Getting started in commercial real estate investing doesn’t have to be daunting. Here are the quick basics to get you going:
- Understand the differences between residential and commercial real estate.
- Analyze comparable properties.
- Learn key metrics for success.
Getting started in the commercial real estate market is an exciting venture with the potential for substantial returns and long-term wealth. Before diving in, it’s crucial to grasp how commercial properties differ from residential ones. For instance, commercial real estate income relates to usable square footage, which means larger properties can generate more revenue. Additionally, commercial leases tend to be longer, offering more stability compared to the residential market.
Matt Woodley from Mover Focus offers a poignant reminder: “Start by doing your research. Make sure you understand the risks and rewards of commercial real estate investing.” This due diligence is vital, ensuring you make well-informed decisions in a competitive field.
I’m Matt Morgan. With over a decade of experience in commercial real estate, specializing in retail and office properties, I’ve guided many investors through getting started in commercial real estate investing. Let’s explore how you can make smart, profitable investments.
Understanding Commercial Real Estate
Before diving into commercial real estate investing, understand what it entails and the different types of properties you can invest in.
Definition of Commercial Real Estate
Commercial real estate refers to properties used primarily for business purposes. This includes spaces that generate income through renting or leasing to businesses or individuals. Unlike residential real estate, which focuses on living spaces, commercial real estate encompasses a variety of property types, each with its own unique characteristics and investment potential.
Types of Commercial Real Estate
There are five main types of commercial real estate: office, retail, industrial, multifamily, and special purpose. Let’s break down each type:
Office
Office spaces are among the most common types of commercial real estate. These can range from single-tenant buildings to towering skyscrapers. They are categorized into three classes:
- Class A: These buildings are usually new or recently renovated, located in prime areas, and managed by professional companies. They attract high-quality tenants and command the highest rents.
- Class B: Often older and in need of minor repairs, these buildings are well-maintained and popular among investors looking to upgrade and resell at a profit.
- Class C: These properties are typically older, poorly located, and require significant investment. They are often targeted for redevelopment.
Retail
Retail properties include strip malls, community retail centers, standalone stores, and restaurants. They are typically located in urban areas and can range from 5,000 to 350,000 square feet. These spaces are designed for businesses that sell goods and services directly to consumers.
Industrial
Industrial properties are used for manufacturing, storage, and distribution. They include warehouses, factories, and large industrial complexes. These properties are often located near major transportation hubs and are designed to accommodate heavy machinery and large-scale operations.
Multifamily
Multifamily properties consist of apartment complexes, high-rise condominiums, and smaller multifamily units. They are classified as commercial real estate if they have more than four units. These properties offer the advantage of multiple income streams from different tenants, though they may require more management due to higher tenant turnover rates.
Special Purpose
Special purpose properties are designed for specific uses that make them difficult to repurpose. Examples include car washes, self-storage facilities, schools, hotels, airports, sports stadiums, and amusement parks. These properties often cater to niche markets and can offer unique investment opportunities.
Mixed-Use Development
Mixed-use properties combine different types of real estate, such as residential, retail, and public spaces, in one development. These properties are increasingly popular due to their versatility and ability to meet various community needs. For instance, a mixed-use building might feature retail shops on the ground floor and apartments on the upper floors.
Understanding these different types of commercial real estate is crucial for making informed investment decisions. Each type offers unique opportunities and challenges, so knowing what you’re getting into can help you choose the best investment for your goals.
Benefits of Commercial Real Estate Investing
Investing in commercial real estate can be a game-changer. It offers several unique advantages that make it an attractive option for investors. Let’s explore some of these benefits.
Higher Income
One of the biggest perks of commercial real estate is the potential for higher income. Commercial properties generally offer a return on investment (ROI) between 6% and 12%, compared to 1% to 4% for single-family residential properties. More units mean more rent checks, which translates to more income.
“Commercial properties tend to have more available units. One vacancy in an office building with 25 spaces impacts less than one vacancy in a residential duplex.”
