Investing In Commercial Real Estate
Investing in real estate can be a way to earn passive income and increase your wealth. While plenty of investors have success in residential real estate, others make a move to commercial real estate to gain even more money.
As with any investment, commercial real estate has both risks and rewards. It’s not for everyone, as investing in it requires a good deal of work — especially in the early stages of the process. While there’s less risk in some cases, you typically need to put down more money upfront. Commercial real estate investing also usually takes longer than buying residential properties.
This guide to investing in commercial real estate for beginners will help you better understand what commercial real estate is and if it’s a good investment option for you.
What Is Commercial Real Estate?
Commercial real estate refers to property used for conducting a business. What form that business takes depends on the premises and area. Commercial real estate comes in a variety of types and classifications.
Types of Commercial Real Estate
Here are a few of the most common types of commercial real estate.
- Retail: Retail real estate includes shopping malls, smaller strip malls or shopping plazas and stand-alone shops. Restaurants and supermarkets or grocery stores also fit into the retail type. Some retail properties can include percentage rents based on breakpoints, like 5 percent of gross sales, which gives the owner the benefit of seeing more profits.
- Multi-family: Multi-family properties like condos and apartment buildings over five units aren’t considered residential. They are commercial buildings because the owner rents them out for profit.
- Hospitality/hotels: Properties such as hotels, motels, inns and resorts all fall under the hospitality category. Hospitality properties should not be confused with a residential property with minimal rental units, like Airbnb.
- Office: Offices of all sizes, from tiny structures to multi-story skyscrapers, are considered commercial.
- Land: Land can be a type of commercial real estate if the person who buys the land intends to rent it out or otherwise use it to make money.
- Agricultural: Large farms fall under the umbrella of commercial real estate, especially if the person buying the farm doesn’t plan on living there.
- Nonprofits: Hospitals, schools and other buildings used by organizations that don’t earn a profit are a type of commercial real estate. If the owner of the property charges the school or other organization rent, the property serves business purposes.
- Industrial: Industrial commercial real estate includes properties such as warehouses, factories, shipping facilities and data warehouses.
Commercial Real Estate Classifications
Along with the different types of commercial real estate, there are a designations or classes to consider, especially when dealing with office buildings. Here are some examples.
- Class A: Class A properties are the best of the best. They might be newer buildings built within the last 15 years or so. They tend to be in downtown centers, and they usually have all the best amenities and features. A Class A office building, for example, will typically be new, located in a central business district and have up-to-date facilities, such as reliable Wi-Fi.
- Class B: Class B properties tend to be older than Class A properties and most likely not as up to date. Additionally, they might have tenants who pay lower-than-average rents.
- Class C: The bottom of the heap, but not necessarily a bad investment, Class C properties tend to be more than 20 years old, and often need updates and renovations.
- Classes D through F: There isn’t much difference in the classification after Class C, and Classes D through F are rare. Occasionally, you might see reference to Class F properties, which are meant to be condemned. Class F buildings typically don’t count toward the building inventory of the market.
Commercial Real Estate Investing 101
Is investing in commercial real estate as easy as finding a property for sale, calling up a commercial real estate agent and making a deal? Well, yes and no.
Commercial real estate investing has some things in common with investing in residential real estate. But there are also some fundamental differences.
Investing in Commercial Real Estate vs. Residential Real Estate
One of the most significant differences between commercial and residential real estate for investors is the way the two types of properties are valued. Square footage, particularly usable square footage, plays a prominent role when it comes to determining the value of a commercial property.
As an investor, you’re more likely to see a better return on investment if you buy a property with five rentable units than if you were to buy a property with one unit or a single-family home. There’s also slightly less involved in commercial real estate, at least in one aspect. If you buy a residential property suited to only one person or family, when that tenant moves out, you lose all your income until you find another renter.
But if you were to buy a five- or 10-unit property and one tenant moves out, you would only lose 10 or 20 percent of income from that property, at least until you find a new tenant.
Even if you don’t buy a multi-family commercial property, commercial real estate has some benefits over residential properties. The lease terms for office or retail spaces tend to be much longer than the rental terms for homes. When a company signs a lease on an office or store, it’s usually for at least five years, if not much longer. Some businesses sign 20- or 30-year leases. You’ll be secure in the knowledge that you’ll have a tenant for the long run.
