Commercial real estate is at the top of many investors’ wish lists for a good reason because of the high rate of return. However, if you are buying commercial property, it is important to understand that increased reward can also mean increased responsibility. That’s why commercial real estate is a departure from traditional single-family investments. With high capital, buying commercial real estate will require more of an investor, especially investment experiences. The following guide will walk you through purchasing commercial real estate and help you start today.
What Is Commercial Real Estate?
Commercial Real Estate is any real estate property specifically used for business purposes. Commercial property is defined as buildings that house businesses, land with the primary purpose of generating profit, and residential rental properties. Using a building as a commercial property affects financing on the property, tax treatment, and specified laws on the building.
Commercial real estate includes malls, grocery stores, office buildings, manufacturing shops, etc.; commercial property performance, including sales prices, new building rates, and occupancy rates, is often used to measure business activity in a given region or economy.
The difference between residential and commercial real estate investments
Before you embark on commercial property investment, you must recognize considerable differences between commercial and industrial properties compared with residential real estate.
The main ones can be summarised as follows:
- Commercial real estates tend to yield a higher return than residential properties – usually between 5% to 10% net; compared to residential properties, which yield 3% to 4% gross (then you still have to pay the rates, taxes, insurance, etc.) That’s because professional investors require a higher rental return from their commercial properties to make up for the relatively weaker capital growth, the longer vacancy factors, and potentially higher risks.
- Leases for commercial real estate tend to be for longer periods, often 3 to 5 years, as opposed to the 12-month lease common in residential properties.
- Rents are usually charged per square meter, and rent reviews are incorporated in the lease document. Rent reviews may be calculated every year or 18 months and can be an increase to market rental or an increase in the amount of the CPI. Some leases have a clause preventing the rent from dropping even if the prevailing market rent drops.
- Tenants in commercial properties usually pay all the outgoings such as rates, taxes, and insurance, while with a residential property, the landlord pays these.
- Because your tenant conduct their business from your commercial property, they tend to look after it better than residential tenants do, usually maintaining and painting the real estate.
- Commercial real estate is less management intensive – tenants don’t bother you for small items like leaking taps.
- Interest rates for a loan on commercial properties are usually higher than residential properties.
- When vacancies occur in commercial properties, they are often vacant for considerably longer periods than the week or two you may have a residential property vacant. How often have you seen a shop in your community shopping center vacant for weeks or months?
- The cycle for commercial properties is different from that for residential properties and is even more dependent on the general economic factors than the residential market.
- The lease required on a commercial property is much more complex and usually requires a solicitor to prepare it.
- It’s easier for you to pick a top-performing residential investment. Most beginning investors know what to look for in residential property – they have lived in a house. Still, few would know what a tenant looks for in a good commercial or industrial property unless they have conducted their own business from one.
Types of commercial real estates
Commercial real estate is a general term for several types of commercial properties. As a rule of thumb, commercial real estate properties are used for business purposes. Commercial spaces are typically categorized into five main categories:
- Office space
- Multifamily (e.g., apartment complexes)
- Retail spaces (e.g., strip malls, malls, or single retail spaces)
- Industrial (e.g., warehouses, data centers, manufacturing buildings, or self-storage)
- Special purpose (e.g., churches, bowling alleys, daycares, hotel lodging, or health care)
Commercial real estate can be purchased by a business owner-occupied or as an investment for cash flow. Like a residential rental property, most Commercial real estate provides passive income to the owner from leasing the unit to a tenant.
How to buy and manage commercial real estate yourself
If you actively invest in commercial real estate, you’re doing the work to find, fund, acquire, manage, and dispose of the property. While you may have funding partners, investors, a third-party management company, or a team of people helping you, you’re ultimately responsible for the success or failure of the investment.
Most active CRE investors choose a sector to specialize in. They might buy only multifamily homes or focus on office buildings. Before purchasing a commercial property, determine the type of CRE property you want to own, the supply and demand of that CRE type in your real estate market, and how to invest properly in that CRE sector.
Understand the Purpose of the Investment
For individual real estate investors, the most logical starting point is to identify the objective of the investment. Doing so will help guide the choice of property type and market.
For example, if an investor’s objective is to earn a stable stream of income with little chance for capital appreciation, they would likely choose a property with high-quality tenants on long-term leases. On the other end of the spectrum, if an investor’s objective is growth, they may choose a real estate investment where there is potential for significant rental increases, which would result in value increases.
In short, identifying the objective of the investment can help provide a more focused approach to the acquisition process.
Understand the Investment Options
Generally, the options for buying commercial real estate can be grouped into two categories, direct and indirect.
Direct investment means that an individual investor – or group of investors – finds and purchases a property directly for their account. With this strategy, they are responsible for identifying the property, finding a lender, contributing the required equity (down payment), and getting the deal closed. They are also responsible for managing the property once they own it. Many investors like this approach because it gives them a significant amount of control over all phases of the investment process. It entitles them to 100% of the property’s cash flow and profits.