Cash Flow
Commercial properties typically provide a steady cash flow. Longer lease periods mean you have a consistent income stream. Plus, many commercial leases are “triple net,” meaning tenants pay for real estate taxes, property insurance, and maintenance costs. This setup increases your net income.
“Known in the industry as a triple net lease, many commercial tenants also pay the building’s real estate taxes, property insurance, and maintenance costs.”
Less Competition
Commercial real estate investing often faces less competition. Many investors perceive commercial investing as more complex, which can deter them. This means fewer people are competing for the same properties, giving you a better shot at good deals.
“Because of the perceived difficulty of commercial investing, the commercial space tends to be less saturated with other investors.”
Longer Leases
Longer leases are another significant benefit. Commercial leases usually last several years, compared to one-year leases for residential properties. This reduces tenant turnover and ensures a more stable income.
“Commercial buildings generally have longer lease agreements with tenants compared to residential properties.”
Business Relationships
Investing in commercial real estate often means forming business relationships. You’ll interact with other business owners, which can lead to more professional and mutually beneficial relationships. This can also help expand your network and get you more involved in the community.
Limited Operational Hours
Lastly, commercial properties typically have limited operational hours. Most businesses operate during regular business hours, meaning you won’t get late-night calls for maintenance issues. This can lead to a better work-life balance for property owners.
Investing in commercial real estate offers numerous benefits, from higher income potential to more stable cash flow. Understanding these advantages can help you make informed decisions and maximize your investment.
Next, let’s explore how to get started in commercial real estate investing.
Getting Started in Commercial Real Estate Investing
Analyze Comparables
To get started in commercial real estate investing, begin by analyzing comparables, or “comps.” Comps are properties similar to the one you’re interested in, and they help you understand the market value. Look at properties with similar square footage, location, and type.
Matt Woodley from Mover Focus advises, “start by doing your research. Make sure you understand the risks and rewards of commercial real estate investing.” This means diving deep into recent sales and lease prices in the area. For example, if you’re evaluating a 10,000 square foot office space, find comps within 10% of that size.
Analyzing comps helps you determine what you should pay and what kind of income you can expect.
Use the Right Success Metrics
Once you have your comps, it’s crucial to use the right success metrics to evaluate potential investments. Here are the key metrics:
Net Operating Income (NOI): This is all the revenue from the property minus operating expenses. For example, if your property brings in $100,000 annually and costs $40,000 to operate, your NOI is $60,000. This gives you a clear picture of the property’s profitability.
Cap Rate (Capitalization Rate): This metric helps you determine the value of income-producing properties. It’s calculated by dividing the NOI by the property’s value. For example, if your property is worth $1,000,000 and has an NOI of $70,000, the cap rate is 7%.
Cash on Cash Return: This measures the return on the actual cash invested. If you put $200,000 down on a property and it generates $20,000 in annual cash flow, your cash on cash return is 10%. This is especially useful for properties bought with financing.
Using these metrics helps you assess whether an investment is worth pursuing.
Reserve Cost Contingencies
Finally, always reserve cost contingencies. These are essentially rainy day funds to cover unexpected acquisition expenses. For instance, you might face early vacancies or need to hire a new property manager.
A good rule of thumb is to set aside 5-15% of your budget for these contingencies. For example, if your expected cash flow in the first few months is $50,000, reserve at least $2,500 to $7,500.
Capital reserves are also important. These funds are built into the operating budget and can be used for unexpected expenses later on. Planning for these costs ensures you won’t be strapped for cash when unforeseen issues arise.
Next, we’ll dig into different ways to invest in commercial real estate. Whether you prefer direct investment, REITs, or crowdfunding, there are options to suit every investor.
How to Invest in Commercial Real Estate
Direct Investment in commercial real estate involves purchasing, developing, and leasing properties yourself. This method gives you full control over the property and its management, but it also requires a significant amount of capital and expertise.
Benefits:
- Full Control: You make all decisions regarding the property.
- Potential for High Returns: You keep all profits from rent and property appreciation.
- Tax Advantages: Direct ownership allows for tax benefits like depreciation and the 1031 exchange.
How to Invest:
- Identify a Property: Look for properties with good potential for income and value appreciation.
