Introduction:
Are there investment strategies for commercial real estate? Yes, there are. Read the following to know how to get the finest deals possible!
Investing in Commercial Real Estate
Property utilized primarily to profit for a business, as opposed to a residence, is classified as commercial real estate (CRE). Retail malls, shopping centers, office complexes, and hotels are all examples of this development. Commercial real estate loans—mortgages backed by liens on commercial property—are commonly used to fund these properties’ purchase, development, and construction.
Banks and private lenders make commercial real estate loans like home mortgages. Commercial real estate financing sources include the Small Business Administration’s 504 Loan program, insurance firms, pension funds, and private investors.
How should I invest in commercial real estate once I’ve decided?
Any property, whether commercial or residential, can be an excellent investment. Commercial assets often provide more financial benefit for your money than residential properties such as rental flats or single-family homes, but there are also more hazards.
Reasons to Invest in Commercial Real Estate
Here are some advantages of purchasing commercial real estate rather than residential property.
The income potential is the best incentive to invest in commercial and residential rentals.
Commercial properties normally offer an annual return on investment of 6 to 12 percent, depending on the area, present economy, and external factors (such as a pandemic). That is a significantly wider range than for single-family home properties (1 percent to 4 percent at best).
Professional connections.
Small business owners are typically proud of their companies and wish to defend their livelihood. Commercial property owners are typically not people but LLCs that run the property as a business. As an outcome, the landlord and renter have a more business-to-business customer relationship, which aids in maintaining professional and courteous contacts.
The general public is watching the property. Retail tenants are vested in keeping their stores and storefront in good condition because it affects their business. As an outcome, commercial tenants’ and property owners’ interests are aligned, allowing the owner to maintain and increase the property’s quality and hence the value of their investment.
Operating hours are limited.
Businesses typically close their doors at night. Except for late emergency calls at night for break-ins or fire alarms, you should be able to sleep without fear of receiving a call at midnight from a renter who needs repairs or has misplaced a key. Commercial premises are also more likely to have an alarm monitoring service, so your alarm provider will contact the appropriate authorities if something happens late at night.
More objective price evaluations.
Commercial property prices are frequently easier to examine than residential property prices because you may request the existing owner’s income statement and calculate what the price should be based on it. Suppose the seller is working with an experienced broker. In that case, the asking price should be set at a level where an investor can earn the area’s typical cap rate for the commercial property type they are interested in (retail, office, industrial, and so forth). Residential real estate is frequently subject to more dynamic pricing.
Leases with three nets.
There are variations on triple net leases, but the core idea is that you, as the property owner, do not have to pay property expenses (as would be the case with residential real estate). All property expenses, including real estate taxes, are handled entirely by the lessee. The only cost you’ll have is your mortgage. Companies like Walgreens, CVS, and Starbucks generally sign these types of leases because they want to retain a look and feel consistent with their brand, so they manage those expenditures, which means you, as an owner, receive one of the lowest maintenance income producers for your money. Strip malls include a range of net leases, including triple nets, which are not commonly done with smaller businesses, but these lease types are ideal and cannot be obtained with residential buildings.
Lease terms are more flexible.
Commercial leases are governed by fewer consumer protection laws, as opposed to the hundreds of state statutes that control residential real estates, such as security deposit restrictions and termination rules.
There are ways to make money in commercial real estate, just like there are ways to make money in residential. You may find that focusing on one strategy is the best option for your goals, experience, and specific scenario. On the other hand, some investors like to tailor their techniques to the specifics of each investment opportunity.
There are numerous commercial real estate investment options regardless of which investment plan you choose. So, in this essay, we’ll go over the advantages and disadvantages of four popular methods. We’ll focus on the following areas:
- The Buy and Hold Approach
- Traditional Advancement
- The Strategy of Value Add
- Owner-Occupied Structures
- Last Thoughts
Overview
Stabilized properties can be found, purchased, and kept running as part of this plan. In other words, they buy a commercial property already earning a profit and plan to hang onto it for the long haul.
When it comes to making money, this technique is to make as little effort as possible. They don’t want to renovate or find tenants for their properties. As an alternative, they buy a property that has previously been proven to be a profitable investment.
