How Can I Invest In Commercial Real Estate?
American economist Paul Samuelson once said, “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” Investing is not gambling; if you’re treating it the same, you are taking the wrong approach! While investing in commercial real estate is not as uneventful as watching the grass creep up on your lawn, it should be strategic, measured, and controlled. Unlike the extreme rollercoaster that is the stock market, the CRE space is, historically, far less volatile. The gains you can realize, however, are exciting.
What is Commercial Real Estate?
Commercial real estate is typically leased for business, retail, and hospitality purposes. It can involve existing buildings/structures and/or raw land purchased for development. Generally, CRE properties are categorized as follows:
- Hospitality (e.g. hotels)
- Special Purpose (e.g. nursing homes, gas stations, theaters, etc.)
Why Commercial Real Estate Is a Good Investment
Before we get into the how of investing in commercial real estate, let’s start with the why. This is an advantageous route for several reasons:
- It is ideal for long-term goals; generally, the longer you hold property, the more equity you build. Building future wealth and security is a top reason why commercial real estate is a good investment.
- Commercial real estate plays a key role in risk diversification. A diversified portfolio most often mitigates your risk.
- You can realize a multitude of tax benefits, such as deductions on mortgage interest, depreciation, operating expenses, and more.
- Higher potential income. Typically, commercial real estate properties have higher returns on investment (ROI). To compare to residential properties, which have an ROI of between 1-4%, commercial properties see an average of 6-12%.
- Turnover is less than residential properties. Given longer lease terms (3-5 years or, in some cases, more) mean you won’t deal with as much turnover. Be aware though that vacancies can hit harder, though, because of these same reasons.
- Consistent cash flow. Again, due to longer lease periods, you will see relatively consistent cash flow. And, with triple net leases, your tenants also pay the building’s real estate taxes, property insurance, and maintenance costs.
- The field is less crowded. Many investors perceive commercial real estate as difficult to enter. This tends to clear out the competition so you are not in as saturated a space.
How to Start Investing in Commercial Real Estate
To our last point, is investing in commercial real estate difficult - or, at least, more difficult than other investment avenues? You may not want to let your potential competition in on the secret, but no. Sure, it is challenging, as is all investment. But there is nothing that you cannot overcome when you do your due diligence, complete your homework, and work with a reliable, experienced strategic investment firm.
Here are 6 tips to help you start:
- Know the Key Differences Between Residential and Commercial Real Estate
As mentioned, due diligence and research is always the first step when investing in commercial real estate - or any other vehicle for that matter. It is essential that you understand the difference between residential and commercial properties; it’s step 1. Not only are you dealing with the needs of commercial clients, the structure of leases and income is also different. For example, leases are typically longer and the income you generate is usually tied to usable square footage.
You will also need to research location and tenant type. For example, corporate office space performs better - as expected - in urban centers rather than neighborhoods that are primarily residential.
- Look at Comparables
What’s going on in the area? Look at comparables and research any development projects that are in the works. You can get a sense of prices paid for similar properties to better determine the current market value of a property in which you are interested.
- Learn Key Formulas and Metrics
You’ll need to have a basic understanding of real estate finance, key formulas, and metrics for success. These include:
- Net Operating Income: NOI is a formula that is used to analyze the profitability of your investment. To arrive at the NOI, you subtract operating expenses from the total revenues a property generates.
- Capitalization Rate: Cap Rate indicates the rate of return you can expect to generate on a property. It is the ratio of net income and original price. A good cap rate is generally between 4-12%.
- Cash on Cash: This is a metric that looks at the rate of return on CRE transactions. It measures the return on your out of pocket case relative to the portion of the property that you finances.
- Be Aware of Common Mistakes When Investing in Commercial Real Estate
Knowing what not to do is equally important as knowing what to do. Mitigating risk is job #1. To do this, avoid common mistakes, such as improper valuations, failure to understand commercial real estate financing, failing to do your due diligence, and believing you can achieve better results (and save money) by working without the counsel of experienced investment strategists.
- Research Financing Options
There are a variety of commercial real estate loan options, each with its own eligibility requirements, terms, and advantages:
- Conventional Loans
- Hard Money Loan (secured by a real property)
- Commercial Bridge Loan
- Conduit Loan
- Small Business Administration (SBA) 7(a) Loan
- Certified Development Company (CDC)/SBA 504 Loan
Financing is complex; if you need assistance navigating your options, reach out to an experienced real estate investment and strategy firm.
- Working with a Trustworthy Partner
As mentioned, working alone can be detrimental to your success when investing in commercial real estate. Find a firm that can deliver personalized, targeted advice - and opportunities - that align with your investment goals. There is no substitute for experience and expertise in the CRE market. Working with a partner shortens the learning curve and allows you to accelerate your results.
Ready to Get Started?
Investing in commercial real estate is not an abandon-all-rules-and-go-to-Vegas proposition. While more exciting than watching grass grow, it tends to be more stable and long-game oriented than other investment vehicles. If this is the right fit for your portfolio, contact a strategic investment firm that can help you get started.