A Beginner Guide to Commercial Real Estate Investment

David Cohn
September 22, 2021
Commercial loans

Putting money in commercial real estate investing is an excellent way to build wealth. A well-chosen and well-managed commercial property investment can provide a sizeable and reliable income stream.

But if you’re a beginner, the industry can be quite intimidating—from the jargon to the high capital requirement to get things going. This is why we’ve put together this comprehensive commercial real estate for beginners.

In this blog, we’ll answer some of the main questions asked by those just starting. How does real estate investing work? How much capital do I need—and where do I get it?

How do I assess if a specific property is a good deal? If you are serious about growing your wealth and would like to know how to invest in commercial real estate, this guide will be useful.

Let’s start with the most basic:

What is “Commercial” Property?

Before we discuss the mechanics of how real estate investing works, let’s talk about the various kinds of commercial property assets. This can help you start pondering on what asset type you may want to specialize in.

The term “commercial real estate” or CRE typically refers to properties leased out for retail and other business purposes. CRE properties can serve a wide range of purposes, but they are generally categorized into the following

1. Retail

Perhaps the most popular type of CRE property is retail buildings. These range from community retail centers and strip malls to restaurants and banks. They are located in highly populated and urbanized areas, with sizes ranging from as small as 5,000 square feet to 350,000 square feet and more.

2. Industrial

Warehouses and large manufacturing sites are categorized as industrial buildings. They are typically leased out or sold to manufacturing industries looking for structures that meet their height specifications and docking requirements, among other needs.

3. Office

Office properties can be as big as skyscrapers or as small as single-tenant offices. They subcategorized into Class A, B, or C.

Class A offices are either extensively renovated or newly built buildings in excellent locations with access to transport and other major. These properties are usually professionally managed.

Class B offices refer to older buildings that may require minor renovations and other kinds of capital investment. They are generally well-managed and maintained but can benefit from minor upgrades, making them quite popular for investors looking to fix and sell for a higher price.

Class C offices lend themselves to redevelopment opportunities. Their vacancy rates are typically high. Many of these buildings are poorly located and also require major capital investments because of outdated infrastructure.

4. Multifamily

Multifamily commercial properties refer to high-rise condominium units, apartment complexes, and apartments with more than four units (anything smaller is not considered commercial real estate).

Many investors who start with residential properties eventually expand into larger multifamily buildings, thereby adding CRE to their portfolios. There are many opportunities in this sector, too.

However, residential lease terms are usually shorter than retail and office lease terms. Turnover should certainly be considered when investing in this asset class.

5. Special purpose

Special purpose commercial properties are built for very specific uses, so it may be hard to repurpose them for another use. Examples include car washes, schools, and self-storage facilities.

A large portion of this asset class is represented by the leisure and tourism industry, too. Hotels, sports stadiums, amusement parks, and airports all fall under this category.

Other types

Mixed-use properties have become prevalent in the CRE industry and continue to grow. These assets mix residential, retail, and sometimes even public sector usage. A good example of a mixed-use property is a building with shopping on the first floor and apartment units upstairs.

Raw land purchased for commercial development is also considered a CRE property. This may include vacant land, farmland, or land being repurposed.

How does Commercial Real Estate Investing Works?

Commercial real estate investing involves buying and/or developing properties designed for commercial tenants. Unlike residential real estate investors who lease out to people, CRE investors collect rent from businesses occupying space in their commercial properties.

What are the benefits of having a commercial property investment?

Learning how to invest in commercial real estate can be rewarding not just financially but also personally. Investing in CRE can grow and secure your wealth while diversifying your portfolio and even allowing you to enjoy tax benefits.

  • Higher-income – One of the biggest benefits CRE investing is that it offers high potential income. Commercial properties generally fetch a higher return on investment—averaging 6% to 12%—compared to single-family properties that make between 1% and 4%.  Besides, CRE leases tend to be longer than residential leases, so CRE investors don’t have to deal with tenant turnover as often.
  • Good cash flow – CRE also has the distinct advantage of generating a relatively consistent cash flow because the lease periods are longer. These properties tend to have more rentable units than residential properties, so you can quickly take advantage of economies of scale to multiple income streams. Many commercial tenants pay for building’s property insurance, maintenance costs, and real estate taxes, too, increasing your benefits as an owner.
  • Less competition – There is relatively less competition in commercial real estate. CRE investing’s perceived complicatedness makes it intimidating to most investors, so the market is less saturated.
  • Business relationships – If you’re interested in establishing and participating in business-to-business relationships, then CRE investing might be for you. Your professional interactions with tenants in your building may allow you to quickly expand your network and get actively involved in developing the community you have invested in.
  • Limited operational hours – If you choose to run your commercial property, you will share working hours with your business tenants for the most part. You will rarely find yourself having to attend to round-the-clock communication or maintenance requests. The same can’t be said for residential real estate, which often demands owners to be on-call and deal with issues as they arise, 24/7.

What are the drawbacks of CRE investing?

Just as there are benefits to owning a commercial property, there are also some drawbacks. It’s important to be aware of them so that you can take the necessary precautions.

Do note that the disadvantages described below are generalities. Each potential commercial property has unique traits that have to be analyzed on their own merits.

