Are you interested in commercial real estate investing? Please read through this guide to find out some of the fundamental concepts of this type of investment. Commercial real estate investment properties can offer a good “passive” income opportunity.
The following guide will lead you through some of the essential steps of a successful investment journey. Also, it will point out why it is important to perform your due diligence (as well as some of the benefits in commercial real estate investment).
Let’s get started!
What Are Some Types Of Commercial Real Estate Properties?
Commercial real estate properties cover a range of assets, including :
- Retail buildings
- Office buildings
- Industrial buildings
- Warehouses
Each property type differs in what’s required to manage the property. To get a general idea of what commercial real estate investing means, let’s have a look at some of the pros and cons of commercial real estate investing.
Pros And Cons Of Commercial Real Estate Investing
Commercial real estate investing has been a hot-button issue in the real estate world, and there has been much debate on whether it is better to invest in a commercial or residential property. Those investing in residential properties say it is the least risky investment, while those fond of commercial properties argue that it is more secure due to the cash flow potential.
Of course, smart investors would rather look at both and determine which type of investment best fits into their portfolios.
Pros of Commercial Real Estate Investing
For your investment to be successful, you must know the benefits and pay attention to the risks to gain steady and stable income. Let’s take a look at the benefits first.
Strong Earning Potential
One of the main reasons why you may invest in commercial real estate over residential is the significant earning potential. Commercial real estate properties usually have an annual return of the buying price of between 6% to 12% (depending on the area) which is much higher range than typical returns for single-family properties (from 1% to 4% at best).
Because commercial real estate properties are often centrally located, property values can increase faster over time. Once property values rise sufficiently, a commercial property owner can make millions in one sale.
Professional Interactions
The landlord and the tenant have more of a business-to-business (B2B) customer relationship in commercial property, so dealing with commercial tenants is often much easier than dealing with residential tenants. The commercial tenant will usually have clear requirements and goals, which allows for efficient and professional interactions.
Aligned Interests of Tenant and Owner
Retail tenants have a settled interest in store maintenance because if they do not, it will affect their businesses. As a result, commercial real estate tenant and property owner interests are aligned, which helps the landlord maintain (and maybe improve) the quality of the property (and eventually, the value of their investment).
Limited Working Hours
Businesses typically go home at night. In other words, you sleep when they sleep. Except for emergency calls (like fire alarms or break-ins), you don’t have to worry about midnight calls due to lost keys or to required repairs. It is also recommended that commercial real estate utilizes an alarm system so that if something does happen during the night, the alarm service company will notify the proper authorities immediately.
More Objective Price Evaluations
It is easier to estimate the property prices of commercial real estate properties. Your Buyer’s Agent can request the current landlord’s income statement and ascertain what the cost should be based on the area’s prevailing CAP rate.
NNN Leases Can Be Simple for the Owner
There are different types of net leases. The most common among the various types of leases is the Triple Net Lease where you as a landlord do not have to pay for any expenses on the property. The lessee handles all the property expenses, including real estate taxes. The only cost you will have to pay is your mortgage.
Businesses like WalGreens, CVS, and Starbucks usually sign these types of leases, because they want to maintain a look at their brand. They manage those expenses, and you, as an investor, have low maintenance expenses. Triple-net leases are not typically common to smaller businesses, but these types of leases are optimal (and you cannot get them with residential properties).
Long Lease Periods
Commercial real estate tenants typically lease properties for longer periods, and this provides the property landlords better cash flow stability. Relocating is expensive, and businesses do not want to be continually moving. Their goal is often to find a great location where they can stay for the long-term. Typically commercial real estate properties have longer lease terms which last from a minimum of 5 to 20 years (significantly longer than most residential leases) and usually have options to renew, with increased rents approximately every 5 years.
Smaller Cash Outlay
Commercial properties are sometimes low-priced compared to residential properties. Therefore, you need a lower capital outlay. For instance, a car park can be as little as $80K as opposed to $400K for a small home. Investing in a commercial real estate property could be an excellent way to enter the market sooner compared to saving big money for a residential property investment.
Price Stability
Expert property appraisers set the value of the commercial real estate. Historically, commercial property prices have lower levels of fluctuation compared to some other investment types.
