A Look at the Pros & Cons of Investing in Commercial Real Estate
When I first got into commercial real estate investing, I was actually working as a real estate agent. My boss at the time wanted out of one of his deals, a 6-unit building consisting of 3 efficiencies and 3 two-bedroom apartments outside of Philadelphia, so I took the plunge and bought it.
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(Note: Anything over 4 units is considered commercial.)
Before I bought my first commercial property, I had about 10 years of experience investing in single family residential (SFR) properties, and investing in commercial real estate myself seemed like the logical next step.
I learned quite a bit from this first deal, as well as the other commercial deals that followed, but I’m glad I had some experience to draw from and that I took the time to educate myself about what I was getting into.
Have you considered commercial property? If so, the first thing I would recommend for those new to this type of investing is to meet with at least one commercial lender and one commercial-focused real estate agent. Before you start looking for deals, it may help to figure out what the banks want to lend on and to find agents who specialize in these properties.
Also, before you jump in, consider some of the advantages and challenges of commercial real estate investing. It is completely different from investing in SFR. Here’s how.
3 Advantages of Commercial Real Estate
1. More Flexible Financing
When it comes to commercial real estate, financing can be much more flexible.
You can buy these very large, valuable properties with none of your own money. For example, when the company I raised money for purchased the mobile home park, it was mostly with private money, and the seller held back a mortgage as well.
Related: 4 Ways Technology is Shaking Up Commercial Real Estate (& Why Multifamily Will Pull Ahead)
For commercial deals, you can also utilize auxiliary financing (up to 100 percent financing, with first or second mortgages), while traditional residential financing tends to frown upon 100 percent financing. Also, valuations are based on rent roll instead of comparable properties nearby.
That said, you may be able to utilize more leverage on a bigger amount, while only having a single mortgage on a commercial property with 50 units, as opposed to 50 mortgages on 50 different SFR properties.
2. Use of Economies of Scale
With more units in one place, you can often develop more favorable contracts with your contractors or outside vendors and negotiate lower costs for improvements and maintenance. You just need the lure of more volume to get them to negotiate.
The most efficient apartment complexes are over 100 units because that enables them to afford on-site help. With an on-site team, you can turn over apartments much more quickly. Although you may still need to bring in some outside contractors, the need would be lessened. I noticed this when I was a painting contractor, as our customers were apartment complexes of all different sizes, and the largest ones needed us less because they had their own staff.
3. More Passive
Of course, if you have on-site maintenance, it’s more passive for the owner as well.
If it’s an office building, you only have a tenant during business hours, and there may be limited maintenance calls during off hours.
If you have a "net-net-net" (or "triple-net") lease in place, which is common with commercial, the tenant is usually responsible for any ongoing property expenses, including taxes, insurance, and maintenance, in addition to paying the rent and utilities.
Although investing in commercial real estate can be more passive than residential, your yield may be lower, especially if the property is more expensive and has a lower cap rate.
2 Challenges of Commercial Real Estate
And here are some disadvantages/challenges to consider.
1. Increased Competition
When it comes to commercial properties, most buyers are looking for opportunity or room for improvement. They often want to increase the value of the commercial property, as this could allow them to refinance with cheaper, traditional financing and buy out their investors (i.e. private or hard money lenders).
This is similar to what I did with the 6-unit building I bought from my boss. It had a high turnover rate on the 3 efficiencies, so I converted the 6-unit building to a triplex (three 4-bedroom and 2-bath units) and paid off the expensive commercial loan with residential financing.
As a buyer, it may be challenging to find existing commercial properties where the numbers make sense, and you would likely have a lot of competition for this type of property.
Maybe the seller is asking too much for the place or there’s too much deferred maintenance. Or maybe there’s not enough room to raise rents or to lower vacancies.
Related: Applying for a Commercial Mortgage? Here’s What You’ll Need
2. The Risk of Poor Management
Let’s say you did find a great commercial property. Will your property management team be able to handle it? Based on whether tenants’ needs are regularly met by management, will the tenants feel comfortable paying a higher rent amount?
If you have a poor manager or an underperforming property management company, this can cause some challenges. I'd say the big questions to ask when hiring a property manager or property management company are the following:
- How efficient are they?
- How much experience do they have?
- Are they compliant?
It’s important that you monitor your property management company to make sure they are managing the property well and that they have the bandwidth to manage all of your units. For example, are evictions filed on time? Is maintenance getting done?
Property management companies often work better with responsive landlords, so if you’re on top of things, your management company may follow suit.
Other potential disadvantages may be that that turnover is often higher in apartments than it is in houses, and the cost of insurance is higher.
My Take on Commercial Real Estate
Considering some of the pros and cons of commercial real estate, I still think that it’s a valuable and profitable investment vehicle for many people. Personally, at this stage in my life, I’d rather remain more passive and I enjoy working with larger numbers. So, I would probably lean more towards investing in commercial than residential.
That said, there are many different ways that one could enter the commercial space. For example, you could own the land, the buildings, the businesses, or any combination of the three.
So, will investing in commercial real estate be your next step, or is it something you look forward to doing later, or will you stick to SFR? Why or why not?
Leave your thoughts below!