- Conduct Due Diligence: Research the property, market, and potential tenants.
- Secure Financing: Choose the right loan type for your investment needs.
- Purchase the Property: Complete the transaction and take ownership.
- Develop and Lease: Make necessary improvements and lease the property to tenants.
Real Estate Investment Trusts (REITs) allow you to invest in commercial real estate without directly owning or managing properties. REITs are companies that own, operate, or finance income-producing real estate and offer shares to investors.
Benefits:
- Liquidity: Shares can be easily bought and sold on stock exchanges.
- Diversification: Invest in a variety of properties without needing large amounts of capital.
- Passive Income: Receive regular dividends without managing properties.
How to Invest:
- Research REITs: Look for REITs that match your investment goals.
- Open a Brokerage Account: Use an online brokerage to buy and sell REIT shares.
- Purchase Shares: Invest in REITs through your brokerage account.
- Monitor Performance: Keep an eye on your REIT investments and market trends.
Crowdfunding platforms pool money from multiple investors to fund commercial real estate projects. This method allows you to invest smaller amounts and diversify your portfolio.
Benefits:
- Low Entry Barrier: Start investing with smaller amounts of money.
- Access to Diverse Projects: Invest in a variety of commercial properties.
- Professional Management: Projects are managed by experienced real estate professionals.
How to Invest:
- Choose a Platform: Select a reputable crowdfunding platform.
- Create an Account: Sign up and verify your identity.
- Browse Projects: Review available investment opportunities.
- Invest: Choose a project and invest the desired amount.
- Monitor Returns: Track the performance of your investments through the platform.
These methods offer different levels of control, risk, and potential returns. Choose the one that aligns best with your investment goals and risk tolerance.
Commercial Real Estate Investing Trends
Post-COVID Recovery
The COVID-19 pandemic shook the commercial real estate market. Offices, hotels, and retail spaces faced significant challenges. However, the market is now experiencing a gradual recovery. According to Kathy Feucht from Deloitte, commercial real estate investors reduced costs by around 25% in 2021, but demand for industrial properties surged unexpectedly.
Office Demand
Office space has undergone massive changes. Remote work led to high vacancies and lower lease values. A December 2023 study by Commercial Edge found that office utilization remains at 50-60% of pre-pandemic levels. The national office vacancy rate is over 18%, making it a risky investment.
McKinsey predicts that demand for office space will stay below pre-pandemic levels. Even with population growth, the need for offices could be 13% lower by 2030.
Retail Change
Retail spaces also faced difficulties during the pandemic. However, there are still growth opportunities. Strip malls, community retail centers, and restaurants are adapting to new consumer behaviors. The shift towards e-commerce means some retail spaces are being repurposed for logistics and last-mile delivery.
Warehouse Growth
Industrial real estate, including warehouses and logistics facilities, is thriving. The National Association of Realtors (NAR) reported a 43% increase in industrial square footage in 2023. This sector benefits from long-term leases and steady demand, driven by the rise of online shopping and digital delivery.
Multifamily Stability
Multifamily properties like apartment complexes have shown resilience. According to the NCREIF Property Index, apartments slightly outperformed other commercial properties, falling only 7.55% from Q4 2022 to Q3 2023. Despite a national slide in rents, multifamily properties remain a stable investment due to consistent demand for housing.
Next, we’ll discuss common mistakes to avoid when getting started in commercial real estate investing.
Common Mistakes to Avoid
When getting started in commercial real estate investing, avoiding common pitfalls can save you time, money, and stress. Here are some mistakes to watch out for:
Improper Valuations
Every commercial property is unique, and getting the valuation wrong can lead to significant financial issues. Unlike residential properties, commercial real estate income depends on usable square footage and lease terms.
Failing to account for these factors can skew your investment analysis. For example, overlooking the potential income from a long-term lease in a high-demand area can lead to undervaluing a property. Always do thorough research and consult experts to ensure accurate valuations.
Financial Ignorance
Commercial real estate deals are more complex than residential transactions. Ignorance of key financial metrics can be devastating.
