Choosing between commercial and residential real estate is a big decision for investors. Choosing the wrong strategy can leave you at a loss and losing money.
We’ve created a guide to investing in commercial real estate for beginners to help you understand what it means to invest in commercial real estate and what it takes.
Understand commercial and residential real estate
When most people think of commercial real estate, they think of retail stores, office space, and medical facilities. It may also include properties with five or more units, such as apartment complexes and hotels.
Residential real estate refers to real estate that is used exclusively for residence. This includes buildings with fewer than five units, such as single-family homes, condominiums, and duplexes.
Commercial and residential real estate both generate rent for landlords and require property owners to manage and maintain, but the similarities end there.
Main difference
Knowing the key differences between residential and commercial real estate can help you decide which investment strategy is right for you.
- Tenant type: Commercial real estate tenants have specific needs. For example, you may acquire a retail tenant, a healthcare worker, or a tenant who needs office space. Residential real estate tenants always need a place to live. Residential properties generally have more tenants.
- Lease terms: Lease terms for commercial real estate are much longer than typical residential leases. Since most residential leases are for one year or less, there is a risk of less stable income and higher vacancy rates compared to commercial properties, which typically have lease terms of three to 10 years.
- Income potential: Commercial real estate typically provides higher and more stable income because tenants sign long-term leases.of Vacancy risk Owning residential property provides a more stable income and typically lower rents.
- Rules: Commercial real estate faces very strict zoning and use guidelines. This can narrow the pool of available tenants. A residential property has only one use: as a place for tenants to live.
- Initial investment requirements: Investors need much less money to invest in residential real estate than commercial real estate. This can be a barrier to entry for those new to commercial real estate.
- Volatility: Commercial real estate is particularly susceptible to market downturns, as businesses are typically the first to suffer during economic downturns. On the other hand, residential real estate is less volatile because everyone needs a place to live.
Benefits of investing in commercial real estate
When investing in commercial real estate, it is important to consider the benefits of choosing it. Like any investment, if things go well, commercial real estate is a solid option.
Here are some of the benefits investors can enjoy.
- high income: Commercial real estate rental prices are typically much higher than residential rents, allowing investors to earn higher monthly cash flow.
- Longer term lease agreements: The peace of mind that a commercial real estate lease provides is worth its weight in gold. Knowing you’ll have a tenant for the next 10 years instead of one year makes investing a lot less stressful.
- Triple net lease: In a triple-net lease, the commercial tenant pays rent in addition to real estate taxes, insurance, and maintenance. This reduces the cost of real estate ownership for investors and increases potential profits.
- Diversification: It’s never a good idea to put all your money into one investment. Therefore, by diversifying into commercial real estate, you can take full advantage of both markets when they are doing well, and make up for losses in each market when one market is struggling. can.
Risks associated with commercial real estate
All investments have risk, and the higher the risk, the greater the potential return. Here are some of the most common risks that beginners should be aware of before choosing to invest in commercial real estate.
- Market sensitivity: When markets are down, businesses, especially those in non-essential industries, can be the first to suffer. A decrease in sales could result in rent arrears or the cancellation of a lease contract.
- Real estate management challenges: Commercial real estate investing usually requires hiring a reputable property management company. If you hire a fraudulent property management company, you could lose your tenants and your money.
- High initial investment: Commercial real estate requires a 30% to 40% down payment and is much more expensive. That means you may need hundreds of thousands of dollars as a down payment.
- Liquidity issues: Residential real estate is much easier to sell when you need to, and can often sell for close to or even more than the price you invested. Commercial real estate doesn’t have the same benefits. It’s often much harder to sell quickly, and depending on current values and economic cycles, you might not get what you paid for.
Beginner steps to start investing in commercial real estate
As a beginner, investing in commercial real estate requires a few steps to ensure you start on the right foot.
Market research
In addition to knowing the economic and employment health of the area, market research is essential before investing in commercial real estate. Not all commercial real estate is profitable. It depends on the overall health of the area and the demand for the type of commercial real estate you’re considering.
