Commercial Real Estate Investing: The Ultimate Guide

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Commercial real estate investing offers an attractive avenue for those looking to diversify their portfolios with income-producing assets. Unlike residential real estate, commercial properties include office buildings, retail spaces, warehouses, and multifamily apartment complexes, each with unique profit potential and risk profiles.

Investing in commercial real estate can provide steady cash flow through tenant leases, tax benefits, and long-term appreciation, often appealing to investors seeking reliable income sources. Whether you’re considering direct property purchases, Real Estate Investment Trusts (REITs), or crowdfunding platforms, understanding the fundamentals of commercial real estate investing is essential to making the most of this dynamic asset class.

What Is Commercial Real Estate?

Commercial real estate (CRE) investing refers to having a stake in a property to generate a profit. This differs from residential real estate investing, in which a purchased property is used for living. Commercial real estate is a business-oriented venture.

Income from commercial real estate is produced in one of the following two ways. The primary source is rental income, in which property owners charge their tenants for renting or leasing their properties.

The other income source comes from capital gains. An owner realizes these after their property value appreciates over time and they sell it for more than what they initially paid for it.

How Does Commercial Real Estate Investing Work?

In commercial real estate, investors purchase certain properties designed for business, such as retail space, warehouses, or offices. They may also obtain multifamily residential buildings like apartment complexes, condominiums, or townhouses.

Owners earn income by charging their tenants monthly rent. Over time, the properties appreciate, increasing owners’ equity. At a certain point, they may decide to sell their buildings for profit, earning capital gains.

An investor can approach CRE in different ways. The most common is direct ownership. This involves you buying the property, making renovations as needed, finding tenants, and collecting rent.

Another approach is a real estate investment trust (REIT), which is a company that owns or finances properties like mutual funds. REITs are traded on the stock market, so anyone can buy shares without the responsibilities that come with direct ownership. Investors can also become members of investment groups and syndicates that hold multiple properties.

Types of Commercial Real Estate

Commercial real estate investors have a diverse range of properties to choose from, such as:

• Multifamily Residential Properties: Apartment complexes, high-rise condominium units, duplexes and other developments that house multiple families are prime CRE opportunities.
• Office Buildings: These are properties designed to be workspaces for businesses. They include high-rise skyscrapers in the city, units in smaller suburban areas, and everything in between.
• Retail Properties: Retail properties house businesses that sell goods and services to customers. They include shopping malls, strip malls, big-box merchandisers, and freestanding shops.
• Medical Buildings: Medical buildings are equipped for healthcare providers and practices. They include structures like examination rooms, labs, waiting rooms, and imaging centers. They also encompass other areas unique to medical services.
• Special-purpose Properties: Some buildings are designed for specific uses. Examples include airports, religious centers, courthouses, car washes, theaters, prisons, amusement parks, bowling alleys, gas stations, and numerous others.
• Self-storage Facilities: Multiunit buildings for individual or group storage of belongings are steady income producers. Commercial property investors are drawn to self-storage facilities for their low upkeep and maintenance needs.
• Hotels and Hospitality: Any building or property that provides temporary lodging and services is a viable investment option. Besides hotels, this category includes resorts, bed and breakfasts, vacation rentals, motor inns, and motels.

Benefits of Commercial Real Estate Investing

Commercial real estate offers many benefits for investors, including:

• Higher potential income from rent or lease payments
• Predictable revenue streams for consistent cash flow
• Less competition than residential real estate investors
• Chance for longer lease agreements, which can reduce turnover and increase income reliability
• Opportunities for business-to-business networking and relationships

Commercial real estate offers a compelling investment path with the chance for many returns.

Risks of Commercial Real Estate Investing

Before getting into commercial real estate investing, consider these potential drawbacks:

• Credit and default risk from late or absent tenant payments
• Market volatility caused by decreasing values or economic conditions
• Inflation affecting operational expenses, vacancy, and rising interest rates
• Less liquidity than other investments

Be mindful of other risks that could hinder the possibility of profits.

How to Start Investing in Commercial Real Estate

Are you ready to jump into commercial real estate investing? Here are a few steps and considerations to take to get in the game.

Understand How Commercial Real Estate Investing Works

On the surface, commercial real estate investing looks fairly simple; you buy a property, find tenants, and charge them rental or lease payments. Within that framework, though, you encounter several complex concerns.

The first step is deciding on a specific investment strategy. Researching and learning all you can about market trends, property types, and vacancy rates is also key. Lining up financing — via bank loans or private lenders — is crucial before buying a property.

After making the purchase, you’ll decide what kind of management structure you want. This can be defined in the lease. You may decide to hand those duties to a property management company or oversee them all yourself.

