Because of its growth potential, generating passive income, and relatively consistent returns, many investors viewed commercial real estate investors as an appealing investment class.
But while commercial properties are potentially profitable, not all investments in the sector are considered equal. It’s important to know what to invest in, when to invest, and how to go about it to ensure the success of your commercial real estate venture.
Using winning strategies and playing it will let you skip over the common mistakes made by first-time CRE investors. But how do you do that? Here are some tips on getting off to a strong start:
1. Keep in mind that CRE property types vary in terms of performance.
There’s a wide variety of commercial real estate asset types. While this sector is typically grouped into five niches—namely office, retail, industrial, particular purpose, and multifamily—there are many other kinds of CRE, including hotel, land, medical, elder care, and self-storage. The sectors vary significantly from each other to yield, supply and demand, and overall profitability.
For example, some types of CRE perform better than others based on the unique supply and demand in the asset location. First-time CRE investors need to know how to determine what asset types will likely be most profitable or offer great opportunities based on the current economy.
Industrial CRE is currently the top-performing sector, and retail is the worst performing (because of the popularity of online shopping). Vacancy rates in some CRE sectors also tend to be higher because they rely on a single tenant, as in a single office space or an industrial warehouse.
Some commercial real estate investors who want to lower their risk choose to invest in multifamily apartments and other properties that can lease out to multiple tenants.
As a beginner, you must do your research on the performance of the asset classes you are interested in based on the current economy. Assessing the investment viability not just of the property itself but of the sector and the current market will help you decide on what property type to pursue.
2. Understand that every market is different.
Every geographical area has its distinct supply and demand. Even property types that do well on a macroeconomic scale might do poorly in your city because of oversupply, or vice versa. First-time investors have to conduct market research to check if there are potential market saturation risks.
One of the essential things you can do is figure out the market supply in the asset location, considering both the existing rentable square footage and additional square footage from planned developments.
Try to identify property types that may be undersupplied in your market, then do a feasibility study to gauge the likelihood of future growth and success in that sector. There are online sources for this, including Deloitte, CBRE, and Realtor.com.
3. Don’t neglect due diligence.
Many first-time investors make the mistake of rushing into a deal. Don’t do this. Keep in mind that knowledge is indeed power. Ensure you know everything about the property and the market in general before you pour money into a project. Here are some things to focus on:
- Do you plan to develop a vacant property? Check (and double-check) if the zoning laws in the area will allow you to utilize the property as intended.
- Do you want to expand a building or start a new construction? Confirm how many additional units the current and near-future market can support.
- Learn about the permitting procedures and associated costs in the city or municipality where the property is located.
It is also important to use current data—nothing older than 2019, if possible. The commercial real estate market is experiencing quick changes, so it’s pointless to rely on market insights or tips from many years ago. You need the freshest information if you want to plan current movements successfully.
It would help if you also made time to read industry-specific books, listen to commercial real estate podcasts, and follow commercial property investing pages on social media. Immerse yourself in the CRE supporting culture.
4. Think about financing early on.
Indeed, location matters, the success of a CRE investment is also largely dependent on whether math makes sense or not. Learn how to use formulas for cap rates, NOI, and other applicable metrics.
Organize your finances before you become serious about looking for commercial properties. Sit down with a financial planner if necessary, so you can examine your financial situation and ensure that you can take on the responsibilities that come with being a CRE investor.
You also want to start exploring financing options, from banks to private commercial lending. Start shopping around, so you have a clear idea of what kind of funding is available out there.
5. Prepare a capital reserve and contingency fund.
Uncertainty is a part of investing. Regardless of how well you prepared, unknown factors will inevitably come up—and they have the potential to affect your overall yield negatively. It’s important to hedge this uncertainty by accounting for cost contingencies.
In simplest terms, cost contingencies are additional funds that you need to set aside to help pay for unexpected expenses that may come up as you raise rents, renovate, rezone, lease-up, etc.
You can also use this money to cover your loan service until the income from the property stabilizes. The standard contingency budget in commercial real estate is anywhere from 5% to 15%, depending on the type of asset and performance.
It’s also a good idea to build a capital reserve (sometimes called replacement reserves fund). This is a pot of money set aside for unexpected expenses or long-term improvements beyond the initial capital improvements you initially planned for. Experts recommend setting this fund aside before getting positive cash flow from your property, and it should be between 3% to 5% of gross rents.
6. Start slow but think big.
As a new investor, you will want to take it slow and fight the temptation to go full speed ahead. Juggling multiple property types when you don’t have much experience in commercial real estate can be difficult and may even cause you to fail.
That said, it’s also important to think big. Make it your goal to branch out as you gain more traction eventually. Don’t expand right away, but don’t avoid expansion, either. After all, there are many benefits associated with a diverse commercial real estate portfolio—including economic resilience and market stability. The key is to grow your holdings steadily as you become better and better at CRE investing.