At a high level, there are two types of investable real estate, commercial and residential. While residential real estate investment can certainly prove to be very profitable, there are a few challenges that may give investors some pause – namely, it is difficult to scale and residential leases tend to be relatively short term, often twelve months. For this reason, commercial real estate investment can prove to be an attractive alternative.
As such, this article is meant to provide a beginner’s guide to commercial real estate investing. In this article, we will address key points like, what is commercial real estate, how does it differ from residential investing, and what are the major types of commercial properties. By the end, readers will have the information needed to determine if a commercial real estate investment is suitable for their own portfolio.
First National Realty Partners is a private equity commercial real estate investment firm that specializes in the purchase and management of grocery store-anchored retail centers. If you are an accredited investor and would like to learn more about our current opportunities, click here.
What is Commercial Real Estate?
The term “commercial real estate” refers to properties that are used for business purposes, rather than for residential use. Commercial real estate investing involves the acquisition and ownership of these properties, with the goal of generating a profit through rental income, appreciation, or both.
Differences Between Residential vs. Commercial Real Estate Investing
There are a number of notable differences between investing in commercial real estate and residential real estate:
1. Property size
Commercial properties are generally larger than residential properties, sometimes significantly so. The average home size in the US is around 2,400 SF while there are commercial properties that are 1,000,000 SF or larger. As a result, commercial properties can be more expensive to purchase and maintain.
Commercial properties are leased to businesses, rather than individuals (with the exception of commercial apartments), which can make them more vulnerable to changes in the local economy and the financial stability of the tenants. Residential properties, on the other hand, are typically leased to individuals, which can make them more stable in terms of rental income.
The financing for a commercial real estate purchase can be far more complex than financing for residential real estate, as commercial properties are generally more expensive and the terms of the loan may be more flexible. For example, the vast majority of residential mortgages are very similar: 30 year term, fixed interest rate, and monthly payments of principal and interest. Commercial loans have a nearly endless combination of terms and conditions that are typically customized for the needs of a transaction.
Commercial leases are generally longer than residential leases, and they may be more complex in terms of the terms and conditions of the agreement. For context, residential leases often expire after twelve months, while commercial leases for a highly desirable property could easily last twenty years or longer.
Commercial real estate investing can be riskier than residential real estate investing, as commercial properties are generally more expensive and are subject to more complex financing and leasing arrangements. However, the potential returns can also be higher. Or, put another way, commercial properties tend to be more sensitive to economic and market conditions while residential properties tend to be more stable because renters tend to prioritize their housing needs through all phases of the economic life cycle.
To summarize, investing in commercial real estate requires a different set of skills and considerations than investing in residential real estate, and it is important to understand the differences when trying to decide between an investment in each.
Types of Commercial Properties
Depending on the specific categorization, there can be up to nine types of commercial properties that an individual could invest in. They include:
- Office buildings: These properties are used for business and administrative purposes, and they can be leased to a variety of tenants. For example, a high rise building in a city’s central business district that is leased to law firms, accounting firms, or technology companies is a good representation of an office building.
- Retail centers: These properties are used for retail businesses, such as stores, restaurants, and other types of retail establishments. For example, our preferred property type is grocery store anchored retail centers.
- Industrial warehouses: These properties are used for storage and distribution purposes, and they are often leased to businesses that need large, open spaces to store and ship goods. For example, Amazon leases warehouses nationwide to serve as distribution facilities to ship thousands of orders every day.
- Multi-family residential properties: These properties are used for rental housing, and they can range in size from small apartment buildings to large complexes with hundreds of units. In addition, they could range from “garden style” with multiple buildings to city center luxury high rises.
- Hotels and resorts: These properties are used for short-term rental accommodation, and they can range in size from small bed and breakfasts to large, luxury resorts. Sometimes, these may be called “hospitality” properties and could include restaurants.
- Self-storage facilities: These properties are used for the rental of storage units to individuals and businesses and they could be outside with rollup doors or inside with a climate controlled environment for important items. It is very common to see these types of facilities in every city across the country.
