Who doesn’t love a slightly controversial headline?
I can already sense the upset commercial mortgage brokers, investors and real estate agents ready to unleash a mouthful of comments below. Now before you take the gloves off, please keep in mind that I’m a big believer in commercial real estate investing and see it as a MUST end game for any investor starting of with single family or multifamily properties.
So don’t take your gloves off just yet and read on.
You might have heard that any type of property, whether it’s commercial or non-commercial, is a good investment opportunity. And more so, commercial properties offer much more financial rewards in comparison to non-commercial properties. But did anyone also tell you that investing in commercial properties is quite a bit riskier and messier than investing in non-commercial real-estate? There are so many issues like legal requirements, additional laws and in-depth knowledge that make commercial properties more difficult to manage.
In this article, I’ll touch on the key issues that make commercial properties so difficult to handle and why you’d better think twice before doing it.
Commercial real estate is a class of property assets that are used for business purposes. It consists of three sectors: office, retail and industrial. Commercial property is often preferred for reasons like high returns on investment, longer leases and smaller deposits. All these factors ring true, but these things look good mostly on paper. There are risks associated with commercial properties that you need to be aware of before investing — risks that just aren’t there with residential property investing.
6 Reasons Investing in Commercial Property Might Be a Bad Idea
Commercial properties are complicated to understand.
Buying a residential property requires you to have a good understanding of the sales and the rental market. You need to learn how much a house will cost, what it will cost to repair the house, the value of the house after repair and the kind of rent that you’ll be able to get from it. Well, all these things come with experience, and none of them are overly complicated. In fact, you can get a lot of information simply by asking people. Need to know more about the neighborhood? Ask the neighbors. Simply looking at what other places nearby are able to collect in rent will immediately give you a good idea of what you can expect.
Not so with commercial property. This requires an understanding of similar concepts, but it is much more complicated than that. Figuring out the numbers requires knowledge that’s not readily available and certainly requires some experience. The other crucial factors that hugely affect the value of a commercial property are the future desirability of your property, the lease period, how solid the tenant is and the type of business that best suits your property. The value and the rent of your property also depend on the types of businesses running in the area in which your property is located. In addition, laws are less strict in some areas. That means that the transaction will be governed by contractual agreements rather than state law. All this together makes it quite complicated to jump into commercial real estate investing. Usually, it comes down to picking a niche and focusing on that.
Commercial properties are sensitive to economic conditions.
Sure, as the economy grows and shrinks, residential properties change with it and can have a lower ROI than expected. But where that might be true, commercial properties are far more sensitive to a changing economic climate. Everyone needs a place to live, and most jobs are relatively stable. Even when the economy is taking a downturn, people will always need to have a roof over their heads.
But the same can’t be said about commercial properties. When the economy is strong, the demand and the price of commercial real estate go up. People renting commercial property may choose to operate from home instead and close shop when the market is bad. But, even when the economy is doing great on a national scale, local economic changes play their part as well. Maybe the location you’re offering is no longer as desirable as it once was. When that happens, your property might go years without having a tenant.
Valuing commercial properties is difficult.
Residential properties are usually rented out by using rent comparison. This means the owner compares his property to similar properties that have recently been rented out in the same area. In the case of residential properties, finding similar residential properties is much easier. It usually means going around the neighborhood. In some cases, you can get by on common sense.
In the case of commercial properties, it is very difficult to compare two properties. A number of factors affect the value of these properties. Also, it is hard to find similar looking properties that have been rented out recently and are also relevant for the same audience. One way to value commercial real estate is to take a look at value per square meter. This is something that can be used when you own a property in a shopping center, for example. Location is important, but at least neighboring properties can be of some guidance here. If that doesn’t work, as an alternative. commercial properties are valued using an income approach.
An income approach takes into account the profit a property can make per year and multiplies it with the market cap rate to reduce the value of the property. The market cap rate varies based on different types of properties, the type of tenant, the length of the lease, the credit rating of the tenant, the condition of the property, market conditions and different locations of a property. But even then, the value of a property is a very fluid concept and requires a lot of insight. This is not something you’ll be doing on your own straight off the bat.
Finding tenants takes longer with commercial properties.
Though commercial properties can enjoy long-term leases of three or even 10 years, once vacant, it usually takes much longer to find suitable tenants for these properties. Since these properties are rented out for business purposes, finding a suitable match between the location of the property, the type of the property and the business requirements of relevant companies usually takes a longer time. That has a pretty big effect on the cash flow. The owner is also expected to cover all the costs during this period. This can be a huge burden on the owner, as taxes can be a lot higher compared to residential real estate.
In addition to all this, the terms for a commercial lease are quite complicated in comparison to a residential lease. A commercial tenant has many options for lease, like a gross lease, modified gross, double net and triple net. The market cap rates also vary depending upon the types of leases. Laws also vary per state, so what might be possible in one state can be downright illegal or way too expensive to try and pull off in another. Once again, handling tenants, lease value and vacancy agreements demands quite a lot of expertise.
Old commercial properties are a threat to new and upgraded properties in the same area.
Investors of old commercial properties are always threatened by newer and upgraded commercial properties in the same area. Tenants always look for modern and upgraded office areas or business spaces. It’s the same with residential properties, of course, but upgrading an office can get a lot more expensive than upgrading a house. As new properties pop up, the risk of vacancy to existing properties increases which might mean more costs.
Financing a commercial property is difficult.
This is not to be underestimated. It is not all that difficult to get financing for purchasing residential rental properties, as there are a large number of lenders available who will offer loan for a period of 15 to 30 years. Usually, the residential real estate isn’t that expensive anyway and is something that can even be paid off using rent money. In the case of commercial properties, the loan amount will be amortized for less than 30 years and will mostly follow a balloon payment mode. This means that the entire balance of the loan will be due after a certain amount of time — let’s say after five or 10 years. The investor is supposed to pay off the loan when the balloon payment is due. This is not always convenient for the investor. Many investors look forward to getting refinanced when the balloon payment comes due, but if the market changes, refinancing the loan is difficult.
Add to that the fact that commercial property is usually more expensive to purchase, and things get even more difficult. It’s true that larger properties can yield a more steady income, but to get that kind of money from a bank, you’ll need experience to go with it.
Commercial property investments require a lot of ground work. You need to pay your due diligence evaluating the market and the property. If you want to go ahead with investing in commercial properties, you better keep a hawk’s eye on local market and property conditions. You have to do a lot of number crunching, as a number of factors affect the value of a commercial property. Lastly, while you do all that, you should have a solid exit strategy in your plan. It’s all these things that make residential real estate so much more attractive for investors, especially those who are just starting out.
What do YOU think — is investing in commercial property worth the hassle?
Feel free to jab me a few comments below, but watch out for my right hook!