The world of “commercial real estate investment” is vast. It consists of various property types, asset classes, and investment opportunities. For new investors, trying to navigate these complexities can be a daunting task. We are here to help.
In this article, we are going to define what commercial real estate is, review the pros and cons of investing in real estate, and highlight two common investment strategies that can be used to gain exposure to this asset class. By the end, readers should have all of the information they need to take their first steps towards making a commercial real estate investment.
At First National Realty Partners, we are a private equity commercial real estate investment firm who specializes in the acquisition and management of commercial retail centers. To learn more about our current investment opportunities, click here.
What It Means to Invest in Commercial Real Estate
The term “commercial real estate” (CRE) describes a broad class of real estate assets that are acquired with the intent to earn a profit through rental income, price appreciation, or both.
As an asset class, commercial real estate has a strong track record of delivering respectable returns over time, which makes it an attractive investment option. Even so, there are a wide variety of investment options within commercial real estate, and trying to choose one can feel confusing or overwhelming for even the most seasoned real estate investor.
Commercial Property vs. Residential Property
What is Commercial Real Estate?
There are many different types of commercial real estate that are purchased with the intent to lease space for a profit. In most cases, the space is leased to other businesses, but commercial multifamily units are leased to individuals. Broadly, commercial properties fall into four categories:
- Retail: Commercial retail space is characterized by tenants who sell their goods and services directly to consumers through a retail storefront. Classic examples of commercial retail space include grocery stores, home improvement stores, electronics stores, and clothing stores. Often, retail space is grouped together in properties like strip malls and shopping centers to make shopping convenient.
- Industrial: Commercial industrial properties are those that have an “industrial” purpose. Often, these include warehouses and logistics facilities as well as manufacturing plants. Common industrial tenants include companies like UPS, FedEx, and Amazon.
- Office: Office space is leased to companies who may use it for general office purposes like accounting and consulting firms. Or, an office building could be used for a specialized purpose like a medical office.
- Multifamily: Commercial apartment buildings are those that contain 5 or more units. Of the commercial property types, apartment complexes are the only ones that are leased to individuals, not businesses.
What is Residential Real Estate?
Residential real estate is typically defined as properties that are owner-occupied or rental properties that are leased to tenants for purposes of living there. Residential properties are usually defined as properties with between one and four units. So, this includes single-family properties up to four unit properties, sometimes referred to as fourplexes or quadplexes. The reason that four units is the cutoff for residential real estate is that properties with five units or more typically need to be financed with a commercial loan, whereas properties with four units or fewer can be financed with residential loans.
How to Get Started in Commercial Real Estate Investing
Beginner inventors looking to break into the commercial real estate market should take the following steps towards making their first investment.
1. Understand Your Goals
Every real estate investor is different and every property investment is purchased with different objectives in mind. It is important for beginning investors to decide what their goals are in commercial real estate investing.
There are two ways to think about goals: return and risk. Return is the money earned on the invested capital. Of course every investor wants to get the biggest returns possible. However, larger returns often come by adding more risk to the deal. For this reason, investors need to decide how much risk they are willing to take on in order to meet their return objectives. Risk can come in different forms, such as leverage, asset type, and geographic market. Investors should be careful to analyze all of these factors before getting started.
2. Create & Follow a Long-Term Plan
Once new investors have settled on their goals for investing in commercial real estate, they should map out a long-term plan to ensure they stick to their goals. Commercial real estate investing presents many opportunities, not all of them good ones. Having a long-term plan in place will help investors filter out deals that don’t meet their criteria and keep them stay on track to achieving their goals. Some things to include in a plan are financing strategy, steps to build relationships with realtors and management companies, holding period, exit strategy, and so on.
3. Know How to Find Deals
The best way to find CRE deals is to maintain strong relationships with commercial real estate brokers. Brokers tend to have long-standing relationships with property owners and can act as a matchmaker between them and buyers with capital to invest. Developing a wide network of broker relationships is a critical element in the effort to build strong deal flow, but just having a relationship may not be enough. It is equally important to build credibility with each broker and to demonstrate the financial capacity to close on deals that they present. Doing so will encourage them to present their best deals early and often.
4. Follow Proper Due Diligence
When a commercial property is advertised for sale, it is common for the marketing documents to portray it in the most positive light possible. In reality, every property has strengths and weaknesses and it is up to the potential buyer to verify/identify them.
From the moment that a property is placed under contract, the buyer is on the clock to conduct their due diligence, which involves a significant amount of research and verification to ensure the property is as advertised in the marketing documents. When doing so, buyers, particularly those who are acting on behalf of investors (like us), have a responsibility and an obligation to be as thorough as possible to prevent any major surprises down the road.
