely between lenders. Some financial institutions may make fully amortized loans with terms up to 25 years and loan-to-value ratios up to 80%, but more likely in the range of 65-75%. Other banks may make interest-only loans with shorter terms and loan-to-value ratios. Beware of penalties for paying off these types of loans early.
SBA 7(a) Loan and SBA 504 (or CDC) Loan
The Small Business Administration guarantees these loans made by banks to small business owners. SBA financing is available for an owner-occupied property – you’ll need to own a business you can move into it, occupying at least 51% of the property.
7(a) loans generally offer more flexibility on terms and potentially lower down payments compared to other financing options. They’re available in amounts up to $5 million to: purchase new land (including construction costs), purchase or expand an existing business, fund startup costs, repair existing capital, refinance existing debt, and purchase machinery, furniture, fixtures, supplies or materials.
According to the SBA, 504 loans can be used to purchase land, existing buildings, or long-term machinery and equipment, make improvements, build new facilities or modernize, or renovate or convert existing facilities.
CMBS loans or conduit loans are commercial mortgages pooled with similar loans, and packaged into bonds for sale to investors on the secondary market. These loans are known for their less stringent credit requirements and often come with fixed-rate terms of 5, 7, or 10 years.
Soft and Hard Money Loans
Hard money loans are asset-based loans secured by the value of a real estate property, often at higher interest rates and shorter terms than traditional commercial mortgages. They are typically utilized to quickly finance deals in the interim while negotiating a longer-term traditional or SBA bank loan. These “bridge like loans” are made by private companies making them easier to qualify for and faster to fund than a traditional mortgage but at higher down payment requirements.
Soft money loans are a cross between hard money loans and traditional mortgages. Soft money lenders will look for creditworthiness and a strong application but be less stringent than traditional mortgage lenders. Which means you can get a lower interest rate and down payment, and longer terms than you would with a hard money loan.
Before jumping into commercial real estate investing there are many things to consider. After reviewing the information covered above, ask yourself these questions:
- What are you looking to use the commercial real estate for? A building for your own business, property to rent out, several units to build a portfolio, and/or something else entirely?
- What type of CRE are you looking for?
- If you’re looking for CRE for your own business, do you need to purchase a building or could you lease a property?
- How important is the location of the property?
- How will you finance the property? Do you have ample cash for down payments, business filings, is your credit history strong?
- Are you willing to consider a partner for the purchase of a property?
- What knowledge and skills do you currently have and what will you need to learn to be successful?
- Do you have time to commit to the property? How much?
- How much work and money are you willing to put into a property?
- Are you willing and able to handle the responsibilities of being a landlord?
- Or will you use a property manager?
- What experts do you currently know who might be good members for your team?
- Finally, are you mentally and financially ready to make a sizeable investment of your time and money in a CRE?
Commercial real estate investing can be a complicated process. So hiring experts to assist with some of the steps may be prudent for success. Who you need may depend on the type and size of the CRE you are considering.
Minimally you’ll likely want to have a commercial realtor and broker, and an accountant, and lawyer specializing in commercial real estate on your team. Additional experts to consider include, appraisers, tax experts, building engineers, architects, environmental specialists.
Once the property is purchased, you may also need assistance with construction, marketing, leasing, maintenance, and more. While there are things you can likely learn and do on your own it may be wise to hire an expert instead; saving you money in the long run.
When you’re ready to view properties, assemble a list of items to consider for each property you see. Some ideas are listed below:
- What is the property type and classification?
- How is it currently being used?
- What other ways can it be used? How can’t it be used?
- How much rent/income is the property currently generating each year?
- What are the current annual operating costs and what taxes are on the property?
- What is the vacancy rate?
- Are there any items in need of repair or replacement soon?
- Why is the owner selling?
- How long has the property been on the market?
- Is the area around the property progressing or regressing?
- Any significant upcoming changes for the neighborhood?
As you view properties and narrow down your options you’ll want to perform thorough due diligence on any CRE you’re interested in submitting offers for. This will help you verify the property is a sensible investment option. You’ll want to ensure you know as much as possible about the property, immediate area and neighborhood around it, current owner, and deal.
This is not a time to skimp on hiring experts as needed. Having as much solid and reliable information as possible before signing a contract will be worth the expense. In addition to researching and inspecting properties, you’ll want to :
- Analyzing comparables – Generally, when finding comps, choose properties with square footage no more than 10 percent higher or lower than the property you have an interest in buying.
- Do the math – Being a successful investor in commercial real estate, requires understanding several formulas such as:
- Net Operating Income: A calculation of all revenue and costs from a property, before taxes. Expenses may consist of property taxes, insurance, utilities, maintenance, repairs, property management, and janitorial fees.
- Cap Rate: A calculation of the value of an income producing property. Basically, it’s the ratio of net operating income to property value.
- Cash On Cash: A calculation – net operating income divided by initial cash investment – providing a rate of return on real estate transactions.
- Know the zoning, occupancy, and environmental ordinances/requirements
- Understand the financing requirements
Proper due diligence will help prevent making these mistakes in commercial real estate investing.
Many people buy a single-family house or a duplex to rent when they begin investing in real estate, while others might try flipping a house. However, investing in commercial real estate may offer a higher earning potential – if you can find the right deal.
As long as you are in a financial position to purchase a commercial property, understand the risks, and have management in place if you need it – CRE investing may be a terrific way for you to diversify your investments.
In addition to sources and articles linked above, information was also gathered from articles found at FortuneBuilders.