Commercial real estate always was and probably always will be a good type of long-term investment—especially multifamily housing, like apartment complexes. But it does need to be done properly and there are barriers that must be overcome in the process in order to succeed.
How to start building wealth with real estate
Being successful in commercial real estate takes more than just initiative. It takes time; money; relationship building with brokers, real estate attorneys, and insurance agents; and most importantly, an ability to cold call and write letters to find prime properties for a possible purchase.
There are several types of commercial real estate worth investing in. Those include:
- Office buildings
- Industrial properties or warehouses
- Retail buildings, like strip malls or shopping malls
- Multifamily housing, like apartment buildings
- Self-storage facilities
Another option: Mixed-use commercial properties. Mixed-use properties combine two or more types of commercial use into one building or development, like a building with shops on the first floor and residential real estate with tenants above.
Investing in commercial real estate is not a “quick fix” to wealth. Although when done properly, it can lead to a lifetime of stable income for an individual and their families, acting as a kind of passive income. A good investment can and should provide enough financial gains to eventually cover the initial investment and allow for continued monthly income.
So, what are the barriers one might encounter when trying to purchase a commercial real estate property?
Know the basics
Even if you’re an experienced residential real estate investor, commercial real estate can feel like a whole new world. And there’s definitely a whole new language. Here are the basics you should learn:
Triple net leases: These are common for retail, industrial, and office properties. Also called NNN leases, these absolve the property owner from paying most building expenses. The commercial tenant will cover real estate taxes, property insurance, and maintenance costs.
Real estate investment trusts (REITs): Not ready to purchase an entire building on your own? A REIT pools cash from many different investors and receive dividends from the building’s income. If the REIT is publicly traded, shares can be purchased via a brokerage. Otherwise, you can buy a share directly from the REIT.
Capitalization rate (cap rate): If you’ve been investing in residential for a while, you’ve likely learned a little about cap rate just from osmosis. But it’s with multifamily properties that this figure becomes truly important. Understanding cap rate can be complicated—but don’t worry! BiggerPockets’ detailed guide to cap rate will walk you through all the details.
Barriers to investing in commercial real estate
Being able to qualify for commercial financing based on your balance sheet can be a challenge. This will vary significantly from one investor to the next.
A good balance sheet will show a steady income, healthy cash flow, and budget knowledge. It can include but is not limited to:
- Profit and loss statements
- Stocks and bonds held
- Investment properties owned
- Various other short- and long-term investments
- Proof of the ability to pay mortgages over extended time periods.
Any investors who show significant losses or who don’t show sustainable profitability and financial stability over the long-term may have their initial mortgage applications rejected by the lender. An impressive balance sheet can be the difference between obtaining a commercial property or losing the bid.
Close attention should be paid to sustaining and maintaining a strong balance sheet and any negative influences should be remedied.
Create an investment plan and determine your financial and investment goals. From there, you can decide how much you want to invest. You can determine this by understanding your net worth and your risk tolerance.
Planning not just how to pay initially but also the overall profit picture years down the road should be considered. Closing costs and needed repairs to the property in question should be factored in.
Any commercial real estate investor should have some prior commercial real estate investing experience. If there is absolutely none, it is a good idea to partner with someone who has experience in the same asset class that you are trying to purchase. They can also help you better understand the commercial real estate market, which is a completely different beast than its residential sibling.
If that is not an option, hiring a well-positioned property management company can help a new investor overcome the challenges that will be faced in this new endeavor. A property management company with enough experience can serve as a good backup to your own lack of prior commercial real estate experience.
Liquidity is defined as the ability to turn assets into cash as quickly as possible. Investors should always have enough liquidity to cover at least the down payment, closing costs, and any renovation fees that might be needed. This will vary from property to property.
Any other assets that are owned should be able to be liquefied quickly. Too many assets that are tied up and not easily liquefied can work against investors.
All initial financial outlays, such as the down payment, the closing costs, and the renovation fees, should be figured into the liquidity aspect before considering a purchase or making an offer on a commercial property.
4. Due diligence
Another significant barrier to entry when considering commercial real estate investing is not performing enough due diligence. Due diligence includes looking into the financial background of the property, the demographics of the property—its location and tenancy figures—the property class that it falls under, and how many times it has been resold in prior years.
Properties that are resold countless times may potentially be a bad investment, and investors should proceed cautiously with them.
Follow commercial trends closely and learn to better predict which types of properties will be sought after. This will help you get the best bang for your buck and increase your success in real estate investing. Always be on the lookout for new vacancies and use commercial trends to determine prices for rents.
Research and know the geographic area where you are seeking to invest. The geographic area can play a large part in the cost of the property and the amount of rent that can be charged, as well as the type of potential tenants you will be getting. This, of course, affects the bottom line of every investor, and if you have a certain budget that you must work within, it is wise to find a geographic area that fits this budget.
Certain areas are much more expensive for all types of housing than others, and this must be kept in mind when researching where to purchase. Cost of living expenses per geographic area are a good indicator of the amount of investment needed before considering purchase. Certain geographic areas simply have higher costs of living overall, and housing prices can vary tremendously.
Another barrier that may be overlooked is proper underwriting. A good underwriter determines the accuracy of the appraisal and ensures no one else is on the title and that the financing fits the loan.
Not performing detailed underwriting or skipping this step altogether can make a potential sale or even a final sale a real nightmare for all parties involved. Insurance issues are also covered by underwriters, as insurance is part of any commercial real estate deal’s affordability.
6. Well-formed team
This next barrier to entry is much overlooked and should not be. Have a “team” in place.
Commercial real estate investing is a venture, plain and simple. Not having others involved who can assist an investor, especially a novice one, can only lead to headaches. You’ll need a:
- Commercial real estate agent with experience in commercial real estate (not all do)
- Real estate attorney
- Property manager, especially on multifamily properties—an investor trying to be both manager and investor can get overwhelmed
- Reputable (and licensed!) contractor
- Private individuals or financial institutions that can loan money immediately outside the initial investment if unforeseen circumstances arise
- Insurance agent on board
Research into the overall market in prior years or the current year can be overlooked by many.
The real estate market—especially the commercial one—can rise and fall sharply within months. There are times to buy and times to withhold a purchase. There are geographic areas that are going up at certain times, while other areas go down, as well.
These statistics are readily available online by the National Association of Realtors (NAR) and are updated regularly. Market fluctuations can be very impactful on the price of an initial sale and the overall stability of a property in future years.
The bottom line
Commercial real estate investing is a great choice for many reasons.
For starters, there are myriad tax benefits for property owners. Self-employment tax deductions may also be available. A good real estate certified public accountant (CPA) can assist with determining which tax benefits apply in each individual case. The government can truly be a real estate investor’s best friend.
This is not to say there are no risks involved, as there are many. Investing in any type of real estate, especially in higher priced commercial real estate (such as MFH) may be risky. The market goes up and down, the area demographics can go up and down, and the overall price of resale can go sharply up or down.
Add to that any changes made to the property. Improving a property can initially add additional rental income. However, occupancy drops during renovations—and hence income generated decreases, too.
As you can see, commercial real estate investing is a great way to diversify a portfolio—if an investor can overcome all the barriers to entry. Doing the research and following the guidelines to overcoming such barriers above will help both novice and experienced investors immensely.
Be wise, be happy, but be thorough!