- Medical office buildings: These properties are used for medical and healthcare purposes, and they can be leased to a variety of different tenants, including doctors, dentists, and other healthcare professionals. In most cases, these properties have very specific interior requirements like advanced air filtration systems or reinforced floors to carry the weight of specialized equipment.
- Agricultural properties: These properties are used for farming and agricultural purposes, and they can include farmland, ranches, and other types of agricultural land. They are typically found in rural areas and can range from just a few acres to thousands of acres in size.
- Special purpose properties: These properties are used for specific purposes, such as churches, movie theaters, schools, and government buildings.
Each one of these types provides a different risk/return profile and come with their own operational quirks. So, for investors, the decision to allocate capital to one of these property types over another is often a function of a variety of factors including personal preference, risk tolerance, time horizon, cost, and operational expertise.
Getting Started in Commercial Real Estate Investing
Despite the complexity, investing in a commercial property is not as intimidating as it may seem. Below is some information about how to get started in commercial real estate investing.
How Much Capital Is Needed to Start?
The amount of capital needed for commercial real estate investment will depend on a variety of factors, including the type and location of the investment property and current market conditions. In general, commercial properties are more expensive than residential properties, so it is likely that a larger amount of capital is needed to get started.
Depending on the method of investment, investors can get started with as little as $100 or may need up to $1,000,000 or more. See the next section for additional detail.
Methods for Investing in Commercial Properties
Depending on an investor’s risk tolerance, time horizon, desire to handle property management activities, and personal return objectives, there are a number of ways to invest in commercial rental property:
This method involves purchasing a commercial property outright and becoming the owner of the property either individually or with partners. Once purchased, the property can then generate income through rental payments and capital gains through price appreciation.
The benefit of this approach is that the owner has complete control over the property identification, financing, due diligence, and closing processes. In addition, they are entitled to 100% of the cash flow and profits produced. The downside is that these can be very time consuming tasks that require a lot of operational expertise so it may not be a good fit for everyone.
In a direct ownership scenario, investors need 20% – 30% of the property’s purchase price to get started.
Commercial Real Estate Investment Trusts (REITs)
REITs are companies that own, manage, or finance commercial properties of all types. Interested investors can purchase shares in the REIT, which entitle them to their proportionate allocation of the rental income and appreciation produced by the underlying commercial building portfolio.
The benefit of this approach is that real estate investors do not have to actually manage the properties themselves. Additionally, shares in publicly traded REITs are highly liquid and can be purchased by anyone with a brokerage account and enough money to buy just one share. The downside is that REITs investors sacrifice control over major property management decisions and may be charged fees by the REIT operator, which can cut into profits.
A partnership is a legal structure where one or more other investors come together to purchase and manage a commercial property.
The benefit of a partnership is that it can help to spread the risk and costs of ownership among multiple parties. In addition, it may allow an individual investor to get access to a larger property than they could afford on their own. The downside is that partnerships can be tricky when the investment does not go as planned and more money has to be injected into the property.
Partnership capital requirements vary, but they are related to the cost of the property and the number of partners. If the total down payment needed is 20% – 30% and there are five partners, then each individual would need to come up with 4% – 6% of the total capital needed.
Commercial Mortgage-Backed Securities (CMBS)
CMBS are not an investment in a commercial real estate property directly, instead they are securities that are backed by commercial mortgages, and they can be purchased by investors as a way to invest in commercial real estate indirectly.
The benefit of a CMBS investment is that it produces passive income in the form of steady monthly payments. The downside is that CMBS investors do not get to participate in the upside of a property’s appreciation.
The amount of capital required for a CMBS investment can vary widely. At the low end, commercial real estate investors can purchase shares in a publicly traded CMBS lender for a few hundred dollars. At the high end, they may need tens of thousands of dollars for a private investment.
