Commercial Real Estate Investing 101: Your Best Bet for Investing
Commercial real estate (CRE) can be a safer bet for an ambitious investor than many other types of investment. Stocks can be flighty and have little more success than gambling. Venture capital can be even more risky and take a long time to net you even a cent. Even in real estate, a residential property could easily cost more than it makes and have limited ROI. By contrast, CRE can have returns that rise to skyscraper heights, and it serves tenants who are responsible and established, with their livelihoods tied up into their workspace.
However, it’s important that you begin investing with a strong, knowledgeable foundation to keep growth stable as you climb higher.
Types of Commercial Real Estate Properties
Start by knowing everything about the businesses that will use the property you’re considering investing in:
The most common type of commercial real estate that might come to mind are multifamily buildings like apartments and condos, and with good reason. It can be a very directly managed type of investment and requires (relatively) little industry experience, because the model is so simple. Buy the big box, rent out all the little boxes inside, and pay a staff to maintain all the pieces of it, along with some other occasional expenses. It can begin paying out right away, especially when you can achieve 0% vacancies. While they can certainly be expensive upfront, financing it is feasible as various renters also pay month to month. And with so many tenants, you aren’t putting all your eggs in one basket.
Office complexes and parks are also strong contenders for simple commercial real estate investments, because they offer the same arrangement as multifamily properties, just on a larger scale. They tend to require more staff, from security to front reception and cleaners on every floor, but there are both high and low-end options depending on your budget. The units have more square footage to heat and maintain. The rents are larger, so tenants have to be have good income prospects. The length of leases is usually longer since continuity is even more important for businesses. Also, the length of vacancies can drag out longer because while residential renters are always scrambling for any spot they can, businesses tend to be more cautious, with multiple people reviewing spending and analysts working out profit-and-loss potentials.
Those simple scenarios represent a plurality of investment properties, but don’t limit your options. Every structure dedicated to operating a business is a potential investment. Warehouses, retail spaces, medical offices, and hotels all have relatively easy-to-understand business models, and tenants can be left to their own devices to profit and get you your rent on time. There might be some special accommodations depending on the business, like space for delivery trucks, different heating for front and back-of-house, and higher voltage hookups, that it would be wise to be educated on before signing a contract for such a property, however.
Specially Regulated Commercial Properties
There are also special property types that may have extra regulations, including everything from gas stations and bowling alleys to churches and mobile home parks. There are opportunities everywhere, but the more specialized the property, the more know-how you need to make a sound investment and to manage the property in a profitable manner. Do you know how to inspect whether farmland is of a high enough quality for an independent tenant to succeed and keep making rent? Do you know what the incomes of people in the area of a gas station are and their public transportation options, and what an increase in gas price will do to its ability to turn a profit? Keep such questions and possibilities in mind as you educate yourself on an industry’s worth of investment properties. Because the barrier to entry is higher, it also keeps competition for such properties lower, and once you specialize you can dominate a local area for such businesses.
Benefits of Investing in Commercial Real Estate
Commercial real estate may be one of the most profitable forms of investments there is, but the benefits don’t stop at having a high number. Other benefits include:
High Liquid Cash Yield
Every tenant, every month, every year. With assets secured by firm leases, you get your money in a spendable and investable form on a predictable and consistent basis. This keeps you agile, solvent, and able to respond to the market quickly, far better than dividends of most stocks.
There’s a reason for the word “real” in real estate. This tangible building and its physical location hold intrinsic value, even during downturns. It can’t melt away like a stock value, or be influenced by such wishy-washy elements as “confidence.” With a careful selection of investments, you can be spared from most market volatility.
With active and proactive management of a CRE property’s attributes and ammenities, value can increase over time by your own actions. Investments into the investment, like putting in hardwood floor or marble countertops across units, can make a property even more valuable for tenants, allowing price increases along with the rest of the market.
Safe from Inflation
Whereas pure financial investments like stocks, bonds, and the old-fashioned savings account can be whittled away by the ongoing decrease in the value of a dollar, rental prices of real estate tend to increase across the board along with inflation.
From depreciation deductions and mortgage interest to writing off property repairs and more, there are numerous ways to shield your revenue when you invest in CRE.
Able to Finance Themselves
To sum up all the above points, you could say that commercial real estate gets you consistent cash that you can spend right now and is also protected against long term devaluation. With a predictable liquid revenue stream, you can make an educated deal to leverage your asset and borrow at a lower rate, profiting as you gain full equity.
Avoiding Risk in Commercial Real Estate
The benefits of CRE are massive, but of course there is some risk in any investment. Even investors new to the CRE game can avoid the worst of it by keeping aware of risk and scrutinizing every detail of a deal. It’s important to keep the longer timeframe of such deals in mind, since all but the most established investors will be giving up significant liquidity on these deals. Finance should also be on your mind – a commercial real estate property will ideally pay for itself shortly after purchase, in small monthly doses.
