To many investors interested in real estate, buying a commercial property seems simple enough. Just buy a property, collect the rental income, sell it, and make a big profit. Unfortunately, it isn’t this easy.
In this article, we are going to discuss seven potential disadvantages of purchasing a commercial investment property directly. For each, we will describe what it is and why it is a disadvantage for a purchase, by the end readers will have the information needed to determine if a direct purchase is a good fit for their own investment strategy.
At First National Realty Partners, we are a private equity firm who specializes in the purchase and management of grocery store anchored retail centers. If you are an accredited investor, interested in partnering with a private equity firm to allocate capital to a commercial real estate investment, click here.
First, What is a Direct Purchase?
At a high level, there are two ways to purchase a commercial property, indirectly or directly.
A direct purchase means that one or more individuals come together to purchase a property directly. As a direct owner of a property, the owner gets 100% of the income and profits it produces.
As the name suggests, an indirect purchase means that investors purchase a property indirectly – often through a third party like a brokerage firm or independent financial advisor. The reason that it is considered an “indirect” purchase is because the investor isn’t actually purchasing a property. They are purchasing shares in a company (usually an LLC) that owns the property. An indirect purchase also means that the third party is responsible for maintenance and upkeep, not the investor – which can produce passive income.
Purchasing an investment property directly may sound very enticing, but investors take 100% of the risk. Within that risk, there are seven potential downsides to a direct purchase of a commercial property.
#1: Capital Requirements
For most real estate investors, the number one deterrent to purchasing a commercial property directly is simply capital. Commercial properties can be very expensive and the upfront capital requirements can be substantial.
For example, the types of properties that we typically purchase – grocery store anchored retail centers – have a price in the range of $20MM – $30MM. Assuming a loan of 75%, the investor would have to come up with $5MM – $8MM on their own. There aren’t many individuals that have this much capital at their disposal.
In addition, the above example assumes that the property is turnkey and does not need any renovations. More often than not, there is some amount of capital that must be invested into renovations or tenant build outs – further increasing the amount of money required up front.
Simply, perhaps the biggest obstacle to a direct commercial property purchase for an individual investor is the amount of money they must come up with. In some cases, it can be staggering.
Even if an investor has the necessary capital, they may not have the time needed to manage the property. A commercial property is a small business – and like any small business it requires a tremendous amount of upkeep to run smoothly. For example, the trash has to be collected, the landscaping has to be maintained, and regulator maintenance must be performed for all major mechanical systems. In addition, time must be devoted to collecting rent, paying property taxes, negotiating lease terms, and managing renovation projects.
In short, managing a large commercial property is a full time job and many investors simply do not have the time to do it. In addition, it takes a significant amount of experience and expertise to manage it well – something all individuals may not have.
The upfront capital discussed in item #1 refers to the equity that must be put into the deal. In this item, the financing refers to the ability to be able to get a loan for the property to go along with the equity capital injected. Financing for commercial properties can be tricky for a number of reasons.
First is the risk. Investors working through traditional loan programs offered by commercial banks may have to provide a personal guarantee to receive the loan. This means that the investor(s) are personally responsible for any loan balances that are not paid if the deal goes bad – which raises the risk profile of the deal.
Second is the property type. Mainstream types of commercial real estate like office buildings, multifamily apartment buildings, industrial buildings, or retail space are much easier to finance than higher risk properties like hotels, restaurants, or raw land. Even when real estate investors are able to find a loan for these property types, the lender’s terms are not nearly as favorable as a lower risk property.
Third is qualifying. Most lenders look at a minimum of two sources of potential repayment for the loan. The first is the cash flow generated by the property. The second is borrower recourse, meaning that the lender wants to make sure the borrower(s) have the personal financial resources to repay the loan if it comes to that. Many individual borrowers are not able to meet the criteria here.
In short, it can be tough to get a loan for a commercial transaction. It takes a significant amount of personal resources and established relationships with lenders, which can be tough to come by.
In a direct ownership scenario, commercial space is not a very liquid asset for two reasons.
