12 Golden rules for investing in commercial real estate

rules for investing in commercial real estate

Did you know that mutual funds and equity investments make up over 65% of an average investor’s portfolio in the US, while real estate takes up less than 15%?

Retail investors overlook real estate investing when it comes to building a sustainable investment portfolio. This is because they aim to create a moderately liquid portfolio that generates immediate returns. Moreover, a majority of the investor believe that commercial real estate investing is risky and requires a higher capital investment. 

But, if you get an idea of the golden rules of investing in commercial real estate, you would be able to earn consistent rental income, benefit from several tax advantages, and achieve financial freedom from inflation-proof investment.

So, before diving straight into the rules for commercial real estate investing, you should have a good understanding of what Commercial Real Estate is and why it is a good investment option for you. 

What is Commercial Real Estate?

Commercial Real Estate comprises non-residential assets that are used exclusively for business purposes or to provide a workspace. Such properties are leased or rented to tenants for the purpose of generating profits either from steady rental income or capital gains. 

This broad category ranges from multifamily properties, offices, and retail properties, to hospitality assets, industrial buildings, single-family rentals, and so on. 

However, investment in commercial real estate generally requires a massive investment amount that is often impossible for any single retail investor to provide. Therefore, retail investors can invest in commercial real estate via publicly or privately traded Real Estate investment trusts (REITs), Fractional Ownership, Real Estate Syndication, etc.

Top reasons to invest in Commercial Real Estate 

The commercial real estate market is best known for its market stability and its reputation for generating wealth while protecting the original investment. The CRE market plays a compelling role in both up and down market cycles as well as in the diversification strategy of the investors. For instance, the commercial real estate market made a spectacular recovery in 2021 despite the economic downturn in 2020. 

So, are you confused about whether you should invest in commercial real estate?

Here are a few reasons why you should consider investing in commercial real estate:

1. Attractive returns in a short time

Commercial properties are appreciating assets. They aim to deliver attractive returns for investors to enjoy consistent cash flow from their investments. Due to higher rents and occupancies, a typical annual return could lie anywhere between 6% to 12%. Furthermore, commercial properties provide various tax benefits making the sector a viable option for investing.

2. Long term lease agreements

Unlike residential real estate which involves short lease agreements with frequent renewals, CRE involves long-term leases. Generally, the lease terms in CRE usually range from 1 to 5 years. As a result, it guarantees a steady cash flow for a long duration. The benefit of having longer leases is that there are fewer renewals. Investors do not have to worry about searching for tenants frequently. 

3. CRE is inflation hedged

Like any other real estate property, commercial real estate properties act as a hedge against inflation due to their appreciating nature. As a result, CRE properties can offset the long-term impact of inflation.

4. Tax Benefits

The ability of CRE to cut down taxes is the most enticing reason for investment in commercial real estate properties. From using 1031 exchanges to using asset depreciation, investors can use several options for eliminating capital gains taxes. Moreover, the interest on a mortgage, depreciation, and non-mortgage expenses can be deducted while investing in the commercial real estate sector. 

5. Fewer Government Interruptions

CRE is less regulated by the government as compared to residential real estate. In commercial real estate, landlords can take harsh actions in case a tenant fails to pay rent. This is why investing in commercial real estate is preferred by most property developers.  

Investing in CRE in 2022 can be a golden opportunity for you because the transaction volumes in the first ten months of 2021 rose to 64% from 2020. The industrial sector and apartments were more than 30% levels and their prices rose at a double-digit rate through Q3 2021. However, the retail and office sector lagged in 2021. But the demand for office properties is expected to accelerate in 2022 as more and more companies are lifting their WFH policies.

12 Golden rules for investing in Commercial Real Estate

1. Evaluate your financial status before jumping in

Thoroughly assess their financial status, along with their risk appetite, investment horizon, and the purpose of investment before entering commercial real estate.

The commercial real estate market is a highly diverse investment realm with lots of attractive investment opportunities. But as the experts say, with great opportunities comes a greater amount of risks. Regardless of how much time and effort you devote to research and study, you will always face unknown factors. Therefore, before you succumb to the lure of attractive opportunities make sure you have the resources and financial condition to ward off such obstacles and protect your investment. 

For example, asset classes like warehouses are highly accident-prone properties equipped with heavy machinery. Contingency funds can be useful in times of accidents or renovations.

Another attractive feature of commercial real is its ability to generate significant returns and steady cash flow. However, you might find yourself in situations where tenants are failing to keep up with their rents or in worst exiting the rental property. Therefore, you must equip yourself with contingency funds at times like this.

As these funds will help you keep your investment steady and floating by paying off your debts or mortgage until the investment recovers. 

