Have you ever talked to a real estate agent about what commercial real estate is and how to become a good real estate investor?
A successful real estate agent will probably talk for hours about the advantages of getting into this type of business investment. If you have ever wondered why and how to start investing in a commercial real estate, please take a look at the article below.
The Basics Of Investing In Commercial Real Estate
Commercial Real Estate represents a property leased only as a workspace, rather than a residence. The types of areas rented for commercial purposes vary from retail stores, restaurants, to hotels, hospital buildings, shopping malls and so on.
Commercial Real Estate includes industrial, retail, office and warehouses. The investor owns the property, rents it and earns money. The value of a commercial real estate property is estimated in rental dollars per square foot each year. Regarding Lease duration, they may vary from one to ten years. Often the bigger the occupied property is, the longer the lease will be.
There are several types of Net Leases on Commercial Properties:
- Single Net Lease, where the lessee pays a monthly fee, including property taxes.
- Double Net Lease, where the lessee pays a monthly fee, including property taxes and insurance.
- Triple Net Lease, where the lessee pays a monthly fee, including property taxes, insurance, and maintenance.
- Gross Lease, where the lessee pays only a monthly fee, and the lessor pays property taxes, insurance, and maintenance.
So depending on the free time you have as an investor you may pick any one of the 4 lease types.
Triple Net Lease is best if you don’t want to bother with all the paperwork and maintenance of the property. This type of a deal is excellent if you own a property that’s far from where you live.
On the other hand, if you love the work around owning a property, Gross Lease may work best for you as an investment style.
There are also several different classifications:
- Class A includes properties which are rather new, high-quality buildings built during the last 15 years. They are often occupied by professionals and have a perfect location, appearance (and access in the market). As might be expected, they require the highest rent with limited maintenance, as well as profitable tenants and low vacancy rates.
- Class B includes properties which are usually not as new and good-looking as Class A properties. They may or may not be occupied by professionals and require lower rent with postponed maintenance and less profitable tenants. Many investors consider these buildings as a good investment opportunity because the properties can be renovated, restored and returned to Class A or Class B+.
- Class C includes properties older than 20 years with unattractive locations. They require renovation and improvement of the infrastructure. Therefore, they have the lowest rent and are often the least desirable for their obsolescence.
It should be noted that each property class brings a different level of risk and reward. Investors know that Class A is the most secure, as they are high-quality properties with little or no additional costs at all. However, Class A locations can react negatively during the recession. Compared to Class A, Class B and C are purchased and sold at higher CAP rate.
Cap Rate or Capitalization Rate is defined as ‘the ratio of Net Operating Income (NOI) to property asset value’. It is calculated when annual net operating income is divided by the cost (or value). For example, if the property costs $1,000,000 and the Net Operating Income is $80,000, the CAP rate would be 8 %. The Cap Rate is the highest if the investment risk is at the highest level.
Class A is the right choice for investors who want to protect their capital, whereas Class B and C for investors who want to increase the value of assets.
Cash Flow / Cash On Cash return is one of the main ways of making a profit in a commercial real estate. After the investor pays the mortgage and all other costs, the amount left from the rental income is what we call cash flow. It is then divided by the down payment of the investor. For instance, if the investor deposits $200,000 and has a cash flow of $ 24.000 for a property of $1,000,000 the cash-on-cash return would be 12%.
There is a difference between cash- on- cash return and capitalization rate. If the investor buys property for $1,000,000, pays cash and earns $100,000 in cash flow, then the capitalization rate would be 10% and cash-on-cash return 10%.
But if the investor leverages money, puts down only $200,000 and borrows the other $800,000 the cash-on-cash would have a better return. That is, if he borrows money at 7% interest and at a duration of 20 years, the annual mortgage payments would be $73,997.
Therefore the cash flow would be $26,003 and cash-on-cash return 13%. With a smaller amount of money, the investor obtains a higher rate of return and will have no debt after those 20 years, as he has paid $800,000 through the earnings.
The risk is higher with leverage because free cash flows are reduced, the cash buyer doesn’t have to pay the mortgage out of other financial resources).
Pros And Cons Of Commercial Real Estate Investments
As mentioned previously, commercial real estate properties have excellent leasing rates. Lease rate is the total sum of money paid for rental properties over a certain period of time. It allows the investor to earn money until the end of the lease term. It is frequently presented in annual dollars per square foot of the area. The tenant needs to know whether the lease is single, double or triple net. This determines who is obliged to pay additional costs (such as maintenance issues, property taxes. insurance, and utilities).
Commercial real estate properties have great returns and substantial monthly cash flow in building regions restricted by land or law. Compared to the residential real estate, commercial real estate have longer leases and long-standing tenants. That is why these properties can offer stable and secure cash flow.
Another plus is that you can make money through appreciation. If the property is well preserved and the area doesn’t depreciate, the property will appreciate over time. In financial statements or documents, the appreciation rate per annum is often 2-3%.
Depreciation is another thing you should consider. The depreciation is key for substantial investments, and thus there are significant tax savings. The investor generates equity from appreciation and repaying the lease, but he does not earn similar cash-on-cash return. The cash-on-cash can grow if the investor places a new loan to the property at a lower interest and pays for another construction. This will lead to considerable cash flow and loan decrease.
Just like every business investment carries a certain amount of risk, commercial real estate investing undergoes certain legal restraints. Property taxes, insurance, maintenance and utility issues are legalized differently depending on the state, region, size, zone etc.
