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Pros and Cons of Commercial Real Estate Investing

Photograph of white commercial buildings with lights on inside and trees in the front of the building

Venturing into commercial real estate (CRE) investing can be as daunting as it is exciting. It stands as a unique avenue for diversifying one’s investment portfolio beyond stocks and bonds. This sector offers the potential for substantial financial gains but, like any investment, comes with its set of risks and challenges. In this resource, we will explore the multifaceted world of commercial real estate investing, unpacking both its benefits and the potential challenges that investors should be wary of. Whether you're considering dipping your toes into office spaces, retail locations, or industrial sites, understanding the pros and cons of commercial real estate investing is crucial for making informed decisions in this dynamic field.

What is Commercial Real Estate?

Commercial real estate, often referred to as investment property or income property, is designed to generate profit through capital appreciation or rental income. Income is generated through the operation of the property, most often through tenants making rental payments, while appreciation is earned through an increase in the property's value over time. There are many different types of commercial real estate properties, ranging from hotels to retail centers to industrial and multi-family properties.

Pros and Cons of Commercial Real Estate Investing

Before venturing deeper into the specifics of commercial real estate investing, it's essential to weigh the pros and cons associated with this type of investment before making any decisions. On the one hand, commercial real estate offers investors the lure of significant returns, potentially higher than those found in residential real estate or the stock market. On the other hand, it requires a substantial initial capital investment and comes with complexities and risks that can be difficult to navigate. Whether you're a seasoned investor or new to the realm of commercial properties, understanding these aspects is vital for making well-informed decisions.

Benefits of Commercial Real Estate Investment

The advantages of investing in commercial real estate can be significant. Here are the main benefits:

1) Income Potential

Investing in commercial properties rather than residential rentals stands out primarily due to its higher earning potential. Commercial real estate owners are entitled to the remaining cash after property expenses and debt service are paid. Typically, commercial real estate offers an annual return on the purchase price ranging from 6% to 12%. This return is influenced by the location, the prevailing economic conditions, and external factors like pandemics. In contrast, the return on investment for single-family homes usually falls between 1% and 4%, showcasing a significantly lower profit margin.

2) Inflation Protection

Commercial real estate acts as a solid hedge against inflation since it's a tangible asset. Developers aim for a specific return on investment before using their resources. If Net Operating Income doesn't rise fast enough to offset inflation-induced costs, developers might hold off on new projects. This limits property supply. In areas with limited supply, rental rates tend to increase, boosting property values. These value surges often keep pace with inflation, making commercial real estate a dependable protection against it.

3) Professional Relationships

Investing in commercial real estate offers the opportunity to forge valuable professional connections and broaden your network. By collaborating with property managers, brokers, and other professionals within the industry, you gain insights into market trends, uncover potential investment opportunities, and gain access to off-market deals. Networking in the commercial real estate sector can lead to partnerships and joint ventures, significantly enhancing your investment portfolio.

4) Property Appreciation & Capital Growth

Commercial properties offer substantial opportunities for appreciation and capital growth. With the rising demand for commercial spaces, the value of these properties often increases over time. Investors focusing on properties in prime locations with high growth prospects stand to gain from long-term capital appreciation. Furthermore, the value of commercial properties can be enhanced through strategic upgrades, renovations, and renegotiating leases.

5) Triple Net Leases

Some properties feature a distinct lease arrangement called a "triple-net lease". This agreement obligates the tenant to pay not only the base rent but also cover all expenses related to taxes, utilities, and maintenance. This arrangement significantly reduces the management duties of the owner, leading to a largely passive income stream.

Disadvantages of Commercial Real Estate Investment

As with any investment, commercial real estate investors face various investment risks that must be carefully considered. Before committing any capital, investors should conduct thorough due diligence to ensure they have strategies in place to mitigate each of these risks.The main risks of investing in commercial real estate include:

1) Time Commitment

In commercial real estate investment, investors face the complexities of managing multiple leases, yearly adjustments of common area maintenance (CAM) costs for which tenants are responsible, increased maintenance challenges, and heightened public safety issues. Essentially, there is a greater management burden; similarly, just as tenants are concerned with public perception, investors must also consider this aspect carefully.