  • More expensive – Commercial real estate usually costs more money than residential property investments. Financing your CRE purchase means working with lenders that offer commercial loans. Down payments for CRE properties also tend to be larger—usually 30% of the purchase price. The larger your commercial property, the more you can expect to spend on capital expenses, too. There is more to repair and maintain.
  • It takes longer – Most things CRE take much longer to complete than in residential investing. Research and inspections can take months instead of just a few days. Finding and vetting tenants may take longer, along with repairs, renovations, or build-outs—though this is often offset by the fact that commercial leases are longer. Selling a CRE asset may not be as easy, either, because these properties attract a limited investor demographic. But if you have the patience to wait for the big payday, then CRE investing may be a good fit for you.
  • Risk of legal issues – Along with more traffic and higher costs comes a greater risk of legal issues. It’s important to have adequate insurance and access to a lawyer who understands commercial property laws.  
  • Many rules and regulations – Aside from having an attorney, it will do you well to use a CRE realtor and an experienced accountant. You can also work with CRE financing specialists to make commercial investing much easier. Most CRE owners likewise hire professional property managers instead of managing their buildings themselves. Be sure to take these costs into account when planning to buy a commercial real estate asset.

As you can see, CRE investments offer an array of advantages, opportunities, and drawbacks that make it unique from other property classes.

Now that you understand what you can potentially gain or lose from commercial real estate investing, it’s time to dive in. Read on to find out how to invest in commercial real estate.

Getting Started: Investment in Commercial Real Estate as a Beginners?

Due diligence is at the core of any investing activity, and it’s even more important in CRE. Doing your homework is the most critical element in succeeding in this niche.

1. Understand how CRE is valued.

Commercial properties are evaluated differently from residential real estate. Unlike in residential properties, the income from CRE is typically associated with “usable” square footage.

Moreover, commercial investors need to pay close attention to the type of tenant they will be catering to and the property’s location. The intersection of these two factors determines demand. For example, a building intended to serve as corporate offices will likely perform better in a dense urban center instead of a primarily residential neighborhood.

2. Learn how to analyze comparable and do your research on future developments.

Analyzing comparable or comps means looking at commercial properties similar to the one you want to buy in terms of size, style, and location and find out how much they sold for, and/or how much they rent for. Analyzing comps is a great way to determine a commercial asset’s current market value and income potential. When comparing, be sure to choose a CRE property whose square footage is no more than 10% lower or higher than that of the asset you want to evaluate.

3. Learn how to use the right CRE terminologies.

CRE investing involves a lot of calculations and a good understanding of property finance. There are many CRE financing formulas to study (see our previous blog), but beginners generally have to focus on these three:

  • Net Operating Income – This refers to all revenue and costs of a particular property, before taxes. It will provide you with a clear picture of how much you can potentially make from the property minus operating expenses such as insurance, utilities, repairs, property management, janitorial fees, property tax, etc.
  • Cap Rate – The capitalization rate or cap rate estimates the property’s future cash flow or profits.
  • Cash on Cash – This metric measures the return on your out-of-pocket investment relative to the financed portion. It can provide you an accurate idea of a CRE investment’s rate of return performance.

The above formulas complement our guide to “Key Commercial Real Estate Investment Terminologies” that every CRE investor should know. Be sure to take the time to read it.

4. Learn what mistakes to avoid.

Mitigating risk exposure is easily the single most important thing in successful commercial real estate investing. To lessen the risk, you have to know what NOT to do. Here’s a list of common mistakes beginners make so you can avoid them.

  • Improper valuations – No two commercial properties are exactly alike. Good investors understand how to spot and account for variances in each asset. Failing to analyze such details can cause financial ruin. To be successful in commercial real estate investing, you have to be completely aware of what exactly you’re buying and for how much.
  • Financial ignorance – CRE investing involves financial intricacies that you won’t encounter in residential property investing. Read our blog on “How to Calculate ROI on Commercial Real Estate Investments” and “A Complete Guide to Commercial Real Estate Loans.”
  • Trying to work alone – Many beginner investors think they can save money doing everything by themselves. They don’t realize that working with a team is more cost-efficient. Going DIY often means losing both time and money—and making expensive mistakes. It’s always better to work with competent agents and financial consultants who know more than you do.

What are the types of Commercial Real Estate Loans?

Now that you have an overview of CRE investing and how to get started, it’s time to understand how to finance these investments.

There are several commercial investment loan types, and the right financing option depends on your situation and the circumstances surrounding the property you are buying. Each loan type has its eligibility requirements, including a minimum credit score, down payment requirement, and experience level. They also have varying loan terms and interest rates.

Some investors need a longer-term loan that offers low-interest rates, while others might need a short-term loan that can be approved quickly to bridge a financial gap. We discuss this topic in-depth in our blog, “A Complete Guide to Commercial Real Estate Loans.”

Is commercial real estate investing the right choice for you?

Perhaps like many investors, you are interested in CRE properties but are still hesitant to leap. Ask yourself these questions if to find out if this asset class makes sense for you:

Can I think big?

You need open-mindedness and the ability to see the bigger picture to succeed in CRE. It’s important to visualize the finished product early on in the stages of redevelopment, for example. You also have to see beyond the surface and do whatever it takes to boost the bottom line.

Do you love to build professional relationships?

It’s not obvious, but the ability to network is an absolute must for CRE investors. You need to build relationships with other investors and private lenders who can help you finance big investments. Most CRE properties cost millions of dollars, so you will likely need funding from people who trust you. Building a reliable network also allows you to see what best practices other investors apply while learning from their mistakes.

Are you ready to do due diligence?

Performing due diligence is arguably the most vital task for CRE investors. Choose your niche and learn everything you can about that specific sector. Look for information about financing options online or talk to CRE financing experts.

Ask questions from like-minded investors. You can even reach out to CRE investment advisory firms in advance to find out exactly what they need you to present to them when the time comes. Preparing is half the battle. This is certainly true for any commercial real estate deal.

In short, having a proper business plan, minding due diligence, understanding your financing options, and building a strong network are the keys to success in commercial real estate investing. Don’t hesitate to talk to a CRE financing advisory firm if you have a project in mind. You can contact us here at Capital Investors Direct.

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