Investing in commercial real estate can be both lucrative and rewarding. This ultimate guide demystifies the process, connecting you with all of the latest information, advice, and market trends that are guiding today’s top real estate investors. Learn how to get started on your own commercial real estate journey today.
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The Basics of Investing in Commercial Real Estate
Here are some of the basics of investing in commercial property:
Understanding Commercial Property Types:
Familiarize yourself with the various types of commercial properties including office buildings, retail properties, industrial properties, and multifamily apartment buildings. There are also other “niche” property types such as hospitality/hotels, data centers, and senior living facilities. Each property type has unique characteristics, tenant considerations, and market dynamics.
In addition to commercial property types, which are sometimes referred to as asset classes, there are also property classifications: Class A, B, and C real estate.
Class A properties tend to be relatively new construction, are well-located, amenity laden, and command top rents. Class A properties are often owned by institutional investors. Class C properties, meanwhile, are of older vintage and generally have fewer (if any) building amenities. They might be located in less desirable submarkets or in up-and-coming neighborhoods. Class C properties often suffer from deferred maintenance and are in need of significant capital improvements to bring rents to market rate. Class B properties, as you might expect, fall somewhere in between Class A and Class C properties.
Conduct thorough market research to identify promising locations and property markets. Consider factors such as population growth, employment rates, infrastructure development, local crime rates and school performance, and local regulations that can impact the demand and profitability of commercial property in a specific area.
Evaluate potential commercial properties based on their financial viability and income-generating potential. Consider factors such as the property’s in-place and projected occupancy rates, existing lease terms, rent rates and projected rent growth, operating expenses, and potential for value appreciation. Assess the property’s physical condition, location, and suitability for the target market based on the research noted above.
Before moving forward with a real estate investment, conduct thorough due diligence on the property. This includes reviewing all existing documents, leases, financial statements, and conducting property inspections. Engage professionals – such as appraisers, inspectors, environmental assessors, and real estate attorneys – to assist with your analysis.
The capital markets can heavily influence the profitability of a deal. Determine your financing options and evaluate the feasibility of obtaining commercial real estate loans from banks or other financial institutions. Understand the anticipated loan terms, interest rates, equity required, and other financing considerations. Having a solid financial plan is essential for successful commercial real estate investing.
Commercial properties require ongoing management to maximize their performance and in turn, their profitability. Consider whether you will manage the property yourself or whether you’d be better off hiring a professional company to do this on your behalf. Property management includes handling all tenant relations, rent collection, routine repairs and maintenance, and other operational duties.
Commercial real estate investments carry risks, such as tenant vacancies, market fluctuations, and unforeseen expenses. Mitigate these risks by diversifying your portfolio across different property types and locations, maintaining cash reserves for unexpected expenses, and staying on top of market trends and conditions.
Investors should approach every deal with an intended exit strategy in mind. This could involve renovating and repositioning the property, then selling it when it appreciates in value. It could involve refinancing to leverage equity. Others may prefer a long-term buy and hold strategy where they leverage tax provisions like the 1031 Exchange to pass the property onto their heirs at a stepped-up basis. Having a clear exit plan helps you align your investment goals with individual real estate opportunities.
Most individuals do not invest in property alone. Even if their equity is the only equity in the deal, they will typically bring on experienced professionals such as real estate attorneys, financial advisors, and asset managers who specialize in commercial property. They can provide valuable guidance to help you navigate the complexities of the commercial real estate industry.
What Are Some of the Ways to Invest in Commercial Property?
There are several ways to invest in commercial real estate, each offering different levels of involvement, risk, and potential returns. Here are some of the most common methods for investing in commercial real estate.
There are two types of commercial real estate investing: active investing and passive real estate investing. Direct ownership is the primary type of active real estate investing – it involves your time, your money, and your expertise. Real Estate Investment Partnerships and Investment Clubs are other forms of direct ownership.
All other forms of real estate investing outlined below are forms of passive investments.
Direct ownership entails purchasing commercial properties outright. This method provides the highest level of control and potential returns, but also requires significant capital and expertise in property development and management. As a direct owner, you are responsible for acquisition, financing, improvements, leasing, stabilization, and ongoing management.
Real Estate Investment Partnerships:
Investment partnerships involve forming a partnership or joint venture with other investors to acquire and manage commercial properties. Each partner contributes capital and may take on specific roles and responsibilities based on their expertise or financial contributions. Partnerships allow for shared risk and expertise while providing an opportunity to invest in larger properties or projects. Some joint ventures may also be opportunistic. For example, someone may not want to sell their property that’s otherwise ideal for redevelopment and instead of selling, will partner with a third-party who then develops the site. The original owner contributes their land value to the deal in exchange for maintaining some percentage of the deal.
Real Estate Investment Clubs:
Investment clubs bring together individual investors interested in commercial real estate. Members pool their knowledge, resources, and capital to jointly invest in properties. Investment clubs offer networking opportunities, educational resources, and a collaborative environment for investment discussions and deal sourcing.
