What The “Experts” Never Tell You About

Commercial Real Estate Investing

11 . 12 . 2019

Commercial real estate is property that is used for business purposes or leased out to tenants by investors. At one time or another, many real estate investors think about making the move into commercial real estate investing. Property is larger with multiple tenants, rents are higher and cash flow is stronger, and profits can be better.

However, along with the increased opportunity of buying commercial property, there are also more potential risks and liabilities. In this article we’ll discuss how to mitigate risk and maximize reward by knowingthe most important things the experts never tell you about commercial real estate investing.

There’s a lot of investment capital flowing into commercial real estate

Commercial real estate includes asset classes such as office, retail, industrial and distribution, special use property, large multifamily apartment buildings, and land. Investors buy commercial real estate to lease out to companies, and sometimes companies buy their own property to owner-occupy.

Since 2010, vacancy rates on all types of commercial property have declined while leasing activity volume has increased annually by between 5% and 15%.1 Over the past 10 years, demand for commercial real estate has more than doubled the average prices for office buildings, shopping centers, and large apartment properties, according to the Federal Reserve Bank.2

What makes commercial real estate so attractive to investors?

Commercial real estate has several unique characteristics compared to alternative investments:

Commercial real estate is valued differently

Commercial real estate is generally valued by the income it produces and the size of the property. Financial formulas used to value commercial property include cap rate, ROI, and cash-on-cash return. Residential real estate is normally valued by the price per square foot and not by the income the property generates.

Multi-tenant commercial real estate helps to diversify risk

If you have a single-family home and your tenant leaves, your vacancy is 100%. On the other hand, if you have a commercial property with 15 tenants and one leaves, your vacancy rate decreases by less than 7%. There’s much less of a negative affect on cash flow when you’re not dependent on one tenant for all of the income.

Gross income and cash flow are higher

Rental yields per square foot are often greater with commercial real estate because you are renting to businesses rather then the general public. Owners are willing to pay a higher rent and stay longer when the space they’re renting adds value to their business.

Lease terms are longer and landlord-friendly

Residential leases are usually for one year or less at a fixed rental rate. A lease on a commercial building can run 5, 10, 15 years or longer with annual rent adjustments made for inflation, making rentalincome more predictable. Many landlords also negotiate net leases, meaning that some or all of the building operating expenses and taxes are passed through to the tenant.

On the other hand, financing commercial property is more expensive. Loans on commercial real estate normally run for shorter periods of time, have higher interest rates and require more money down.

While many residential mortgages last for 30 years, it’s common to see commercial loans terms of around 5 years, with a balloon payment due at the end. Lenders also frequently expect the borrower to have previous commercial real estate investing experience.

How to avoid common commercial real estate investing mistakes

Investing in commercial real estate isn’t necessarily the right choice for every investor. Transactions are more complicated and owning and managing commercial property is more time consuming and capital intensive.

Commercial real estate investing is best for well-capitalized, experienced investors with high risk tolerance, joint ventures and limited partnerships that pool funds to diversify risk, and real estate investment trusts that specialize in specific asset classes.

Here are the four most common mistakes commercial real estate investors make and how to avoid them.

#1 Public listing information isn’t always accurate

When you buy a rental house, most of the information you need is available on the MLS. Historical and pending sales, current asking prices, neighborhood information and much more can be found with just a couple of clicks on the keyboard.

However, public listing information for commercial real estate isn’t always available or accurate. Some common mistakes include:

  • Relying too much on the real estate broker for accurate information instead of independently conducting your research and verifying property income and expenses and allowed property uses
  • Failing to do thorough due diligence by investigating zoning, fire alarm and sprinkler control systems, licenses and certificates of occupancy, and that tenants are using the space legally and have been paying their rent on time
  • Forgetting that the seller cap rate can be different from the buyer cap rate due to deferred maintenance, assuming tenants will accept rent increases, and underestimating the increase in property taxes and real estate transfer taxes in states such as California3

#2 Underestimating the risks and liabilities

The U.S. economy has been growing for 121 consecutive months, marking the longest period of economic expansion since 1854.4 After more than 10 years of positive economic growth, it’s understandable that real estate investors may become passive, believing that the good times will go on forever.

