3 Things You Need to Know to Invest in Commercial Real Estate
Many investors want to enter into the world of commercial real estate without truly knowing the basics. You have to constantly educate yourself on the basics of analyzing commercial properties (I don’t just mean popping numbers into an Excel spreadsheet), even if they are properties that you are not in a position to purchase. You need to be able to analyze a deal with nothing more than a pen and piece of paper if necessary.
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Often times, new commercial investors simply pop numbers into a spreadsheet with pre-determined formulas and get all of the information that is critical to a deal, but do they truly understand the information that you are receiving? If you had the deal of a lifetime and had nothing more than a pen and paper, could you crunch the numbers on that investment?
You might be surprised to find out that many people can not crunch the numbers, but you better make sure that you can. With that in mind, I thought it important to discuss those things that any new commercial investor needs to understand.
Here are the 3 Things that You Need to Know to Invest in Commercial Real Estate
1.) You Need to Know the Vocabulary
The main concepts and terms that you must familiarize yourself with are as follows:
-Effective Gross Income (EGI)
-Net Operating Income (NOI)
-Capitalization Rate (Cap Rate)
A quick Google search will give you more information on these terms and what they mean and why they are used. Although we do not have time to go deep into each term in this post, if you have a particular questions, feel free to leave a comment below. I’ll also be covering these terms more in upcoming posts.
2.) You Need to Know Percentages
If you are going to be serious about commercial real estate, you will need to know and understand percentages, in particular, what percentages are acceptable for most of the vocabulary words above. You will need to know how to calculate vacancy rates and what is considered to be a high percentage of vacancies for your area. You will need to know what percentage of gross income your operating expenses consume. For example, with apartment buildings over 50 units in your area, you may learn though experience that operating expenses are normally 45% of the gross income. Therefore, if you find a building with operating expenses of 55% of gross income, you may see an opportunity to eliminate some of these expenses in order to make the property operate more efficiently and profitably.
Percentages will also play a part in how you structure the deal with your investors in terms of preferred rates of returns, cash on cash returns, and internal rates of returns. The bottom line is that you need to understand percentages and how to calculate them “on-the-fly” with nothing more than your brain or a basic calculator.
3.) Internalize and Understand what the Numbers Mean
Once you have a good understanding of the vocabulary and the percentages, you still need to be able to put everything together and understand what the numbers mean. You should know what a cap rate of 5% means in your marketplace as opposed to a property that has a cap rate of 10%. You should know what operating expenses of 55% mean on a property as opposed to operating expenses of 25% on a similar property.
In the words of Robert Kiyosaki of Rich Dad, Poor Dad fame, “The numbers tell a story”, and he is absolutely correct in that assessment, but the million dollar question is….
Do You Understand the Story that the Numbers are Telling You?
If you are serious about getting into commercial real estate, you MUST know, understand, and internalize the three concepts above, with NO EXCEPTIONS!! I hope this article was helpful and wasn’t too theoretical.
As always, if you have any questions, we can carry the conversation over into the comments below so please let me know your thoughts and comment below.