Investing in real estate is a great route to not only building wealth but also generating consistent monthly cash flow. More specifically, commercial real estate has become an ever-popular asset class for investors looking to diversify outside of the stock market. However, commercial real estate investing does come with its share of risks, and investors need to understand the intricacies of commercial real estate, before adding it to their portfolio.
What is Commercial Real Estate Investing
When people discuss commercial real estate, they are really referencing several different real estate asset classes.
These asset classes include:
Retail buildings are properties ranging from large malls, and retail centers to restaurants, banks, and strip malls. Typically, these properties are located in urban areas, and the actual size can vary widely, from a few thousand square feet to a few hundred thousand square feet.
Office buildings, and office space; are one of the most common types of commercial real estate. These properties will range from large office high-rises to single-tenant offices, and they are normally called by one of these class categories; Class A, Class B, or Class C.
- Class A office space is normally newly built, or renovated, is located in very desirable locations, and is close to many amenities.
- Class B commercial office buildings are usually older properties, that may require updating; but they are well-managed, and maintained.
- Class C commercial office buildings are commonly utilized for redevelopment projects. These properties are typically located in less-than-ideal areas and require a large capital investment in order to improve the building’s infrastructure and its high vacancy rates.
Industrial commercial properties include; manufacturing buildings of all sizes, and warehouses that might range from a storage unit with a few hundred square feet, and a loading dock, to a 500,000-square-foot standalone facility. It is common for these buildings to have unique features and specifications that allow businesses to utilize them efficiently for their businesses. These specifications could include; loading docks, large rollup doors, warehouses with an office, and cold storage (typically used for storing food).
Apartments/Multifamily (complexes with 5+ units)
Apartment complexes with 5 or more units are considered commercial properties. These properties range from small 5-unit apartment buildings to apartment complexes with 500 units. Similar to office space, these properties are classified by class. Class A properties are the nicest, while Class C properties require a capital investment to correct any deferred maintenance and make renovations that will increase occupancy, along with the overall value of the property. It is common for small landlords to “graduate” into commercial multifamily properties after successfully investing in 1–4-unit rental properties.
Special-purpose, commercial real estate properties, are specifically designed for unique use. A use so specific, that it could not be easily repurposed for another use. Special-purpose properties include; self-storage facilities, car washes, marinas, car dealerships, parking garages, stadiums, amusement parks, and gas stations to name a few.
It is very typical to see different commercial real estate asset classes, mixed together. This is commonly referred to as mixed-use properties. Examples of mixed-use properties might be a building with a restaurant that shares the first floor of the building with an office while having apartments on the floors above. Malls are another example of mixed-use properties. It is common for a mall to have retail, hospitality (restaurants), and possibly offices. Certain developments might even have residential properties mixed in, usually on the floors above the commercial units. Many high-rise properties in city centers are mixed-use buildings.
Hospitality properties are a subset of special-purpose properties but they represent a sizeable portion of commercial real estate. These properties vary widely from standalone restaurants (typically occupied by chain restaurants) to large resorts.
How Does Commercial Real Estate Investing Work?
Commercial real estate is an alternative asset that offers many benefits to its investors. Commercial real estate encompasses several different asset classes within the realm of real estate including; offices, apartments, retail, and special-purpose properties.
Commercial real estate investors are able to earn a return through the income earned through property operations, in addition to value appreciation. The majority of the income generated through property operations is derived from tenants paying their rent. Other ancillary income is usually attributed to other services provided by the landlord and management. These other income sources could include; parking, trash services, on-site storage units, package services, laundry services, gyms, and other conveniences that tenants utilize.
Property appreciation is produced as the asset’s value increases over time. Good management is key to increasing a property’s value by, making necessary repairs, and updates, that in turn promote new tenancy, along with retention of the current tenant base. When a property owner looks to sell or refinance their property; appraisers, underwriters, and potential buyers will review these financials to see strong demand from the market for the property’s units, in addition to a high retention rate. Therefore, demonstrating the reliability of the property’s income.
Calculating property appreciation is much harder than calculating a property’s potential income after acquisition. Accurately determining the value of a property in 5, 10, or 15 years is very difficult. It is possible to make value assumptions based on prior performance, or expectations of where the market will be at some certain point in the future, but these are all educated guesses.