For this technique to work, investors must first identify the type of property they want (multifamily/apartments, offices, industrial, etc.). Investors should also take into account the following factors when deciding on a property type:
If so, how much of a role do you intend to play in day-to-day operations? By reducing your property management costs, you’ll likely get a larger return on your investment. However, this also means that the building must be in your area and that you cannot use the time you spend maintaining the building to concentrate on new investments.
Aims for the long term: What is your long-term financial goal for the transaction? There are two distinct types of investors in commercial real estate: those who want a quick exit and those who want long-term success.
Pros
- Investors have three obvious avenues for earning from these properties, all due to the stabilized nature of these assets. To begin, you’ll need to collect rent payments from tenants. Secondly, loan amortization increases your equity in the property each month as you pay down your loan principal over time. Because these arrangements are long-term, you can reap the rewards of property appreciation.
- With a stabilized property, there are fewer dangers because someone else (usually a real estate developer) has already taken on the bulk of the risk. If you’ve already made a purchase, you know this bargain is a winner. In addition, you can use those exact data in your underwriting analysis.
- There are no rehab or construction needs: Again, this allows you to start making money right now. Investors don’t have to supervise the work of contractors because they don’t have to wait while a property is rehabilitated.
Cons
- If you’re buying a stabilized home, you’ll probably pay retail. Unlike distressed property deals, investors often don’t get discounts on these transactions. Because of this, you are finding a package that fits your financial needs can be difficult. Rather, these qualities are more like long-term bonds, generating steady but lower returns over time.
Overview
Investors use this method to take a project through the complete lifecycle: from the initial vision to planning and development, building, and stabilization. It is up to the investor to agree whether or not to continue operating the stabilized property.
Even if there are numerous ways to go about this, the following phases are always present:
- The beginning of a project is marked by creating a vision and “big picture” strategy. How will the property turn out in the end? What are the probabilities? Based on this information, investors will be able to validate their capital stack or the mix of stock and debt.
- Formal development is the process of putting the vision mentioned above into action. Site selection and a detailed plan for the property needs to be done with the assistance of engineers, architects, contractors, and zoning specialists. Developers create specific pro formas for stable property based on their formal plans. Investors can now get the money they need to buy the property and begin construction.
- Developers typically acquire and begin development on a property with short-term commercial financing. For investors, overseeing the construction of a property is essential at this phase.
- Investors promote the property and secure long-term leases for tenants to ensure its long-term viability. Long-term financing can be secured once the property reaches a certain occupancy level. Alternatively, they can leave the deal by selling the property to other investors.
- Traditional commercial real estate development is the most lucrative business opportunity for investors.
- With a clear goal, development gives investors the freedom to plan and implement that vision in their unique way. It’s difficult to make major changes to a stabilized property, even if you intend to renovate it. Creating a property from scratch is possible when you start with a small piece of land (albeit within zoning, financial, and structural limitations).
- Investors with little or no prior experience should avoid pursuing this course of action. When it comes to developing a property, experience is key. Commercial financing, zoning rules, construction, real estate legal constraints, tenant marketing, and placement, to name just a few, are just a few of the areas in which investors must be knowledgeable. In addition, new projects necessitate large investments in the beginning. For investors to secure finance, they must conduct feasibility studies and designs that cost tens of thousands of dollars.
- As a result of its high risk and great reward, traditional development is best avoided. All of your initial investment is likely to be lost if you fail to complete the work.
- Unfortunately, the IRS often treats developers as real estate dealers regarding taxes. As a result, most development-related profits will be taxed as regular income (as opposed to the more favorable long-term capital gains rate). But even if a tax expert can help, developers must still prepare for the larger tax burden.
The Strategy of Value Add
Overview
This technique involves purchasing an income-producing property, enhancing it (i.e., increasing its value), and then operating it. The term “commercial BRRRR” has gained currency in the investment community due to the strategy’s widespread use in residential real estate.
