An Introduction to How to Buy Commercial Property

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The demand for commercial property will continue to be fueled by economic growth, the need for space, and increasing investment across all commercial real estate asset classes. 

As CBRE’s U.S. Real Estate Market Outlook 2022 reveals, this year should see record investment in commercial real estate due to high levels of low-interest rate debt and the attractive risk-adjusted returns from commercial property.

Benefits of Commercial Property Investments

Commercial property can be an excellent way to diversify an investment portfolio, offering numerous tax advantages and robust returns for the buy-and-hold investor. As this article from Forbes recently explained, there are several reasons why commercial real estate is an important asset class:

  • Higher returns: The average annual return from commercial property over a 20 year holding period is approximately 9.5%. By comparison, the S&P 500 delivered average annual returns of about 8.5% over the same period.
  • Tangible asset: Commercial property is an asset class that can be seen and touched. Due diligence is easy to perform, and potential financial returns are easier to forecast than a high-flying stock whose value could decline by double digits in a single trading day.
  • Leverage: Returns from a commercial property can increase with the wise use of leverage (other people’s money). Instead of paying all cash, many investors use a down payment of 30% of property value to control 100% of the rental income, appreciation, and tax benefits.
  • Low stock market correlation: Real estate also has a low correlation with the stock market. Unlike stocks that frequently move up or down, commercial property is a non correlated investment unaffected by stock market volatility.
  • Tax benefits: Writing off operating expenses, owner expenses, and using depreciation to reduce pre-tax income, are three of the many tax benefits of investing in commercial property. Investors can also defer capital gains taxes by using a tax-deferred exchange to sell one commercial property and replace it with another within a specific period.
  • Inflation hedge: Commercial property can also hedge against inflation when increased operating expenses are passed through to a tenant. Investors can include annual CPI rent increases and use a triple net lease where the tenant is responsible for a pro rata share of maintenance, property taxes, and insurance in addition to monthly base rent.

How to Buy Commercial Property

There are plenty of potential advantages to investing in commercial real estate by buying the right property in the right place at the right time. Here are the general steps to follow to buy a commercial property.

1. Research

Begin by learning about the different commercial property types, deciding on an investment strategy, and researching the best markets for commercial real estate investing. There are five main types of commercial property asset classes to invest in:

  • Office
  • Retail
  • Multifamily
  • Industrial
  • Hospitality

Each commercial real estate asset class has its pros and cons, with opportunities that differ based on an investor’s strategy. Common investing strategies for commercial property include: 

  • Buy-and-hold to collect recurring rental income and profit from appreciation over the long-term
  • Adding value by updating a Class C apartment building to Class B
  • Repositioning an undervalued hotel to meet the growing demand of affordable housing

The commercial real estate market in 2022 should continue to see growing demand from both investors and occupiers as the economy recovers. Some of the top markets for commercial property investment include Nashville, Phoenix, Tampa/St. Petersburg, Dallas/Fort Worth, and Seattle.

2. Returns

After identifying the best market to buy commercial property, the next step is to drill down and analyze the investment’s potential returns. Standard financial metrics used to forecast commercial real estate returns include:

  • Net operating income, also known as NOI, is the cash remaining at the end of each period after paying regular operating expenses. NOI does not include capital expenses, a mortgage payment, or owner taxes that vary from one investor to the next.
  • Cap rate measures the annual return assuming the purchase is made in cash. Cap rate is calculated by dividing NOI by the property value or purchase price.
  • Cash flow is the amount of pre-tax cash remaining at the end of each period after all expenses have been paid, including any mortgage payment and capital expenses.
  • Cash on cash return measures the cash earned compared to the amount of money invested (it considers the use of leverage). For example, if a one million dollar office building is purchased using a $30,000 down payment and the property generates a cash flow of $5,000 per year, the cash on cash return is 16.7%.
  • Internal rate of return or IRR is the percentage return on each dollar invested for each period over the entire holding period. Investors use IRR to compare the potential return of commercial property to a ‘risk-free’ investment such as a Treasury Bill and compare alternative investments to one another.
  • Gross rent multiplier or GRM is a quick and easy calculation used to compare the amount of gross rental income a property generates to the purchase price. The lower the GRM is, the better the investment could be, everything else being equal. However, GRM does not consider important factors such as operating expenses or the need for capital improvements.

3. Financing

Financing commercial real estate is generally more expensive than obtaining a home loan. Down payments usually run about 30% of the purchase price, with higher interest rates and shorter loan terms. 

In addition to looking at a borrower’s personal and business credit scores and assets, a lender may also expect a borrower to have experience with the type of commercial property being purchased or partner with a co-investor who does.

Types of financing for commercial property include:

  • SBA 504 loan
  • Conventional mortgage
  • Private or hard money loan
  • Bridge loan

4. Team

Investing in commercial real estate is a team sport, with an investor acting as the coach. A commercial real estate team should include a good commercial real estate broker, mortgage lender or broker, escrow officer, inspector and appraiser, contractors, insurance agents or brokers, a commercial real estate attorney and CPA, and a property management company to take care of the tenants and the property after the transaction.

5. Offer

There are two main steps to making an offer on commercial property:

The Letter of Intent (LOI), also known as a memorandum of understanding or MOU, is an informal written negotiation where buyer and seller come to a ‘meeting of the minds.’ An LOI typically includes names of both parties, property address, price and financing terms, required documents for review, and contingencies such as financing and due diligence.

A Purchase and Sale Agreement (PSA) is generally drawn up with a commercial real estate broker and attorney’s assistance and reviewed by each party’s CPA. Both buyer and seller sign the PSA document to make it legally binding, open escrow, and kick-off due diligence. After seller documents are reviewed, and a property inspection has been completed, additional negotiations may occur, such as seller concessions or repairs before escrow closes.

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Shanti Ryle
Shanti Ryle

Content Marketing Manager

Shanti leads Crexi's content marketing strategies with 7+ years of content development experience, creating everything from blog posts to award-winning podcasts. Previously, she worked on content teams at Snapchat, Weedmaps, and HopSkipDrive as well as developed copy, articles, and media for freelance publications.

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