Commercial Real Estate – An Investment Worth Making?
If you are considering buying commercial property, you are probably wondering whether it is worth your investment money. Here are some facts to consider before making the leap.
In this article, we will explain what commercial real estate is, what categories it falls into, and the pros and cons of commercial property investment.
You will also learn more about the benefits of commercial property ownership and how to find the best investment property.
What is Commercial Real Estate
While residential real estate is primarily used for personal use, commercial properties are usually built to generate income for their owners. For example, an owner of a single-family house might lease the property to tenants in order to generate income. Multi-family property, on the other hand, is typically made up of multiple businesses in a single building. And special-purpose properties are those that don’t fit into any other category. A special-purpose property may be a warehouse for retail, a warehouse for industrial use, or some other specific type of property.
While investing in commercial real estate is an excellent way to diversify your portfolio, there are some things you should consider before you invest. Before you invest in any property, make sure you have the time to review it’s financial records. Also, consider the capitalization opportunities for the property. Multi-family real estate is often cheaper per unit than other types of commercial property. That makes it easier to attract tenants and bring in revenue. It also tends to perform better over time than other types of investments.
Four Main Classes of Commercial Real Estate Property
There are four main classes of commercial real estate property, and they each meet different needs. Each class has its own characteristics, investment costs and benefits, so it’s important to know the differences between them before investing. Here’s a brief overview of the major types of commercial real estate:
1. Industrial accommodations
Industrial accommodations are intended for large-scale manufacturing, shipping/receiving operations, and warehouse spaces.
Industrial rentals are generally not profitable for personal use as they tend to be large and lack amenities. Investors tend to rent these spaces to companies who use them for logistical purposes such as storage and shipping.
2. Multi-family rentals,
Multi-family rentals are residential dwellings with separate units that can be rented out individually. These usually range from two-unit buildings (such as a duplex) all the way up to a large apartment complex.
While single-family houses can be profitable investments, multi-family properties are often more cost-effective in terms of both space efficiency and cost management due to economies of scale. This type of property is also sometimes referred to as residential income or nonresidential income property.
3. Office or workspace
This class of commercial real estate includes single-tenant properties, small professional offices, and large office complexes.
These buildings can be quite different from each other, but they all have something in common – their primary purpose is to provide a space to work.
Retail properties include space for shopping centers and individual stores.
Categories of Commercial Property Investment
There are many categories of commercial real estate (CRE) investments, but two are particularly risky. These are single-tenant, single-use buildings and industrial properties. The risk associated with these types of properties is that they could become vacant for long periods of time.
There are many categories of commercial property investment, which are further subdivided by key characteristics.
- Class A buildings tend to be newer, more prestigious, and in prime locations.
- Class B buildings tend to be older and are not as competitive, though investors sometimes seek out old buildings to renovate.
- Class C buildings, are typically more than 20 years old and need urgent maintenance.
Pros of Commercial Real Estate Investment
1. High income potential
Commercial properties tend to come with higher rents than residential properties, and they also generally have longer leases. That means that the income they generate can be more consistent. They also generally appreciate faster than residential properties — so if you sell a building at a profit, it could be much bigger than the profit you might make selling a house or apartment building.
2. Longer rental contracts
Tenants of commercial property stay longer than those of residential property because they don’t want to go through the process of moving their business every few years. They like to stay where they are so long as it is convenient and affordable for them. This means less turnover, which translates into more stability.
3. Less interruption
With residential properties, you might occasionally have a tenant move out unexpectedly, requiring you to make repairs and find new tenants quickly so you don’t lose too much money on the property. This doesn’t happen as often with commercial tenants because they have an incentive to sign long-term leases rather than risk being without a location for their business.
4. Huge capital gain
Commercial real estate investment has some unique benefits that make it an attractive option for investors. One of the best aspects of investing in commercial real estate is that you can take advantage of high capital gains.
Because commercial properties are typically very large, they’re more expensive than residential properties—and when you sell them, you’ll get a big chunk back. This makes it easier to generate a profit and find success as an investor.
Commercial real estate also has less competition than residential investment, so there’s less of a chance that you’ll be outbid on a property by someone who already owns a number of rental homes in the neighborhood. You can also reduce your risks by diversifying your holdings across several properties rather than putting all your eggs in one basket.
Cons of Commercial Real Estate Investment
1. Require more initial capital
One disadvantage is that the initial investment is usually much higher than usual residential properties as they are usually bigger in size and cost more.
In addition, commercial property purchase loans generally require a larger down payment on the purchase price. This is because banks see commercial real estate as riskier than residential real estate and therefore require a higher down payment percentage in order to approve the loan.
2. Affected by bad economy
The commercial market tends to fluctuate more than the residential market does. When the economy is bad, businesses fail and people lose jobs, which means that commercial property investors may have to deal with several months of vacancies at once.
Not only does this mean that the investor will not be making any money during these months, but it also means that he or she will still have to pay for property taxes and insurance on an empty building.
A vacancy can quickly eliminate all of the profits from an investment and put the investor in a position where he or she is losing money on a deal.
3. Longer time commitment
Commercial tenants generally sign longer leases than residential tenants do, often between three and 10 years. While this can help provide investors with regular rental income, it can also make it more difficult to get out of an investment without significant losses if needed.
4. More responsibility
Residential landlords are generally only responsible for maintenance of the unit they’re renting out, while commercial landlords are responsible for the entire building and grounds. This means more liability and higher costs for commercial landlords, especially if something goes wrong or a tenant needs something repaired immediately
Reasons to Prefer Commercial over Residential real estate
Compared to residential property, the income from commercial properties is consistent and regular. Unlike residential properties, which are subject to varying lease periods, commercial properties are a better investment choice if you want to secure steady monthly cash flows.
- In addition to attractive lease rates, other benefits of commercial real estate investment include the low amount of operating costs and the low risk involved.
- One of the key benefits of commercial property investing is the ability to leverage your investment. By putting 20% of the value of the property down, you can obtain assets that are 5x higher than your initial outlay.
- You can also enjoy a higher income from rental property. You will not need to worry about paying the monthly rents, letting tenants move out, or even selling the property.
- Moreover, you can benefit from the long-term growth of the property’s value.
The reasons for such high returns on commercial property are varied. Some factors that can influence your returns include the type of asset class you are investing in, the market in which it’s located, and the capital structure for the property.
Each decision has a specific plot on the risk-return spectrum. The higher your risk tolerance, the higher your returns will be. Conversely, lower risk investments will likely yield lower returns. A commercial real estate investment can provide a steady and reliable income for years to come.
Despite these risks, there are ways to maximize your returns. Purchasing properties that are in need of renovations and repairs may be an excellent opportunity for active commercial real estate investors. However, if you plan on being passive, these problems may surface after you purchase the property. Expenses and maintenance could significantly eat into your ROI.
The best way to minimize these risks is to consider the investment’s risk and return profile before investing in any commercial real estate property.
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