What Is Commercial Real Estate Property?
Commercial real estate property is any kind of land or structure that is used to make a profit. Also known as commercial real estate, commercial property, or investment property, the profit can be in the form of rental income or capital gains and includes office buildings, brick-and-mortar retail stores, warehouses, restaurants, vacant lots for storage, farmland, and a variety of multi-tenant housing. Wikipedia lists ‘cash inflows’ from commercial property to include rent, operating expense recoveries, fees (parking, vending, services, etc.), proceeds from sales, tax benefits, depreciation, and tax credits.
Is Commercial Real Estate a Good Investment?
The short answer here is “Yes… It can be.” Like most other investments, investing in commercial real estate has its pros and cons and is rarely without risk. With that said, commercial properties are considered better investments with better rewards than residential properties. The legal website, nolo.com, lists some pros and cons to purchasing and owning commercial real estate.
Pros:
Professionalism – Renting to commercial tenants usually has the advantage of the tenant taking good care of the property. A business owner wants their property to look manicured and professional, whereas home renters have been known to completely trash a property with little regard to its appearance. Commercial properties are usually owned by an LLC which is a business, and this creates a business-to-business relationship where the landlord and tenant are more likely to have a mutual respect.
Earning Potential – Commercial properties usually have a higher return on investment (ROI) than residential properties, with a commercial average annual return rate of 6%-12% towering over the annual return for residential properties at 1%-4%.
Less Time Spent at Property – With a residential property, your tenants can inhabit the property 24/7. They might temporarily leave the property for work, but there are often still children or a spouse in a home, whereas renters of a commercial property typically spend their evenings and weekends at home, away from the commercial property. This reduces the chances of a late-night call from the tenant requiring the landlord (you) to have to scramble and find a plumber, electrician, or other service workers to attend to the property. Also, a commercial business renter will be more apt to have an alarm system in place to prevent theft of their business assets.
More Accurate Evaluations – When you are purchasing a commercial property, you can simply ask for the income statement of the owner to show you the historical income the property has produced. Armed with that knowledge, you can determine a fair purchase price for the property. With a residential property, you often won’t have that luxury if it has never been rented. Additionally, when people sell their homes, it’s common for them to have emotional attachments giving them an inflated idea of what the home is worth. The emotional homeowner will eventually realize they are listing at an unreasonably high price, but even then they’ll be hesitant to lower the price to its fair market value.
Flexible Lease Terms – There are not as many consumer protection laws surrounding commercial leases like there are for residential properties. Residential properties have stricter state rules and laws regarding issues such as termination and security deposit.
Cons:
Increased Time Dedicated to Property – If you are renting out a commercial property with multiple tenants in one building, prepare yourself for spending more time dealing with different leases, common area maintenance costs, who is responsible for what, keeping the property safe, and keeping the property groomed and maintained. This will not only eat up your time, but it can also take a bite out of your wallet.
Professional Services Needed – Your commercial real estate will eventually, and probably always, need the assistance of various professionals to handle maintenance, grounds, emergencies, security, and more. So unless you do all that yourself, be prepared to pay licensed workers to come in and handle these issues. And don’t forget to include it in your management expense account. However, if you decide to use a property management company, be prepared to pay 5%-10% of the revenue from rent. After these expenses, how is your bottom-line looking?
Initial Costs – Purchasing a commercial property usually means you’ll be paying a larger initial investment than you would for a residential investment property. Expect the unexpected with a commercial property. There might suddenly be a broken pipe that is not immediately detected resulting in unexpected water damage and the price of fixing the pipe(s). If the business you are renting to has a large number of customers, that translates into more wear and tear on the property and its facilities. And that means more costs. Be sure your cash inflow is significantly higher than your cash outflow.
Increased Risks – If there is a large number of customers patronizing the business you rented your commercial property to, there is also a higher risk of something bad happening to one of them. People can accidentally fall, they can get hit by a vehicle on the property, or something can fall off the shelf and land on them. As unlikely and rare as these events might be, they do happen. And the more customers there are moving about the premises, the higher the chance and risk of a mishap. The risk is lower for a residential property simply because there are usually fewer people occupying the property.
