Investing in commercial real estate provides significant returns, passive income, and generates growth potential. However, a beginner CRE investor can get confused while picking a suitable strategy, asset class, or asset type. So, Lilypads brings to you the Pros, Cons, and Key factors to consider while investing in commercial real estate.
The key factors to consider before investing in Commercial Property
A real estate business is a lucrative form of investment generating a steady and stable income. Investing in commercial real estate diversifies the portfolio. But, to start with such a capital-intensive investment option requires adequate preparation.
Here, are a few factors to consider before investing in commercial properties.
1. Market trends of commercial real estate
The latest CRE market trends play a huge role in influencing the success of your investment. You must analyze the current and projected rate hikes, trending business sectors, unemployment rate, etc before investment.
Once the market area is analyzed it’s time to cater to the economic and demographic data of that area. Moreover, the data must be collected from the latest and most reliable sources.
Determining the vacancy rate is equally important. Because if an area suffers from a high vacancy rate then that place is not suitable for investing. An area with a 5% vacancy rate is considered optimal for investing.
You must also account for the net absorption rate before investing. It’s the net change in the supply of commercial space in a particular area over a given span of time. The net absorption rate can be both positive and negative. A negative value indicates a lower probability of a good return from the investment.
And lastly, while analyzing the market trends you must consider the demand and the supply chain of a given market. Since demand and supply chain are the sources of current market value, it helps you to get a better result from market analysis.
2. Location and valuation of the commercial property
Choosing the correct location is equally important for investors as it reduces the risk of capital loss and helps in finding more tenants. If the location suffers from downturns then the investment could suffer. Hence, before investing you must consult with the brokers about the advantages and disadvantages of that selected area.
Valuation of the property is also crucial as it assesses the accurate value of the property, the listing price, investment analysis, and taxation. It also determines the net income earned from the property after subtracting the operating expenses like insurance and property tax.
3. Assess the risks in Commercial Real Estate
Risk assessment through due diligence in commercial properties is crucial.
Firstly, you must assess the condition of the property, along with its papers. Furthermore, you must verify the zoning documents, financials, environmental assessments, and also scrutinize the property structure.
After inspecting the property condition it’s important to review the tenant and how long they have been on the property. Before investing in commercial real estate you must check the tenant lease and also the rent prices.
Understanding the types of tenants available in the market is also essential to achieving a good return. To generate a steady and stable cash flow you must lease your property to any successful business. Also, be sure enough about any existing legal issues with the tenants.
4. Identify the investment purpose and investment horizon
To avoid financial distress in the investment you must know your objective and time horizon of investment. If the investment is mortgaged you must identify the best property for you as it gives low liquidity and high value. Therefore, determine the strategies and plan accordingly.
- Buy and self-use
In this type, you save on rent by self utilizing the property and also getting value appreciation.
- Buy and lease
In this type, you can generate a steady cash flow along with long-term value appreciation.
- Buy and sell (short-term)
These properties are generally under construction and it generates quick and small to medium profits.
- Buy and sell (long-term)
These focus on long-term intrinsic value appreciation. It can be an alternative for a long-term goal such as retirement.
5. Calculate your expected cash flow and leverage
Calculating the expected cash flow is crucial for real estate businesses. Cash flow determines the amount left after all the expenses. A positive cash flow indicates a good rate of return on the property. Furthermore, for buying a commercial property, you may secure loans. However, be careful about how to handle the loans and avoid high levels of debt. Carefully pick a mortgage with suitable terms and conditions.
6. Consider the scope of marketability
It’s always a good idea to invest in a property that provides superior designs, and a plethora of amenities and facilities. This ensures the marketability of your property. You must also consider the reputation of your property’s location, to have a better earning potential.
Pros and Cons of investing in Commercial Real Estate
Let’s consider the pros and cons of investing in commercial real estate now.
Pros of investing in commercial real estate
1. Higher rental yield
The rental yield in commercial properties is usually higher than in residential properties. Properties having multiple tenants such as retail centers, shopping malls, warehouses, office spaces, apartment complexes, etc generate multiple income potential.
The rate of the annual return on the purchase price is between 12% to 14% depending on the location and the condition.
2. Professional tenants
In commercial properties, the tenants are usually business owners, corporates, and executives. Hence, dealing with those professional tenants is much easier. For example, if you rent a property to a retail store then it’s their priority to maintain the building for the purpose of customer satisfaction. Hence, you don’t have to bother about the maintenance. And the landlords and tenants have a more positive business-to-business relationship.
3. Regular and steady cash flow
In comparison with residential properties, commercial properties generate a more stable flow of income. Residential properties may face vacancy risks whereas commercial real estate has an assured rental income because of multiple tenants. Furthermore, commercial property leases are typically long-term ensuring a steady cash flow over a long time span.
4. Triple net leases (zero maintenance costs)
In commercial real estate, the lease terms are usually triple net. It means that the expenses of maintenance and operations including property taxes, insurances are solely done by the tenants. Thus, it reduces the day-to-day responsibilities of the landlord and helps them make more money.
Also, the terms of leases in commercial properties are more flexible than in residential properties. Here you can create agreements according to your personal preferences, and also negotiate with the tenants as per your requirements.
5. Diversifies your portfolio
To diversify your real estate portfolio, you can invest in commercial properties like warehouses, retail spaces, industrial spaces, office buildings, etc. Further, you can also ensure consistent earnings this way.
Cons of investing in commercial real estate
1. Large investment
One of the major demerits of commercial properties is that it requires a huge investment. So, before investing the investor must be financially ready to invest a large amount. If you opt for a bank loan, you need to pay a huge down payment. So, if you may require prior financial stability.
2. Difficulty in finding tenants
Commercial properties have more difficulty finding suitable tenants than residential properties. Also, when a tenant moves out the term of vacancy can be longer due to the difficulty of finding another. So, the landlord must keep some emergency funds for the operating expenses during this period.
3. Unexpected maintenance expenses
As the commercial properties have more public visitors so the chances of damage can also be larger. In residential properties, the renovation work is limited to minor electrical or plumbing issues. But in commercial properties, the damage can be huge such as accidents in the parking lots, retail space damages, etc. Thus, if you are risk-averse, then commercial properties are not suitable for you.
4. Professional assistance required
Commercial properties come with a specific range of needs. Therefore, investors need to perform thorough research and proper guidance from experts prior to investing.
You must be well aware of the overall expenses, taxes involved, zonal laws, and the annual return of the property. And for this information, you need the help of a property manager which is quite expensive. Since property management companies can charge 5% – 10% of rent revenues for their services.
Investing in Commercial Real Estate can seem intimidating at first but it holds lots of opportunities. So, the key is to do proper due diligence and adequate preparation. With the proper utilization of time, money, and effort you can create wonders in the commercial real estate market. However, make sure you thoroughly revise the key factors along with the pros and cons discussed before investing.