A Look at the Pros & Cons of Investing in Commercial Real Estate

by | BiggerPockets.com

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.

(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.

apartment-value

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!

About Author

Dave Van Horn

Dave Van Horn is President at PPR The Note Co. - an operating entity that manages several funds that buy/sell/hold residential mortgages, both performing and delinquent. Dave has been in the Real Estate business for over 25 years, starting out as a Realtor and contractor and moving onto everything from fix and flips to Raising Private Money.

12 Comments

  1. Christopher Smith

    Interesting Article

    I’ve been contemplating for some time now making a jump from SFR’s to Commercial. I’ve been stymied by a few things:

    1) The tax bite and transnational costs of disposing of my SFR’s (a bad thing) which are vastly appreciated (a good thing). Not sure how I should go about selling / disposing of them. 1031 is an option, but its a bit awkward and the additional transnational costs can be high.

    2) The primary market where I have my SFRs (and where I live) is absolutely swamped with foreign cash inflows, and those investors are not generally too concerned with making a profit more just a place to park their money outside the long arm of their local governments. As a result, prices have been bid sky high and being a novice at the game to begin with I don’t see any realistic way I could make these “over priced” properties viable.

    3) I have access to another secondary SFR market in the Midwest where I have put out the word that I am looking for commercial as well as SFR’s, but as with everything else, if you can’t be there that makes it more of a challenge to be successful in generating leads.

    4) I’d frankly be happy at this point to give up some underlying price appreciation potential (which is fairly strong in my primary SFR market), for a moderately higher cash flow yield from a commercial property.

    Any thoughts?

    • Dave Van Horn

      Thanks Christopher!

      As for your questions, outside of the 1031 exchange here are my thoughts:

      1.) Well, who says you have to get rid of these SFR properties to get into commercial? Most of the commercial investing I have done is with none of my own money (unless I’m just putting skin in the game as a Class B member or capital contribution). I’ve raised private equity from other investors, pooling together money to buy commercial real estate – which is pretty common among most serious commercial real estate investors. If you’re not looking to raise money, you could just borrow out of your SFR properties and use that to invest in commercial as well.

      2.) I think this goes into number 3 a bit, but commercial investing isn’t about staying local. In fact, most commercial investors I know (including myself) invest all over the country, usually in up and coming areas. And as a counterpoint: Why not make these foreign investors equity partners in your commercial real estate fund?

      3.) I agree but I also think it comes down to having the right connections in the area that act as boots on the ground. These relationships don’t happen overnight but I would put the word out in local REIA’s in those areas or try to find interested parties here on BP.

      4.) I don’t know if you need to give anything up. With commercial, it’s not as much about cash flow (which is always important) as it is about cap rate and increasing the property’s value based on net operating income.

      That’s just my take. I hope this info helps. Do let me know if you have any other questions.

      Best,
      Dave

  2. John Thedford

    Definitely my next serious move. Some of my friends have huge incomes from NNN commercial properties. They are making a lot of money, have tremendous freedom, and cash to do as they please. SFR have treated me well and given me a lot of freedom but nothing compared to my friends that invest in NNN commercial.

  3. Kris Falcher

    I don’t think that investing in commercial is appropriate for newbies at this point in the business cycle. Competition is fierce, even after the massive run up in prices over the past few years. Instead, buy a few block houses in good school districts. And STAY AWAY from duplexes and quads in low income areas.

    • Jake Moran

      Kris, what makes you so against multifamily residential in low income areas if I am a newbie? I was actually just looking at exactly that in Richmond VA. The cash flow looks amazing on paper, but is it not worth the headaches/risks?

      • Dave Van Horn

        I’m with you on this one Jake. I think multi-units in low income areas can be a great entry way into the business.

        But I also agree with Kris on the commercial side in the sense that it’s usually tougher to enter that space unless you have a background in finance and raising private capital. Brian Adams (a contributor here on BP) was someone with little commercial experience that went into the space, I would suggest any newbies interested in commercial to reach out to him here on the site.

        Best,
        Dave

  4. I like that you mention commercial real estate as being a helpful investment vehicle for a lot of people. It makes sense that since there are so many types of commercial real estate, investing in it can be a worthwhile and unique experience. I\’ll have just to remember that money isn\’t necessarily the most expensive part of commercial real estate investment, rather, the time and effort it takes to make that investment profitable. Thanks for the post!

  5. Mark Lucido

    Thank you Dave! I can’t understand why more people aren’t investing in commercial properties but that lessens the competition for me! I’m a newbie investor who still works full time in IT for a very prominant Fortune 100 company. I also have a 6 year old and am working on completing my MBA so I require something very passive yet I want to learn the in and outs of Property Managment. Because of my time constraints, I elected to enter REI via a C-Class commercial property in an area that is in the middle of regentrification. It’s been one of the best experiences of my life despite a few inherited tenants that fell behind. After writing off those losses I did replace those tenants with more suitable ones and I expect this year to be much better. I’ve bought a second property now (retail duplex) which has proven even better with 2 national tenants that pay via EFT on the 1st of every month. Commercial will be in my future for some time.

  6. Commercial real estate definitely gives you more leverage over your debt and more scalability, but with that comes more required diligence and planning. As you mentioned, having a good property management company with great visibility into what they’re doing is crucial.

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