Cons Of Commercial Real Estate Investing
While there are dozens of positive reasons to invest in commercial property over residential, there are also some “cons” to take into consideration.
Time Commitment
If you own a commercial retail property with multiple tenants, you may have more management issues than with a residential property. You cannot be an “escapee owner,” and then expect to inflate the return on your investment.
With commercial real estate, you are probably dealing with multiple leases, annual Common Area Maintenance adjustments (costs that the tenants are responsible for), public safety concerns, and maintenance issues. In a nutshell, you have more stakeholders to manage; you have to worry about the public eye, just as your tenants have to.
Professional Help Needed
If you are a do-it-yourself person, you better be licensed if you’re going to handle the maintenance issues. The likelihood is that you will not be able to handle the maintenance issues yourself, and you’ll need to hire someone to aid in repairs and emergencies. While this added cost may not be ideal, you will have to add it to your expenses if you want to care for your property properly.
Remember to factor in property management costs when estimating the price to pay for a commercial property. Property management companies charge between 5%-10% of rent revenues for their services, including lease administration. Determine beforehand if you want to manage the relationships and the lease yourself, or alternatively, if you want to distribute those responsibilities to property management services.
Tenant Turnover
Tenant turnover represents one of the biggest risks in commercial real estate investing. If your commercial tenant vacates, and you must find a new one, you may see that extensive restorations are necessary before the new tenant moves in. Each business offers different services and requires the space to fulfill various purposes. Plus, vacancy is expensive for you.
Zoning
Zoning issues can also cause headaches for the owners of commercial properties. The land and buildings that make up a commercial site are usually zoned for a particular use (such as retail or manufacturing). If the landlord wants to use the site differently, then it is necessary to apply for a zoning variance. This can be a pricey and complicated process that does not guarantee a positive outcome for the property owner.
Property Taxes
Another potential negative regarding commercial real estate investing is potential property tax hikes. As the property values rise, so do the taxes that the landlord must pay. These tax hikes could be passed along to tenants, but this can also result in tenant turnover.
Changes in Infrastructure can be Harmful
While significant infrastructure changes may attract commercial investments in the area, it can also lure the tenants away from the existing areas and from older commercial buildings. This could lead to a vacancy. Values can drop significantly.
The value of a commercial real estate property closely correlates with the lease on that property. So if the lease is about to expire or if the property becomes vacant, its value will fall. In contrast, any price-falls linked with residential properties are usually less dramatic and typically happen progressively over a more extended period.
Expensive Upgrades
Even though the cost of the upgrades will depend on the type of the property, renovating a commercial building, such as a retail or office, may be relatively costly compared to renovating a home. That is because upgrades for a commercial property can require a more significant scope of work for a more extensive area and include major tasks like the removal of asbestos, safety issues, or reorganizing the space to meet the tenant’s needs. In comparison, upgrades to a home can include inexpensive tasks like painting or installing some new appliances.
Whether you will or will not be investing in commercial real estate property will depend on your budget, the time commitment you are willing to make, and your risk tolerance.
How To Invest In Commercial Real Estate Properties
The question on ‘how to invest in commercial properties’ has only one answer: with due diligence.
Due diligence is a crucial exercise to ensure success in real estate investment. Learning the ins and outs of this type of investment is essential, but actively conducting market research is more important. In principle, the function of due diligence is to confirm that the commercial property is a feasible investment option.
As an investor, your first step is to understand that commercial real estate is valued differently than residential. Unlike with residential properties, income from commercials is directly related to the usable square footage. Therefore, investors will usually earn more income on retail and industrial buildings. Hence, commercial leases are longer than residential ones and will pave the path for more significant cash flow.
The location of the property is another critical feature that investors need to consider. If the location is not in demand, finding tenants will be hard and this difficulty can result in vacancies.
Newbee investors should also examine the potential commercial property’s neighborhood. By going to open buildings and talking to landlords in the neighborhood, investors will gain a better understanding of that property as a long-term investment.
Your next step is to analyze comparables in that area, including research for future development. Also known as ‘comps,’ these assessments refer to the amounts paid for recently sold buildings that are similar in location, style, and size.
