How to Get Started Investing in Commercial Real Estate
This beginner’s guide to commercial real estate investing will tell you what you need to know to get started investing.
REITs for Hands-Off Commercial Real Estate Investing
Real Estate Investment Trusts, or REITs, are the simplest way to get started investing in commercial real estate. You don’t need to buy an expensive commercial building. Instead, you invest the amount you want in a trust, and the trust pools your money with that of other investors to make commercial real estate investments and generate passive income.
REITs pay no corporate tax on their profits (unlike publicly traded companies) as long as they earn at least 75% of their income from real estate and pay at least 90% of their taxable income to shareholders.
REITs can invest in apartment buildings, offices, hotels, data centers, self-storage facilities, healthcare properties, and more. They might hold rentals or even fix-and-flip houses. The main characteristic of REITs is that the investors don’t actively participate.
- You don’t have to understand real estate or property management. Experts purchase and sell properties, manage rentals, and deal with repairs and maintenance on your and your fellow investors’ behalf.
- It’s easier to limit losses. You’ll never have to put up additional money after you make your initial investment. The trust spreads your investment across diverse properties, so the bad luck that can befall any single investment property (toxic mold, local economy, zoning changes, etc.) won’t wipe you out.
- REITs are highly liquid: you can sell them immediately at any time for their total market value. While the rise of CRE tech makes traditional transactions faster, you still don’t want to try that with an office building.
- Most REITs are geared to generate stable returns and steady income. They won’t set the world on fire, but they also won’t keep you up at night.
REITs afford you many advantages of rental property ownership without owning the properties yourself. Due to their economies of scale, most REITs pay above-average dividends and generate impressive property appreciation. According to Nareit, equity REITs are up over 30% as of Q3 2021, while mortgage REITs are up by 21.5%.
Purchasing and Managing Commercial Real Estate
If you want more control and potentially higher (sometimes much higher!) returns, you can invest in commercial real estate yourself. An experienced commercial real estate agent and property manager can alleviate much of the burden and take care of the tasks you can’t or don’t want to do.
Annual rental income for commercial properties ranges between 6% and 12% of purchase price. That’s in addition to any property appreciation you realize. According to the Commercial Property Price Index (CPPI), for example, industrial property prices increased 24% in 2021. If you earn 12% in annual rent and 4-5% in yearly appreciation, that’s a healthy 17% annual return.
Types of Commercial Property
There are several main commercial property types, and they don’t all offer the same returns. According to the most recent National Commercial Real Estate Investor Fiduciary’s Property Index, quarterly returns (Q4 2021) for commercial sectors were:
- Industrial: 13.34%
- Office: 1.68%
- Apartment: 6.82%
- Hotel: 4.64%
- Retail: 2.18%
The quarterly return for unleveraged core real estate held by institutional investors was 6.15% , consisting of 1.03% from income and 5.12% from appreciation. Properties with debt financing have a leveraged total quarterly return of 8.05%. Besides the above-referenced property types, you can choose from alternatives such as self-storage, medical, elder care, land, parking, and event space.
Different property types also vary in cost and respond to ongoing market changes, so research into historical market performance is essential. If you have unique expertise in a specific industry, you might have an advantage over less-informed investors.
What Does a Commercial Real Estate Agent Do?
To purchase commercial real estate, you’ll want to rely on the advice and assistance of a commercial real estate agent. The seller’s agent represents the interests of the seller. You’ll want your own agent to look after your interests as a buyer. (Both agents split a real estate commission paid by the seller).
A commercial real estate agent’s job is more complicated than a residential real estate agent’s. That’s because a commercial real estate investment is a business with many moving parts.
Here are the services a commercial real estate agent may provide for you:
- Evaluate property using local comparables or “comps” to determine fair market values
- Provide financial information and analysis
- Show and explain the features of buildings
- Discuss the costs of maintaining facilities and possible renovations
- Determine the best method of purchase and review financials
- Ensure all paperwork is completed properly
- Ensure the purchase is legal and binding
- Identify, analyze, and prepare redevelopment plans
- Have all properties inspected thoroughly and identify possible repairs
- Help negotiate property prices and settlement details
- Work with commercial attorneys, loan officers, and agencies to complete the purchase
- Help arrange financing
Unless you are very comfortable with financing and real estate, buying property without an experienced commercial real estate agent’s assistance is probably a big mistake. If you don’t understand these formulas, don’t even think about going it alone:
- Net Operating Income (NOI): This is revenue minus costs. Operating costs typically include insurance, property management fees, utilities, repairs and maintenance, and property tax.
- Cap Rate: Short for “capitalization rate,” this percentage equals net operating income divided by purchase price.
- Cash on Cash: Cash on cash tells you how quickly you’ll recoup your initial out-of-pocket investment. To calculate cash on cash return, divide the cash income earned after paying all operating expenses (including any debt service) by the total money invested.
