How to Start Investing in Commercial Real Estate
The size of the commercial real estate market in the U.S. is estimated to be $16 trillion, according to the most recent research from Nareit. Although the pandemic has affected economies around the world, as recovery begins so should the overall demand for commercial real estate.
With the Federal Reserve planning to keep interest rates near zero for the next couple of years, CBRE observes that commercial real estate investors are being rewarded with a wider yield spread and additional gains from asset value appreciation.
In this article we will explain how to start investing in commercial real estate and discuss which property types perform historically well through all economic cycles.
What is Commercial Real Estate?
Commercial real estate (CRE) describes property with the potential of generating income for its owner. CRE differs from residential real estate, which is typically occupied by a homeowner or by an investor owning a single-family rental or a small property of four units or less.
Although historically CRE has been considered an alternative asset class, investing in commercial real estate is becoming more mainstream. A growing number of investors are attracted to commercial properties for the numerous advantages the asset class offers, including recurring cash flow through tenant rent payments, increase in property value over the long-term, and the tax benefits that commercial real estate provides.
Commercial real estate investments can range from a small mom-and-pop retail storefront to a large apartment complex, or special-use properties such as data centers or self-storage units.
Types of Commercial Real Estate
Office buildings come in all shapes and sizes, from one- or two-story properties in a suburban office complex to mid-rise and high-rise office buildings in a central business district. Tenants may include professional services, medical users, or high-tech startups. Office space leases are often run for five years or more.
Multifamily properties with more than four units are considered to be commercial real estate. Building types can include apartment communities, condominiums, townhomes, and co-operatives. Unlike other types of commercial real estate leased to businesses, multifamily units are rented to the general public. Leases for multifamily units generally are one year or less, with some landlords renting month-to-month.
Retail commercial real estate runs the gamut from single-tenant buildings to small community shopping centers and large retail power centers occupied by national tenants. Typical uses include local insurance agents or tax providers, clothing and electronics stores, health and beauty services, restaurants and bars, and anchor tenants such as grocery stores. Retail lease agreements normally run five years or more.
Industrial property is usually located in areas with easy access to transportation, and parts of town not desirable for multifamily or retail property. Uses may include heavy and light manufacturing, assembly, storage, distribution, or research and development facilities. Lease agreements for industrial space usually run in the five-year to ten-year range.
Industrial commercial real estate also includes special purpose property such as data centers, health care facilities, manufactured housing, and self-storage. According to the 2021 U.S. Real Estate Market Outlook report from CBRE, investors are attracted to alternatives for their relatively high yields, stable income, and lower tenant turnover. Some special purpose properties also historically offer downturn protection.
Pros of Investing in Commercial Real Estate
- Higher income potential compared to residential rental property with a lower vacancy risk due to multiple tenants and long-term leases.
- Cash flow from more stable credit tenants on longer leases, with multi-tenant properties generating multiple income streams.
- Triple net leases are long term and allow operating costs such as real estate taxes, property insurance, and building repair and maintenance to be passed through to the tenant, creating less ownership risk for the investor.
- Professional relationships between landlord and tenant with both parties having a vested interest in maintaining a good business-to-business relationship versus renters of residential real estate.
- Limited operating hours of commercial real estate can make property management easier, because both the landlord and tenant share the same business hours.
Cons of Investing in Commercial Real Estate
- Financing commercial real estate is more complicated and expensive, with larger down payments, higher fees and interest rates, shorter loan terms, and more stringent borrower qualification requirements.
- Competition for commercial property is also intense, with small buyers frequently vying with well-capitalized institutional investors, hedge funds, family offices, and more experienced private investors for the best commercial real estate opportunities.
- Economy impacts commercial real estate differently, with property types such as multifamily, self-storage, and special purpose generally performing well through all phases of the economic cycle.
- Specialized property management is required with commercial properties, with management companies who have experience with commercial property maintenance, leasing and tenant relationships, and municipal building codes.