Real Estate Investment Trusts (REITs):
REITS are publicly traded companies that own and operate income-generating properties. When you invest in a REIT, you are investing in shares of that company; you are not investing in the specific properties that they own. REITs are required to distribute upwards of 90% of their profits to shareholders in the form of dividends. Investing in REITs is one way to preserve liquidity while still investing in real estate. This is because REITs shares can be purchased and sold as easily as other publicly traded stocks or bonds.
Real Estate Syndication:
Real estate syndication is when a sponsor forms a special purpose entity, generally an LLC, that they use to invest in a commercial property. The syndicator, or sponsor, then raises capital from individual investors to invest in that property through the syndication. By participating in a syndication, you can invest in larger-scale projects that may offer higher potential returns than individual investments. The sponsor manages the property on the limited partners’ behalf. The LPs then receive distributions based on their pro rata share of the capital contributions.
Real Estate Private Equity Funds:
There are some private equity funds that focus exclusively on investing in commercial property. These funds are typically managed by professional investment firms and require significant investment amounts. Investors become limited partners in the fund and benefit from the expertise and deal flow of the fund manager. Unlike a syndication, a private equity fund may not have identified a specific real estate deal before soliciting capital investment. Instead, the fund manager sets the parameters for which it intends to invest as opportunities arise.
Real Estate Crowdfunding:
Real estate crowdfunding platforms are a relatively new phenomenon that allow sponsors to raise money for a syndication or fund online. Through these platforms, investors can contribute capital to finance commercial real estate projects alongside other investors. Crowdfunding provides access to a wider range of investment opportunities and allows investors to participate with lower investment amounts compared to traditional “country club” investing opportunities.
Commercial Real Estate Investing Strategies
There are generally four commercial real estate investment strategies: core, core-plus, value-add, and opportunistic.
- Core investing entails buying well-located, stabilized assets that are already generating cash flow. Core assets tend to command a premium and therefore, are often purchased by institutional investors looking for relatively “safe” and stable assets. These properties tend to be lower risk but also generate more modest returns, typically around 5-8% depending on the specific asset and timing in the market cycle.
- Core-Plus properties are slightly older than Core properties and/or are located in secondary markets (e.g., on the periphery of the top markets). In most situations, core-plus properties need minor investments to reach their full cash flowing potential. The expected returns on a core-plus property can range from 8-12%. Core-Plus investing is similar to buying dividend growth stocks and have a similar risk profile.
- Value-Add real estate investing is a popular strategy in which someone purchases a property with the intention of making modest or significant property improvements that in turn, generate substantially more cash flow and therefore, increases the property’s value. A light value-add strategy might involve refreshing the units in an apartment building, whereas a heavy value-add investment might require reconfiguring unit layouts, adding amenities, and renovating the building’s exterior and landscaping. Value-add investments generate both income and appreciation, with returns expected to be somewhere between 12-20%.
- Opportunistic real estate investing in unquestionably the riskiest form of real estate investing. It includes land speculation, ground-up development, and/or the conversion of a building from one use to another. For example, someone might purchase a former dry cleaning facility with plans to redevelop that site into a 200-unit apartment building. Another example is converting an outdated hotel into a new apartment complex. Opportunistic real estate can have long time horizons and are especially complicated, which is why they are generally best spearheaded by those with significant real estate expertise. Given the risk profile of these deals, investors can expect to earn returns in excess of 20%. However, these deals can often go sideways in which case, investors may earn no profit or worse, may lose their entire investment altogether.
Evaluate Financial Risk vs. Potential Reward
As with any type of investment strategy, researching the financial risk vs. reward measurements can help to determine whether a specific commercial deal is worth pursuing. Review potential opportunities to understand what kinds of returns are projected and decide whether or not these make sense relative to your own investment objectives. For example, a higher return may mean that there is more risk involved and/or a longer commitment period. Conversely, lower returns could also signify a more stable financial venture with less potential volatility.
Do You Need to be an “Accredited Investor” to Buy Commercial Property?
Depending on the specific real estate opportunity and investment vehicle, someone may need to qualify as an accredited investor. This is often true with real estate funds and syndications. To qualify as an accredited investor, someone must have an annual income of at least $200,000 (or $300,000 with a spouse) for the past two years or have a net worth of at least $1 million excluding their primary residence.
However, non-accredited investors can still buy commercial property. They can do so by purchasing real estate directly (Direct Ownership), through real estate partnerships, through some real estate crowdfunding platforms, and by investing in REITs.
Consult with your tax professional to determine whether you qualify as an accredited investor, as this may influence how you invest and in what increments. Some funds, for example, require you to be both an accredited investor and invest a minimum amount—and that minimum can be substantial (e.g., $250,000 or more per person).
There are certainly benefits to investing in commercial real estate. Most notably, investing in commercial property is a great way to earn passive income and build generational wealth.
However, it is also important to note that investing in commercial real estate requires substantial capital, market knowledge, and a thorough understanding of the associated risks. Conduct comprehensive research, seek professional advice, and carefully analyze potential investments before committing your resources.