That all being said, here are a couple red flags that can help a new CRE investor keep out of risky deals:
- Poorly-Designed, Unclear, or Deceitful Valuation and Contracts
If you’ve spent any time investing in this industry, you have no doubt heard of its unicorn – the “triple-net property.” This term, when used truthfully, means a property wherein the tenant is responsible for:
- All operating expenses and taxes
- Insurance, including liability and casualty insurance
- All maintenance, from structure to mechanical parts, plumbing and more
This is obviously attractive for a buyer because that means they can keep every cent of rent they collect once the property is all paid for. However, this term, and many others like it, have been used and abused to the point where they are often little more than marketing speak, like “Premium,” “All Natural,” or “Original.”
What this example illustrates is the necessity of due diligence on your part – inspect every line of the contract and verify every claim. It’s a red flag when euphemistic claims are frequent, and hard facts and details are obscured in communications and documentations. In fact, by bringing a checklist of tough, unambiguous questions with you to your meetings with the seller, you can simply gauge their character from their reactions. Do they squirm, are they frustrated by them, are they eager to move on or simply lack clear answers to honest questions? Many bad deals can be avoided with a simple thorough look.
- A Building with a “Fixer-Upper” Situation That Can’t Always Be Fixed
Investors are fantastic optimists, but the best ones have a healthy dose of caution, too. A “fixer-upper” is a common sell in residential real estate, where amateur Property Brothers look for the best houses to flip. Though it’s unlikely that a dilapidated building will be in your crosshairs for CRE, it may have other less than ideal attributes keeping its price low.
However, it is a potential red flag when a seller is advertising an “undiscovered opportunity” and pushing you to move fast before you lose out. A diamond in the rough is no good in CRE, because it’s all about location, location, location, and the rough is part of the sale. You cannot guarantee an area in a downturn will gentrify soon because of one organic coffee shop, any more than you can guarantee that a main street restoration project will undo years of crime which has run rampant on property values.
Just as a home-buyer might consider elements like Walk Score, nearby school districts, and commuting options, as a CRE investor you should consider elements like local economic health, average area incomes, and current events in government and other news that could affect your investment. Price is only a starting point.
Financing Your Commercial Real Estate Investments
CRE investment isn’t the domain of only well-to-do corporations and beneficiaries of inheritance – as mentioned in the benefits section above, there are a wealth of financing options out there make this a feasible path to a much higher income bracket. There are a few things to know about financing before you dive in.
Amortization and Term
Rather than the 30-year fixed mortgage of a house, standard commercial real estate loans are from 5 to 20 years, and can amortize afterwards. Often this happens through “Balloon Payments,” in which a large proportion of the actual loan is paid back after a short period of much smaller payment chunks. This is based on the idea that you secure the asset up front, and then will profit massively from it, able to pay back a fairly high interest years down the road.
As with the mortgage of your home, typically the property asset itself is at stake should financing fall through. Obviously, it’s the entire reason for the enterprise, so protect it carefully.
Commercial real estate is often purchased by business entities formed to buy and sell real estate, instead of individuals. If you have formed such a company, it may not yet have a financial track record, requiring you as the entity owner to guaranty the asset, meaning your debtors can recover their losses from you should you default. Non-recourse loans are those in which the property is the only collateral, and protect you from additional collections in that case.
Loan to Value Ratio
This is the metric that determines how much you actually have to borrow against when buying a property, calculated as Loan Amount / Property Value. In commercial real estate, standards can hover around 60% - 80%, and the actual value will depend on third party appraisers. Different banks may have different standards, and it can be worth shopping around for.
Unlike many smaller consumer loans, a commercial real estate loan is typically locked in at its price (and the associated interest payments) by prepayment fees. This means you can be penalized for paying off the debt early. These come in a few forms:
- Defeasance is an arrangement that has you prepay using a cash flowing asset like Treasury bonds instead of cash, so the lender gets the same cash flow but you have another long term investment to pay off.
- Yield maintenance or breakfunding means you pay the same interest yield at early payment as if you had made all the scheduled payments to maturity.
- SWAP arrangements use a 3rd party called a “Swap Party” who actually owns the loan, who you pay and in turn they pay the lender. They typically charge massive fees without the same negotiation a bank might have if you try to pay back early.
The Bottom Line on Commercial Real Estate Deals
Commercial real estate is potentially one of the safer and certainly one of the higher-netting investments you can make, and it benefits from having a strong paper trail and lots of supplemental information that can be reliably interpreted for strong ROI. The risks involved are manageable, with the right attention to detail and reliable partners.
And with the financing options available, it is accessible to ambitious investors of all levels, but it is recommended to get some guidance. It’s one thing to know you can profit from a property, but quite another to secure the loans to make it happen over the long term at a fair, manageable rate. In this case, it’s best to rely on experts who are unaffiliated with specific institutions and interests, and therefore can always have your interests in mind. If you ever need help with this significant portion of a commercial real estate deal, we at Bellevue Capital Group are happy to guide you towards success.