- Net Operating Income (NOI): This metric helps you understand how much income a property generates after operating expenses but before taxes.
- Cap Rate: This measures the expected return on investment. It’s the ratio of NOI to property value.
- Cash on Cash Return: This calculates the return on out-of-pocket cash invested relative to the portion that was financed.
Understanding these metrics is crucial. For instance, a high cap rate might indicate higher risk, while a low cap rate suggests a stable but lower return.
Neglecting Due Diligence
In the world of real estate, skipping due diligence is a recipe for disaster. Always investigate a property thoroughly before committing.
- Inspect the Property: Look for structural issues, zoning laws, and any potential legal problems.
- Analyze Comparables: Research recent sales of similar properties to understand the market value.
- Review Financials: Examine the property’s income and expenses to ensure it meets your investment criteria.
Matt Woodley from Mover Focus advises, “It’s better to lose a deal to someone else than to buy into a deal you aren’t prepared for.” Taking the time to do your homework can save you from costly mistakes.
Next, we’ll explore different ways to invest in commercial real estate, from direct investments to REITs and crowdfunding.
Frequently Asked Questions about Getting Started in Commercial Real Estate Investing
What is a good ROI for commercial real estate investment?
A good return on investment (ROI) for commercial real estate depends on several factors. Generally, many investors aim to meet or exceed the average annual return of the S&P 500, which is about 10%. However, the desired ROI can vary based on:
- Risk Tolerance: Higher risk usually means higher potential returns.
- Market Conditions: Economic factors can impact property values and rental income.
- Property Type: Different types of commercial properties (office, retail, industrial) have varying ROI benchmarks.
Pro Tip: Always compare the potential ROI against other investment options you have.
How do you passively invest in commercial real estate?
Not everyone wants to manage properties directly. Here are some ways to passively invest in commercial real estate:
- Real Estate Investment Trusts (REITs): These are companies that own or finance income-producing real estate. They offer a way to invest in real estate without owning physical properties. REITs can be bought and sold like stocks.
- Crowdfunding: Platforms pool money from multiple investors to fund real estate projects. Though riskier, top platforms boast annualized returns between 2% and 20%.
- Mutual Funds: Some mutual funds focus on real estate investments, offering another way to diversify without direct involvement.
Note: Passive investments are ideal if you want real estate exposure without the hands-on management.
What is the most profitable commercial real estate?
The profitability of commercial real estate varies by property type. Here are some key types:
- Office Buildings: These can be highly profitable, especially in urban centers with high demand for office space.
- Retail Outlets: Retail properties like strip malls and community centers can offer steady income, though they are sensitive to economic shifts.
- Industrial Warehouses: These have seen increased demand, especially with the rise of e-commerce. They often offer long-term leases and stable income.
Fact: During the COVID-19 pandemic, industrial properties performed well, while office and retail spaces faced higher vacancy rates.
Next, we’ll explore different ways to invest in commercial real estate, from direct investments to REITs and crowdfunding.
Conclusion
Investing in commercial real estate offers opportunities for higher income, longer leases, and stable cash flow. Whether you’re considering office buildings, industrial warehouses, or multifamily units, each type of property has its unique benefits and risks.
Summary: Getting started in commercial real estate investing involves understanding market trends, performing due diligence, and choosing the right investment strategy. It requires careful planning and a solid grasp of financial metrics like net operating income and cap rates.
At IPA Commercial Real Estate, we bring decades of market knowledge and experience to help you steer this complex field. Our team offers personalized service, ensuring that every client receives custom advice and solutions. Whether you’re a first-time investor or looking to expand your portfolio, our consulting services can guide you through every step of the process.
Our Services:
- Brokerage: We help you find and acquire the best commercial properties.
- Property Management: Our team ensures your investments are well-maintained and profitable.
- Consulting: Benefit from our extensive market insights and strategic advice.
Ready to take the next step in commercial real estate investing? Contact IPA Commercial Real Estate today to learn how we can help you achieve your investment goals.
Investing in commercial real estate can be highly rewarding, but it requires the right knowledge and support. Let’s build your future together!