Calculating a property’s future income can be a much easier process than guessing a property’s future value. If it was not easy to reasonably calculate future income, commercial real estate assets would sell at much lower prices, and lenders would be much more conservative when making loans since it would be unknown what the future holds for a specific property. When a mortgage is taken out for a piece of commercial real estate, the lender wants to know the property’s current value; this is why an appraisal is done. After the loan is funded, the lender’s main concern is the property’s income.
The future income of a property is created mainly by using the property’s actual historical data over the past 12 months. Underwriters will then design a proforma for what they feel the property operations will look like in future years. Maybe the new owners are going to replace some roofs which will lower the monthly insurance payments or they are renovating all the property’s units over the next 24 months which will negatively affect cash flow in the first year but, then will begin a steady increase past current income by the end of the second year. Maybe the expenses on the current financials are too low, and the management will not be able to provide their level of service at the prices outlined. Either way, the underwriters are taking actual data, and tweaking it to give an accurate depiction of what the future holds for the subject property. This is a much more accurate strategy than guessing where the commercial real estate market will be in 10 years.
How to Invest in Commercial Real Estate?
When investing in commercial real estate, there are two main options to choose from; direct investing or indirect investing. Direct investing is not for the faint of heart. It is comprised of reviewing, underwriting, and purchasing a piece of commercial real estate. Typically, this is completed through an entity that is created for the sole purpose of purchasing the specific property. Indirect investing, also known as passive investing, can be done by investing in a real estate syndication, or in a real estate investment trust (REIT).
Direct Real Estate Investing
• Allows the investor to control all aspects of the property
• Offers the most flexibility
• Provides tax benefits
• A very active investment (even with a property manager)
• Typically requires a large upfront investment
• An illiquid investment, normally requiring at least a month to sell or refinance
Direct investing is similar to purchasing a business. The owners need to be very hands-on or, hire a property management company to oversee most of the day-to-day activities. Even with a property manager, owners (or their representatives) need to perform asset management on the property, and the manager.
Directly investing is a very time-consuming endeavor. From finding, and underwriting properties, to purchasing, managing, and selling them. For this reason, most busy professionals, and entrepreneurs prefer indirect (passive) real estate investing.
Indirect Real Estate Investing
• Ability to start with much less capital
• Completely passive real estate investing
• Easy portfolio diversification
• Certain indirect investments (REITs) are liquid
• Certain indirect investments (syndications) provide tax benefits
• No control over purchasing or selling the property
• No control over managing the property
• REIT income is taxed as ordinary income
Indirect real estate investing is the best choice for investors looking for real estate benefits without the hassles of actually buying, and managing properties. Smaller investors might find indirect investing as a better route to owning real estate because the capital required is typically less than purchasing a property directly.
Indirect and passive real estate investing makes it easy for investors to invest in properties outside of their city, state, or even country. The indirect investor is completely hands-off since the properties are managed by a team of seasoned professionals. Allowing the investor, the ability to focus on more high-level activities within the realm of their core competency.
How To Learn About Commercial Real Estate Investing?
Commercial real estate is a broad term that encompasses several different types of properties. Most commercial properties are utilized for business activities or actually occupied by businesses.
Commercial real estate includes the following property types:
- Office space
- Retail storefronts, and shopping centers
- Industrial buildings, and warehouses
- Medical office buildings, hospitals, and other healthcare facilities
- (Self) Storage properties
- Apartment complexes with 5 or more units
- Hotels, motels, and resorts
Furthermore, commercial real estate properties are classified into three (sometimes four) quality/condition categories; Class A, Class B, Class C, and sometimes Class D. The classes are based on; age, amenities, quality, and the overall condition of the property.
As you would expect, the class of the property might differ from investor to investor or broker to broker. A Class B property advertised by one broker might be considered a Class C/C+ property by an investor. Nonetheless, the grading helps describe the condition and quality of the asset.