Because there are so many tasks to complete in a relatively short period of time, it is common for experienced buyers to use a “Due Diligence Checklist” to ensure no stone is left unturned. Our buyer due diligence checklist has been developed through years of experience and dozens of transaction repetitions.
5. Identify the Most Ideal Method for Investment
First, investors must choose whether they want to pursue a passive or active investment path. As we will discuss later, for most investors who are getting started, the passive path may make the most sense. But, for those who have a bit more experience and/or expertise, the active path may be a viable option.
Commercial real estate should be part of a broadly diversified investment portfolio. So, investors should review the size of their portfolio and determine how much of it they would like to allocate to CRE assets.
For active investors, the most logical investment vehicle is a direct purchase. These investors also need to decide which type of commercial buildings to focus on: storage facilities, multifamily properties, mixed-use, etc. For passive investors, the most common choice is between a REIT or private equity firm.
Methods to Invest in Commercial Real Estate
There are many different ways that an investor can generate rental income through commercial real estate. The strategies that investors use can be split into two groups: passive and active. The difference boils down to how much work the investor puts in after making the initial investment. Some popular passive investments are REITs, crowdfunding, and private equity. Direct purchase is the most common active form of commercial real estate investing. Let’s take a look at a few of these options in more detail.
A real estate investment trust (REIT) is a specialized type of real estate company that buys, sells, manages, and/or finances commercial real estate. The primary advantage to investing in a REIT is the tax benefits associated with doing so. As long as they comply with a specific set of IRA rules, REIT investments are not taxed at the entity level. Instead, property cash flow is distributed to investors who are taxed at the individual level.
REITs tend to specialize in specific property types and they can be publicly or privately traded. For example, one of the largest publicly traded REITs is American Tower, Inc who specializes in the acquisition and management of communications infrastructure equipment like cell phone towers.
REITs are publicly traded, like stocks or ETFs, and they can be bought or sold by any investor with a brokerage account and the minimum investment required to purchase at least one share. Investors like REITs for their low minimums, liquidity, passive income streams, and good returns.
Privately traded REITs offer the same tax advantaged structure, but they can only be purchased by “accredited investors,” who meet minimum income and net worth requirements. Investors like privately traded REITs for their specialization, expertise, and their ability to leverage relationships to find the best deals.
If, for whatever reason, real estate investors are not interested in the REIT structure, the other passive alternative is to work with a Private Equity firm.
Crowdfunding is a funding option that involves many investors contributing small sums of money to collectively purchase a property. Nowadays there are online crowdfunding websites that manage the collection of these contributions and the flow of funds to the holding company which will ultimately buy the property. Investors can often start with very small sums, sometimes as little as $10. They end up owning a small fraction of the total deal, and earn a profit in proportion to their ownership stake. Crowdfunded properties earn a return for investors much the same as other strategies. Basically, the property is either leased to a tenant and the cash flow is passed along to the investor in proportion to their ownership level, or the property is sold and the proceeds are distributed proportionately.
Crowdfunding is a popular way to break into commercial real estate investing using small amounts of money, and it eliminates the need to actively manage the property after closing. Crowdfunding investors are also able to diversify simply by putting money into multiple deals, even in different property types and geographic markets. The downside is that the profit is shared among all the investors, so it requires a significant investment in order to build wealth in a meaningful way.
3. Private Equity Real Estate
Private equity firms and REITs have a similar mandate: to deploy investor capital into commercial real estate assets, but they are structurally very different. For example, private equity firms do not have the same tax advantaged structure as REITs, and they are not required to distribute a high percentage of their income and profits.
Private equity investments come in two structures: funds and deals. In a fund structure, investors contribute capital for the general purpose of real estate investment and the private equity firm decides how it will be deployed. In a deal structure, capital is raised to purchase a specific property. This way investors know exactly what their money will be used for and they can complete their own due diligence on the asset before making a capital commitment.
Whether passive investors choose the REIT path or the private equity path, both require placing trust in the real estate investment firm to make sound investment decisions and deploy investor funds responsibly. To that end, passive investors should perform their own due diligence on the investment firm they are planning to partner with.
4. Direct Purchase
Direct purchase is probably the first form of CRE investing that comes to mind for most new investors. It entails purchasing a property outright, whether individually or with a small group of investors working together. The investor group puts up equity and might also borrow funds to purchase one or more commercial buildings. These investors are responsible for doing their own due diligence and determining whether the opportunity represents a good deal. Once the deal closes, the investors are responsible for managing the property. This includes everything from taking care of any maintenance issues to leasing the space to tenants and collecting rent.
