A commercial real estate investment guide for new investors

commercial real estate
Commercial real estate investment is highly profitable for new investors

Time and again real estate investors have eyed the commercial real estate market as an alternative to residential properties and single-tenant investments. Depending on individual goals and market trends, the commercial property asset class generates increased returns on investment. So, this article will be a commercial real estate investing guide for new investors.

A step by step guide for new investors to purchase their first commercial real estate asset

 1. Set your goals

To get started with commercial real estate investing, investors must determine the purpose and financial goals before building a portfolio. 

An investor must have a clear vision of what they want to achieve from a particular investment before they get into commercial real estate investing.

Investors must know whether they want a steady flow of monthly income or long-term capital appreciation from the commercial investment. 

Do they want to focus on investing in office buildings? Or are industrial properties or retail spaces more up their sleeve? 

Thus an investor must know if they want to be an active or passive investor or if their end goal is to reach financial freedom. Some of the investment strategies include:

Depending on the investor’s long-term and short-term goals, they must select a suitable investment strategy.

Read Lilypads’ article on Real estate investment trusts here.

2. Determine your commercial real estate asset investment strategy

Commercial real estate investment is divided into four main strategies: core, core-plus, value-add, and opportunistic. 

These strategies depend on the risk tolerance and the return targets of the investors.

1. Core assets

Buyers consider commercial real estate investment in core assets as the safest bet. These assets are in fairly good condition in prime locations and are almost never vacant. 

Hence, core assets are stable assets because it generates steady income flow in the form of market rents. 

Thus, investors adopt a buy-and-hold strategy for such assets as they involve little or no risks. 

Furthermore, here, investors aim for capital preservation and a reliable cash flow rather than asset appreciation. 

Core assets deliver around 7-10% of returns on investment.

2. Core plus assets

A Core plus asset is in similar condition as core assets, but it requires a certain degree of renovation. 

These offer a steady income for the investors who are willing to tolerate moderate risks to reap more returns after redevelopments. 

So, after renovations, investors can renew the leases of the existing tenants and even raise the rents and increase income. 

Core plus assets deliver around 9-12% of returns on investment.

3. Value add assets

Value add properties are higher up in the risk-returns scale as such assets require extensive renovations and repositioning. 

These properties are not fully occupied and have low demand and a decent amount of vacancies. 

Therefore, value-added investments not only generate income but provide value appreciation. 

Moreover, investors increase rents and the net operating income of the property post renovations. As a result, the value of the property thoroughly improves. 

Hence, value-add assets are a combination of risks and returns. 

And, they deliver around 12-18% of the returns on investment.

4. Opportunistic assets

Opportunistic assets offer the highest risk-reward investment strategy. Such properties require massive or complete renovations. 

Hence, these assets are also called distressed assets. 

Moreover, they include repositioning a building from one use to another. 

Furthermore, these properties are located in developing markets. As a result, opportunistic assets witness high vacancy rates notwithstanding their market potential. 

Hence, the investors apply the buy and flip strategy to generate maximum returns and value appreciation. 

Besides, they wait for anywhere around 7 years till the property reaches its desired appreciation. 

After the property reaches its required potential, the investors ‘flip’ or sell the property at a much higher price. Thus, opportunistic assets generate around 15%+ returns on investment.

Passive commercial real estate investment

Like active investments in residential real estate, passive investments in the commercial real estate market are also gaining popularity among investors.

Passive investment is a strategy where the investors generate passive incomes through commercial real estate properties. Some of the modes of passive investments include Real estate investment trusts (REITs) and crowdfunding.

Crowdfunding in commercial real estate is a way of pooling small sums of money from multiple investors to invest in large commercial real estate projects. 

And, in exchange for their capital contribution, each investor receives great returns. 

Furthermore, crowdfunding enables investors to diversify their portfolios and make several short-term investments.

Read more about Lilypads’ article on REITs here.

Read Lilypads’ article on Crowdfunding investing in real estate here.

3. Build a reliable partnership

There is no right commercial real estate investing tips for beginners.

So it is ideal to partner with experts and seasoned professionals to select the most suited investment and get maximum returns.

Collaborating with a reputed commercial real estate sponsor mitigates potential issues in the investment. 

This is because the right sponsor makes smart decisions. 

And, they have experience in relevant niches and know how to operate a property, build its value and maximize ROI. 

Based on the specific investment parameters, institutional sponsors, private equity real estate sponsors, and other real estate investment platforms, are helpful. 

Such platforms identify the end goals and risk tolerance of the investors and determine appropriate strategies for them.

However, it is wise to conduct extensive research on the partners before entering into a partnership with them. Investors should look for a few things before associating with them:

4. Run the numbers that matter

It is important to underwrite a commercial real estate investment. It helps to understand how a potential investment will perform in the future.

Some of the important metrics for a commercial real estate deal include:

1. Internal Rate of return (IRR)

IRR measures a project’s profitability. It is the annual rate of return on investment and it is expressed as a percentage.

This metric takes into account initial investment costs, cash flow, and property sale proceeds. 

Hence, a property’s internal rate of return estimates the value of the property in the holding period. 

Thus, a higher IRR is more profitable for investment. IRR is 

2. Equity Multiple

Equity multiple measures the ratio of total cash returns to the paid-in capital over the entire time span of an investment.

For instance, an investor puts $200,000 into a property and receives $400,000 from distribution and sale proceeds over the total hold period. Here, the investor will receive a 2x equity multiple. This is because the returns of $400,000 divided by the invested amount of $200,000 equal 2.0. 

Equity multiple is also referred to as return on equity or multiple on invested capital.

3. Cash on cash return

The cash on cash return denotes the ratio of annual pre-tax operating net cash flow to the total amount of cash (equity) invested in the deal. 

And, the annual pre-tax cash flow is divided by total cash investment to get cash on cash returns of a property for that year. It is also expressed as a percentage. 

Also, Cash on cash returns helps investors to understand how an investment will perform in the current as well as the future.

It also helps investors to determine the future income profitability against their initial investment.

4. Net operating income (NOI)

NOI in a commercial real estate investment is the total income a property generates, minus the total amount spent on its capital expenditures. 

A commercial property produces income from various sources including potential rental income, vending machines, parking fees, and so on. 

However,  the property incurs operating expenses in the form of vacancies, utilities and maintenance charges, property taxes, fees of property managers, etc.

Read Lilypads’ article to know more about the net operating income (NOI) of a commercial real estate asset.

5. Never underestimate the power of due diligence

Before acquiring commercial real estate, investors need to conduct large-scale due diligence. This helps in determining the value of the property. 

Furthermore, due diligence helps investors to discover the financial demerits of a property beforehand.

Prospective buyers must carefully scrutinize the fundamentals of the property. These include the financials, compliance obligations, risk assessments, and other liabilities.

For this reason, it is beneficial to partner with an experienced real estate sponsor. Their expertise in studying the resources to evaluate the value of a property or a portfolio limits the emergence of post-purchase risks.

The Lilypads Bottomline

Purchasing one’s first commercial real estate is certainly profitable and a great way to diversify one’s portfolio. However, identifying one’s investment goals and strategy, and partnering with experts and extensive due diligence will lead the way to the best ROI vehicle.