Commercial Real Estate Investing — What Do I Need To Know?

  • Benefits of owning CRE
  • Drawbacks to CRE investments
  • Commercial real estate lingo
  • Financing basics/options
  • Tough questions to ask yourself
  • Assembling a team of experts
  • Research and inspection of properties
  • Completing your due diligence

Types and Classifications of Commercial Investment Properties

There are different types of commercial real estate investments, and each can be further classified based on characteristics including purpose, size, location, and kind of construction.

Classifications for Commercial Office Buildings

A classification rating system helps investors, landlords, tenants, and real estate brokers identify and compare commercial office buildings. These classifications are subjective and may vary greatly between geographic locations, and between landlords and tenants.

  1. Class B — Think more sensible but still very nice and functional. Comfortable spaces, possibly former Class A buildings, at a more favorable price just slightly outdated.
  2. Class C — Think out-of-date, rough but useable space. Economical commercial space with no (or very few) amenities.

Benefits of Owning Commercial Real Estate

Note: The benefits of owning commercial real estate described below are generalizations. Every potential property has specific traits that need to be considered on its own merits.

  • Tenants may take better care of your property. If you purchase a strip mall or a building with a retail store or a restaurant, the businesses renting from you want to attract customers to make a profit. This may benefit you because they will focus on keeping up your property.
  • Longer leases can stabilize cash flow. Other than multi-family properties, CRE leases tend to be longer which helps with the stability of your cash flow. It may also be easier to remove non-paying tenants in CRE investments than to evict people in residential housing.
  • Less competition. If you decide to invest in the commercial real estate market, you may face less competition from other investors. Higher upfront costs and a lack of experience and knowledge will keep many from investing in CRE.

Drawbacks to Commercial Real Estate Investing

Note: The drawbacks of owning commercial real estate described below are generalizations. Every potential property has specific traits that need to be considered on its own merits.

  • It will likely take longer. When comparing CRE investing to residential RE investing, most things take longer to complete. Researching and inspecting properties is months long versus a few days or weeks. Finding and approving tenants will usually take longer. Any repairs, build-outs, or renovations will typically take longer as well. However, the typical commercial lease is longer too. Staying patient is key.
  • There’s a greater chance of legal issues. Along with higher costs from more traffic comes a greater chance of legal problems too. It will be essential to have adequate insurance and to have a lawyer who understands CRE to advise you.
  • So many rules and regulations. This is another reason to surround yourself with a team experienced with CRE’s if you choose to invest in one. In addition to your attorney, using a realtor with commercial property experience and an experienced accountant can make owning the property much easier.

Commercial Real Estate Lingo

There are many commercial real estate terms you’ll benefit from knowing if you decide to invest in CRE. Here are a few to start with:

  • Capital Improvement: Significant physical development or redevelopment of a property to extend the life of the property; may include upgrading of building mechanicals, replacement of the roof, renovations of common areas, or refacing of building exterior.
  • Capitalization Rate (Cap Rate): Income of the property divided by the total value of the property. Cap rates can be used to roughly estimate how quickly an investment will pay for itself. A higher cap rate is better when you’re the buyer.
  • Cash on Cash Return (CoC): Annual income over how much you actually invested. The amount invested may be no more than the amount of your down payment
  • Common Area Maintenance (CAM): Additional rent charged to tenants, in addition to base rent, for maintaining any common areas of a property shared by building tenants; may include outdoor lighting, sidewalks, snow removal, parking areas, insurance, property taxes, etc.
  • Debt Service Coverage Ratio (DSC) or Debt coverage ratio (DCR): Operating income over total debt. Basically how much debt you’ll cover each year with income received.
  • Gross Lease: Property lease whereby the landlord (i.e., lessor) pays for all property charges usually included in ownership; may include utilities, taxes, and maintenance, among others.
  • Loan-To-Value (LTV): A ratio of how much money you’re asking to borrow versus the total value of the property you want to purchase.
  • Loss Factor: The percentage of gross space area lost due to walls, elevators, escalators, etc.
  • Net Lease or Triple Net Lease (NNN): When a lessee pays additional expenses on top of their fixed rent it is considered a net lease. A single net lease typically includes property taxes in addition to rent. A double net lease usually involves paying property taxes and insurance premiums plus rent. And with a triple net lease (NNN), the tenant pays taxes, insurance, and maintenance expenses in addition to fixed rent and utilities.
  • Net Operating Income: Net operating income (NOI) is a calculation of all property revenue minus any reasonable and necessary operating expenses, excluding loan principal and interest payments, capital expenditures, depreciation, and amortization.
  • Percentage Lease: This type of lease may be used in retail settings where the rent is based on a percentage of sales volume made on the property premises. Often there is a clause for a minimum rental amount to be paid.
  • Real Estate Investment Trust (REIT): A specified company that allows individual investors to buy shares in commercial real estate portfolios. These CRE portfolios receive rental income from a variety of property types such as apartment complexes, retail shopping centers, and office buildings. The REIT owns the property, leases the space, collects the rents from tenants, and then distributes income as dividends to portfolio shareholders.
  • Return on Investment (ROI): ROI is a term used in accounting to indicate the percentage of invested money recouped after deductions for associated costs. For further explanation as to how it’s used in real estate investing see this article from Investopedia.
  • Tenant Improvements: Interior work done within a rented space. Depending on terms of the lease, these improvements may be paid for by the landlord, tenant, or some combination of both.
  • Usable vs. Rentable Square Feet: Usable square feet is the wall to wall area you occupy for your business. If you were to lease an entire floor of a building, it would include the hallways, restrooms, lobby area, etc.. But, if you do not occupy an entire floor, it does not include the common area hallways, lobbies, restrooms, storage rooms, etc. Rentable square feet is the usable square feet plus a percentage of the building’s shared space or common areas.
  • Vacancy Rate: Percentage of properties that are vacant in a specified time period in a given area.