Private Equity Deals or Funds
Private equity deals and funds are investment vehicles that pool together money from multiple investors and use it to purchase and manage commercial properties like office buildings or apartment complexes.
For investors, the benefit of this approach is passive income and exposure to institutional grade assets that they could likely not afford on their own. In addition, they benefit from the expertise and know how of the private equity firm when it comes to finding, selecting, financing, and managing a commercial investment. The downside is that private equity investments can be illiquid, and subject to fees imposed by the private equity firm.
Private equity investments are typically only available to investors who meet minimum net worth or income criteria and thus require high amounts of capital, often $25,000 or $50,000 at a minimum.
It’s important to carefully consider which investment method is the most suitable fit based on investable assets, risk tolerance, and investment goals. It may also be helpful for investors to work with a financial advisor or professional to determine the best course of action for their particular situation.
Important Terms to Understand
Like any type of investment, commercial real estate comes with its own set of jargon that potential investors should understand. The most important include:
Capitalization Rate (Cap Rate)
The cap rate is a measure of the potential return on an investment in a commercial property. It is calculated by dividing a property’s net operating income (NOI) by its purchase price or current market value. A higher cap rate indicates a higher potential return on investment but also higher risk. Whereas lower cap rates are typically associated with higher quality properties with more stable cash flow.
Net Operating Income (NOI)
NOI is a measure of the income generated by a commercial property, less operating expenses such as property taxes, insurance, and maintenance. It is used to determine the profitability of a property and is an important factor in calculating the cap rate and the ultimate value of a property.
Gross Rent Multiplier (GRM)
The GRM is a measure of the value of a commercial property compared to its rental income. It is calculated by dividing the price of the property by the annual gross rental income. A lower GRM indicates a potentially better investment, as it suggests that the property is being sold at a lower price relative to its rental income.
A lease is a legal agreement between a property owner and a business tenant, setting out the terms and conditions under which the tenant can use the property. Commercial leases are generally longer and more complex than residential leases, and they can include provisions for things like rent increases, property maintenance, and tenant improvements.
Tenant Improvements (TI)
Tenant improvements are modifications or additions made to a commercial property by the tenant in order to customize the space for their business needs. These improvements may be paid for by the tenant or by the property owner, depending on the terms of the lease. For example, office space may require significant tenant improvements like individual offices, communications equipment, conference rooms, and break area.
Triple Net Lease (NNN lease)
A triple net lease is a type of commercial lease in which the tenant is responsible for paying all of the operating expenses for the property, including property taxes, insurance, and maintenance. This type of lease is generally considered to be more favorable to the property owner, as it shifts the burden of these expenses onto the tenant. NNN leases are particularly common in retail properties like the grocery store anchored centers we own and operate.
Understanding these terms (and others) is important for evaluating the potential return on investment for a commercial property and for understanding the terms and conditions of a commercial lease, both of which are important parts of the pre-investment due diligence process.
The Benefits of Investing in Commercial Real Estate
For investors who ultimately decide that a commercial real estate investment is a good fit for their own objectives, they may realize one more more of the following benefits:
- Potential for higher returns: Commercial real estate can offer the potential for higher returns compared to other types of investments, such as stocks or bonds. This is due in part to the fact that commercial properties can generate income through rent payments, which can provide a steady stream of income over time, and increase in value which can be particularly beneficial in a strong real estate market environment.
- Diversification: Commercial property prices are generally loosely correlated to price movements in other asset classes like stocks and bonds. As a result, investing in commercial real estate can help to diversify an investment portfolio, while reducing overall risk.
- Professional management: Many commercial real estate investment opportunities are run by a professional property management company, which can produce passive income for investors in the form of periodic dividends and distributions.
- Potential for tax benefits: Commercial real estate investments can offer potential tax benefits, such as the ability to write off certain expenses and depreciation on the property. In addition, investors can defer capital gains taxes in the profitable sale of a property as long as the proceeds are reinvested into another property in a transaction known as a 1031 Exchange.
