What You Need To Know About Investing In Commercial Real Estate

It’s not all about investing in residential homes. There are big gains to be made with commercial real estate. However, entering the commercial real estate game can be harder, especially if you don’t have the right contacts or experience.

So, we thought we’d give you a quick rundown of what commercial real estate entails, as well as some of the pros, cons and best strategies for newer real estate investors.

What is Commercial Real Estate?

In short, commercial real estate is any property owned for the purpose of producing income through leases and that isn’t residential. In the US there’s around $6 trillion worth of commercial real estate. Due to it being such a large industry, there is plenty of room for new investors.

Here is a break down of the five largest categories of commercial real estate:

#1 Retail

This includes retail and grocery stores, restaurants and bars as well as things like shopping malls. Unsurprisingly this is the biggest segment of commercial real estate making up around a 1/3rd of the total commercial real estate in the US. It consists of at least 9.5 billion square feet of shopping center space.

#2 Hotels

Hotels are next on the list. This category also includes things like motels, resorts and business hotels. One thing to note though is that this category does not include homes rented through Airbnb. This segment is worth just under $2 trillion.

#3 Office Building

Everything from the Manhattan skyline to your local lawyer’s office. There are roughly 4 billion square feet of office space with a value that comes in just behind that of hotels.

#4 Apartment Buildings

Apartment buildings owned by companies and leased out are also categorized as commercial real estate. Not all apartments are commercial real estate though. Homes that are rented out by their owners count as residential real estate which is an important differentiation.

#5 Industrial

Industrial property includes things like factories and warehouses. Essentially places where industrial business takes place. Like apartments, this isn’t always commercial real estate especially in land use plans and in zoning. There are 13 billion square feet of industrial property worth around $240 billion.

There are other categories which include things like schools, hospitals, and non-profits, but these are the main five that need to be considered.

A final note is that vacant land can also be commercial real estate if it is leased, not sold.

Pros and Cons of Commercial Real Estate

Pros

Income Potentials

The main reason to invest in commercial real estate over residential is the potential returns involved. Commercial property generally has an annual return of the purchase price of between 6% and 12% (this is dependent on the area and type of real estate you invest in). In comparison, a Single Family Home (SFH) generally makes 1% – 4%.

Professional Tenants

Generally speaking, though not always, small business owners take great pride in their businesses. This means they will spend money to look after the property, and they will do what they need to protect their livelihood. This means they are less likely to be late on the rent or abuse the property.

Plus, most owners of commercial properties are companies, which makes the transaction business to business. This more formal relationship helps keep the interactions professional and courteous.

Long Leases

In general, when you lease a property to a business they are going to want the space for as long as they need it, this will be until they either upsize or close.

From my experience working with a company that managed hospitality property, the businesses would want, at the very least, 5 years on the lease. Any less than that and it isn’t worth the input of cash to renovate the restaurant or bar to generate the profits that are needed. In fact, businesses often look for properties with leases set for 10 – 20 years to get more favorable terms.

Essentially what this means as the landlord, is there will likely be far less time when the property is vacant, in practicality meaning less rent loss – plus far less effort spent keeping the properties occupied.

Business Presentation

The building space in this scenario is the business’s presentation to the public. Most successful businesses will want to present themselves in the best manner possible to the public and their clients. In order to do this they will want to keep the building well maintained – often undergoing renovations. This helps maintain the overall quality of the building and ultimately the value of their business. With less effort and expense required from you.

More flexibility in lease terms.

Fewer consumer protection laws govern commercial leases, unlike the dozens of state laws, such as security deposit limits and termination rules, that cover residential real estate. This makes the industry a little easier to navigate and is less skewed in favor of the lessee.

Cons

Time commitment.

If you own a commercial retail building with five tenants, you have more to manage than you do with a residential investment. You can’t be an absentee landlord and still maximize the return on your investment.

With commercial, you are likely dealing with multiple leases, annual CAM adjustments (Common Area Maintenance costs that tenants are responsible for), more maintenance issues, and public safety concerns. In a nutshell, you have more to manage; and just as your tenants have to worry about the public eye, you do as well.

More help required

Whilst you may be called upon less to help maintain the property, if you are called in you will need to be qualified if you want to do any of the maintenance work yourself.

This is more costly, though it does in its own way have benefits. You will need to make sure you have a budget set aside for this. You will also want to carefully evaluate whether or not you will want to manage the property yourself or outsource to a professional company.

Bigger initial investment

Property of any sort comes with a pretty high monetary barrier. Commercial property is no different. Typically it requires more capital upfront than a residential rental in the same area which makes it a bit more of a challenge getting your foot in the door.

On top of this, there are some bigger property costs entailed as well – due to the fact the property itself is often larger and there are more leaseholders.

REITs and Commercial Real Estate on a Budget

As we just mentioned, commercial real estate comes with a high monetary barrier. Higher even than residential property. This makes it hard for many people to benefit from the huge opportunity that commercial real estate offers.

This is where a Real Estate Investment Trust (REIT) could come in. REITs are public companies that own a portfolio of real estate. Some of these companies specifically own just commercial or just residential. Some are more specific investing only in something like storage space. The benefits of an REIT are that they allow people to buy shares in a real estate portfolio – meaning your investment at any level, is going directly into real estate.

They lower the monetary entrance barrier, they are also seen as much safer investments than purchasing your own individual properties due to the portfolio having a diverse selection of properties to mitigate potential risks.

An REIT in the US must payout 90% of its rental profits to its shareholders. This is both good and bad. The upside is they can’t hoard profits, and you as an investor will see real rewards. However, this means they only have 10% left to reinvest in the expansion of the portfolio meaning an REIT’s growth is generally quite slow.

There are other things that should be considered before investing in an REIT. As always it’s worth doing your research about them before making any investment decisions.

Commercial Real Estate Investing Risks

There are always risks when investing. Commercial real estate is no different.

Properties intended for commercial use have more public visitors and therefore have more people on the property each day that can get hurt which you as the property owner would potentially be liable for. Or the increased number of people could add exponential “wear and tear” to the property.

Incidents like a car hitting a visitor in the parking lot, or someone slipping on ice that should have been cleared can occur anywhere, but chances of experiencing something like these events go up when investing in commercial properties. If you’re risk-averse, you may want to look more closely at putting your money in residential properties instead.

We hope you found this blog interesting! However, do note that it should not be used as a substitute for competent legal and/or other advice from a licensed professional.