First, there aren’t many parties who can afford to pay $10MM + to acquire a property so the pool of buyers is somewhat limited and it can take some time to sell a property.
The second is transaction costs – the fees are very high to buy and sell commercial properties. Notably, most commercial property transactions take place through a broker who can charge as much as 6% of the sales price for their services.
For both of these reasons, commercial property profits are made over the long term. If investors need money quickly, it can be difficult or very expensive to pull it out of a commercial property.
#5: Property Management
As described above, the day to day management of a commercial property can be very time consuming and require a significant amount of experience and expertise to do well. In a direct purchase scenario, this can be a full time job for investors.
Specifically, property management entails taking care of all the day-to-day operational responsibilities that come with owning a commercial property. One example of a common property management responsibility is maintaining the property, including taking care of any repairs that need to be completed. Property management may also include marketing the property, leasing, and collecting rent.
Professional property management firms have experience in these areas and are very familiar with the local market where the property is located. This experience allows the property management company to carry out these tasks efficiently. Direct owners often view property management as a pain point and some owners struggle to find the time to do it well. Unfortunately, poor property management can result in a property that performs below its potential.
#6: Variable Income
Imagine this scenario, an investor purchases office space with three large commercial tenants. For a while, everything is going well, but one of the tenant’s commercial leases expires and they decide not to renew it. Overnight, the rental income produced by the property is reduced by one third and it may or may not be enough to cover the property’s operating expenses. These types of things happen all the time and can cause a significant amount of volatility in the property’s income.
When the income is volatile, it is possible that the property owners may need to step in and inject more capital into the property to cover any operating deficits while a new tenant is found for the empty space. Ideally, this “down time” is short, but it is possible it could extend for months or years, really putting a strain on the property owner’s finances.
#7: Negative Leverage
As a general rule, more debt on a property can lead to higher returns. But there are certain scenarios when this may not be the case. Specifically, when the interest rate on the debt is higher than the cap rate used to determine the purchase price, a situation known as “negative leverage” can arise.
A negative leverage scenario is not necessarily a deal breaker, but it should be an important factor in the ultimate investment decision because it means that investors will have to inject more capital into a property to achieve their desired returns. In rare instances, they may even need to pay cash for it.
Alternative to Direct Investing: Private Equity Real Estate
To be clear, a direct commercial real estate purchase is not a bad thing. But, it may not be the best fit for individual investors given the reasons described above. As an alternative, there are two options that should be considered.
The first is a private equity commercial real estate investment. In this indirect scenario, investors partner with a private equity firm to make the purchase – they provide the capital and the firm does the hard work of finding, financing, and managing the property. This is a passive investment that will allow individual investors to get all of the benefits of real estate ownership, without many of the challenges described above. It should be noted that most private equity investments are only available to “accredited investors” who meet certain income and/or net worth criteria.
The second option is to purchase shares in a “REIT” or Real Estate Investment Trust. These are companies that own, operate, or finance commercial real estate assets (NOTE: Some REITs may also invest in residential real estate). REITs may specialize in certain real estate property types or asset classes, like mixed-use, apartments, or office and their shares can be publicly traded, which means they are available to anyone with a brokerage account.
Between these two, private equity investment opportunities tend to be a good fit for investors with a long term time horizon, lots of investable capital, and no immediate need for liquidity. REITs tend to be a good fit for newer investors or those with a shorter time horizon, less investable capital, and a short to intermediate need for liquidity.
Summary of Direct Real Estate Investing Disadvantages
A direct real estate purchase occurs when one or more individuals come together to purchase a property directly. In doing so, they are entitled to 100% of the annual return produced, but they also take 100% of the responsibility for managing it.
While a direct purchase can certainly be very profitable, there are several potential downsides to this approach. It takes a lot of capital, they can be illiquid, management requires a lot of expertise, and the income can be variable based on market conditions.
As an alternative to a direct purchase, investors could consider working with a private equity firm or purchasing shares in a REIT.
To determine whether a direct or indirect investment is most suitable, investors should complete their own due diligence on both types of investment and consider their own preferences before making a decision.
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 would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.