If you’re new to commercial real estate investing, you’re probably debating what type of income property is best for beginners.
The truth is that there are a wide variety of property types to choose from, but in order to choose the right property, you’ll first need to consider the factors below.
Your risk level
The level of risk you’re willing to take depends on your age, investment goals, and the amount of money you have to invest. Older investors tend to look for properties that give steady returns, with few to no management responsibilities.
Properties are meant to provide a stable income for their retirement years, with the expectation of being passed down to future generations. Their portfolios may be more diversified, as they have had more time to accumulate other investments, or they may have whittled down their portfolios to a few key investments.
Younger investors, on the other hand, often prefer investments with higher returns, which necessarily means properties that are also higher risk, in that volatile returns means profits can go down as easily as they go up.
Since they are both young and less likely to have built up a substantial investment portfolio of stocks, bonds, or other investments, they may be open to buying a wider variety of properties, including those that require more hands-on management.
Both older and younger investors need to consider how much of their money they are willing to tie up in a property and whether they are willing to use leverage to finance additional property purchases.
Whether they choose to go for a mortgage or approach private lenders, your ability to use other people’s money to finance good deals greatly affects your ability to scale your investments and increase profits.
Keep in mind that certain types of properties are less forgiving to newbies – retail properties being one example – while others are turnkey properties that offer steady returns and no management responsibilities, such as triple net leases.
Make sure you know local market conditions
Understanding the local market conditions is a critical part of vetting a property. A particular property might seem like it fits the portrait of a perfect property, but if it’s located in the wrong area, it could be a disaster in the making. At the same time, a property that appears to have very little potential but is located in a great market could end up being extremely profitable.
It’s not easy to tell the difference. As a newbie, you most likely won’t have enough experience to know yourself, and you may not have built up a large network of fellow investors who can give you detailed information.
You can, however, analyze detailed information like population growth, average income, employment, job growth, competitors, planned government or private projects, and more.
Most data can be found online, either by using a specialized data provider for commercial investors. This blog post gives a detailed list of 52 commercial real estate data sources. Once you’ve taken a look at the date, it’s always a good idea to spend some time walking around the area your desired property is located in.
Take a look for yourself at who actually lives in the neighborhood, and the stores that are doing well – and not so well. Do you see subtle signs that indicate the neighborhood is on the up and up? Younger singles and couples moving in, hip restaurants and other stores geared to the new demographic, a Whole Foods Stores are all indications that the neighborhood is likely on the up and up.
On the other hand, if you see an increasing number of houses that appear to be in disrepair if talking to store owners reveals they aren’t happy with profits over the last few years – even though they appear on the outside things seem to be fine – then you might want to re-consider.
Thorough due diligence on the local market conditions is as important, if not more important, then due diligence on the property. Take the time to do it right, and consult a local experienced commercial real estate broker if you’re having a hard time reading the signs on the wall.
Don’t shy away from the math.
Even if you hated math in school, getting comfortable with math and various formulas is a must if you plan on investing in commercial real estate. Fortunately, there are plenty of online calculators that will do the work for you, so all you’ll need to do is plug the numbers you’ve gotten through your due diligence, and see where things fall out.
Make sure the numbers you get from the seller are real numbers, not projections based on estimated expenses or potential gross income. Your profit is dependent on getting the numbers right, and an accurate proforma is critical.
This means confirming every number you’re given, and ensuring the debt service is included in your projections. Don’t try to finesse numbers that don’t look good by assuming you’ll be able to lower expenses, raise rents, or otherwise finagle a more profitable deal if the deal starts out in the red.
The first and foremost rule of a property is that it must produce a profit. Very experienced investors may have the knowledge, experience, and deep pockets to wait for an investment property to become profitable. You don’t – at least right now.
Don’t borrow more than you can handle.
Here’s where emotion and wishful thinking often come together with disastrous results.
Hopeful investors over-leveraging a property by borrowing too much has ended more than a few investment careers. Aside from the fact that it’s highly unlikely an experienced lender will grant you 100% financing, it still wouldn’t be a good idea in light of what is called the break-even ratio.
The break-even ratio, also called the default ratio, is a formula used by lenders to determine whether or not they should lend you money for a property. It measures the proportion between incoming and outgoing cash flow so that lenders can determine how much of a property’s rental income can be lost before the break-even point (the point at which the amount of money coming in equals the amount of money going out) is reached.
Although it’s not always well-understood, it’s a good idea for you to include it when running the numbers for a potential CRE deal. The formula is as follows:
Break-Even Ratio (BER) = (Operating Expenses + Debt Service) / Gross Operating Income
Generally, lenders look for a BER of 85% or less. This means that rents can go down by as much as 15%, and the property will still break-even.
Always have an exit strategy.
Although it may seem pessimistic, planning multiple exit strategies is a smart move. Since your goal is to get as much profit from the property as possible, you’ll need to decide a) exactly how you plan to squeeze out more money from the property (especially if the seller was unable to) with the least amount of blowback, and (b) how you’ll get your money out whether things go wrong or right.
The bare minimum is three exit strategies, although the average is around six or more. It may seem ironic, but in commercial real estate, planning to fail is the best path towards success.
The best property for new commercial real estate investors
You may still be wondering why I haven’t given a specific type of property. The answer is that there is no specific type of property type that is best for all investors. Doing your homework and taking the plunge is the only way to find out what works best for you.
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