- More potential risk with commercial real estate and the general public, including parking lot accidents, seasonal hazards such as snow and ice, and vandalism.
Getting Started in Investing: Step-by-step guide
1. Know the difference between commercial and residential real estate
One of the biggest differences between commercial and residential real estate is the way property is valued. Even when single-family houses and small multifamily property is rented, residential valuation is usually determined on a price-per-square-foot basis.
On the other hand, commercial real estate values are based on the current and future income a property generates. Property type and location, tenants and lease lengths, and scarcity in many markets all have a significant impact on commercial properties values.
These are also the reasons why commercial real estate can generate higher potential returns than residential real estate.
The location of a commercial property often affects property value more so than residential real estate. For example, retail or self-storage properties located near apartment buildings and residential subdivisions may generate more consistent cash flows than those away from populated areas.
2. Research comps
Comparables (or comps) is a term used by real estate appraisers and investors that refers to properties that have similar characteristics to one another, and consequently similar values.
Commercial real estate comparables are determined by conducting a comparable market analysis (CMA). There are five main steps to researching comps and creating a CMA for commercial real estate investment:
- Define the market area relevant to the property type, such as 1 – 1.5 miles for retail or 3 – 5 miles for self-storage.
- Review similar sold properties in the same market area, gathering details such as physical characteristics including occupancy level and square footage, the spread between asking and selling price, improvements, and financing methods.
- Identify improvements on the subject property (the only being purchased or sold) to adjust comparable value upward or downward.
- Research listed property that has gone off of the market to gain a better understanding of market trends affecting the value of the subject property.
3. Calculating potential return
The potential return of a commercial property is determined by using a variety of different valuation formulas. When calculating potential return, commercial real estate investors should use several formulas to create a holistic view of property value and anticipated returns.
Net operating income (NOI) is calculated by subtracting normal property operating expenses such as management and leasing fees, repairs and maintenance, and property taxes and insurance from the gross rents received. NOI does not include a deduction for debt service since the amount of debt will vary from investor to investor:
- NOI = Gross income – Operating expenses
Short for capitalization rate, cap rate is a ratio used to compare the value of income-producing properties that are similar to each other and located in the same market or sub-market. The cap rate formula can also be used to calculate property value and NOI, provided that two of the three variables of the cap rate formula are known:
- Cap rate = NOI / Property value
Internal rate of return
Internal rate of return (IRR) estimates the percentage of interest earned on each dollar invested in an income-producing property over the entire holding period. If a property’s IRR is 15%, an investor can expect to earn an average annual return of 15%.
Internal rate of return is calculated by determining the discount rate that makes the present value of future after-tax cash flows equal to the cost of capital in an investment. IRR can be calculated using Excel or with an online IRR calculator.
Debt service is the amount of money needed to repay the interest and principal on a loan for a specific period of time. The debt service coverage ratio (DSCR) is calculated by dividing the property’s NOI by the annual debt payment. For example, if the DSCR of a property if 1.25 the property is generating enough income to cover the debt 1.25 times in a year:
- DSCR = NOI / Debt service
Cash on cash
Cash on cash (CoC) return compares the amount of cash earned from a property to the amount of cash invested in a property. Another way of thinking about CoC is that it is an after-debt service metric that measures the rate of return on an investment:
- Cash on Cash Return = Annual before-tax cash flow / Total cash invested
4. Find a great agent
The final step for getting started in commercial real estate investing is to find a great agent or broker to represent you. Finding a commercial agent is similar to the process you’d go through for finding a lawyer, doctor, or financial advisor.
Unlike residential real estate agents who are more generalized, commercial real estate brokers tend to specialize in certain fields, such as medical office leasing, apartment brokerage, or special purpose investments.
Items to look for in a commercial real estate agent include:
- Expertise in the niche you will be investing in.
- Experience representing new investors in commercial real estate transactions.
- Length of time the agent has worked in the industry and the specialized training and certifications they hold, such as CCIM or an SIOR member.
