Tips You Need to Know Before Investing in Commercial Real Estate



Most people start their real estate career investing in residential properties. Some eventually look to commercial investing because it is much more profitable. Before you jump into commercial real estate there is very different information you need and a different approach compared to residential investing.

Six Tips to Get You Started in Commercial Real Estate

  1. Commercial real estate is valued differently than residential. Residential properties derive their value based on recent comparable sales of similar properties in the neighborhood. The value of commercial property is determined based on cash flow. Two buildings, each with 6,000 square feet and located on the same downtown block will have different asking prices. A single tenant small grocery store will have less cash flow than a four tenant office building for attorneys and CPAs.
  2. Market and sector knowledge is critical to your success. If you have personal knowledge about a particular commercial sector, stay with that sector. If you have no knowledge about a sector, gain the knowledge you need before investing. Even if you’re only the landlord, you don’t want to invest in a hotel if you don’t know anything about the hospitality industry. Same thing with the manufacturing sector. You don’t want to own an industrial strip if you don’t know the best use of the property to maximize cash flow.
  3. Different formulas are used in commercial real estate investing. Along with sector knowledge, you need to learn new profit and loss formulas before investing in commercial properties. In residential you may have only bought properties for 75% of after repair market value or rentals that cash flowed 20% above expenses. In commercial real estate, you need to understand cap rates, net operating income, and loan to value ratios. They’re not difficult but you need to fully understand what each means and how they affect your profitability.
  4. Patience is a virtue when investing in commercial real estate. You don’t always want to invest in whatever is currently on the market just because you have the money. First, you want to determine what you want to invest in based on tip 2 above. Next, build a network of professionals involved in the type of investment you want to make. Finally, wait for the right property to come along at the right price based on the formulas in tip 3.
  5. Consider the long term impacts before investing. Beside the immediate cash flow, you need to understand what is likely to happen to commercial real estate in the surrounding area in the coming years. Is it located in a city where the core infrastructure has been neglected for years? If so, businesses will slowly begin locating elsewhere in the years ahead. Look at things such as a major employer in the area struggling financially and it’s becoming questionable if they will survive. Look at the tax base of the community. Has it consistently been declining along with associated services?
  6. Don’t put all of your eggs in one basket. If you’ve had success as a residential investor, keep some on your holdings in residential. The commercial and residential sectors don’t always run in the same business cycle. Whether investing in stocks and bonds or real estate, smart investors always strive for a diversified portfolio.

Commercial real estate is a great way to invest to become wealthy and can provide a passive income stream for retirement. Following these commercial investing tips and building a strong network greatly increases your chances at success.

Please leave a comment if this article was helpful or if you have a question.

Image Credit: danevans via pixabay

BioAuthor bio: Brian Kline has been investing in real estate for more than 35 years and writing about real estate investing for seven years. He also draws upon 30 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest. In the Olympic Mountains with the Pacific Ocean a couple of miles in the opposite direction.

Comments

  1. Brian,

    I enjoyed reading your article and would like to add some additional thoughts to the tips you provided.

    1. The value of commercial real estate investments are derived by using a market capitalization rate (CAP Rate) which is a percentage of the Net Operating Income (NOI) that the investment produces. For example, a 6,000 square foot single tenant commercial building may generate $54,000.00 in gross annual income and after expenses generates $45,000.00 in NOI. A CAP Rate is applied, say market rate at 8%, to determine the market value of the investment which in this example is $562,500.00/$93.75 per square foot. Some of the variables that may separate the two buildings when compared could be the age of the building, how it has been maintained, credit worthiness of the tenant, the start and end date of the lease, rental rate increases, and options to renew just to name a few.
    2. Today’s investors are often diversified and own investments in one or more geographical locations and/or asset class. As you suggested, if an investor is not familiar with an asset class then he/she should avoid pursuing that investment.
    3. In addition to understanding CAP Rates, net operating income, and loan to value ratios it is important to understand the net cash flow before and after debt service, if the investment is financed, and the eventual ‘yield’ that the investment will produce. Yield is an important indicator and allows the investor to say ‘If I placed my money somewhere else, say the stock market or bonds, what would that investment yield as compared to the commercial building I am interested in purchasing?’
    4. As you pointed out it is imperative that an investor surround himself with knowledgeable and professional individuals who understand current a prospective market trends. These individuals can make or break an investor so it is prudent to align oneself with the right resources.
    5. Since real estate is not a liquid asset, most investors have an and entry and exit strategy when acquiring an investment. It may be tied to an event such as mortgage maturity, a five-year hold on a value-added investment acquisition or a neighborhood that will see values appreciate over a prospective period of time.
    6. Diversification is one of the key strategies to investing in any real estate investment so when the market takes a turn the diversified investor may be less prone to exposure.

    • Brian Kline says:

      Tom,
      Thanks for the well thought out comment. Obviously, an entire book can be written on this subject. The one point you made that I’m not completely in agreement with is comparing commercial property yields to stock market yields. Personally, I think the stock market is too unpredictable to be a reliable comparison.
      Brian Kline

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