Investing in commercial real estate can be a highly rewarding venture, offering opportunities for significant financial growth, portfolio diversification, and long-term stability. However, for beginners, navigating this complex landscape can be daunting. Whether you're looking to generate passive income, achieve capital appreciation, or expand your investment portfolio, understanding the fundamentals is crucial to making informed and successful decisions.
What is Commercial Real Estate Investing?
Commercial real estate investing involves purchasing properties used for business purposes to generate income. The types of commercial properties include office buildings, retail spaces, industrial properties, and multi-family residential units like apartment complexes. Typically, investors own these properties, collecting rent from the businesses operating within. Unlike residential real estate, CRE investments often come with longer lease terms and higher rental income.
How to Start Investing in Commercial Real Estate
Getting started with commercial real estate (CRE) investing may seem overwhelming, but breaking it down into manageable steps can simplify the process. The main steps involved with investing in commercial real estate are:
Understanding the nuances of commercial real estate
Networking and building relationships
Understanding your goals and making a plan
Using the right success metrics
Determining your investment method
Knowing how to find deals
Conducting thorough due diligence
Reserving cost contingencies
1) Understand the Nuances of Commercial Real Estate
Before investing in any commercial properties, start by doing your research. Make sure that you understand the pros and cons of commercial real estate investing. Familiarize yourself with the different types of properties, their market trends, and potential returns. Understand that commercial real estate investments require a large amount of money upfront and that market conditions can significantly impact the profitability of your investment.
It's important to remember that commercial real estate is a different ball game compared to residential real estate. For example, unlike residential real estate, the income from commercial real estate is typically related to square footage. Here are some additional nuances to consider:
Longer Lease Terms: Commercial properties often have lease terms ranging from 3 to 10 years, providing more stable income.
Triple Net Leases: Tenants are responsible for property expenses like maintenance, insurance, and taxes.
Market Trends: Keep an eye on local and national trends that can affect property values and rental income.
2) Network and Build Relationships
Networking is crucial in commercial real estate investing. Attend industry events, join local professional organizations, and connect with other investors to gain valuable insights and build relationships. A strong network can also provide access to off-market deals or partnerships that could enhance your investment opportunities.
If you're just getting started with commercial property investing, consider opportunities to get hands-on experience through interning or assisting at a CRE firm, volunteer for relevant projects, and engage with industry professionals to expand your skill set and gain a deeper understanding of the industry.
3) Understand Your Goals and Make a Plan
Every commercial real estate investor is unique, and each property investment comes with distinct objectives. Before diving into CRE investing, it's essential to clearly define these goals. Goals can be categorized into two main aspects: return and risk.
Return refers to the profit generated from the invested capital. Naturally, every investor aims to achieve the highest possible returns. However, higher returns often come with increased risk. Therefore, investors must determine the level of risk they are willing to accept to achieve their return targets.
Risk can manifest in various forms, such as leverage, asset type, and geographic market. It is crucial for investors to thoroughly analyze these factors before proceeding. Are you aiming for short-term gains, long-term income, or a combination of both? Understanding your financial goals will enable you to make well-informed decisions.
To move forward, start by setting clear objectives, defining whether you aim for capital appreciation, steady cash flow, or portfolio diversification. Next, create a timeline outlining your investment horizon, be it 5, 10, or 20 years. Finally, engage in financial planning to determine the capital you can invest and explore available financing options. Your plan should include steps to build relationships with realtors and management companies, holding periods, and exit strategies.
4) Use the Right Success Metrics
Commercial real estate investing involves a wide array of calculations and an understanding of real estate finance, so understanding the critical metrics in assessing commercial business can assist you with settling on more educated choices. To gauge the success of your investments, use metrics like:
Net Operating Income (NOI): NOI gives insight into a property's potential profitability. It is calculated by subtracting operating expenses from gross income.
Cap Rate: NOI divided by the property’s purchase price. This percentage value shows the potential return on investment without considering financing factors, such as loans or equity arrangements. A higher percentage indicates greater risk but potentially larger returns.
Cash on Cash Return: Annual pre-tax cash flow divided by the total cash invested. This is the ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage.Â
Internal Rate of Return (IRR): Measures the profitability of potential investments. This metric is used as a guideline for evaluating whether or not an investment opportunity is worth pursuing.
5) Determine Investment Method
Commercial property investors must choose whether they want to pursue a passive or an active investment path. There are several ways to invest in commercial real estate:
Direct Ownership: Direct ownership involves purchasing a property outright, either individually or with a small group of investors. These investors must conduct their own due diligence to assess whether the opportunity is worthwhile. Once the deal is finalized, they bear the responsibility for property management. This encompasses everything from addressing maintenance issues to leasing the space and collecting rent from tenants.
Real Estate Investment Trusts (REITs): A real estate investment trust (REIT) is a specialized company that buys, sells, manages, and finances commercial properties. The main advantage of investing in a REIT is the associated tax benefits. By adhering to certain IRA regulations, REITs avoid taxation at the entity level. Instead, the cash flow from properties is distributed to investors, who are then taxed individually.