Analyzing comparables will help the investors ascertain the current market value of the property. A common rule of thumb when determining comparables is to pick a property where the square footage is not beyond 10% lower or higher than that of the property being estimated.
Your third step is to understand the common key metrics used to evaluate real estate. Believe it or not, commercial real estate investing involves a wide array of math and an understanding of real estate finance. If you want to be a good player in a commercial real estate, you should know the following formulas.
● Net Operating Income
NOI is a calculation that equals all costs and revenue from a specific property. Configured before taxes, this calculation provides the investors with an idea of how much they will make from an investment minus all the necessary operating expenses, which are necessary costs to run and maintain one commercial building. Expenses usually consist of insurance, utilities, property management fees, repairs and janitorial fees, and property tax.
● Cap Rate
CAP rate calculates the value of income-producing properties. The capitalization (CAP) rate will provide the investors with an estimate of future proceeds or cash flow. In principle, that is the ratio of net operating income to the property asset value.
● Cash On Cash
Cash on Cash is a metric that provides the investors a rate of return on their transaction. Investors who rely on financing to buy their property are the ones who mostly use it. Cash on cash will calculate the return on the actual money invested, which will give an accurate analysis of the investment’s performance.
Market research is the key to commercial real estate investing success. Even though learning these formulas may be confusing at times, investors who overcome these real estate numbers will increase their odds of success significantly. For those looking toward investing in a commercial real estate, the formulas mentioned above will ensure that you get off to the right start.
Types Of Commercial Real Estate Investments
If you have decided to invest in commercial real estate property, please take note of the several types of commercial real estate investments.
Retail Buildings
These buildings can be anything from a single, stand-alone building to a large strip or shopping mall. Anyone can invest in a retail space. These types of buildings include stores, bars, restaurants, insurance offices, fitness or dance studios and so on. These types of buildings can be an excellent investment opportunity because you get to branch out your portfolio and gather more rent per square foot by possessing a multi-purpose space.
Office Buildings
Office buildings can be an excellent commercial investment because corporate tenants typically stay in their location for a longer time and are expected to pay on time. The classification of these buildings is by their construction and location. A “Class A” building is highly desirable regarding both location and construction, whereas a “Class C” is less desirable because of its location and age.
Some buildings have a layout that can support multiple businesses while others are less flexible when it comes to the floor plan. The prices vary tremendously based on the building’s class rating, location, square footage, access to the nearby amenities, etc. All of these factors impact how easy or hard it may be for tenants to rent out space in a commercial office building. Therefore, make sure to estimate all aspects of your purchase carefully before you buy.
Industrial Buildings
These types of commercial buildings can include anything from substantial manufacturing plants to small warehouses. Industrial buildings often contain a vast amount of storage or workspace in addition to one or a couple of minor offices. One of the more significant benefits of possessing a large industrial building is that it is multifunctional and you can usually charge a quite high rent. The negative side is that it can be quite challenging to rent out a building.
How To Lease Commercial Real Estate
First, let’s make clear what a commercial real estate lease is.
Commercial leases are rental agreements that allow a business to rent a commercial space from a property owner. They are divided into three forms: net leases, modified gross leases, and full-service leases.
To identify, negotiate, and sign a commercial lease is a complicated and lengthy process and it’s critical to understand the essential steps written in details in this thorough guide.
1. Set Your Property Parameters
Your first step when leasing is to set your commercial real estate parameters. This is because there’s a wide range of commercial real estate properties available for all types of businesses. These parameters help you limit your search to only commercial spaces that meet your needs.
Specifically, you need to understand the following:
- Property type and zoning
- Maximum budget
- Ideal customer
- Accessibility
- Desired size
Let’s review each of these parameters.
Property Type and Zoning
As we mentioned above, all commercial properties are zoned for a particular use. A warehouse is a great example of a commercial real estate property zoned for industrial use. Other commercial real estate zoning includes office, retail, restaurant, and leisure. The type of zoning commands the kind of business that can work out of the commercial building.
Make sure you understand your local zoning laws and the type of zoning your business requires.