2. Location is the key to your success

The location has a vital impact on the commercial real estate business and it can be the difference between success and failure. For example, a new restaurant requires a visible location or high-traffic regions. Whereas an office space must be in a place with good communication. Hence, the right location is a crucial ingredient for success.

Different businesses attract different locations. A hotel may be dependent on automobile traffic but a retail store must be available in regions of high foot traffic. Therefore, choose the location that is drawing customers who would visit your business. 

When you’re choosing a commercial property you are engaging in a long-term lease agreement. Make sure to choose a location that has less than 5% vacancy rates. This will ensure that there is adequate supply and the tenants would not generally vacate. As a result, tenants will stay put leading to higher rents and capital appreciation. On the contrary, if your asset is in a high vacancy area, the tenants would move frequently and negotiate rents. 

Moreover, the quality of your asset would depend on its accessibility via roads, major highways, airports, and seaports. These factors can make or break the value of the asset. 

For example, a well-connected spot close to harbors can be a great option for a warehouse or manufacturing space. 

3. Understand the market cycles

A major reason for the volatility behind US real estate market trends is the lag between demand growth and supply response. As an investor, you must be aware of the commercial real estate market cycle since it gives information about the possible returns of an investment property. You must check whether your property is in the recovery, expansion, hyper-supply, or recession phase of the real estate market. 

Before investing it’s crucial to research the performance of each asset class. The real estate cycle correlates with certain investment trends. There is no particular strategy you need to follow but has some common investment types based on the real estate cycles to consider:

This rule will help you get an idea of when to buy or sell a property to maximize your chances of profits. 

4. Evaluate the real estate market

Whether you are a single investor, a fractional owner, or a part of a REIT, having the knowledge of the historical market performance will help you understand the current market situation, forecast the future performance of your investments as well as compare similar properties. 

Note that here the term market refers to a particular location and the economic ties related to that area.  

The market can be divided into two parts based on the area and population of the region. To perform an apt market analysis, you must define the market and track the market characteristics of the submarket in it. Some of the characteristics that denote a good market/submarket are:

Once you have these results, you can proceed with the investment. 

5. Check the demand vs supply

Demand vs supply is the most crucial thing that an investor must analyze before putting their foot into the commercial market. Many investors fail to properly research the market to identify any future risks associated with the demand for that property type.

For example, if you think that flexible working is the future of office space, then you might want to consider investing in Hybrid offices in regions where the present supply is low.

Demand for eCommerce warehouses is growing day by day. However, investing in regions with previously present warehouses will lead to over-exceeding supply compared to demand. Thus, the market may saturate soon.

Industrial space and warehouses will continue to remain at their height in 2022 also.

6. Calculate the cash on cash or ROI of the property

The main aim of investing in CRE assets is to generate high returns. Therefore it is quite obvious for an investor to research previous data to figure out the possible returns on today’s date.  As per the rules of commercial real estate investing, ROI is calculated by taking the monthly or annual cash flow of an asset and dividing it by the net amount of invested money. ROI gives the investor a quick snapshot of the profitability of the deal. 

For example in multifamily properties, you can compare it to another type of property to figure out the rents which will help in determining the ROI.

7. Analyze the risk factors

Investing in Commercial real estate comes with its share of risks and rewards. Thus before diving into this sector it’s important to analyze the risk factors. The general saying that goes around in real estate is “higher the risks, the better the rewards. 

Risks in real estate can be anything, from an economic downturn to prolonged vacancies. Vacancy risks are one of the harsh realities of commercial properties. For example, an investor can wait for months or even years to get a new tenant after the completion of the lease terms. 

During COVID, the most affected real estate asset classes were the office spaces and retail industry. Renowned retail brands like JC Penney, Neiman Marcus, and others had closed down several physical stores due to the pandemic. Leaving the spot vacant for a long time. Companies like Zapier and GitLab are switching to a fully remote company leaving their physical office spot permanently.

Some investments have safer zones while others are highly risky which provides accredited investors with high-net-worth investments. The profitability increases simultaneously with the potential of risks. Hence, before investing in commercial real estate, consult with the property manager to know the risk level of the properties. 

8. Check tenant profile

Evaluating the tenant’s profile is crucial to ensure a good rental income for your property. If you are investing in a property with tenant occupancy then take a thorough investigation of the financial stability of the business. 

As commercial properties are usually leased for the long term, you must screen your tenant applicants thoroughly to ensure a continuous and steady cash flow. 

Perform a background check to evaluate your tenant’s credit score, and the previous history to get a clear view of the tenant’s profile. Furthermore, data on lease terms and vacancies will also provide you with an idea of mitigating the situations if a tenancy gap occurs. 

