Investing in Commercial Real Estate, the Pros and Cons
Investing in Commercial Real Estate can be an excellent opportunity when it’s time to make your money work for you. But if you’re on the fence on whether to invest in commercial or residential real estate, know that commercial properties tend to offer more financial rewards.
There can also be many more risks! Make sure you fully understand the pros and cons of investing in commercial real estate before making the leap. You will want to ensure that your investment is the right decision for you.
Investing in Commercial Real Estate
One way to describe commercial real estate would be the following. Commercial real estate is any real estate that is not residential, and is not 4 units or less. So for instance, a home is residential real estate. A duplex, a two flat, a 3 unit and a 4 unit are all considered residential real estate.
That leaves an entire world of real estate, outside of those narrow parameters, that can be considered commercial real estate. You may even see folks in the commercial real estate industry refer to the business as CRE real estate or just CRE. When thinking of what commercial real estate properties are, we can review various types.
Types of Commercial Real Estate
- Retail buildings (inline strip centers, neighborhood centers, power centers, stand alone buildings, malls, etc.)
- Hospitality properties (hotels, motels, bed and breakfast, and more)
- Office buildings
- Medical Offices
- Warehouses / Industrial buildings (cold storage, high bay, food grade, rail access, cranes, etc.)
- Apartment buildings (larger than 4 units or a portfolio of smaller properties)
- “Mixed use” buildings, where there is a mix between retail, office and apartments.
There can be many different factors to consider when thinking of managing any of the above types of properties. You may have your work cut out for you if you’re not fully prepared on what it takes to successfully invest in commercial real estate. Therefore, let’s look at the pros and cons of investing in commercial real estate in more detail.
Pros When Investing in Commercial Real Estate
1. Income Potential
There is no doubt that the right piece of commercial real estate has the opportunity to offer you greater earning potential over residential real estate. Commercial properties generally have an annual rate of return in the range of 6-12%, which is much better than typical single family home properties that see a 1-4% annual return, at best.
2. Professional Relationship Interactions
When owning commercial real estate, you generally will operate the property under an LLC, not your individual name. It’s typically easier to keep things more professional with commercial tenants. After all, commercial tenants are in business and treat their interactions as such. You may still have difficult commercial tenants, but it is not as common as it is in residential properties.
3. Public Image
Tenants in a retail or office space want to make sure their storefront and interior space is maintained and looking good. Otherwise, it will affect their own business. Because of this, commercial tenants and the property owner have a vested interest in making sure the quality of the property is maintained. Ultimately, this means the value of their investment is safer, as well.
4. Work Is Held During Business Hours
Tenants in commercial real estate usually go home at night when their own business closes. Therefore, you can rest at night without worrying about a tenant calling with a midnight emergency because something needs to be repaired. Commercial properties are also more likely to have a security service, so if anything does happen at night, the alarm company will take on the brunt of notifying the authorities immediately.
5. Property Price Evaluations When Investing in Commercial Real Estate
Because you can request the current owner’s income statement and determine what the price should be for your commercial real estate, it’s often easier to evaluate the prices of commercial real estate. You can also ask a commercial real estate broker to provide a lease comp analysis to verify that the commercial tenant’s lease is inline with market pricing.
Residential properties, on the other hand, tend to be subject to more emotional pricing, which can affect the overall investment value. In addition, residential properties tend to follow the overall market cycle. There isn’t much different between two houses, with the same floor plan, in the same neighborhood. It can be hard to differentiate one home from another.
6. Triple Net Leases (NNN)
This is an overall concept that says that you, as the property owner, do not have to pay any expenses on the property. The three N’s stand for: Property Insurance, Real Estate Taxes and Common Area Maintenance (CAM). In other words, the lessee handles all property expenses directly. That means that the only expense you’ll have as a commercial real estate owner is the mortgage expense!
Many larger businesses typically sign NNN leases. These companies want to maintain a look and feel in keeping with their brand. They manage the costs and you, as an investor, have one of the lowest maintenance income producers for your money.
Depending on the type of tenant(s) in your commercial property, you may still manage the arrangements for all of the services needed, such as snow removal, lawn care, and property insurance. The key with a NNN lease is you get to pass those expenses on to your Tenant(s). This includes your ability to pass through the costs you incur managing the property yourself.
Your property management fee is part of the CAM. And if you want your property as close to hassle free as possible, hire a commercial property management company to handle all of the logistics.