Financing for CRE

Commercial property loans are not generally made out to individuals but instead to business entities — corporations, S-corps, LLCs, developers, limited partnerships, funds, trusts, etc. For newer businesses who may not have a lengthy financial record or credit rating, the lender will likely require a guarantee of the loan by the entity owners or principals.

Traditional Commercial Mortgage

Most CRE loans are typically made by banks, to entities with strong credit scores and histories. Similar to residential mortgages, the commercial loan is secured by the purchased property.

SBA 7(a) Loan and SBA 504 (or CDC) Loan

The Small Business Administration guarantees these loans made by banks to small business owners.

Conduit/CMBS Loans

CMBS loans or conduit loans are commercial mortgages pooled with similar loans, and packaged into bonds for sale to investors on the secondary market. These loans are known for their less stringent credit requirements and often come with fixed-rate terms of 5, 7, or 10 years.

Soft and Hard Money Loans

Hard money loans are asset-based loans secured by the value of a real estate property, often at higher interest rates and shorter terms than traditional commercial mortgages. They are typically utilized to quickly finance deals in the interim while negotiating a longer-term traditional or SBA bank loan. These “bridge like loans” are made by private companies making them easier to qualify for and faster to fund than a traditional mortgage but at higher down payment requirements.

Questions to Ask Yourself as You Consider CRE Investing

Before jumping into commercial real estate investing there are many things to consider. After reviewing the information covered above, ask yourself these questions:

  1. What type of CRE are you looking for?
  2. If you’re looking for CRE for your own business, do you need to purchase a building or could you lease a property?
  3. How important is the location of the property?
  4. How will you finance the property? Do you have ample cash for down payments, business filings, is your credit history strong?
  5. Are you willing to consider a partner for the purchase of a property?
  6. What knowledge and skills do you currently have and what will you need to learn to be successful?
  7. Do you have time to commit to the property? How much?
  8. How much work and money are you willing to put into a property?
  9. Are you willing and able to handle the responsibilities of being a landlord?
  10. Or will you use a property manager?
  11. What experts do you currently know who might be good members for your team?
  12. Finally, are you mentally and financially ready to make a sizeable investment of your time and money in a CRE?

Assembling an Expert Team

Commercial real estate investing can be a complicated process. So hiring experts to assist with some of the steps may be prudent for success. Who you need may depend on the type and size of the CRE you are considering.

Research and Inspection of Properties

When you’re ready to view properties, assemble a list of items to consider for each property you see. Some ideas are listed below:

  1. How is it currently being used?
  2. What other ways can it be used? How can’t it be used?
  3. How much rent/income is the property currently generating each year?
  4. What are the current annual operating costs and what taxes are on the property?
  5. What is the vacancy rate?
  6. Are there any items in need of repair or replacement soon?
  7. Why is the owner selling?
  8. How long has the property been on the market?
  9. Is the area around the property progressing or regressing?
  10. Any significant upcoming changes for the neighborhood?

Due Diligence

As you view properties and narrow down your options you’ll want to perform thorough due diligence on any CRE you’re interested in submitting offers for. This will help you verify the property is a sensible investment option. You’ll want to ensure you know as much as possible about the property, immediate area and neighborhood around it, current owner, and deal.

  • Do the math — Being a successful investor in commercial real estate, requires understanding several formulas such as:
  • Net Operating Income: A calculation of all revenue and costs from a property, before taxes. Expenses may consist of property taxes, insurance, utilities, maintenance, repairs, property management, and janitorial fees.
  • Cap Rate: A calculation of the value of an income producing property. Basically, it’s the ratio of net operating income to property value.
  • Cash On Cash: A calculation — net operating income divided by initial cash investment — providing a rate of return on real estate transactions.
  • Know the zoning, occupancy, and environmental ordinances/requirements
  • Understand the financing requirements

Summary

Many people buy a single-family house or a duplex to rent when they begin investing in real estate, while others might try flipping a house. However, investing in commercial real estate may offer a higher earning potential — if you can find the right deal.

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