Also, look for quality bluechip multinational tenants who can amplify the value and reputation of your property. Moreover, they will pay rent on time, pay higher deposits, and also be your tenants for longer periods. 

9. Consider the lease terms

The lease structure of commercial properties is different from residential properties. The lease agreement is not only an important factor but also a must for every investment in commercial real estate. 

Unlike residential real estate, commercial real estate leases are subjected to a lot of negotiation before signing the agreement. On top of that, there are various types of leases available in the market, such as Gross lease, Net lease, Modified Gross lease, and others. Based on the nature of the contract between the tenant and landlord, each of these leases is different from the others. For example, Gross leases are structured based on the agreement that the landlord will pay the property expenses, tax, and insurance from the rents collected. Whereas in Net Leases, tenants have to pay a part of the property expenses in addition to base rent. 

To know more about Commercial Real Estate Leases, click here.

Lease agreements are also time-bounded, meaning a tenant cannot walk out of a rental property in the middle of the lease term. Also, an owner will legally be barred from evicting a tenant in the middle of a lease term.

10. Ensure your asset protection

Before investing in a commercial property you have to ensure its security. As a property owner, you must check whether your property is protected from legal issues or liabilities. If you acquire a property that already has tenants then you must gather adequate information about them. 

The main objective of asset protection is to reduce the risks involved and protect assets from lawsuits and claims of creditors. There are various legal structures or arrangements used in asset protection planning, such as corporations, partnerships, and trusts. Apart from these, you should also protect your assets from financial risks by obtaining the required property insurance.

Hence, to avoid any mishaps it is recommended to start investing in small commercial properties as it reduces the overall risk of huge losses. 

11. Get the right team

To pull off a successful investment, you’ll need to put in lots of effort. Having an appropriate team by your side to oversee major aspects of your investment could be a turning point for your deal. From brokers and general contractors to real estate attorneys, having a professional experienced member can help you save costs on your investments. 

Lilypads Community platform allows you to connect with commercial real estate experts and expand your network. 

12. Do thorough Due Diligence

The due diligence period is the time in which you can conduct thorough research on the investment opportunity. This includes reviewing financials, documents, tax returns, and profit and loss statements from the previous owner as well as conducting surveys, property inspections, a feasibility study, etc. Having a solid understanding of what needs to be investigated, carefully analyzed, and inspected before buying will save you from making costly mistakes.

5 Common Mistakes to avoid while investing in CRE

Investing in commercial properties promises lucrative earning opportunities but it also has risks if not conducted properly. The 5 common mistakes which you should avoid as an investor are:

  1. Inadequate due diligence – It’s crucial to conduct proper due diligence on the property as well as on the market trends before investing to avoid any kind of risk.
  1. Incorrect calculation of gross income – Being an investor it’s your major criterion whether the return from the property is authenticated or not. Hence, to derive a genuine return you must calculate the gross income diligently. 
  1. No exit strategy – Executing an effective plan must have an exit strategy too. 
  1. Considering only ROI – Focusing on ROI is crucial but considering cash flow, capital appreciation, and tax benefits of your investment is equally important.
  1. Failing to appoint the right professional – Seeking help from expertise leads to a rewarding investment. Hence, try not to make any kind of mistakes from your side. 

Is it wise to invest in commercial real estate in the post-pandemic era?

The US real estate economy has made a spectacular recovery in 2021 and will continue the streak in 2022. At present, the commercial real estate market has gradually started recovering from the wounds of the pandemic but is yet to surpass pre-pandemic levels in certain sectors.

Although Omicron slowed down business in the first two months of 2022, commercial real estate asset classes like apartments and offices still managed to deliver results. Multifamily apartments saw a significant drop in vacancy rates. Apart from that, hybrid offices have taken over the CRE market as people have started returning to their offices. 

The issuance rises in CMBS and commercial loan obligations from $64.3 billion in 2020 to $154,6 billion in 2021. 2021 has seen the return of foreign investors and also the return of banks and life companies. This combination led to a tremendous growth in transaction volume in 2021 which will gain momentum in 2022. 

All these data indicate that despite the harsh market and economic conditions, commercial real estate has and will always be an investment that generates results.

The Lilypads Bottomline 

We have discovered that no matter what the circumstances are commercial real estate is a profitable investment if executed properly. While it might get confusing choosing between the right properties due to a lack of experience, the above-mentioned rules and guidelines can help you get back on track. These 12 golden rules for investing in commercial real estate will help you evaluate properties and make informed decisions that will turn the smallest opportunities into lucrative investments.

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