- Buy
- Renovate
- Rent
- Refinance
- Repeat
Investors first hunt for an inexpensive property. Distress, a previous owner who violated a loan covenant, or a variety of other factors could be to blame. The structure is then renovated by investors, which increases its perceived value (hence, value-add). Improvements to BRRRR include:
- Redesigned and improved lighting
- Fresh paint for the interior and exterior of the home
- Renovated flooring
- Refurbished public spaces and new signage
In addition, investors rarely undertake a total renovation of a building when making BRRRR enhancements. While maintaining within the confines of an agreement’s budget, the goal is to renovate the building to appear new (or at least significantly newer than before).
Investors discover, screen, and arrange qualified renters after rehabilitating a property. The third “R” – refinancing – is now possible. BRRRR investors typically use short-term finance to acquire and refurbish a property. Improvements have been made, tenants have been found, and an increase in net operating income should have been achieved (NOI). As a result, they can secure a long-term loan on the property. As a result, the “R” stands for “repeat,” which will help investors return their initial capital. It’s possible to reinvest this initial capital investment in a new contract after recouping this original capital investment.
- BRRRR investors will only be significantly interested in marked-down properties if you’re looking to buy a distressed property. But even with these expenditures, investors can often get into these ventures at a lower price than if they were to acquire a stable property on the open market.
- Replicability: As previously indicated, investors can recoup their initial investment when they refinance using a well-evaluated BRRRR contract. As a result, a repeatable investment approach is possible. At the beginning of the project, let’s say you raise a total of $200,000. A $1,000,000 down payment can be made via a buy-and-hold strategy. An initial investment of $200,000 with BRRRR can be used for various transactions.
Cons
Renovations take time and effort, especially if they have to be staggered with the tenancy of current residents (e.g., renovating a 100-unit apartment building). This technique also requires many investors’ efforts to supervise contractor activity. This may not be the finest option for someone who wants to put money into an investment with the least amount of work.
This method’s success depends on the post-rehab value matching your estimated worth. Your investment may be derailed if the property’s value drops significantly following the renovations, making it difficult to recoup your expenses. Investors can avoid this consequence by constantly using cautious underwriting procedures when evaluating future values.
Overview
This method is similar to “house hacking,” in which the owner lives in one room while renting out the rest of the property. Commercially, this involves owning a building and leasing out the remaining units to other businesses while operating out of a piece of it.
Your company may have nothing to do with real estate. You can run a financial consulting service and invest in real estate on the side. Regardless of the circumstances, this strategy shifts the priorities of a real estate investor. Owner-occupied properties necessitate a business-first, investment-second strategy. To put it another way, how can you match your company’s requirements with your real estate investing objectives?
Typically, investors set up a separate legal corporation to purchase real estate on their behalf (e.g., 123 Main Street, LLC). You then enter into a separate lease agreement with this property company. This legal arrangement separates your company’s assets from the property’s liabilities while facilitating the transaction’s tax advantages.
- Many lenders are willing to offer favorable commercial mortgage terms if you occupy a portion of the property you’re purchasing (e.g., lower rates and longer terms).
- When you are both landlord and tenant, you have complete control over the space in which you operate your business. You don’t need to negotiate with a different landlord if you wish to make any adjustments.
- Using this technique, you’ll be able to turn your business’s rent expenses into passive rental revenue, which depreciation deductions can offset. As a result, you benefit from a double tax reduction. Rent for your business is always deductible because it is a fundamental component of your overall operations. This rent becomes tax-favored passive income when you pay it to yourself (as a separate legal entity).
- To be eligible for owner-occupied financing, your company must occupy a specified percentage of the building’s space, usually 50 percent, as most lenders require. Design the other rental apartments in a building restricts your options.
- Mixing business with real estate is a disaster since no landlord wants to deal with angry renters. This can happen if your business is housed in the same building as unrelated tenants. However, you may keep this from happening if you hire a third-party management business to appropriately organize the building’s operations.
Commercial real estate investing strategies aren’t limited to those described here. However, because they are so widespread, novice investors should become familiar with them. There are distinct considerations, advantages, and disadvantages to each technique. You can make an informed judgment about whether the method best supports your personal investment goals if you thoroughly understand both.
Don’t hesitate to contact us for more information on different commercial real estate investment alternatives. Set an appointment with us to discuss potential real estate investment possibilities and the corresponding strategies by sending us a message.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.