Crowdfunding: Crowdfunding involves many investors contributing small sums to collectively purchase a property. Numerous online platforms manage these contributions and the flow of funds to the holding company that buys the property. Investors can start with as little as $10, owning a fraction of the deal and earning profit proportionate to their stake. Crowdfunded properties generate returns similarly to other strategies: through leased property cash flow or sale proceeds, both distributed according to ownership level.
For most new beginners, passive investment strategies such as crowdfunding and REITs are more common, while active investment strategies are more viable for those with more experience and expertise.
6) Know How to Find Deals
Securing great deals is a cornerstone of commercial real estate (CRE) investing. Networking is a valuable way to discover top opportunities, as you can learn from the successes of experienced investors. Online platforms also offer a powerful means to locate commercial properties and analyze market trends. Using online platforms, you can find motivated sellers that may be willing to sell properties below market value. If your seller isn't motivated to sell, then they won't be as willing to negotiate.
Moreover, it's critical to consider exit strategies from the beginning; the best deals are those from which you can easily disengage if necessary. Always remain vigilant for property damage and potential risks to ensure that investments align with your financial goals.
7) Conduct Proper Due Diligence
Once you find a potential deal for a commercial property, be sure to conduct thorough due diligence. This process involves evaluating all relevant information and verifying the property's condition, physical & environmental risks, and financial performance. To start, evaluating the local market is a critical aspect of commercial real estate due diligence. Be sure to conduct market research to evaluate comparable properties in the area and determine if the asking price is fair. Ensure that you also evaluate the area's growth potential and specific property's proximity to amenities as well!
Due diligence for commercial real estate investing includes conducting a physical inspection of the property. Consider hiring a professional inspector to assess the property's structure, systems, and overall condition. Location is frequently cited as one of the most important factors in determining a property's value, so it's recommended that investors evaluate other potential risk factors such as environmental hazards that may impact the property's value.
The first step to assessing environmental risk is to get a Phase 1 Environmental Report. A more affordable precursor to getting a formal Phase 1 report is to subscribe to LandApp! You can easily assess any potential environmental and natural risks associated with any property nationwide with LandApp. Along with natural risks, LandApp also provides contamination risks and the location of toxic sites to help you assess any potential risks associated with a property with the click of a button:
As a part of the due diligence process, be sure to review financial statements and records for at least three years prior to purchase. This will give you an accurate picture of the property's income, expenses, occupancy rates, and any red flags. Beginner commercial real estate investors should also familiarize themselves with the 1% and 2% rules to ensure successful investments.
What is the 1% Rule in Commercial Real Estate?
The 1% rule in real estate investing is a simple guideline that compares the price of an investment property to the gross rental income it can generate. According to this rule, a property’s monthly rent should be at least 1% of its purchase price to be considered a worthwhile investment.
For investors, the 1% rule serves as a quick and practical tool to evaluate potential properties and align them with their financial goals. For instance, if you’re considering a property priced at $300,000, it should generate at least $3,000 in monthly rent to meet the 1% benchmark. If achieving this rent isn’t feasible due to factors like location or property size, it might be wise to explore other options. By applying the 1% rule, you can quickly identify opportunities that are more likely to deliver the returns you’re aiming for, saving time and streamlining your search for the right investment.
What is the 2% Rule in Commercial Real Estate?
The 2% rule operates similarly to the 1% rule but sets a higher benchmark for evaluating investment properties. It suggests that a property’s monthly rent should equal at least 2% of its purchase price. For example, under this rule, if your monthly mortgage payment is $3,000, you should aim to charge $3,000 in rent.
While the 2% rule is more aggressive than the 1% rule—essentially doubling the expected rent—it can be viable in certain markets. This approach provides a stronger financial buffer, helping investors cover unexpected expenses like major repairs or prolonged vacancies. Whether you follow the 1% or 2% rule, running the numbers on a potential property is essential to ensure you're making a sound and affordable investment.
Overall, due diligence is crucial in mitigating risks associated with commercial real estate investments. It allows investors to identify potential issues that may affect their investment returns and make informed decisions accordingly. Remember that it’s better to lose a deal to someone else than to buy into a property you aren’t prepared for.Â
8) Reserve Cost Contingencies
Unexpected costs can arise at any time, making cost contingencies essential. These rainy day funds are set aside to cover unforeseen acquisition expenses. This budget portion can address lost cash flow from early vacancies, renovations, and other upfront costs. For instance, the property may need rezoning, or you might need to hire a new property manager. Such expenses often occur before a stable cash flow is established.
The Importance of Due Diligence in CRE Investing
In conclusion, commercial real estate investing can be a lucrative endeavor when approached with the right strategies and sufficient knowledge. From understanding various investment methods like direct ownership, REITs, and crowdfunding, to mastering deal-finding techniques and conducting thorough due diligence, each step is crucial for informed and successful investing. Newcomers may find passive strategies more suitable, while experienced investors might prefer more hands-on approaches. Regardless of the strategy, always keeping a contingency budget for unexpected costs while noting the things to avoid when investing in commercial real estate ensures smoother financial management.
One of the most important factors for successfully investing in commercial real estate is to conduct proper due diligence. For $10, check out LandApp's property due diligence tools. Analyze property factors relevant to commercial real estate specifically, such as proximity to amenities, environmental risks, sales & transaction data, and more for properties nationwide with the click of a button.
