Commercial real estate (CRE) is a property used for business purposes. This sector of real estate is becoming more popular as an investment because of high returns, consistent income, and growth potential. Acquiring a CRE can be far more expensive than residential properties but you can partner on investment or be a part of a crowdfunding deal.
Types of Commercial Real Estate
- Office spaces range from single-tenant offices to entire buildings filled with different offices.
- Retail space is a business premise for selling products directly to consumers – shopping malls and single retail spaces like restaurants, banks, and are often located in urban areas. With the rise in online shopping, the growth of retail spaces has declined.
- Industrial real estate is used for industrial business operations – warehouses, data centers, manufacturing units. Lease agreements for industrial real estate are typically for five years or more.
Benefits of commercial real estate
- High-yielding income. The biggest benefit of investing in commercial real estate is the higher income potential.
- Consistent cash flow.
- Longer leases. Commercial real estate also benefits from comparably longer lease contracts with tenants than residential real estate.
- Better capital appreciation. In addition to offering a stable, rich source of income, commercial real estate offers the potential for capital appreciation
Drawbacks of commercial real estate
- Capital requirement for acquisition. For those looking to invest directly, buying a commercial property is a costly proposition than a residential property.
- Highly illiquid asset. Commercial spaces are among the more illiquid of asset classes
- Higher renovation and maintenance costs. With a commercial property, each tenant may have very different needs than those of previous or future tenants. The property owner has to adapt the space to accommodate each tenant’s requirement which is costly.
Getting Started With Commercial Real Estate
- Find and evaluate the investment opportunity
Before you purchase a commercial property. Evaluate:
- Type of CRE property
Before investing, you need to understand if the type of property you are buying is in demand in a specific location. Some properties perform better than others and it’s crucial to know if you are looking at the right asset type. Retail spaces are the lowest-performing sector while industrial real estate offers the highest return.
- Market Research
One of the most important things to know is that every market is different. Every location has its own unique supply and demand. The goal is to find a property type that is undersupplied and in high demand.
- Market cycles
The performance of commercial real estate is dependent on the economic factors of the market. A close look at the market cycle can indicate the income and appreciation performance of a property.
- Due diligence
Due diligence is the process of determining whether the property is suitable for your needs.
No matter what type of property you’re buying, you need to know what kind of condition it’s in and whether it will be needing any significant repairs.
Before buying a property, you need to make sure it has a clean title. This means that there are no outstanding debts on the property and that no one else has a claim to its rights. For example, if you bought a property without realizing there was a tax lien, you could end up with an unexpected foreclosure notice.
Real estate is all about making a return on investment. When you review the financials you need to look at the property’s financials for the last three years.
- Gross rent collected.
- Vacancy rate.
- Maintenance/repair expenses.
- Utility expenses.
- Net operating income (NOI).
- Analyze the return potential
On top of understanding how the generation of rental income and appreciation work, there are several ways to calculate and assess a property’s current or projected return potential.
- Net Operating Income (NOI): The net operating income is the revenue (income) generated by the investment property after operating expenses. This is essentially the cash flow generated from rent over a given time period, minus any expenses associated with owning the property.
- Capitalization rate (Cap Rate): The capitalization rate is the rate of return that is expected to be generated from the real estate investment. The capitalization rate is calculated by dividing a property’s net operating income by the current market value.
- Internal rate of return (IRR): The internal rate of return (IRR) is a metric used to measure the rate of growth a project is expected to generate. Any project with the IRR greater than its cost of capital is a profitable investment.
- Managing the property
One of the ways to increase the value of a commercial real is through good property management. There is always uncertainty with any investment. Always set aside a contingency budget to cover any expenses that might arise – repairs, renovations, vacancies.
Owning a CRE property requires substantial work which includes:
- Hiring a manager to oversee the maintenance and management.
- Finding and screening tenants.
- Using management software to manage rental units.
Even though it comes at a cost, it’s often worth hiring a professional.