- Income: In a sense, commercial properties are like a bond investment in that they may pay out dividends derived from their rental income.
Overall, investing in commercial real estate can offer the potential for strong returns and a variety of other benefits while providing diversification for an investment portfolio. Although these benefits may sound impressive, it is important for investors to weigh them against potential risks to determine if a specific opportunity is suitable for their needs.
A Brief Rundown of Commercial Leases
As described above, one of the defining factors of a commercial investment is a lease. However there may be several key differences between a commercial lease and a residential lease.
Commercial vs. Residential Leases
There are several key differences between commercial real estate leases and residential leases:
- Length: Commercial leases are generally longer than residential leases, with terms that can range from a few years to several decades. This is because business owners typically need more stability and predictability in their lease agreements than individuals.
- Lease terms and conditions: Commercial leases are generally more complex than residential leases, with more detailed terms and conditions, including provisions for things like rent increases, property maintenance, and tenant improvements.
- Operating expenses: In a commercial lease, the tenant is typically responsible for paying a larger share of the operating expenses for the property, such as property taxes, insurance, and maintenance. In a residential lease, these expenses are generally the responsibility of the property owner.
- Lease Termination: Commercial leases typically have stricter provisions for terminating the lease early, compared to residential leases because businesses rely on the stability and predictability of the lease to plan their operations and finances.
- Property use: Commercial leases may also have more specific provisions regarding the use of the property, including restrictions on the type of business that can be conducted on the property. In most cases, this is for competitive reasons. For example, a coffee shop may have a lease provision that says there cannot be any other coffee shops in the same shopping center.
Even with this complexity, it is important to note that all leases are unique and written for the specific needs of the property and the tenant. So, from a due diligence standpoint, it is always important for investors to read leases carefully to ensure they are comfortable with the language.
Measuring Returns in Commercial Real Estate
Because of the added complexity associated with a commercial property, there are several ways to measure the returns on a commercial real estate investment, including:
- Capitalization rate (cap rate): As described above, the cap rate is a measure of the potential return on an investment and it is calculated by dividing a property’s net operating income (NOI) of a property by its purchase price or current market value. The higher the cap rate, the higher the implied return on investment.
- Internal rate of return (IRR): The IRR is a measure of the rate of return on an investment over time, taking into account the time value of money. For most commercial investments, it is the primary metric by which a return is measured.
- Gross rent multiplier (GRM): The GRM is a measure of the value of a commercial property compared to its rental income. It is calculated by dividing the price of the property by the annual gross rental income. A lower GRM indicates a potentially better investment, as it suggests that the property is being sold at a lower price relative to its rental income.
- Cash on cash return: The cash on cash return is a measure of the annual return on an investment, calculated by dividing the annual cash flow from the property by the initial cash investment. This measure is useful for evaluating the short-term profitability of a commercial real estate investment.
From an investment due diligence standpoint, it is important for investors to consider multiple return metrics because they provide information about different aspects of the opportunity.
Is Investing in Commercial Real Estate a Good Idea?
The short answer is that yes, investing in commercial real estate can be a good idea for some investors, depending on their financial goals, risk tolerance, time horizon, and investment strategy. But, every investor’s objectives and financial situation are unique so it is important that they consider all of the benefits and risks to determine if a CRE investment is a good fit.
Summary of Commercial Real Estate Investing for Beginners
The term “commercial real estate” refers to properties that are used for business purposes, rather than for residential use and “commercial real estate investing” involves the acquisition and ownership of these properties, with the goal of generating a profit through rental income, appreciation, or the sale of the property.
There are a number of differences between investing in commercial properties and residential options including, complexity, cost, lease term, and tenant types.
The potential benefits of a commercial investment is income, tax benefits, price appreciation, and portfolio diversification. But, these should be weighed against the idiosyncratic risk for each opportunity.
For investors who determine that a commercial property is a good fit for their needs, capital can be allocated through a direct purchase, REIT, partnership, or private equity opportunity.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.If you are an Accredited Real Estate Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.