Updated: Mar 7
You have probably listened to tens of investors who all seem to have one point to make: investing in real estate is the path to financial independence. This message has been drummed into people’s heads year in year out, encouraging more people to get into real estate. Then comes the first big decision- residential real estate or commercial real estate?
Now, here is the thing. There are generally two areas in which you can invest in real estate- commercial and residential. These categories feature subsets that you can explore as you move ahead. None is necessarily better than the other, as they all come with their advantages and disadvantages. Today, we look at commercial real estate and what it could have in store for you.
Return on Investment
You can expect a steady stream of income from a commercial investment property that grows over time. During this growth phase, the property value also increases, enabling you to demand more of your tenants. Please note that this form of investment does not enable you to adopt a get-rich-quick approach, but it pays off in the end.
Unlike with most residential properties where tenants can up and leave as they want, there is a higher degree of permanency with commercial tenants. The leases often range from 3 to 10 years, and even where a tenant wants out, they have to give a lengthy notice. It buys you time to start advertising the vacancy long before they leave. The average lease for an McDonald's franchise usually is 20 years long with 5 year renewal options.
There are different sectors you can explore in commercial real estate. You can choose to work with office buildings which for the most part depend on long-term supply and demand mechanics. Or you can decide to get closer to consumers by getting into retail spaces. Whatever your budget or expected outcome, you should have a variety of choices. The main six kind of commercial real estate investing are: land, office buildings, retail space, storage units, multifamily housing, and industrial property.
Compared to traditional investment options such as stocks and bonds, commercial real estate tends to be less risky, enabling you to not only hold onto but also grow your capital investment. If you want a portfolio you can work on over the years, this would be an excellent choice. A big contribution to this fact are very long leases that can least 5-20 years.
You probably already know that real estate comes with a bevy of tax advantages. With commercial real estate, you can get in on these and more by also including your building expenses. You can keep more of your money while reducing the costs incurred to run the property.
For more information on tax advantages with real estate click here
Inflation is a part of any economy. Unfortunately, not many investments can give you the time value of your money some years down the line. Most of them can only match the inflation rate, which does little for you. Commercial real estate, on the other hand, can supersede this rate, enabling you to make a tidy profit.
Most leases, unless otherwise decided, are transferrable. Instead of you having to go out there and put the property up for leasing, your tenant can take care of this side of things. With less time spent on marketing, you can get down to what really matters.
A property may not look like much now, but you can always up its market value by doing some work on it. Simple works such as improving its aesthetic appearance could give you a difference between what you paid for it and what you get from it. Also, tenants add value to the space when doing their renovations, which are benefits you can reap in the property's sale.
Did you know that you can borrow against your property? As your property value grows, you will have the opportunity to finance other assets against it, enabling you to grow your portfolio substantially even without much capital. How great is that!
Utility bills fall on the tenant, allowing you to enjoy the profit and use it as you please. When the council comes calling, it is the tenant who will need to answer. What a responsibility off your shoulders! Lease structuring dictates the tenant's responsibility. You have gross leases and net leases when it comes to commercial real estate. I prefer the gross leases due to the tenant being responsible for all operating costs which include maintenance.
As much as commercial real estate has a bright side, you should also be aware of its potential risks as follows:
Compared to residential real estate investments, commercial properties tend to cost much more, necessitating you to put up more money for the purchase price. However, you can get an affordable property by looking for one in areas experiencing an economic downturn. When doing so, be sure to look at if you can get a good return on your investment with the current situation.
Unlike residential properties where you can easily calculate your expected return on investment, commercial real estate tends to be a bit more intricate. Small errors in judgment can cost you greatly, more so if you do not consider demand and supply mechanics. How often have investors put up commercial buildings only to spend months trying to convince tenants to lease their spaces? Everything needs to make fiscal sense from the start. While a property may have a good market value, its returns may not be as promising.
Your property’s ability to attract tenants also depends on the state of the economy. When the economy takes a turn for the worse, commercial properties take the hardest hit. As much as residential real estate sales and leases dwindle, they do not do so as sharply as commercial ones.
High Interest Rates
Given the high risks involved in commercial real estate investments compared to residential categories, lenders tend to be stricter with the financing. You can expect to pay as much as 5%-9% in interest (bank loan) which is more than what people pay for residential real estate loans.
It can be hard to find a tenant for some property types. For example, when leasing out space in an office building, it might take a while before you find someone willing to take it. But with retail spaces, the uptake is often high when the economy is doing well. Working with bigger commercial spaces often results in long vacancy periods.
Given the long vacancy periods, you may suffer a loss of income that may affect your ability to repay the loan. Keep in mind that the average loan to value ratio is 60%, and you would thus need to fork out quite a chunk of equity to finance the purchase in the first place. The average loan from a traditional bank is $1 million
Slow Capital Growth
As we stated earlier, it takes a while for the capital investment to grow in value. As such, if you are investing with the hope of reaping a high-value increment in a short period, commercial real estate would not be the best choice. It works for people who want to sit back and watch their nest egg mature.
In the same way that finding tenants is hard, you will also face some hurdles when putting up the commercial property for sale on an open market. It takes a while to find a keen investor. Thus, before purchasing such a property, you should consider how pressed you will be to sell it (if at all).
As much as the tenants pay for utility bills, it is upon you to ensure that the common areas remain clean. You may also find that you have to cater to their security needs, prompting you to hire guards, cleaners, a property manager, and other personnel to keep tenants happy. It adds to your running costs significantly.
When laws change, commercial properties often bear the brunt of it. A good example would be COVID-19 restrictions where commercial spaces were subject to governed operating hours. Such regulations can affect the tenants’ ability to pay their rents, thereby affecting your net operating income.
The easiest way to maximize the upsides while mitigating the potential risks is to be thorough with your due diligence. From the information gathered during this exercise, you can tell if a property has a high chance of giving you an acceptable return on your investment. All the best!
To learn more about investing from Robert Kiyosaki (Rich Dad Poor Dad) click here
Recommended book for commercial real estate investing:
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