Good resources for finding a commercial real estate agent in your market include online commercial listing websites such as LoopNet or CREXi, conducting an internet search using ‘Your City + commercial real estate agent + Property Type’, and directly contacting commercial real estate firms in your market.
Ways of Generating Income
Commercial real estate can earn income for investors in two different ways. Recurring cash flow is created each month by leasing space to tenants and collecting rents. Commercial property also generates returns for investors over the long term when property appreciates in value above the rate of inflation.
Income from tenant rent payments becomes revenue for the commercial real estate investors after the building’s operating expenses and mortgage payment has been made.
Most commercial investors hire a property management company to take care of day-to-day details such as leasing and tenant relations, repairs and maintenance, and accounts receivable and payable. By engaging the service of a professional manager, the rental income received from the property becomes passive income for a commercial real estate investor.
Increase in equity value
All commercial real estate has the potential to increase in value over the long term, oftentimes much more so than residential property, because commercial property is a unique and scarce asset.
When demand for a certain property type increases in the market, occupancy levels and rents go up, generating more net operating income and demand from other investors for commercial real estate. In addition to normal long-term market appreciation, investors can also add value to the property by offering features tenants are willing to pay more for, such as 24-hour security and flexible leasing plans.
Successful Strategies in Commercial Real Estate Investing
Commercial real estate can be complex and a challenge to invest in, but at the end of the day the main strategies for successfully investing in commercial real estate are relatively straightforward.
By determining the future demand for a particular property type, commercial real estate investors can identify undervalued assets that other investors may overlook until prices begin to rise.
Passive vs direct investing
Direct investing requires an active, hands-on approach and deep knowledge of the local commercial real estate market and idiosyncrasies of the asset class invested in. While the idea of directly investing in real estate may sound attractive, it can be very difficult and time-consuming to maximize potential returns.
Passive investors invest for the long term. By participating in a real estate syndication and working with a professional sponsor, passive investors can gain access to special-purpose properties such as self-storage that can provide downturn protection while generating higher yields and more stable income.
- Syndicated real estate investments generate tax-deferred returns passive investors with a pro rata share of depreciation expense to offset income.
- Property management is delegated to an experienced general partner who handles tenant issues and manages repairs, maintenance, and value-add improvements.
- Sponsors of private real estate funds already have established relationships with banks, saving participants the time and trouble of having to directly obtain bank financing.
- Passive investors also benefit from the expertise of experienced commercial real estate syndicators specialize in identifying, acquiring, and managing projects to generate the highest potential risk-adjusted returns.
Passive investing strategies
- Participate in “land banking” by investing in land in the path of progress, such as tertiary markets or cities where population is growing past the city limit.
- Develop commercial real estate, or reposition existing property to a new use, by acquiring the land, creating the site, developing the project, leasing and managing the property, and collecting the recurring cash flow.
- Long-term buy and hold commercial real estate investors often focus on single-tenant net leased property or special purpose property such as self-storage where income is more stable and yields are relatively higher.
Commercial Real Estate Investing Mistakes
As with any other type of investment, the most successful commercial real estate investors mitigate downside risk in order to maximize potential upside rewards. Common commercial real estate investment mistakes to avoid include:
- Selecting the wrong type of property by not understanding that different properties typically generate higher returns than others.
- Not adequately researching your target market or submarket by analyzing economic and population growth trends, new construction coming to market, and current cap rates and occupancy levels.
- Overlooking due diligence including scrutinizing existing lease agreements and seller financial statements, conducting physical and environmental inspections, and researching local, state, and federal building guidelines.
- Underestimating operating expenses by not being prepared for higher than anticipated tenant improvement costs, routine maintenance and repairs, and unexpected CapEx (capital expenditures) such as major roof repairs or an HVAC replacement.
When the right property is purchased in the right market at the right time, commercial real estate can be the ideal investment for people seeking to diversify and grow an investment portfolio. Some types of commercial real estate perform historically well through all phases of the economic cycle, delivering stable income streams and relatively higher yields when bought and held over the long term.