Step-by-Step Guide to Invest in Rental Property

David Cohn
Mar 29, 2023
Rental Property

Investing in commercial real estate (CRE) is a wise choice for those looking to build financial security for the future. Commercial properties offer some of the highest income streams available.

Suppose you have been considering diversifying your portfolio and branching out into commercial property investment but need help figuring out where to start.

In that case, this guide will provide all the basics you need to know.

The Benefits of Owning Commercial Rental Properties

Investing in commercial real estate has the potential to provide substantial personal and financial rewards. Whether you're seeking a secure future, tax benefits, or wish to diversify your portfolio, many advantages come with investing in this type of property:

1. Greater returns -

Generally speaking, you can expect a return on investment of 6% to 12% from these properties, which is in stark contrast to single-family assets that provide an average of between 1% and 4%.

2. Better cash flow -

One key benefit of commercial real estate is the potential for a steady income flow due to longer lease terms. In addition, commercial properties often have more units than residential properties, allowing for multiple income streams and cost savings through economies of scale. A triple net lease type, in which tenants pay for building taxes, insurance, and maintenance, can also add to the financial benefits for the property owner.

3. Less Competition

This industry tends to be less competitive due to the perceived complexity of investing in commercial properties.

4. Networking -

Investing in commercial real estate can provide the potential to be part of business-to-business relationships and create meaningful connections with tenants.

You can build a network or become more involved in the community, as these cordial interactions could lead you to form friendly ties with the business owners renting within your building.

5. Better hours -

Operational hours are limited in commercial real estate. As a commercial property owner, you generally share the same working hours as your tenants.

This means that you don't need to handle maintenance requests or other communications around the clock, unlike residential real estate.

Many commercial investors who manage their properties appreciate this benefit as it allows for a clear separation between property ownership and personal life.

Commercial real estate investing provides opportunities and benefits not found in other investment options. Understanding these benefits is the first step in getting started.

How to begin investing in commercial real estate

The key to successful commercial real estate investing is thorough due diligence.

In addition to learning about commercial investing, it’s essential to understand the commercial real estate market and how it differs from the residential market. If you are ready to begin your first commercial real estate venture, make sure to follow these tips:

1. Recognize how commercial rental properties are different from residential rentals.

The first step for a commercial real estate investor is understanding that commercial properties are valued differently than residential ones. The income from commercial real estate is usually based on the usable square footage, and commercial leases are generally longer than residential leases.

These two factors contribute to the potential for higher income in CRE investing.

Awareness of the risks and potential rewards of commercial real estate investing is essential. Also, be prepared to make a significant initial investment and be able to handle complex market conditions. Location is crucial in property investing, and CRE is no exception.

But aside from the site, commercial investors should also consider the type of tenant they want to attract. The location and tenant type intersect closely when determining demand.

For example, a space intended for corporate offices will likely perform better in an urban area than in a residential neighborhood.

Analyzing recent comparable properties can provide insight into how the property you are interested in may perform.

2. Study similar properties.

The next step is to study similar properties and research any upcoming developments. “Comparable properties” or “comps” refer to prices paid for recently sold properties identical in location, size, and style. Analyzing comps will help you determine the current market value of a property you’re interested in.

When selecting comps, a general rule of thumb is to choose properties where the square footage does not vary by more than 10% higher or lower than the evaluated property. This will ensure the most accurate results.

3. Use appropriate performance metrics.

Investing in commercial real estate involves various calculations and knowledge of real estate finance. To be successful in commercial real estate, it's essential to have a solid understanding of several vital formulas and performance metrics. These metrics will help you evaluate the potential return on investment and help you make informed decisions about buying and managing a CRE asset.

Net Operating Income (NOI) calculates an investment property's total revenue and costs. This measure accounts for all operating expenses like insurance, utilities, taxes, repairs, and more before any deductions are made.

As a result, NOI provides investors with the insight they need to determine their potential return on investment after accounting for necessary expenditures.

Cap Rate: This metric is a fundamental tool for understanding the potential return on investment of commercial properties. It's calculated by taking the net operating income and dividing it by the property's value so that investors can anticipate future cash flow or profits.

As a result, the cap rate, which is short for capitalization rate, provides an accurate appraisal of income-generating assets and helps savvy investors make more informed decisions.

Cash on Cash: This metric determines the rate of return on a commercial real estate investment. It’s commonly used by investors who use financing to purchase properties.It calculates the return on the cash invested by the investor relative to the amount financed. This metric is helpful in evaluating an investment's performance, as it considers the effect of financing on the ROI.

4. Set aside funds for unexpected costs.

Cost contingencies are funds to cover unexpected expenses while acquiring a property. For example, these funds cover lost cash flow from early vacancies, renovations, and other upfront costs.

By including cost contingencies in your budget from the beginning, you can ensure that you have the funds to cover these unexpected expenses.

A typical cost contingency budget for commercial investing is between 5% and 15%. To determine the appropriate amount for your investment, consider your expected cash flow during the first few months and whether that amount will cover early loan expenses and changes to the property.

Even if you expect cash flow to be sustainable early on, it’s always wise to have extra funds as a safety measure. In addition to cost contingencies, many investors also set aside a capital reserve fund, which later serves the same purpose. These funds can be used for unexpected expenses and are included in the operating budget.

Cost contingencies and cash reserves are essential components of commercial investing. You can avoid cash flow issues by planning for these costs throughout the investment process.

Common mistakes in CRE investing

For beginner CRE investors, understanding what to avoid is as crucial as knowing which actions to take. Here are some of the most common mistakes commercial real estate investors should avoid:

  • Inaccurate valuations: Getting the property value wrong can impact every step of the investment process, so getting it right at the time of acquisition is crucial. Remember that every commercial property is unique, and it's essential to account for variations in each asset. CRE investors must thoroughly understand what they are buying and for what price.
  • Lack of financial knowledge: Commercial deals differ from residential deals, and investors need to understand the differences, including loan-to-value (LTV) and debt service coverage ratio (DSCR). Failing to understand the financial complexities of commercial real estate investing can be damaging.
  • Failing to do due diligence: While quick decision-making is essential in today's market, it’s crucial to conduct due diligence. It’s better to lose a deal to someone else than to buy into an agreement if you are unprepared.

Therefore, more investors need to take the time to learn as much as they can about a property before buying it.

Work with experts

Many investors try to save money by doing everything themselves. Don’t make this mistake. You could be losing both money and time by working alone.

For example, if you need CRE financing, align yourself with a competent commercial loan placement and advisory firm like Capital Investors Direct.

Trust us  to do the job you hired us for. We are likely more knowledgeable in every process than you are.