Class A Properties:
- Newest and most expensive luxury properties
- High-income tenant base
- Usually, $125,000+ per unit and up
- Typically constructed within the past decade
- If constructed more than 10 years ago; they have been fully renovated
- Very high level of construction
- Best locations – close to shopping, offices – downtown areas
- Nicely landscaped
- If less than 10 years old, they will have all of the amenities (dog park, pool, gym, valet trash service, covered parking, electric vehicle stations, pool tables, outdoor kitchens, spas) – similar to living in a resort
Class B Properties:
- Properties that were usually built in the past 20-30 years
- Middle-class tenant base
- There usually have been some updates since construction
- Minimal deferred maintenance
- B+ property will differ significantly from a B- property
- Well-constructed properties
- Nicely taken care of – good curb appeal
- Minimal functionality issues – not enough parking or narrow hallways or small bathrooms – small windows – low ceilings
- Larger B properties will usually have some amenities
- These properties are located in steady neighborhoods with a demand
Class C Properties:
- Properties that were typically built 35-60 years ago
- Functionality issues of some sort
- The tenant base is middle class
- Vacancy rates and the property’s appreciation are average (5% vacancy and appreciation of 3%)
- Typical good cash-flowing properties
- Usually, they are outdated and require renovation
- Minimal amenities
- The areas they are located in are steady or possibly the area is declining
Class D Properties:
- Very rough neighborhoods – bad locations
- 40+ years old
- A lot of illicit activities occur on them or around them
- These properties are poorly constructed – in need of major renovation but there is no upside after performing major renovation – the only exit strategy is cashflow and headaches
- Never any amenities or if there are, they are not functional
- Major functional obsolescence
Additionally, the area and location of the asset are also graded, similarly to the property itself, and it is not uncommon to see a property considered to be a Class C property in a Class B area (or Class B property in a Class A area). In fact, many value-add real estate investors, prefer to purchase lower-quality properties in better locations. This signifies that the property has the ability to be renovated, and repositioned for a profit.
The next step when learning how to invest in commercial real estate is understanding common terms used within the commercial real estate industry.
- Net Operating Income (NOI): Subtract expenses from the gross income
- Cash-on-Cash Return (COC): Annual property cash flow divided by the total amount invested (by the investor) in the property (i.e., not counting any debt)
- Cap Rate: Net operating income divided by the purchase price
- Debt Service Coverage Ratio (DSCR): Net operating income divided by the total annual debt payment
- Zoning: Regulations that determine the types of buildings/businesses that can be built/operated on a specific property or in a specific area
- Building Classification: Property grading; from A-D, that denotes both the quality and location of the building. D being the lowest, and A being the best, and highest.
- Build-to-suit: A property that was built to specifically meet the needs of a tenant
- Triple Net Lease: A lease where the tenants pay rent to the owner, while also paying the operating expenses of the property; including property taxes, insurance, and maintenance.
- Common Area Maintenance (CAM): The cost to maintain common areas, and operate a building. These costs are usually allocated to tenants based on their square footage.
- Parking Ratio: The total rental square footage of a property divided by the number of parking spaces at the property. This determines how many parking spaces are available to each tenant.
Another important aspect of learning how to invest in commercial real estate is understanding how commercial real estate is valued. Similar to all other types of real estate, a commercial property’s value is largely dependent on its location. Well-located commercial properties will fetch a premium when compared to properties in less ideal locales.
In addition to location, there are a number of other aspects that play a role in the value of commercial real estate. Changes in demographics have led to a demand for commercial real estate assets, particularly throughout the Sunbelt. Apartment rents and values in the Sunbelt have increased disproportionally to apartments in other metros throughout the United States. Another example might be the strong demand for senior housing and assisted living properties as many Americans reach retirement. Accelerated by COVID, the office, and retail environment has permanently been altered. Some employees now work from home full-time while others are in the office only a couple of days a week. Industrial, and warehouse properties have also seen growth as many consumers continue to have items delivered to their homes.
Valuing commercial real estate can be a difficult task since subtle differences between otherwise similar properties could dramatically affect their values. A retail property on the wrong side of the street, or maybe a restaurant property without a traffic signal, or possibly an apartment complex that is surrounded by warehouses; could be grounds for a much lower valuation. This is why building relationships with experienced brokers is paramount to understanding the commercial real estate market.
Lastly, commercial real estate is valued by its actual net operating income (NOI), which differs from residential real estate which is mainly valued off of nearby, recent comparable sales.
How to Get Started Investing in Commercial Real Estate?
Investing in commercial real estate begins with research and due diligence. No matter what subsection of commercial real estate you want to invest in; education, research, and due diligence will be crucial to becoming a successful investor.
- Understand the Differences Between Commercial and Residential Real Estate: Commercial properties are valued differently from residential properties. Commercial real estate is valued by its NOI, not comparable sales. Commercial retail, office, and restaurant tenants, usually also have longer leases than typical residential leases.