2) Requires Professional Help

Maintenance and property management expenses can add up and must be factored in when evaluating the price to pay for a commercial investment property. Prospective investors should evaluate beforehand whether they want to manage leasing and the relationships themselves or outsource those responsibilities.

3) Large Initial Investment Requirements

Commercial properties, particularly the most sought-after ones, command high prices, making them accessible primarily to well-funded investors and firms. This scenario presents two key risks. Firstly, the high cost of commercial properties necessitates a substantial capital investment, increasing the risk of significant financial loss. Secondly, the substantial investment required to acquire a commercial property could restrict an investor's capacity to diversify their portfolio, given the large allocation of resources to a single asset.

4) Vacancy Risks

Vacancy poses a significant risk as it equates to a loss of income for the property. This risk is especially acute for commercial properties that rely on a limited number of tenants, where losing even one can result in a substantial income disruption for the property.

5) Property Damage Risks

Properties intended for commercial use have more public visitors and therefore have more people on the property each day that can get hurt or do something to damage your property. Cars can hit patrons in parking lots, people can slip on ice during the winter, and vandals can spray paint the sides of the building. Incidents like these can occur anywhere, but chances of experiencing something like these events go up when investing in commercial properties. The environment can also cause property damage in the form of natural disasters and contamination. Environmental risks and contamination risks should be assessed as part of the due diligence process through a Phase 1 Environmental Report or with the guidance of a professional.

Prospective investors can utilize LandApp's risk indexes to assess a specific property's environmental and industrial contamination risk for any U.S. property at the click of a button. Although this does not replace a formal Phase 1 report, it is a great precursor to investing in a formal Phase 1 report:

Screenshot of LandGate's risk index scores

Is it a Good Idea to Invest in Commercial Real Estate?

Commercial real estate stands as a solid asset, offering a strong and consistent cash flow, and adds diversification to investment portfolios. Nonetheless, investors should meticulously assess their risk tolerance, investment goals, and time frame to identify the most appropriate type of commercial property investment for their specific circumstances.

How to Find Commercial Properties for Sale

Finding commercial properties for sale requires a multifaceted approach, leveraging both digital and traditional resources. One effective starting point is commercial real estate listing websites. These platforms provide comprehensive listings that include various types of commercial properties across different geographical locations.

Additionally, networking with local real estate brokers can uncover not only listed properties but also off-market deals which are not publicly advertised. Subscribing to industry newsletters and participating in local investment forums or real estate clubs can also be fruitful, offering insights into available properties and emerging market trends. Attending commercial real estate auctions, either in person or online, presents another opportunity to find properties that may be sold at a competitive price. Prospective investors can also utilize social media platforms and real estate investment groups, where members often share leads on potential properties for sale.

Due Diligence for Commercial Real Estate Investing

When choosing to invest in commercial real estate, investors should always consult with professionals that are familiar with commercial real estate investing specifically. They should also ensure that they conduct thorough due diligence to minimize the potential risks associated with investing in a commercial property.

Due diligence is a critical phase in the commercial real estate investment process, enabling investors to make informed decisions and minimize risks. It requires a multifaceted approach, considering legal, financial, physical, and environmental aspects to ensure that the investment will meet the investor's goals and objectives. Failure to conduct thorough due diligence can expose an investor to significant risks and unforeseen expenses, emphasizing the importance of this phase in securing a sound investment.

LandApp can help prospective commercial property investors uncover properties for sale across the U.S. and conduct due diligence. For example, it can easily identify any property's potential risks compared directly to state and county averages with the click of a button and more to help with initial due diligence. Explore LandApp's property data and analytics here, and subscribe for just $10 per month below:


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