The upside of the direct purchase strategy is that the investors get to keep all of the profits from the rent roll after paying expenses. The downside of direct purchases is that they require a lot of work on the part of the investors to make the investment a successful one. Because commercial real estate usually requires a lot of capital to purchase, a single investor or a small group will probably be limited in how much diversification they can achieve, and this opens them up to the risk that the property will underperform their expectations.
Benefits of Investing in Commercial Real Estate vs. Residential Real Estate
Now that commercial real estate has been defined, potential investors should note that there are material benefits to investing in commercial real estate, especially when compared to residential real estate investment.
1. Greater Passive Income & Returns
When comparing commercial investment properties to residential real estate, the primary benefit is scale. Instead of buying a one rental house, a commercial investor can buy multiple units within the same property. This affords greater scale, which can result in higher passive income and returns.
2. Increased Cash Flow
From a pure dollars perspective, the amount of cash flow involved in a commercial property can be more than that involved in a residential property.
3. Less Competition
Although competitive, the pool of buyers for commercial real estate properties is much smaller than those for residential assets. As a result, there is less competition when it comes to acquiring an asset at an attractive price.
4. Lease Length
Commercial leases tend to be longer than traditional residential leases. For example, a standard residential lease is 1 year, whereas a standard commercial lease can be in the 3-5 year range. In some cases, strategic locations mean that tenants are willing to sign leases of 25 years or longer.
5. Building Relationships With Businesses
Leasing space to businesses means developing long-term relationships with those same businesses. This can provide an opportunity to become a trusted partner for a large company who needs to lease space in multiple locations.
How Commercial Real Estate Investors Make Money
The most common way that real estate investors make money is by leasing space to tenants, who in turn pay rent to the property owners. The gross rent is used to pay expenses related to maintenance, insurance, property taxes, etc., and the difference is cash flow that investors get to keep. Even better, some commercial landlords use triple net leases, which require tenants to pay base monthly rent plus three of the major operating expense categories, usually property taxes, insurance, and maintenance. This increases the amount of cash flow leftover for the equity investor.
Perhaps the biggest benefit of commercial real estate investment (when compared to residential) is that commercial property owners have the ability to “force” a property’s valuation to rise. This is because commercial properties are valued based on the amount of net operating income (NOI) that they produce, which is calculated as gross income less operating expenses. By pursuing projects that increase income, decrease expenses, or both, investors can make a property more valuable through efficient management practices. At a 7% cap rate, every $1 added to NOI will increase the property’s value by $14.
Active vs. Passive Commercial Real Estate Investments
Commercial real estate investors come with all levels of resources, experience, knowledge, and objectives. As a result, there are a wide variety of investment opportunities meant to accommodate an equally wide variety of investor needs. Broadly, these investment opportunities can be grouped into two buckets: active and passive.
Passive Investing in Commercial Real Estate
From an individual investor standpoint, a passive investment is exactly what it sounds like. All of the work to find, finance, purchase, and manage commercial properties must still be done. It is just done by someone else. In short, a passive investment provides all of the benefits of real estate ownership without the hassle of actually managing it. The day-to-day work of finding and managing real estate deals is done by professional firms who have the experience and expertise needed to do it well.
Active Investing in Commercial Real Estate
In an active investment, one or more real estate investors come together to purchase a property directly, for their own account. The primary benefit of this approach is control because the investor controls the property identification, selection, financing, due diligence, and property management processes. While this can certainly yield favorable results, active investing can also be incredibly time consuming and it requires experience and expertise in the three phases of a transaction.
The point about active real estate investment is this: for many investors, maintaining control over the entire investment process is attractive. But, they must be realistic about the amount of work, experience, and expertise that it requires. Not everyone has it. For this reason, a passive investment may be a more suitable alternative for many.
How to Finance Commercial Real Estate Investments
Once an acceptable commercial property is found, the next step is to arrange the financing. As a general rule of thumb, the more dollars that are involved in the transaction, the more complicated and time consuming the financing process will be.
Arranging financing for CRE investments includes activities like presenting the deal to potential lenders, negotiating the required down payment and interest rates, gathering the documents requested by the lender, and responding to lender questions and concerns. Borrowers may have to go through this process with three or four different lenders before their deal is approved. Again, it can be incredibly time consuming.
How to Find & Assess CRE Investment Opportunities
In order to purchase real estate, active investors must first find a property. In some cases, this can be the most time consuming part of the entire investment process. Properties can be found by doing internet searches on sites like Loopnet.com or CRExi.com. Or, they can be found through established relationships with real estate agents.