Assemble a team of experts
Investing in commercial real estate requires a strong team of professionals to support you at every step of the process. This team includes real estate agents, lenders, accountants, property managers, contractors, and attorneys. The right team will oversee the purchase and management of commercial real estate to help you reap the benefits.
Financial analysis and budgeting
Financial analysis of real estate is the key to making a solid commercial real estate investment. As with residential real estate, consider rental history, property management fees, taxes, and insurance. However, you should also consider the number of units, vacancy history, zoning regulations, the property’s net operating income, and cash flow.
You will also need to determine your personal budget and whether you qualify for a loan. This requires a large down payment and ongoing funding for the operation and management of the property.
secure funding
Securing financing for commercial real estate is different from securing investment financing for residential properties. As mentioned above, you’ll need a larger down payment, but you’ll also need to prove that you have the experience and knowledge to manage a profitable commercial real estate investment.
In addition to the standard financial statements required for residential real estate investments, you must demonstrate that you have the necessary experience to operate a commercial real estate investment with documentary evidence such as: Profit and loss statement.
due diligence
Research is the key to successful commercial real estate investing. Consider the property’s cap rate, cash-on-cash return, and net operating income. Compare these numbers to your overall investment plan to see how they fit together.
General strategies for investing in commercial real estate
There are many options for commercial real estate investing for beginners, from direct investing to crowdfunding. There are opportunities for all income levels.
direct investment
When most people think of investing in commercial real estate, they think of direct investing. This means buying commercial real estate and renting it out to tenants. This requires a large down payment, loan qualification, and an understanding of how to manage the property during ownership.
REIT
A real estate investment trust (REIT) is a real estate holding company that purchases commercial real estate and sells its shares to investors. Investors become real estate investors by default and earn a prorated return on their portfolio. This is a hands-off approach to real estate investing.
real estate syndication
If you find investing in commercial real estate alone too difficult, you can also join a real estate syndicate. A real estate syndicate is a group of real estate investors who pool their assets and resources to invest in real estate. This gives you more power than investing in a REIT, reducing capital requirements and overall risk. Returns, valuations, and percentage ownership are directly correlated to the size of the investment.
crowdfunding platform
Crowdfunding real estate platforms enable more investors to invest in commercial real estate. Some crowdfunding platforms have low investment requirements, with a minimum amount of $100. This commercial real estate investment strategy is 100% passive. This means you don’t have to do any work to manage your property. Invest your money and take back a portion of it when you make a profit.
Managing commercial real estate investments
The main element of investing in commercial real estate is its management. Consider the following factors when deciding whether investing in commercial real estate is right for you.
asset management
When investing in commercial real estate, you need to decide whether to manage the property yourself or hire a professional property manager.
Property management involves owning commercial real estate, managing property maintenance plans, managing tenants, handling vacancies, collecting rent, and performing day-to-day tasks such as budgeting and reporting.
Hiring a property management company will increase your expenses, but will reduce the time and effort required for management.
Property improvements and upgrades
Improvements and upgrades can help you save money and get a higher rent in the long run. Tenants are always looking for upgraded spaces with the latest amenities. Upgrading your commercial space also reduces repair costs and makes your property last longer.
Tenant-related processing
The most important part of commercial real estate investing is building relationships with tenants. We negotiate leases and lease renewals, collect rent, discuss rent increases allowed under lease agreements, and accommodate tenant needs within lease agreements.
Legal and tax considerations
Tax and legal considerations are important when investing in commercial or residential real estate.
Property taxes for residential properties are generally lower than for commercial properties, but the depreciation period for commercial properties is shorter than for residential properties (27.5 years vs. 39 years).
Having a strong real estate team is essential to ensure you understand the legal and tax requirements both before choosing a real estate investment and during ownership.
final thoughts
Investing in commercial real estate for beginners requires strategic planning, due diligence, and a solid real estate team. With the right people on your side and the right research, you can diversify your real estate investment portfolio to include investments in residential and commercial real estate.
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Note by BiggerPockets: These are the opinions expressed by the author and do not necessarily represent the opinions of BiggerPockets.