What Are Examples of Good Investment Properties?
Most times when someone wants to find the ‘best’, the answer is subjective. What one investor has found to be an incredible investment type, another investor might not touch with a 10-foot pole. So do your homework to find out what you’re looking for, gather all pertinent information you can about the property you are interested in, and crunch the numbers yourself before making any purchasing decision of an investment property. Below are three examples of properties mentioned in an article by Commercial Property Advisors, LLC.
Self-Storage Facilities – These are simply buildings with separate and secure rooms to store items you own. The size of the rooms varies, some are air-conditioned while others are not, and the level of security can depend on the location of the storage and other factors. Like anything, there are pros and cons.
Let’s start with the pros. If a tenant stops paying, there is no eviction of people. Instead, facility owners usually just auction off the contents of a storage unit, sight unseen. Self-storage units are also considered by experts to be impervious to a changing economy, and they maintain a consistent cash flow. Additionally, it is not necessary for a live human to be on the premises of a self-storage facility. Very often, a self-storage facility is the second business of a business owner. An example would be someone who rents out vehicles and owns a storage facility nearby. When you want a storage facility unit and go to pay and pick up a key or security code, you would handle the transaction at the vehicle rental location. Another plus of renting out self-storage facilities is the length of time the typical renter keeps the unit. According to neighbor.com, the average rental duration for a self-storage unit is 14 months. That’s a pretty good time period to not worry about finding new renters for a unit.
Cons with owning self-storage facilities include the time it takes to have all of your units occupied. If they are sitting empty, you are losing potential income, and you may have to pay to ramp up your marketing efforts to keep the units filled. Another concern would be a neighborhood where properties are depreciating. Paying customers will be less inclined to rent units in this situation.
Strip Malls (Shopping Centers) – When a strip mall is in good shape, it can be a popular place that is frequently visited by neighborhood locals. People love dealing with mom-and-pop shops, and huge mammoth-sized malls are becoming a thing of the past. If a strip mall is in poor condition and you don’t mind spending some capital on upgrades, this might be a good investment. With the right upgrades and maintenance procedures, an investor can transform a rundown strip mall into an attractive location for local businesses, and thus end up making a handsome profit that will continue. Potential tenants can include any type of business, and some of the more popular tenants include pizza dine-in or delivery, Chinese pickup, sandwich shops, beauty supply, salons, cell phone retail, consignment shops, dollar stores, and a variety of other type shops people commonly frequent.
Investing in your own strip mall isn’t for the faint of heart. Plan on spending plenty of money upfront, and then plan on paying the mortgage every month. If you have tenants that are habitually late on their rent, you may have trouble paying your mortgage. This current pandemic in 2020 and 2021 is not a common occurrence, and businesses all over the country have had trouble paying the rent for their business. If you are the landlord in such a situation, this could present major problems for you. But we know this pandemic will not last forever, and a strip mall could be a good investment for you in the future.
Office Buildings – When you find the right tenant(s) for an office building, this can be a very lucrative investment. This is especially true if your office building is in a business district where clients or customers of your tenants are nearby. An example would be a downtown law office that caters to business owners. When someone can walk to your location in minutes, that person is more likely to patronize that business instead of a similar one that is far away. Owning an office building in a business district may be more expensive, but the rents will also be higher and more likely to be stable and long-lasting. And don’t forget that those rents can go up yearly while your mortgage payment will stay constant.
If you calculate what you can afford, research the market and location of a potential investment property, and evaluate all potential financial scenarios of what could happen, you will have a better chance of making the right decision on investing in a real estate property. If those calculations show that a particular scenario isn’t a viable one, then maybe you should start thinking of a project that doesn’t involve as much capital or is in a different industry. Or maybe you should just scrap the idea until the right investment property comes along. If done correctly at the right time, you can turn an investment property into a healthy and long-lasting source of income.