Your agent should help you calculate these figures and determine which properties make the best investments.
How Much Work Is Commercial Property Investing?
Here are some important points when deciding if you want to handle your properties entirely or outsource some or all of the work:
- Business owners renting commercial space have a vested interest in maintaining their premises because their business will suffer if they don’t. This is like having them on your management team, taking on a chunk of the workload.
- Most businesses close at night and have an alarm monitoring service so that if anything does happen at night, the alarm company notifies the authorities. Less work for you.
- Commercial property can be easier to value because you can see the seller’s income statement. A knowledgeable broker should establish a price that delivers your area’s prevailing return (known as the “cap rate”).
- Commercial properties often come with “triple net” leases. This means the tenant is responsible for all property maintenance and expenses, including real estate taxes.
- If you have many properties or buy apartment buildings, you’ll have to invest time as well as money (or hire a property manager). You may have to administer multiple leases, calculate annual CAM (Common Area Maintenance) adjustment costs that tenants are responsible for, maintenance and repair, liability, and public safety.
- It’s risky to DIY your property management unless you’re licensed to do the tasks you take on because of the liability potential. Include applicable property management/maintenance costs when determining what you’ll pay for a commercial investment property. Property management typically costs 5% to 10% of rent revenues. You may wish to save by managing your properties but outsourcing the maintenance and repair.
- Commercial properties usually have more public visitors, creating additional opportunities for damage, injury, and theft. Look into insurance coverage and cost when evaluating a commercial property.
If you lack commercial property management experience, you may wish to hire a property manager initially, even if you eventually want to manage your buildings yourself.
What Does a Property Manager Do?
If the list above appears daunting, relax. You can bring in professional help. Here are the services (when applicable) your commercial property management fees can buy:
- Establish and maintain a maintenance schedule
- Establish and implement housekeeping programs
- Supervise all vendors
- Supervise repairs and alterations
- Analyze service contracts to determine if other providers are more cost-effective
- Collect all rents, additional charges, and miscellaneous income
- Review existing leases and prepare new leases
- Provide monthly financial reports
- Pay real estate and personal property tax, improvement assessments, and other charges
- Prepare tenant analysis for retail spaces
- Make all mortgage, ground lease, and promissory note payments and comply with mortgage documents
- Enforce leases per their terms and notify you of any defaults
- Distribute income to you at your request
The service you require from a property manager depends on the number of tenants and leases and the type of operation you’re running. If you own a single building with one industrial tenant and a triple-net lease, that’s much less work than an apartment complex with 100 residential tenants and leases.
Financing Commercial Real Estate
There are many ways to finance commercial real estate, depending on the type of building and what you’re doing with it. Your agent should be able to point you in the right direction for appropriate loans.
Small Business Administration (SBA) 7(a) and 504 Loans
SBA 7(a) loans and SBA 504 loans are business loans backed by the Small Business Administration (SBA). SBA 7(a) loans are the most common type of SBA loan used to purchase commercial properties up to $5 million. You usually need at least 10% down, a minimum credit score of 680, and at least three years in business. Interest rates range from 5% to 8.75%.
The property must be at least 51% owner-occupied, which means you can use it for your own business and rent to other tenants, as long as your space accounts for more than half of the total square footage.
SBA 504 Loans are similar to the 7(a) loan, except the 504 does not have a maximum loan amount.
Conventional Commercial Mortgage
Lenders typically require a 25% down payment minimum in exchange for a fixed-rate mortgage ranging from 5 to 30 years (most commonly between 5 and 10 years). Excellent credit is required, but the interest rates are among the lowest for commercial real estate financing.
These loans are appropriate for properties in good condition with established income.
Commercial Bridge Loan
A commercial bridge loan is a 6-to-12 month loan you might use if you need to improve or lease your property before you can refinance it into a long-term loan with better terms.
Because they have short terms, bridge loans come with higher interest rates and fees. Expect to pay an interest rate that’s .5% to 2% higher than a traditional, fixed-rate mortgage.
Hard Money Loan
Hard money loans are an alternative form of capital provided outside traditional lending channels, either by individuals or companies. You might use one if you need to move very quickly to purchase a property, but they have concise terms and high fees.
Hard money lenders care primarily about the property value and less about your creditworthiness. Hard money loans are also called private mortgages and don’t have the same consumer protections most other products do. Expect to pay interest rates ranging between 10% and 20%.
How Much Involvement? It’s Your Choice
Real estate investment can be as involved and complicated as you want to make it. There’s a whole spectrum of involvement, risk, and potential return, from entirely passive REITs to 100% owner-selected and -managed buildings and everything in between.
A knowledgeable broker and proficient property manager are probably worth every penny and a great way to learn without being burned if you’re just getting started.
Ben Mizes is the Co-Founder and CEO at Clever Real Estate, the nation’s leading real estate education platform for home buyers, sellers, and investors.