While the property is under your control, you’ll collect tenant rental and lease payments. When it’s time to sell, the hope is that your property has appreciated to the point where you can sell it for a healthy profit.

Create an Investment Strategy

The most important step to take before investing is to decide what approach you’ll take. Without a strategy in place, you may make unforced errors or market miscalculations that could jeopardize your investments. Key components of a solid investment strategy incorporate the following:

• Know your Goals: Do you seek steady income from rental payments or eventual capital gains?
• Know your Risk Tolerance: Are you happy with low-risk investments with steady returns, or are you looking for more risks and higher returns?
• Learn More about the Market: Research property types, current values, market trends, and other dynamics that drive your investment plan.

It’s also crucial to set a reasonable budget and find financing opportunities. When doing so, consider operational expenses, how much you expect to make, and what support you need to be successful.

If direct ownership isn’t for you, there are several other options for commercial real estate to consider. These include:

• Real Estate Investment Trusts (REITs): More liquid than most other options, REITs must pay shareholders regular dividends, so passive income is expected.
• Crowdfunding: This option often has lower investment minimums for more diverse sources and can bring passive income because the ownership is fractional.
• Rental Properties: You control rental rates, tenant selection, and more.

With rental properties, you have the option of passing those responsibilities to a property management company.

Conduct Comparable Analysis

Comparable analysis or “comps” are critical to several real estate disciplines. Investors find recently sold properties similar to the ones they’re considering for investment. Commonly compared data include:

• Property type
• Location
• Size
• Age
• Condition
• Features

One rule of thumb for finding properties dictates that a comparable property’s square footage should be within 10% of the main property you’re considering — no more, no less.

Know Success Metrics

Three key metrics measure success in commercial real estate investing. The first is net operating income (NOI). Monitoring operating expenses allows investors to compare potential income generation across properties. A healthy NOI gives investors a better chance of finding financing for future deals.

The second is the capitalization rate. Divide your NOI by the purchase price of your investment. The result, expressed as a percentage, is your cap rate, a key metric in evaluating a property’s income potential.

The third metric for success is cash-on-cash, and it is derived by dividing your annual after-tax cash flow by your total cash investment. A high result indicates higher returns and gives a clear idea of the financial benefit.

Have Cost Contingencies

Cost contingencies are built into commercial investment budgets as buffers that cover unexpected property costs, like building delays or cost overruns. For newly built investments, an allocation of 5% to 10% of the budget should serve well as a cost contingency amount, while older properties might need slightly more.

Cost contingencies are often confused with capital reserve funds, which also set aside money to defray certain expenses. However, capital reserve funds address what is expected — issues that the ownership group knew about at purchase time. Cost contingencies address surprise expenses.

Manage and Monitor Your Investments

Investors must regularly track and measure their investments for long-term success and profitability. One is through financial capability. Operating expenses, rental income, and cash flow, all impact your return on investment. This allows you to make more meaningful budget and financing decisions.

Another tracking method is access to capital. Lenders want to be assured of your investment property’s viability and value. Tracking your property’s financial performance and monitoring issues before they become emergencies may open up capital funding.

A third way to measure your success is through the investment type. Compare your property’s performance using standard industry benchmarks and milestones. Keep an eye on market fluctuations, vacancy rates, and other market events that affect your property type.

Types of Commercial Leases

Commercial leases list terms and conditions for business use in an investment property. They’re more complex than residential leases because there are more roles to fill, including owners, tenants, third-party services, and more. Here are four of the most common commercial lease structures:

• Triple-Net Lease: This lease is favorable for hands-off investors because the tenant is responsible for operating expenses on top of rent. Such expenses may include insurance, maintenance and taxes. Tenants often receive a lower base rent in exchange.
• Single-Net Lease: In a single-net lease, the tenant handles base rent and only one other expense — usually property taxes. The property owner pays the remaining expenses.
• Modified Gross Income: In this flexible lease agreement, property owners and tenants share operating expenses more evenly. The tenant’s share is frequently calculated as a percentage of their modified gross income, the rental revenue paid by all tenants combined.
• Gross Lease: In a gross lease, the landlord or owner takes responsibility for all operating expenses, which include taxes, insurance, maintenance, and utilities. The tenant’s rental rate, generally a bit higher than other leases, covers those costs. For owners, a gross lease supports consistent, guaranteed income.

Get Started With Commercial Real Estate Investing

From multitenant residential units to business and mixed-use developments, access to commercial real estate investments is wider than ever. Private investors can diversify their holdings and realize gains with a few basic strategies for success.

Frequently Asked Questions