With an indirect approach, commercial real estate investors allocate capital to an investment manager who pools it with money from other investors and uses it to purchase institutional-grade commercial assets like multifamily apartment buildings, industrial property, or office buildings. The investment manager can range from a mutual fund to a private equity firm or a real estate investment trust or (REIT). The upside to this approach is that it benefits commercial real estate property ownership without the hassle of managing it. In addition, it can provide higher levels of portfolio diversification and, in some cases, liquidity. However, the downside is that investors have little control over how their capital is deployed.
Once an investment option is chosen, a property can be identified and placed under contract.
Build a Team
Commercial real estate investing is not a solo endeavor. It takes a team to find, close, and manage a saleable asset.
If a direct investment approach is taken, it is up to the individual investor to create their team. The exact composition of the group may vary by the investor, but it usually consists of real estate brokers, real estate attorneys, property managers, and realtors. It is the job of these real estate professionals to assist the investor with property identification, underwriting, and management processes.
With an indirect investment approach, it is the job of the investment manager/transaction sponsor to form the team. For an individual investor, one of the benefits of an indirect approach is that they get access to the manager’s group, typically formed over many years and dozens of successful transactions.
Identify a Property
If the team is successful, one of the results is a steady stream of deals and investment opportunities. This helps identify an investment property that can have a profitable return. It may take reviewing dozens or even hundreds of deals before a suitable one is found.
Make an Offer
Once a suitable rental property is discovered, the next step is to offer it. The actual process of making an offer is a relatively straightforward one. In it, an investor works with their broker and/or their representatives to deliver an official submission to the seller.
However, deciding upon an offer price is a bit trickier. This process is unique to each investor/investment firm, but it typically involves using widely accepted commercial property valuation methodologies. The “income capitalization approach” is the most commonly used in commercial real estate, but the cost approach and the sales comparison approach are also popular. In some cases, an investor may use all three and take an average to determine their final offer price.
The offer and all of the details surrounding it are written up in a purchase and sale agreement document.
Complete the Purchase and Sale Agreement
The Purchase and Sale Agreement is typically prepared by the broker and/or an attorney, and it outlines the offer’s details. The details are unique to each transaction, but it typically includes sections on things like how much of an earnest deposit will be placed into escrow, the length of the due diligence period, what happens if there is a major issue found during due diligence, the transaction closing date, and how the property will be managed in the interim period between the contract and closing dates.
It is common for there to be several rounds of back and forth between the buyer and seller before the Purchase and Sale Agreement is finalized.
Nearly all commercial real estate purchases are financed with some combination of debt and equity, and it is the buyer’s responsibility to secure it. In a direct purchase, the investor will have to do it independently. In an indirect purchase, this task is outsourced to the investment manager.
Debt is the formal name for financing a bank or real estate lender offers. A typical commercial real estate deal will account for 60% – 80% of the total purchase price. The difference between the amount of debt offered by a lender and the purchase price represents the equity required to close the transaction. In a direct investment strategy, this money needs to come from the property owners. In an indirect strategy, this money is raised by the investment manager from a group of individual investors.
Perform a Final Walkthrough
After due diligence is completed, the final step before closing is to perform a final walkthrough of the property. The purpose of this walkthrough is to ensure that nothing has changed since the completion of due diligence and to address it if it has. More often than not, this involves physically walking the property and doing things like testing outlets, faucets, and toilets to ensure everything is in working order.
Close the Deal
The act of closing a deal is not one task, it is a group of several functions that must take place in rapid succession before the final transfer of ownership. These tasks include things like: finalizing the loan and equity raise, performing a title search and obtaining title insurance, exchanging keys and access codes, and signing the necessary legal paperwork.
Once the paperwork is signed, and the keys are exchanged, the transaction is complete. It can take around 90-180 days to get through all ten steps described above to give a sense of timing. It could also take more or less time, depending on the specifics of the transaction and whether there are any complications.
How to invest passive commercial real estate
In passive real estate investments, the investor doesn’t actively own or manage the property themselves. Passive investing typically generates income in a dividend, preferred return, equity split, or a combination.
Below is a brief overview of the various ways to passively invest in CRE. Each type of passive commercial real estate investment has benefits and risks, so conduct your due diligence on each method before investing.
Real estate investment trusts (REIT)
REITs are one of the easiest forms of investing in commercial real estate. A REIT pools money to purchase and professionally manage multiple commercial properties and pays dividends to investors. REITs receive special tax benefits if they pay 90% or more of their income as dividends to their investors, making them a reliable source of passive income.
There are two REIT classifications: equity REITs and mortgage REITs. You can buy shares of both types through a brokerage account (for public REITs) or from the REIT directly (for private ones). Publicly traded REITs are the most popular choice and can be purchased with as little as a few hundred dollars.
Tokenized real estate
Tokenization is an advancement of REIT and aims to eliminate most of the problems encountered with this model by utilizing blockchain technology. As tokenization is highly flexible in its usability, the token could represent ownership in real estate in many ways. The overall type of real estate tokenized can vary just like traditional real estate investing; however, tokenization would allow for little third-party input over the investors. As physical assets would back the tokens, the value of the tokens would fluctuate based on the performance of the investment, similar to traditional real estate investing but with the ease of transfer conferred by the utilization of blockchain technology.
Buying commercial real estate can certainly be worth your time if you do it right. Hope the above guidelines of GIG will help you.\
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