The one drawback of investing in commercial real estate over residential properties is that banks and lenders tend to look at commercial properties differently. Even though you’re likely to earn more from a commercial property, your lender might see it as a higher-risk venture. That means you can expect to have to put down more upfront than if you were buying a home.
Mortgages for Commercial Real Estate
Another significant difference between commercial and residential real estate is the type of terms offered on mortgages. Generally speaking, it’s a lot easier to get a mortgage on a residential property than it is for a commercial one.
Often, lenders expect people or businesses buying commercial real estate to put down a much more substantial down payment. In some cases, that deposit can be up to 35 percent of the property’s value.
You also end up paying back a mortgage on a commercial property differently from how you’d pay back a home loan. With a commercial real estate loan, the lender might divide up payments on a 20-year schedule, but then put the loan on a five- or seven-year repayment schedule.
That means you’d make monthly payments based on what you’d pay over the course of 20 years for five or seven years. But once those five or seven years are up, your lender might expect you to make one big, balloon payment for the entire amount remaining on the loan.
How to Get Into Commercial Real Estate Investing
Investing in commercial real estate isn’t a project you need to complete on your own. In fact, it’s often in your best interest to have a team of experts around you to help you with every step throughout the process.
As you would when buying a residential property, step one of getting into commercial real estate is making sure your finances are in order. In this stage, hire an accountant to look over your books and ascertain what you’d gain or lose if you were to buy a particular property.
It also means you must work with a lender to learn more about mortgages for commercial properties and whether you’d qualify. You also want to hire a lawyer to help you with all the paperwork and to help you through the negotiation process. Your lawyer can also explain any tricky concepts and keep you from signing documents that aren’t in your favor.
Finally, you’ll want to find a commercial real estate agent or broker. Your agent can help you locate properties, schedule showings and guide you through the process of making an offer.
Finding and Buying Commercial Property for Investment
When it comes to finding the right commercial property for investment, one thing trumps all the rest — location. If a property you’re looking at is in a less-than-ideal area, it will be difficult for you to find people or businesses to lease it. Even if a property in an out-of-the-way area seems like a steal, if you can’t find people to occupy it, it will be a money-losing proposition for you.
Usually, the more centrally located a property is, the better. If you’re looking for office space to invest in, you’ll have a much easier time finding tenants for a building located in the heart of a downtown area than you will for a building located in an exurban area or a more remote suburban area.
Property located near many amenities, such as schools, hospitals and shopping centers, is also a good pick, even if it’s not in the middle of downtown.
Of course, location isn’t everything. You want to make sure the property doesn’t have too many skeletons in its closet. For example, you want to know how the property is zoned and how easy — or difficult — it would be to change the zoning, if needed.
It’s also worth considering the age of the building before buying. Usually, newer buildings will be in better condition than older ones. They are also more likely to have up-to-date amenities and features tenants want.
That’s not to say an older building isn’t worth investing in. For the right price, it can make sense to renovate and fix up an aged property completely. It’s all about how much effort you want to put into it. Consider whether you’d rather spend more upfront for a turnkey, ready-to-lease property, or if it would be worth it to put some time and effort into repairing a worn-out, outdated property.
Identifying the Right Commercial Property
When checking out properties, get to know the current tenants and the businesses in the buildings or properties adjacent. Your agent can ask them what problems, if any, they’ve had with the building, what they like about doing business — or living — in that area and how long they plan on remaining.
Once you’ve found a property that seems to be “the one,” the next steps are very similar to the process when buying residential properties.
You’ll want to work with your real estate agent and your attorney to figure out what the best offer amount is, then your lawyer can draft up a letter of intent.
Even if the seller accepts your offer, the process of buying the property isn’t over yet. Now it’s time to check up on the property with due diligence. You’ll want to order a title survey to find out the exact boundaries of the property, as well as the location of easements and the history of the building. You’ll also want to hire inspectors to assess the condition of the building to make sure there are no deal-breaking issues with it.
Commercial Real Estate Tips and Tricks
Although investing in commercial real estate can be a reliable way to improve your assets portfolio and build wealth, a lot can go wrong if you rush headfirst into it. These tips and tricks will help you make the best choices for your own needs and enjoy the best return on investment possible:
- Sometimes a Great Deal Isn’t- It’s easy to get blindsided by a low price or another too-good-to-be-true offer on a property. But just because you’ll save money upfront doesn’t mean a piece of real estate is the best deal. Always research before buying any property.