What makes this phase so time consuming for active real estate investors is that finding a property can involve going through dozens or even hundreds of deals to find just one that is acceptable. For each property, investors must do things like:
- analyze financial statements,
- make financial projections,
- review existing lease terms, and
- negotiate an acceptable purchase price.
Imagine how much work this is for just one property and then multiply it by dozens, knowing that much of that work will be for naught.
Developing Steady Cash Flows
Once a property has been purchased, the real work of property management begins, and it is not a one time event. Property management is a set of activities that need to take place every day. These tasks include things like: collecting rent, chasing late payments, routine repairs and maintenance, responding to tenant issues, and managing leasing activity and vacancy rates. Some active investors prefer to outsource this activity to a third-party property manager, and others like to do it themselves. In either case, the intent of managing a commercial property is to stabilize it to the point that it produces a steady stream of cash flow for its owners/investors.
Although we manage our own properties at FNRP, many direct investors and sponsors hire property management companies to take care of the day-to-day management of the property. For a fee, usually calculated as a percentage of the gross rent amount, the management company will take responsibility for the property on a daily basis. They will oversee maintenance and capital projects, collect rent, and sometimes work with tenants on leasing. This lifts a burden off the property owners, but it comes at a cost. Every investor needs to decide whether to hire a property management company or self manage.
Commercial Real Estate Investment Mistakes to Avoid
There are two common mistakes that should be avoided in commercial real estate investing.
1. Not Enough Due Diligence
First is not completing enough due diligence on the deal. If investing directly in a property, the investor must spend the time necessary to build a proforma and analyze the potential of the property as well as the risks involved.
If investing with a sponsor, it is critically important to perform due diligence on their track record, experience, expertise, and fee structure to ensure they are suitable. The best sponsors have a verifiable track record of performance over a long period of time.
2. Not Knowing the Fee Structure
In the case of investing with sponsors, another mistake is not doing enough due diligence on the fee structure of the deal. Sponsors charge fees, which typically consist of some nominal upfront amount plus some share of the transaction’s profits. The structure of every CRE deal is unique, so it is important to read all of the disclosures, fee schedules, and offering documents to make an accurate comparison of real estate investment options.
Fees aren’t the only metric that potential investors should review. They should also look at things like net operating income (NOI), allowable depreciation, property values per square foot, and whether or not there are plans for renovations.
Why Is Investing in Commercial Real Estate a Good Idea in 2022?
So far, 2022 has been characterized by rising interest rates and high inflation. A few things make commercial real estate a strong option for investors in this type of environment.
1. Better Deals
Generally, as interest rates increase, asset value decreases. This means that as interest rates move higher, investors may find better deals on commercial real estate than they have in recent years. Savvy investors won’t be intimidated by price cuts, and will capitalize on these opportunities.
2. Inflation Protection
One of the biggest reasons why investors like commercial real estate is that it is a good inflation hedge. Property values tend to increase over time along with general prices. Many landlords include rent escalators in their leases so that rents automatically increase every year. This ensures that the gross rent income increases to offset the negative impact of inflation.
3. Tax Advantages
Commercial real estate has always been valued for the tax advantages that investors receive from owning it. Notably, depreciation allows investors to expense wear and tear on the property every year, which reduces their tax bill on the income generated by the property.
4. Less Volatile than the Stock Market
Even during periods where prices are rising or falling, commercial real estate tends to be less volatile than other investments such as stocks or Bitcoin. Many investors find that commercial real estate fits well into their portfolio for this reason. This stability becomes even more important when other asset classes are losing value.
How to Perform Due Diligence on a CRE Investment Firm
For commercial real estate investing beginners, the major benefit of working with a REIT or private equity firm is the ability to leverage their knowledge, experience, expertise, and connections in pursuit of a high rate of return. To accomplish this, there must be a tremendous amount of trust between the firm and the investor.
To ensure they are trustworthy, investors should perform their own due diligence on the investment firm by reviewing the following aspects of their history and performance:
- History & Experience: How long has the firm been in business? Do they have relevant experience in the desired property types?
- Reputation: Does the firm have a good reputation in the marketplace? Have there been any complaints filed against them with regulatory authorities?
- Track Record: Can the firm demonstrate a track record of delivering steady returns to their investors?
- Outliers: It can be helpful to ask the firm about their best and worst deals and what they learned from each. But, this information should be taken with a grain of salt because they tend to be outliers. The true measure of success is consistency, which is demonstrated by years of stable returns.
- Communication: The best investment firms have open and transparent lines of communication to their investors. Communication should be frequent and consistent and should always leave investors with a clear picture of their investment’s performance.
When there is a strong relationship between a firm and its investors, it can be mutually beneficial for both parties.
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.