Maximum Budget
Determining your maximum monthly budget will help you limit your searches to only areas that you can afford. Your maximum budget largely depends on your business’s performance and size.
To help, it’s crucial to determine the average sum per square foot for your area. The amount per square foot is usually derived from the annual lease price divided by the entire rentable square feet of the space.
Once you discover the average price per square foot, take it and multiply it by the square footage that your business needs. This should give you the expected annual budget for your commercial lease. To find your expected monthly lease payment, divide the annual by 12.
Then, you’ll want to add up the expected utilities and common area maintenance fees and include it in your maximum budget calculations. Utilities will usually cost $2 per square foot annually, and common area maintenance fees will vary between 15% to 35% of the annual lease payment.
With that being said, you must ensure that your max budget does not exceed 8% of your presumed annual gross income. Anything higher can put your business in financial distress.
Ideal Customer
Understanding your ideal customer is the most crucial parameter if you are a business looking to attract visitors to your location. Retail, restaurants, and similar types of businesses are great examples. Also, these companies should know the location of their ideal customers.
For instance, a fast-casual restaurant will want to lease a commercial space in an area inhabited by people who like fast-casual dining. Alternatively, a Michelin Star restaurant may want to pick another location in a more distinguished area.
However, if you are looking for office space, this is not as important. Rather, you will want to find a commercial space that is convenient for your employees. You can carry out a similar analysis and find an area that is highly desired by your ideal customers (such as is the case with the technology industry and Silicon Valley).
Accessibility
Accessibility is also a critical parameter for restaurant and retail businesses. For instance, these businesses will want to have an adequate parking lot for their customers. Moreover, they’ll want to pick a location with high traffic count.
Determining the size of your parking lot is easy. A wise rule to follow is to have a parking spot for each third customer.
Desired Size
The available commercial lease options largely depend on the size and the layout of the space that you need. To determine the size, you will need to calculate the number of your customers or the size of your workforce to get the necessary square footage.
For instance, retail and restaurant locations on average require 15 square feet per customer. On the other hand, offices usually need between 100 and 150 square feet of usable workspace per one employee.
Hence, if you’re looking for a restaurant or retail location, you’ll want to discover how many customers approximately you’ll have, and multiply this by 15 square feet. And if you are looking for an office space, you will want to predict the desired size of your workforce and then multiply it by 100 to 150. This will give you the needed size of the commercial space.
2. Find a Commercial Real Estate Agent
Agents facilitate most commercial real estate leases. There are usually two types of commercial real estate agents involved:
- Buyer’s Agent (an agent who represents tenants/buyers)
- Seller’s Agent (an agent who represents landlords/sellers)
Landlords hire Seller’s Agents to list their commercial property. The Seller’s Agents earn a commission paid by the landlord, usually between 3% to 6% of the total lease.
Buyer’s Agents represent tenant interests. They also receive a percentage of the full commission paid by the property owner, known as the Buyer’s Agent fee.
That means that a Seller’s Agent must always act in the best interest of the property owner. While the Buyer’s Agent has a duty to work toward the benefit of the tenant.
When to Use a Buyer’s Agent
A Buyer’s Agent can usually help a tenant in the following ways:
- Accurate market pricing and compensation data
- Knowledge of local market conditions
- List of available real estate
- Access to financing options
- Negotiating skills
Moreover, this value is typically free to the tenant since the property owner usually covers the Buyer’s Agent fee. Therefore, it is a good idea to engage a Buyer’s Agent and have them aid you in finding appropriate locations to lease.
What To Ask When Looking For A Commercial Real Estate Agent
- What is the Agent experience with your particular commercial needs?
- Does the Agent have a decent knowledge of the local market?
- What is the size of that Agent practice?
- How is the Agent being compensated (what is his or her fee structure)?
- What’s the Agent fiduciary duty?
You will want to find a Commercial Real Estate Agent who has a variety of experience and attention.
How to Work Without a Commercial Real Estate Agent
As we mentioned above, signing an agreement with a commercial real estate agent is not mandatory. A Buyer’s Agent is helpful, but if you choose to look for commercial real estate properties yourself, you will have to execute the following without the experienced Buyer’s Agent help:
- Setting up walkthroughs
- Negotiating the lease
- Finding new listings
3. Understanding The Various Types Of Commercial Leases
There are usually 3 types of commercial leases. The difference between them is the way fees and costs are estimated. The three types are:
- Full-service lease
- Net lease
- Modified gross lease
Let’s review each type of lease more thoroughly.
