Published on Monday, March 19, 2018 by Land Century
When you think of real estate investing, commercial property is usually the first thing that comes to mind. After all, commercial development is where the money is at. As lucrative as it may be, commercial property is not the type of investment you want to dive head-first into without an education.
How Commercial Real Estate Investing Works
When people invest in commercial real estate, they're investing in real property, and that property is used to generate a profit.
Commercial real estate can include:
- Apartment complexes
- Shopping malls
- Industrial property
- Office buildings
- Medical centers
Any property that is used for commercial purposes, or to run a business, is considered commercial property.
Investments generate money in two ways:
- Leases, which generate rental income
- Appreciation of property value over time
Finding property in an in-demand area is the key to making a smart investment.
The Pros and Cons of Commercial Property Investing
Any kind of property – whether commercial or residential – can be a good investment. But in most cases, commercial properties offer a better return on investment. Still, there are drawbacks that need to be considered. Before you make a decision on whether to invest in commercial real estate, you should understand the pros and cons.
The Pros of Commercial Real Estate Investing
There are plenty of benefits to investing in commercial real estate. These include:
The most obvious advantage is income potential. With commercial real estate, the income-generating potential is generally much higher than with residential property investing.
Commercial properties typically have an annual return of 6%-12%, depending on the location. Single family home properties usually have a return of 1%-4% at most.
Fewer Active Responsibilities
Residential properties usually require more hands-on management. As a landlord, you're on the hook for maintenance and other management responsibilities 24/7.
With commercial properties, your tenants will typically only be on the premises during business hours: 9am-5pm. Property insurance and maintenance may also be the responsibility of the tenant, depending on the commercial lease. These are called triple net leases, and they're favored by larger brands that want to maintain a specific image, such as Starbucks or Walgreens.
Commercial tenants will be more likely to sign longer leases, which will save you the hassle of having to find tenants on a regular basis.
Better Financing Terms
Financing terms are usually more favorable and flexible for commercial tenants. Some owners can obtain 100% financing on a first or second mortgage, which is something you can't do with residential properties.
The relationship between commercial property owners and tenants is usually a professional one. You're dealing with a business – not a family or individual. Interactions are usually more courteous and professional as a result.
Better Price Evaluation
Commercial property is usually easier to evaluate in terms of pricing because you can see the current owner's income statement. That statement will give you a good idea of a fair price for the property.
With residential properties, pricing is usually based more on emotion than anything else.
The Cons of Commercial Real Estate Investing
While there are plenty of advantages to investing in real estate, there are also some disadvantages that need to be considered.
Do-it-yourself property management may be okay with a residential property, but you'll need to hire a professional to manage a commercial property. Special licensing is typically required to handle the maintenance tasks associated with commercial real estate.
What happens if you get stuck with a bad management team? If they slack on their responsibilities or treat tenants in an unprofessional manner, this can reflect badly on you as a landlord and may even get you in legal trouble.
The fact that you have to hire a professional to manage the property may also be a disadvantage to some investors. Hiring a management company comes with added expenses and other concerns that you wouldn't have with a residential property.
Property management companies usually charge between 5% and 10% of the rent revenue in fees.
Commercial real estate can be fiercely competitive, depending on your location. With more competition, you may wind up paying a lot more for property than you had anticipated.
Unlike with residential properties, commercial properties have public visitors. The more public visitors on the preemies, the greater the risk of someone getting injured. Liability concerns may be a turn-off to you as an investor.
Big Initial Investment
By nature, commercial real estate is more expensive than residential real estate. That means you'll need to make a bigger initial investment.
The large initial investment makes it difficult for some investors to get their foot in the door with commercial real estate.
How to Secure Good Deals
With any real estate investment, being able to spot a good deal is the key to finding success. The top real estate professionals know exactly what to look for when combing through properties.
First, make sure that you have an exit strategy. A good deal is a deal that you know you can walk away from.
Along with having an "out," you also want to learn how to properly assess a property. Know how to look for damages and estimate the cost of repairs. Learn how to assess the risk of investing in each property you look at. And don't forget to estimate the costs of buying and managing the property to make sure it fits your financial goals.
As for finding a good opportunity, that part is more of an art than a science. But if you're just getting started, you'll want to look at the neighborhood the property is located in. Is the area in high demand? Is the local economy thriving, or slacking?
Talk to neighbors. Get a feel for the area. Trust your instincts.
When evaluating a property, there are a few things you can look at to assess its value:
- NOI (Net Operating Income). This is calculated by subtracting operating expenses from the first-year gross operating income. You only want to consider properties with a positive NOI.
- Cash on Cash: This involves comparing the first-year performance of nearby competing properties.
- Cap Rate: A property's capitalization rate can be used to calculate the value of the property. This method is often used when evaluating apartment complexes and small strip malls.
How Commercial Properties are Sold
Commerical properties are sold much in the same way residential properties are sold. But instead of considering the wants and needs of families and individuals, you need to consider the investor's perspective.
What type of buyer are you aiming for? Someone looking for a 100% turnkey property, or someone who wants to make improvements on the property?
The purchase process may take longer than with a residential property, and the evaluation process is certainly more complex. But generally, properties are sold in the same way any other real estate property is sold.
If you're thinking of investing in commercial real estate, weigh the pros and cons carefully and take the time to educate yourself on the process. When it comes time to search, look for sellers who are motivated and ready to sell for less than the market value of the property. Unmotivated sellers are far less willing to negotiate, which will make it harder to secure a good deal.