- Research Comparables: Even though commercial properties are not valued by comparables, it is important to research similar properties in your target market. What are they renting for, what is their current vacancy, and what have comparable properties traded for in the last 12 months? How do these compare to your subject property? Are the comparables renting for more or less? The comparables will tell you what should be done with the subject property in order to massive the NOI.
- Utilize the Correct Valuation Metric: There are 3 main formulas you will utilize to accurately compare pricing, values, and cash flow. Net Operating Income (NOI), Cap Rate, and Cash on Cash (COC).
- Maintain Capital Reserves: If you have found a commercial property that is a “deal,” chances are, it will need work. In addition to having a reserve fund for the initial renovations, investors should also have a reserve fund for future repairs; that they contribute to on a regular basis.
- Avoid Common Mistakes:
- Ignoring the numbers. Not understanding the current condition of the property and/or not using direct comparable properties to create your proforma. For example; if you are buying a property built in 1960 that has not been updated in 30 years, basing your future estimates on the numbers of a property built in 2010 is most likely not going to be accurate.
- Not performing proper due diligence. Investors that neglect to inspect a property with a team of professionals are only asking for future problems. Furthermore, when you add tenants into the picture, buyers need to perform due diligence on the current tenants, in addition to the physical asset.
Commercial Real Estate Investing
Commercial real estate refers to a large class of properties that are specifically purchased under the guise of both; generating monthly cash flow and value appreciation. Commercial real estate includes a number of different subsets but as a whole, it has delivered steady returns to investors over many decades, making it a very popular investment vehicle.
New commercial real estate investors might be confused by the wide range of commercial real estate subsections however, successful CRE investors typically identity, and focus on one specific category. Directing your energy to one specific asset class will dramatically increase your likelihood of success.
Investing in Commercial Real Estate
There are a number of advantages and disadvantages to investing in commercial real estate. Many investors enjoy the possibility of higher profits but, with more income potential, there is usually more risk.
Pros of Investing in Commercial Real Estate
- Higher Income Potential: Commercial real estate is more profitable than residential real estate.
- Business Tenants: Long leases, and a more professional tenant base.
- Limited Operating Hours: Limits the majority of after-hours emergency calls, and contact with tenants typically only happens during regular business hours.
- Simpler Valuations: Commercial real estate valuations consist of mainly using just 2 numbers; cap rate, and net operating income.
- Triple Net Leases: This lease type pushes the majority of the costs (and hassles) from the landlord to the tenant. With a triple net lease, tenants pay their own property taxes, insurance, and maintenance, while also paying the landlord’s rent.
Cons to Investing in Commercial Real Estate
- Larger Investments: Commercial properties start in the seven figures and go up from there. Commonly, commercial properties are purchased by a group of investors.
- Requires a Professional Team: Commercial real estate is more time intensive, and is rare to find a commercial property that is not managed by a professional property management company. Unlike with a small rental house, commercial properties require licensed, and insured vendors to maintain the asset. This increases the cost but, it lowers the risk for investors.
- More Risk: With larger properties, and larger investments, there is more risk and more legal exposure.
How to Get into Commercial Real Estate
The easiest path for most investors to invest in commercial real estate is to invest in a real estate investment trust (REIT). REITs are able to own, finance, manage, and operate properties. REITs generate the majority of their income from their tenant’s rental payments. It is estimated that REITs own nearly ½ million commercial real estate properties throughout the United States.
Another reason why REITs are one of the most popular avenues for investing in commercial real estate is that the minimum investment is usually only $1,000. Additionally, investing in REITs is a very easy process, with the majority of publicly-traded REITs being available for investment through most brokerages.
Investors looking to directly invest in commercial real estate will start the process by narrowing down their target markets, while also identifying a specific asset class. Their next step will include building a team of professionals, partners, and possibly investors in order to purchase, fund, and manage their investment. Once this is complete, investors will start reviewing, and underwriting potential acquisitions.
More sophisticated investors may opt to invest in commercial real estate by passively investing in a real estate syndication.
Passive Commercial Real Estate Investing
Passive real estate investing through syndications has become extremely popular over the past decade since it allows smaller investors, the ability to invest with a team of professionals who manage all aspects of the deal. Real estate syndications are groups of investors that pool their funds in order to purchase large commercial properties.
There are two groups in a syndication; the general partners (deal operators), and the limited partners (passive investors). The general partners manage all of the deal operations; including finding, purchasing, managing, and selling the property. However, the limited partners have just one role, and that is to invest. The deal operators will provide monthly property updates, along with regular distributions to investors.