Full-Service Lease
A full-service lease is the most common type of commercial real estate lease for office buildings. That means that the property owner is responsible for paying the costs linked to the property, including maintenance and repairs, property taxes and insurance, and utilities and janitorial services.
This type of lease is by far the most simplistic for the tenant. There are no hidden expenses, and businesses can predict their monthly and annual lease costs. In this scenario, the responsibility of maintaining the property belongs to the landlord.
Net Lease
A net lease is an agreement where the property owner charges a lower annual rent, compared to the full-service lease. However, owners can include monthly costs which include things like property taxes and insurance, and common area maintenance costs (CAMs). Net leases can be a single, double, or triple net lease.
In a single net lease, the tenant pays the rent and a pro-rata share of the building’s taxes. In a double net lease, a tenant pays a part of the property’s insurance in addition to the rent and property taxes. And in a triple net lease, a tenant pays the pro-rata share of the property taxes, insurance, and CAM.
This means that while the base-rent is lower for the tenant, the tenant is also responsible for the monthly expenses linked to maintaining the property. These costs are usually added onto the base-rent on a monthly basis. Triple-net leases are the most simplistic for the landlord. They are most common in retail and restaurant locations.
Modified Gross Lease
A modified gross lease is a blend of the full-service lease and the net lease. In a modified gross lease, the tenant might pay for his part of property taxes, insurance, and CAM costs, but pays it as a lump price payment along with the rent.
The rent on the modified gross lease is therefore fixed, and no hidden costs or unexpected charges are present. If any of the property taxes, insurance, or CAM costs increase, the rent remains the same. This is not the case with the net lease. The landlord covers utilities and janitorial services with a modified gross lease.
4. Identify The Proper Commercial Property
When looking for different commercial property listings, make sure you evaluate the following in addition to the property parameters:
Location. Aim that the property is either near your ideal customer or workforce. Also, make sure to find a space that has high traffic count as well as sufficient parking for customers or employees.
Amenities and Services. You need to understand the full range of amenities provided by a commercial property. These amenities and services can include things such as communal rooms, loading bays and docks, free Wi-Fi, dining options, functional sewage and utilities, on-site security, outdoor space, and more. The zoning of your space will dictate the type of services and amenities you need.
History of Landlord. It is crucial to understand this since commercial leases are usually multi-year agreements. The property owner of the property you choose may have already settled the lease agreement, its changes, rental increases, and more.
Anchor Tenants. Some multi-unit commercial spaces have an “anchor tenant.” This tenant anchors a mall or shopping center. If the tenant leaves, the property owner might be able to get out of the property’s other leases legally.
WestWood Net Lease can do a ton of the legwork for you in this sector.
Conduct Multiple Walkthroughs
You and your Buyer’s Agent need to view multiple commercial spaces. This will help you get a better understanding of the average price and will give you a leg-up during the negotiation process. While you research, you might also want to compare the prices to each other to ensure that you’re staying on budget.
A great rule of thumb is that you should review between 4 to 10 commercial properties before you sign the contract.
Let’s Discuss the Most Common and Various Types of Commercial Lease Terms
- Negotiate the Commercial Lease Terms
Once you have reviewed your commercial property options and the linked leases, it’s time to choose a commercial space and negotiate the lease. When formally entering into the negotiation process, you will want to begin by requesting the terms in writing. The request can originate from you or from your Buyer’s Agent, and the landlord’s Seller’s Agent supplies it.
From there on, your Buyer’s Agent should write a business Letter of Intent that represents your intended offer. This can be particularly beneficial in a commercial real estate market with a high demand.
Things you might consider including in the letter are:
- List of products and services, including pricing
- Statement of your intent to lease
- Number of years in business
- Description of your business
- Your proposed terms
The terms can be either identical with the terms that the landlord’s Seller’s Agent proposed, or they can be a counter-offer from your Buyer’s Agent. The terms include the type of lease and the price (and some more nuanced terms). Again, you can counter the lease, and if you do so, the negotiation process begins.