But historically, markets can and do change. Research by Harvard University notes that there are four phases to the real estate market cycle: Recovery, Expansion, Hyper Supply, and Recession.5

Regardless of the market phase, real estate investors can find opportunity in all parts of the real estate cycle by accurately assessing potential risks and liabilities:

  • Focusing on net income instead of gross income by factoring in both actual and potential expenses such as capital repairs, interest rate and property tax increases
  • Accurately forecasting vacancy and TI (tenant improvement) costs by having enough capital reserved when investing in a building that needs a lot of improvements or has tenants that aren’t credit quality
  • Conservatively estimating cash flow by taking the seller’s numbers with a grain of salt, not expecting 100% of the tenants to renew their leases, and identifying the phase of the real estate investment cycle
  • Understanding and complying with business and tax regulations, and maximizing the benefits offered real estate investors by the Internal Revenue tax code such as 1031 exchanges to minimize losses from business and real estate taxes6

#3 Selling commercial real estate takes longer

In today’s strong housing market, a seller can list a home on the MLS in the morning and have multiple offers by the end of the day. Not so with commercial real estate.

Successfully selling commercial real estate to achieve your exit strategy and investment objectives requires timing, focus, and hard work.

Identify and target potential buyers

Businesses looking to occupy their own space, individuals and partnerships, REITs, crowdfunds, and institutional investors all invest in commercial real estate for different reasons. The three common investment strategies are:

  • Core property with credit quality tenants on long-term net leases
  • Value add real estate offering the potential for creating additional cash flow streams
  • Opportunistic investments requiring additional capital for repositioning or ground-up development

Planning ahead and understanding how your property fits into which investment strategy makes it much easier to create a ‘property story’ that tells investors what they want to hear.

Create an outstanding story

Once you know who you’re selling to, your next step is to create a compelling reason your target market should buy. Value add opportunities, brand new NNN (triple net) leases with credit quality tenants, and property in markets with low vacancy and little product in the pipeline help put the laws of supply and demand in your favor.

Ensure the transaction can be financed

Commercial real estate buyers frequently underestimate the stringent requirements of obtaining a mortgage and financing investment real estate. The process takes more time, has higher upfront costs such as appraisals, Phase I environmental reports and site inspections, and higher loan commitment fees.

When a buyer underestimates lender requirements and loan funding time frames, deals can get delayed or even fall through. Before you spend time, energy, and money looking for a property, meet with several lenders to understand what their requirements are and how much money they’re willing to lend:

  • Make the lender’s job easier by providing all documents and information ahead of time rather than waiting until the last minute
  • Disclosing negative issues about the property or borrower early-on to allow enough time to for creative problem solving
  • Demonstrate financial strength, liquidity, and management expertise with adequate capital reserves and investment partners

#4 Commercial real estate can go into foreclosure

Last but not least, many investors make the mistake of believing that because commercial property is high value, it won’t go into foreclosure like residential property does. The fact is that commercial real estate can and does sometimes go into foreclosure. That’s because banks don’t want a non-performing asset on their books, regardless of whether it’s a house or a hotel.

Fortunately, real estate investors can avoid potential problems by doing enough homework to make the right investment decision:

  • Secret-shop the tenant by posing as a customer to see what they like and don’t like about the property and location7
  • Ask them how business is and if they plan on staying when their lease is up for renewal
  • Research the population and job growth, and income levels in the area and compare them to local and national averages
  • Determine if more residential property is being built near by which will increase the demand for commercial services
  • If big-box retailers like Walmart and Home Depot are opening up, it’s a good sign that there will be an increased need for commercial property in the area

Diversifying with commercial real estate investments

Commercial real estate provides an excellent way to diversify your investment portfolio when you know things the experts never tell you.

Owning a single property means exposing yourself to the risks of one asset in a local market. However, you can easily diversify your investment portfolio with commercial real estate by:

  • Owning different asset classes including multi-family, office, retail, industrial and distribution, and special use property like self-storage and senior housing
  • Geographically diversifying by owning property in different markets across the U.S.
  • Diversifying investment capital by using different channels including direct investment, REITs, and crowdfunding to own a share of prime income-producing real estate rented to credit-quality tenants in major markets throughout the country

 

References

  1. https://www.nar.realtor/sites/default/files/documents/2019-q2-commercial-real-estate-market-trends-and-outlook-07-29-2019.pdf
  2. https://fred.stlouisfed.org/series/COMREPUSQ159N
  3. https://www.ucop.edu/loan-programs/resources/consumer-information/property-taxes-in-california.html
  4. https://www.ft.com/content/5c443804-9c41-11e9-b8ce-8b459ed04726
  5. https://www.extension.harvard.edu/inside-extension/how-use-real-estate-trends-predict-next-housing-bubble
  6. https://www.irs.gov/businesses/small-businesses-self-employed/like-kind-exchanges-real-estate-tax-tips
  7. https://www.inc.com/encyclopedia/mystery-shopping.html