An additional problem the investors face is the tenant turnover. Tenant turnover refers to the pace of accumulating cash or selling the inventory. Each commercial property tenant may require expensive renovation and reconstruction and for that reason, the property owner needs to reorganize the area to satisfy each tenant’s deal. Low vacancy and high tenant turnover can cause loss of money.
Commercial Real Estate Investment Types
Anyone who owns a business can invest in a commercial real estate. It can be a huge plus to own your own building rather than to rent it. People who are experts in this field and its finances and regulations can also invest (as well as hire other people to find useable investment properties).
Supply and demand are one of the principal points to take in mind when investing in commercial properties.
Low vacancy areas and locations with limited expansion are the best. Low supply and high demand contribute to beneficial lease and appreciation rates. It is also important to take into account the costs and the time needed for commercial real estate investing.
In order to be successful in real estate, you need to do your work with due diligence. That is, to be able to make a thorough research on the market and create a whole picture of the commercial investing.
There are two ways of investing:
- Directly- Direct investments are simple. The investor can hold a small area directly or through personal partnership, but the payment needs are much higher. Another alternative is through real estate limited partnership, but this is a significant real estate investment.
- Indirectly- Indirect investments are less risky and more practical if you don’t want to bother with all the inconveniences direct investors face (such as large investment and management costs).
REITs or Real Estate Investment Trusts present a method for indirect commercial real estate investment. Real estate investment trusts hold a range of investment properties but are operated publicly. The managers are responsible for all aspects of trade, maintenance, and leaseholders. They usually tackle the rental income and capital appreciation.
CMBS or Commercial Mortgage-Backed Securities are another way of indirect commercial real estate investment that keeps a mass of commercial mortgages.
Before You Start: What Role Is Best For You?
Knowing all that you know now, one of the final steps is to figure out how engaged do you want to be in your commercial real estate investing activities. Some want it all from finding locations to dealing with building contractors. Others, prefer the quiet life of owning and leasing.
- Land Development – An investor can be involved in various aspects of development such as the establishment of the project, management, and lease issues. Developers could buy land and build, for example, a retail store or office building. In this case, they would organize the financing, leasing, contract, and so on, and follow up the progress of the construction until it’s rented.
- Property Management – When the property is established, it requires management. The manager is responsible for operating the property, from contracting, hiring, repairing to maintenance and service issues.
- Property Owner – If you prefer minimal hands-on engagement in working with a commercial real estate property, maybe the best route is to simply purchase a property after it’s been built, and just pick one of the 4 lease models mentioned previously. Most of the times, property owners opt for Triple Net Lease style because this minimizes hands-on work with the property.
Let’s Make Commercial Real Estate Investing Work For You
- Make a Plan – Establishing a decision-making framework is a key to successful commercial real estate contract. In other words, you need to know the amount you can spend, and then compare the price and quality of different contracts, (just to be informed how much your payments will be for the time of the mortgage). A Mortgage calculator is a very useful tool that will give you a clue of the total costs. Another thing you should be aware of is the deal expectations, the people who are involved in, the tenants, the rental areas.
- Learn to Recognize a Good Deal – Top professionals certainly have a secret when it comes to recognizing a quality deal. First and foremost is the exit strategy. For example, if the business is unsuccessful and does not generate profit, the investor may choose to apply the exit strategy, for the purpose of diminishing loss. The investor should be able to evaluate risk and renovation time, as well as ensure that the property meets his or her objectives.
- Find Motivated Sellers – Noticing enthusiastic sellers who would sell the market value is a bonus. A quality deal often involves a motivated seller who will be pleased to negotiate over the contract.
- Evaluate the Locations – Real estate investors should think about the location when trying to find the right property investment. The best way to do this is to investigate the local areas and search for vacancies.
- Get Experts to Help – Commercial real estate investment demands expert assistance, regardless of your personal expertise. You might think that your own strategies are always right, but try reviewing and joining additional strategies to make your business bloom. If you follow your own gut feeling, you may end up paying a hefty price for it. Veteran real estate brokers like the team at Westwood Net Lease Advisors have decades of experience with hundreds of deals. This is the perfect case of relying on the expertise of others for your gains.
To Wrap It Up
Commercial real estate property investment can be a great opportunity to build wealth. Such deals generate income and can allow the investor to be protected during a recession.
Another possibility is the capital appreciation. Commercial real estate properties are great ‘guardians’ during inflation since the rents get bigger.
Leverage is also one of the reasons why commercial real estate is an exceptional type of investment. Usually, commercial real estates are bought with 20 to 30% cash, and the rest is paid with a mortgage.
Commercial real estate properties offer security and diversity, and they allow you to build wealth quickly. They are regarded as one of the most beneficial types of real estate and many millionaires have become successful and made fortunes during their career as real estate investors.
That being said, we hope we have convinced you to get into this type of investment and to incorporate it into your investment portfolio in the near future. It’s a great way to make a great living.
But, before you go, a word of warning: If commercial real estate investing was easy, everybody would do it. The reality is that it’s not so easy. There are plenty of rocks to turn over in order to be sure that a good-looking deal is a good deal for real. Get in touch with professionals. Seek their guidance. Even if it means paying a consultation fee.
The good news though is that Westwood Net Lease Advisors work as advisors for people who want to become commercial real estate investors. If you have a few properties that you have on your shortlist, contact us and we can look things over together. Our advice to you is completely free of charge. We get paid by the seller, not the buyer. You have nothing to lose by calling us for advice. Let us help you, and make sure that you really get the best possible deal from the properties you chose. Or maybe, we could have an even better deal as we have access to almost all of the commercial properties nation-wide, both listed an not listed on public websites.