- Common Commercial Lease Terms
Despite the type of the lease, commercial leases often have similar lease terms. The payment structure might differ, but all leases include things as the length of the lease, the required deposit, and more.
Mainly, you should be able to understand the following terms of the lease:
Use clause. This use clause determines what type of business can use the space. For instance, some spaces are zoned for office while others for retail. This clause is especially important if you plan to sublease your property in the future because it limits the businesses available to sublease.
Assignability. A lease must be “assignable” if a business wants to sublease the property in the future. Moreover, an assignable lease makes it possible to involve the lease in the sale of the business. For instance, a restaurant with a good location might be bought by another restaurant because the location is excellent.
Length of the lease. Commercial leases usually range from 1 to 10 years. A short lease can be more advantageous since it gives the business flexibility and reduces future financial burdens.
Capital expenditures. The capital expenditures determine who is responsible for the repairs, maintenance costs, and other expenses associated with the property. A net lease, for instance, charges the tenant for all the capital expenditures. On the other hand, a full-service lease requires the property owner to cover all the capital expenses.
Rent escalation. All leases demand monthly or annual rent and also can include any future rent escalations. Rent escalation is a term that allows the landlord to increase the rent during the lease per the contract. It is common to see escalations of 3% per year.
Deposit. Often, leases require a deposit. This deposit is often completely refundable and protects the owner from a delinquent tenant and from significant damage to the property. The usual deposit is between 3 to 6 months rent.
Lease build-out credits. The build-out credits represent the ability for the tenant to make leasehold improvements in the commercial space at the cost of the property owner. These improvements and expansions are necessary to the success of the business. With build-out credits, property owners either offer a reduced rent or pay directly out of pocket.
Termination clause. It is a clause within the lease that permits the landlord and/or the tenant to terminate the contract under specific conditions. Termination clauses are excellent if they allow you to terminate the lease, but raises your risk if the property owner can also terminate the contract.
Rent Abatement. This term demands that if there’s damage to the commercial property, the tenant will not have to pay (or pay a reduced) rent until the damage is repaired. This is an excellent way to reduce a business’s risk.
Commercial Real Estate: Leasing vs. Buying
After looking at some properties that are available to lease, you might start to wonder whether it is better to lease or purchase a commercial real estate property. There are situations when it might be better to buy commercial real estate instead of leasing it. For instance, if you buy a commercial property, you will take advantage of equity, cash flow, depreciation, and asset appreciation.
The benefits of purchasing over leasing commercial real estate property include:
- Own an appreciating asset. Over time, commercial real estate properties can rise in value letting you sell for a profit (eventually). However, assets can also decrease in value, making it an investment with a risk that you need to consider.
- Increase cash flow. Commercial properties usually need owner-occupied businesses to occupy 50% of the building. Nevertheless, you can rent the remaining space and get rental income.
- Depreciate the building. You can include the annual depreciation on your tax returns.
- Build equity. You can use the equity as collateral for additional expansions.
Moreover, it is not uncommon for a commercial building to be sold which can leave the lease in the lurch. If you are leasing a property that is sold to another landlord, you might get terminated out of your space. This is usually part of the termination clause. This issue is largely remedied if you own your own building.
When it comes to the pros of leasing, the tenants avoid any down payments. Instead, tenants pay a refundable deposit equal to 3 to 6 months rent, which is typically far below the 10% to 35% down payment required for a commercial loan.
Moreover, lease payments can be deducted, which will reduce a business’s tax burden. On the contrary, owning a property only allows you to depreciate the property over its useful life. If you finance a commercial real estate property, you can also deduct origination fees and interest payments.
What’s more, owning a commercial real estate property can be more stable than leasing it.
Conclusion
Market research is the key to commercial real estate investing success. As an investor, you need to understand the pros and cons of investing in commercial real estate properties so that you can make the right decision.
It is also important that, when you are looking for a commercial lease, you first need to set your property parameters. Don’t forget the most critical thing: that is, to choose an excellent location.
Interested in buying a commercial real estate property?
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