Factors to Consider When Investing in Commercial Real Estate
As with most investments, purchasing commercial real estate comes with rewards and risks. And for investors who have the money to risk, the rewards can be significant. However, before taking the plunge, you should understand the pros and cons of purchasing a commercial property. Read on to learn the basics so you can make an informed decision.
First of all, what is commercial real estate? These types of properties include retail buildings, office and industrial sites, warehouses, apartments and mixed-use developments that may encompass a combination of retail, office and apartments.
Advantages of Purchasing Commercial Real Estate
Higher Rents. We may be stating the obvious, but commercial property owners can charge higher rents than residential. Commercial real estate is often larger, centrally located near major roadways, and offers enhanced services. In addition, tenants leasing commercial space are in business to make money so they can afford higher rents. Thus, owning commercial real estate can lead to greater income potential.
Longer Lease Terms. Unlike residential leases that are usually six to twelve months, a commercial lease typically runs three to ten years. As a property owner, this can work to your advantage because you’ll have a steady stream of income for the duration of the lease. Most leases are now set up as NNN (triple net), which means that the tenant is responsible for its proportional share of taxes, insurance and common area maintenance of the property thereby preventing any uncontrollable costs to the landlord that would diminish the return.
Property Appreciation. Some commercial property owners choose to make little if any money on rent. They charge enough to cover operating expenses including taxes, insurance and maintenance. Then, they make money at the time of sale because the value of commercial property increases over time. Of course, this tactic depends on the economy. If there’s a recession, the value of the property could decrease.
Conscientious Tenants. Retail and business tenants have a sincere interest in maintaining the space they rent. The way a store or office looks speaks volumes to customers and clients. Therefore, commercial property tenants and owners are usually of a like mind when it comes to upkeep and improvements.
Things to Consider when Investing in Commercial Real Estate
Although there are certainly many advantages to investing in commercial properties, there are also aspects that you must consider when investing. Here are a few facts to keep in mind.
A large initial investment. Commercial property can be more expensive than residential and might involve large loans that could require recourse or personal guarantees. Therefore, more capital up front is usually necessary.
Costly maintenance. As buildings age, they will eventually need updating. Some examples would be a new roof or HVAC system. These kinds of repairs can happen unexpectedly and may require a significant outlay of capital.
Economic Volatility. Commercial real estate tends to be more vulnerable than residential when there is an economic downturn. If a tenant defaults, replacing the vacancy becomes imperative and can be very expensive. In most cases, a new tenant will require several modifications to the existing space.
Zoning. Commercial property is often strictly zoned for a particular use. For example, let’s say that a site is zoned for retail or office, but you want to rent to a tenant who does small-scale manufacturing. In this case, applying for a zoning variance can be costly, and there’s no guarantee that the zoning board will decide in your favor.
Property taxes. If the value of commercial property rises, so do the taxes. Raising rental rates may be one way to offset this expense, but this could lead to tenant turnover. This is an example of the advantage of a triple net lease. In this case, the tenant would be responsible for the increased expense.
Owning commercial real estate can be an excellent way to diversify your investment portfolio. Just be sure to consult with a qualified professional to guide you to the right decision.
The information contained in this article is general in nature and should not be construed as financial, tax or legal advice. As with any financial or legal matter, consult your tax advisor and legal counsel.