A residential investment property is likely to stay just that, residential. However, with commercial real estate properties there can be a wide variety of uses for the property. It is common for suite sizes to change in overall size and configuration when new tenants arrive.
In addition, commercial tenants often pay for their own remodeling. In events where you pay for the remodel, you will likely have a strong commercial grade credit guaranteeing the lease and any commercial loans you have in place for your property.
8. Property Appreciation When Investing in Commercial Real Estate
Well located commercial properties often appreciate over time. Planned new developments planned nearby can increase the value of your property. New traffic corridors can direct more traffic to your commercial real estate. Growing businesses moving to town can generate housing and retail demands for your property. Is there vacant land not fully utilized on the commercial property that could be developed? Could the property be subdivided and split into multiple properties? Are the lease rates currently below market? Could you lease the property to a new tenant at a higher lease rate once the current lease term expires?
There can be many opportunities to create appreciation in commercial real estate. There typically are not as many creative strategies in residential real estate.
9. Tax Advantages
Tax advantages can be one of the biggest long-term positive factors in owning a commercial property. You can potentially claim your mortgage-interest expense, along with real estate taxes and the depreciation of the building. Costs of maintaining the property may be deductible, as well.
Cons When Investing in Commercial Real Estate
1. Time Commitment
If you own a commercial retail building that has multiple tenants, that means you have to manage a lot more than you would with a single-family home tenant. It is not always possible to be an absentee landlord and maximize the return on your investment. You also will be dealing with many leases, all starting and ending at unique times. You may have more repair issues and public safety concerns to think about, as well. Because there is more to manage, it will require a larger time commitment.
A good commercial property management company can help with many of these time commitments, but you will still want to be the lead negotiator for all of your leases. After all, your leases are your cash flow. Your leases provide the Net Operating Income (NOI) your property needs to maximize its value.
2. Professional Help Needed When Investing in Commercial Real Estate
Do you prefer to do things yourself? If so, you might want to get licensed to handle different maintenance issues that will crop up at a commercial property. More likely, however, is that you will not be able to handle all of the maintenance issues yourself. You will need to hire someone to help with emergencies and repairs.
Therefore, make sure you add this cost to your set of expenses in order to properly care for the property. Keep in mind, you can often pass through property management expenses to your tenants in a NNN investment. However, if your expenses get out of control and get too high, the total monthly rent your tenants have to pay may price your space out of the market. Your tenants will leave you if your rents are too high.
Commercial property management companies can charge between 5-10% of rent revenues for the things they do, such as lease and contractor administration. Make sure you are fully aware of what you are taking on if you want to manage the leasing and relationships yourself.
3. Larger Initial Investment
Typically, you will need more up-front capital to buy a commercial property than you would to buy a residential rental. This is one of the main reasons individuals do not go into commercial real estate, as they can not afford the initial down payment. That means it can be a little difficult to get your foot in the door. You can also expect larger capital expenditures to follow, like a major bill to potentially replace a roof or furnace!
With more customers, there are more facilities to maintain, which can generate costs you may not have considered. Hopefully, the gains in revenue outweighs the costs in the end. On a similar note, it may also cost a lot more to get a loan, which may make it prohibitive for you. Make sure you evaluate your options before committing to a commercial real estate property.
4. Increased Risks When Investing in Commercial Real Estate
More people visit commercial properties than residential properties. More people can potentially get hurt or damage your property. Vandals can damage things, people can get hit by a car in the parking lot, or many other incidents could happen.
You can manage these risks by owning your properties with a business such as an LLC, rather than personally. In addition, you will want to make sure all of your insurance is up to speed. You need to make sure that snow and ice are removed promptly during winter months. You need all work completed on your property to be up to code and safe. Make sure you to hire contractors who are bonded and insured.
5. May Have Better Ways to Spend the Money
You may be able to better use the money you would use to buy a commercial property to help with cash-flow issues you may have in a current business. Or, you may want that cushion in order to invest in other opportunities that may be better suited for you.
6. May Not Be Cost-Effective If Moving Your Business
Do you see yourself remaining in the building for an extended period of time? Do you have a business that will be located in the commercial property, as well? If you do and that business won’t remain in that current location for long, it may not be the most cost-effective use of your money.
Your business may be tied to the commercial real estate. You need to plan out your financial road map for many years ahead. This can be a challenge because your business may experience fluctuations along the way. The commercial real estate market has its own market cycle. And sometimes, your business and the CRE market cycle don’t always line up.