How to Get Started in Commercial Real Estate Investing
Commercial real estate surrounds us. In fact, you might be reading this blog in a commercial property. Are you in an apartment, office or coffee shop? These are all examples of commercial real estate (CRE), and someone (or an entity such as an LLC) owns that property. Investing in CRE offers several advantages over residential—especially the possibility of building passive wealth. If you’ve been thinking about investing in commercial, then read on for a basic understanding of what can be a valuable addition to a diversified portfolio.
What Constitutes Commercial Real Estate?
According to dictionary.com, the definition of commercial is anything prepared, done or acted upon with the “sole or chief emphasis on salability, profit or success.” Therefore, commercial real estate describes a property used to generate a profit. Examples include office buildings, retail centers, healthcare facilities, warehouses, multifamily housing and land on which any these will be developed.
How Do I Know If a Commercial Property Is Right For Me?
Before beginning your search, know your goals. Then, as you visit properties that are for sale—and you should tour many—you’ll be able to rule out those that aren’t a match. Answering the following questions will help.
- What type of property are you in the market to buy?
- Do you plan to use the building for your own business or rent to tenants?
- What kind of location are you looking for?
- Is the price within your budget when you consider your position as concerns cash, financing and down payment?
- Do you plan to manage the property or hire out that responsibility?
- How much risk are you willing to bear?
- Are you ready to be a landlord and make a sizable purchase?
Ultimately, you want a property that is in accord with your goals in terms of price, location, use and investment needs.
How Can I Profit from Owning Commercial Real Estate?
There are two main ways to gain a profit from owning commercial property: leasing the property and charging tenants rent in exchange for use, and secondly through the property’s appreciation in value over time. Let’s take a closer look at both.
The rent that commercial tenants pay provides property owners with a fairly reliable and consistent stream of income. There’s also the advantage of probably having several tenants, because if one falls on hard times, you’ll still have income from the others.
In addition, commercial properties tend to have longer leases than, say, a single-family home, so they provide income month after month for several years. And when the time comes to renew the lease, an increase in rent may be warranted… which brings us to the second way commercial real estate bears a profit.
Over the time of ownership, the value of property tends to appreciate. Of course, there is no guarantee; unforeseeable events can occur. Nevertheless, every piece of real estate is unique and land is a scarce asset—they’re not making more of it, as the saying goes. If your property is located in a busy urban environment, then that scarcity drives demand up. When demand for property in your area increases, tenants will likely be willing to pay higher rent. Also, a buyer will have to pay you more than your original purchase price when you’re ready to sell.
How Do I Know If a Commercial Property is a Good Deal?
Finding a good deal is both an art and a science. For example, in addition to evaluating the property itself (Are repairs necessary? How much will you have to spend to maintain the property?), you also need to consider the neighborhood. Look around and talk to business owners nearby. If there’s strong demand for the area and a robust local economy, then chances are you’ve found a good opportunity.
In addition, there are formulas you can use to help you assess commercial real estate.
- Net Operating Income (NOI) is a measure of a real estate investment’s profitability. NOI equals all income collected from operations minus all expenses from operations. Obviously, you should consider properties with a positive NOI.
- Cap or Capitalization Rate is the ratio of NOI to current market value or sales price. It is used to measure the potential return on a real estate investment or to determine the market value of a property. Expressed as a percentage, lower cap rates indicate that the overall risk and return on investment are low, and higher cap rates represent high risk and return.
- Cash on Cash Return (also called the equity dividend rate) equals annual before tax cash flow divided by total cash invested. Investors that finance to purchase real estate use cash on cash to measure the return on cash invested, which presents a more accurate evaluation of an investment’s performance.
Finally, if you are thinking of buying commercial real estate, take your time. Educate yourself. Talk to people you know that are already in the business of buying and selling commercial property. Learn how to spot a motivated seller who is willing to negotiate. Start building relationships now, and you’ll be ready to act when the right property comes along.
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.