Commercial real estate — non-residential properties for industrial or business purposes — can be productive, wealth-generating assets for those with the means and knowledge to support the investment. However, it can only work if they strategize, prepare and understand the process, options and risks, which this guide will outline.
Investors flock to commercial real estate for its many pros, including:
-
Potential for higher returns compared to residential real estate
-
Steady cash flow from tenant rent payments
-
Opportunities for capital appreciation
-
Tax advantages like claiming depreciation and other special deductions
However, anyone considering an investment in commercial real estate must consider the following drawbacks.
-
Commercial properties are especially vulnerable to market fluctuations and economic downturns.
-
High vacancy rates and frequent tenant turnover can eat into profits and increase the likelihood of default.
-
High upfront capital requirements and maintenance costs.
-
Low liquidity — commercial properties can be hard to sell quickly, even by the standards of real estate, in general, and certainly compared to stocks or bonds.
Those considering commercial real estate investments have several options, depending on their budgets, risk tolerance, goals and strategies.
|
Property Type |
Benefits |
Risks |
Best For |
|---|---|---|---|
|
Office Buildings |
Consistent income from long-term leases that can last for decades Potential for steep appreciation Often situated in prime locations Flexibility — can accommodate many kinds of tenants Comparatively low maintenance |
High upfront costs Stiff competition High vacancy rates can be disastrous Uncertainty in the era of remote work of rapidly changing workplace culture Significant regulatory hurdles and compliance requirements Vulnerable to inflation and recessions |
High-net-worth investors, institutional investors, accredited private equity investors and retail investors looking for exposure through alternative routes like REITs and crowdfunding |
|
Retail Properties |
Can entice strong tenants with durable brands and business models Long-term leases can minimize turnover and vacancies Potential for magnified appreciation through urbanization and population increases |
Vulnerable to market changes and shifts in consumer culture Large initial investments. |
High-net-worth investors, institutional investors, accredited private equity investors and retail investors looking for exposure through alternative routes like REITs and crowdfunding |
|
Industrial Properties |
Comparatively low tenant turnover Rise in e-commerce causing a sharp demand for warehouse and storage facilities Enhanced portfolio diversification |
Sensitive to overall economic conditions and hyper-sensitive to industry-specific downturns Often tied to the fortunes of a single tenant, unlike office buildings, which can host several or many lessees Risk of obsolescence or costly re-adaptations as many industrial properties are customized for specific industries or individual tenants. |
Those in real estate investment clubs, real estate investment syndicates, high-net-worth investors and family offices |
|
Multi-Family Units |
Strong cash flow and steady passive income Comparatively numerous and simple financing options Strong potential for capital appreciation |
Comparatively short-term leases and higher turnover rates Higher maintenance costs Strict tenant-protection laws More complex management requirements |
Long-term investors, house hackers and investors willing to perform at least some self-management |
|
Mixed-Use Development |
Highly diversified income streams Lower vacancy rates Potential to earn higher returns while contributing to revitalization efforts |
Highly complex management requirements Complicated and costly zoning laws and regulatory landscape Potential for community conflict and challenges |
Experienced investors who understand the complexities of both commercial and residential real estate |
|
Land Investments |
Flexibility — land can be leased as-is or developed for commercial, residential, agricultural or recreational use Reliable hedge against inflation Comparatively low upfront costs and very low maintenance costs |
Illiquidity — land can be difficult to sell. Fewer financing options Greater potential for depreciation |
Investors in areas primed for future growth, long-term buy-and-hold investors and investors not concerned with immediate cash flow or income |
Investors use several key metrics to analyze and evaluate potential commercial properties, including:
-
Capitalization rate: Investors use the cap rate to estimate a property’s net operating income (NOI), or unleveraged rate of return — unleveraged is key because NOI presumes the building was paid in full with cash and does not include financing costs like mortgage payments.
-
Rental yield: This metric measures the rental income a property is capable of generating. Investors find the gross rental yield by dividing the annual rental income by the property’s cost or market value. To find net rental yield, first subtract operating costs from the annual rental income, then divide the remainder by the property’s cost or value.
-
Cash-on-cash return: Measures the annual pre-tax cash a property gives back to its investors relative to the upfront investment.
Advertisement: High Yield Savings Offers
Investors must also conduct exhaustive research regarding the location, market and tenant demand before performing financial modeling and projections using metrics like cap rate, rental yield and cash-on-cash return. Finally, a thorough building inspection is essential — but nothing is more important than research-based knowledge.
“The investors best suited for commercial real estate understand the local market and can properly assess risk.”
— Real estate attorney David Greiner, Esq., owner of Grenier Law Corp.
The amount you’ll need upfront depends on many variables, but typical costs include:
-
A down payment of 10% to 40%
-
Closing costs, including appraisals and inspections, title insurance, lender fees and environmental reports
-
Legal fees
-
Brokerage fees
-
Taxes
Investors who don’t buy properties outright might pursue conventional commercial loans, which are similar to residential mortgages but tend to be shorter and more expensive, although SBA loans can offer better terms.
That, however, is just one OPM (other people’s money) strategy for investing in commercial real estate. Others include:
-
Hard money loans from private lenders
-
Private loans from friends and family members
-
Leveraging your existing property’s equity through HELOCs or home equity loans
-
Crowdfunding
-
Seller financing
Jumping directly into commercial real estate investing is a heavy lift for most novices, who might be better served by first partnering with a more experienced investor on an initial project. Another option is to invest indirectly through REITs, which are funds that sell shares on the open market, just like stocks, to finance real estate investment projects.
Finally, consider real estate crowdfunding platforms, which offer access to quick financing but often at higher rates or in exchange for an equity stake.
Commercial real estate investing is not for everyone due to its substantial upfront costs, the specialized knowledge and research techniques it requires, and numerous associated risks and expenses. However, for those with the capital, savvy and skills, commercial real estate can diversify portfolios and generate outsized profits.
“Returns won’t happen overnight, but for patient investors seeking long-term income and appreciation, commercial real estate may be worth considering,” said Greiner. “The key is finding the right property for your needs and risk appetite. With some due diligence, the rewards can be substantial.”
More From GOBankingRates
This article originally appeared on GOBankingRates.com: Is Commercial Real Estate a Good Investment?