- Know Your Budget- Although you can expect to earn income from your investment, it’s important not to go overboard and buy more property than you can afford. Don’t just look at the price of the property — add up what it will cost over the life of the mortgage, plus costs like property tax and maintenance and repairs on the property.
- Cash Is King in Commercial Real Estate- When it comes to residential properties, buyers and agents tend to look at “comps” to get a sense of how much a property is worth. If a similar property sold for $150,000, a buyer might make an offer in that range. But in commercial real estate, it doesn’t matter if a similar building or property sold for $10 million.What matters when it comes to determining a property’s value is how much cash it brings in. If that $10 million property brings in less per month than the property you’re looking at, you can expect to pay more for the for-sale real estate.
- Always Have an Exit Strategy- When you invest in anything, you want to have a plan for leaving if things don’t go as planned, or whenever you decide you’re through with that investment. That’s the case with real estate. Know how you’ll get out, and put that plan into action when needed.
- Know What’s in Store for the Area- The property you’re looking at might be in a great location — today. But what’s in store for the location in the future? Will a new high-rise building be going up, blocking the view? Will a major player in the area be moving out of town? Having an idea of what’s going to happen within the next few years will help you avoid buying a property that turns out to be a dud.To get a sense of what’s going on in the area, look up business and real estate news for that region. Local newspapers typically have sections devoted to commercial developments and business. It can also be helpful to look up census data and unemployment statistics for an area. Census data gives you an idea of whether people are moving in or out of an area. Unemployment statistics can let you know if business is booming or not.
- Spending up Front May Save You a Lot of Money Down the Line- Hiring inspectors, attorneys and other professionals can seem like needless money spent. But if that inspection keeps you from buying a severely worn-out building, or if that attorney saves you from a terrible contract, you can consider that money well spent.
- Have a Plan for Upkeep and Repairs- That shiny new office building won’t stay shiny and new forever. When you buy commercial property, it’s essential to maintain it on a regular basis, especially if you hope to keep renting it out and attracting tenants.
The Benefits of Investing in Commercial Real Estate
If you’re already comfortable investing in residential real estate, you might not see the advantage of switching over to or at least trying your hand at commercial real estate. While you might want to continue to own and manage residential properties, giving commercial real estate a try has many benefits.
- Better income options: Commercial properties often cost more to rent than similar-sized residential properties. Even if you buy a multifamily property for people to live in, you’ll typically bring in more per month renting out multiple units than you would renting out a single-family home. You might also have the option of increasing the rent over the course of the lease with a commercial property.
- Properties appreciate: Another benefit of investing in commercial real estate is that the value of the property can go up over time. That’s good news for you if you decide to sell the property. Additionally, appreciation of the property means you can charge more for rent when signing on new tenants.
- Lease terms are longer: When you rent retail or office space to a business, that business typically signs a multi-year lease. That multi-year lease means you don’t have to check in with tenants every 12 months, nor do you need to advertise for new tenants regularly. Another benefit of a long-term lease is that you can include an acceleration clause in it. If a retail tenant signs a five-year contract, but closes up shop after just a few months or a year, the remaining amount of the lease becomes due right away.
- Tenants can be easier to deal with: Admittedly, this isn’t universally true. But generally, business tenants cause less drama and can be less difficult than residential tenants. When a company signs a lease with you, its reputation is on the line as well. That means you can expect it to be more likely to keep the property looking good and in good repair.
- Fewer expenses for you: Depending on the type of lease your tenants sign, you might end up having to pay fewer expenses than when you rent out residential properties. Some tenants agree to pay all the utilities, as well as property taxes, in exchange for more freedom to design or decorate the property however they’d like. These details are part of the negotiation process, which is where a strong agent can properly assist.
How We Can Help Investors
We have more than 3,000 Coldwell Banker Commercial real estate professionals around the world. Our teams of real estate agents are experts in their local markets and can help you find the right property to invest in. We offer a range of commercial real estate types, including retail, office, land and multi-family homes.
To learn more about what we can do for you, contact a Coldwell Banker Commercial real estate agent in your area today.