Commercial Property Investing for Beginners: Tips & More

Did you know that investing in commercial real estate offers numerous advantages and potential benefits to the savvy investor, such as steady cash flow, readily available tenants, lower vacancy risks, and higher income potential? For those new to this strategy or those currently considering investing in retail, office, warehouse, industrial, mixed-use, and apartments, we’ve rounded up the eight fundamentals of commercial property investing for beginners.

Below, we outline the need-to-knows of commercial property investing for beginners, including terminology and how to choose a commercial property that’s right for your overarching financial strategy. Read on to learn how to get started.

Remember, before simply buying any commercial property, investors must complete their due diligence, to ensure the property aligns with their investment strategy.

1. Determine if Commercial Property Investing is the Right Strategy for You

Like residential real estate, investing in commercial properties will require your own due diligence. These complex real estate transactions will help you understand if the potential property fits the right investment strategy for your financial needs and goals.

Cash Flow

As its name suggests, a cash flow strategy involves understanding and managing your expectations. Before you move forward with this type of strategy, ask yourself the following types of questions:

If the property has a lower monthly cash flow, does that mean it’s not as good of a deal?
If the property has a higher monthly cash flow, but has other risks, does this mean that it is a good choice for my portfolio?

As you answer these questions, remember that strategies will differ for each property. Identify your expectations, manage those expectations, and then with an unbiased view, determine if the property will meet these expectations and thus reach your financial goals. Finally, the goal of cash flow properties is to be a more passive investment strategy, requiring a less hands-on approach (especially when compared to a value add property).

Value Add

A property that is deemed “value add” typically refers to one that needs some work completed before it can either a) achieve higher monthly rent values or b) be rented out to tenants. With this in mind, a value add property typically meets the following criteria:

It needs renovation.
There is deferred maintenance.
The exterior / landscaping of the property needs to be improved.

The critical thing to remember about a value add property is that this is an active strategy. Additionally, it will have many moving parts, so you will need to rely on your local team to complete every stage effectively. Finally, as you add value to the property, you should recognize that your cash flow will typically be lower. However, once the value has been added to the property, you will typically start to see higher cash flows and a higher sale value when you decide to sell the commercial property eventually.

Holding Time

When you are looking at a property, you must determine an acceptable time frame. For example, cash flow properties are typically ready to be leased out immediately, while value-added properties will need work done before leasing the units and/or the entire building. There are some general timelines that can be expected for each type of commercial investment strategy.

Value add properties typically have a holding time of one to three years.
Buying and selling within 12 months typically aligns with a flipping strategy (vs. a buy-and-hold strategy).
Cash flow properties can generate the income needed to invest in another property.
Commercial properties in high-appreciation areas are typically held onto since the opportunity for increased market rents is greater.

Appreciation

As you look at commercial properties, consider the potential appreciation. The following questions will help determine how long you want to hold onto the property before deciding to sell.

Is there a high demand for land/space to build locally?
Are more people (year over year) moving into the area?
Have rental prices continued to increase (or decrease)?
Are businesses flocking to the area?

These questions can help determine your holding time for a commercial property and provide insights into its projected appreciation.

2. Determine if Multi-Family Investing is the Right Strategy for You

When investing in multi-family properties, you must decide what type of project you want to purchase. Since multi-family properties are the closest to residential properties, most people and beginners of commercial property investing tend to gravitate towards this type of building.

Cash Flow Project

A cash flow project will typically have the following features:

Cash flow is the main driver for owning a multi-family property.
High occupancy rates (ideally coupled with low turnover rates, i.e., residents typically renew their leases year over year).
The units are leasing at or above current market rental rates.
Expenses are low and/or covered by the rental rates being earned.

Value Add Project

A value add project will typically have the following features:

Lower occupancy rates (especially when compared with competitor properties in the local area).
The units are leasing below the current market rental rates.
The exterior or interior needs to be updated.
Operational costs are high (perhaps due to higher maintenance costs, increased expenses, or poor management).
Typically, it is more challenging to manage than a cash flow property.

Hold Period Project

For a hold period project, first, compare cash flow to the property’s value-added potential. The following questions can help determine if the multi-family property aligns with your cash flow needs and overall investment strategy.

How do rents compare to the current market rental rates?
How does the property’s interior and exterior (and units) compare to other properties in the area?
Does the occupancy rate provide a high enough monthly cash flow?
What can be done to either a) increase monthly rents, b) increase occupancy rates, or c) reduce operational costs?

3. Determine if Retail / Triple Net Lease is the Right Strategy for You

A triple net lease (triple net or NNN) refers to a lease agreement in which the tenant pays all real estate taxes, maintenance, and building insurance on the commercial property. Additionally, the tenant pays the agreed upon “normal fees,” such as rent, utilities, etc. Investors might want to purchase a commercial property and implement a triple net lease for the following reasons:

A less hands-on strategy (typically used with a retail client).
Returns can be less than other investment strategies, however this is a more passive strategy.
The risk tends to be a bit lower.
Easy to manage (generally, the management fee is lower if a property manager is involved; however, most triple-net leases don’t have a property manager).

This strategy is often implemented when you want to stimulate your portfolio.

4. Understand Commercial Property Financing

Commercial property financing is typically different from that of a residential property. In fact, many commercial opportunities require investors to meet higher income or net worth standards while also being able to make a larger financial commitment.

Interest Rates

Interest rates for commercial properties are dependent on the current prime rate, as well as an understanding of how banks borrow the money needed to give you a loan with a fixed or floating interest rate.

Prime Rate. The lowest rate of money can be borrowed commercially.
How Banks Borrow. Banks borrow money at the prime rate, loan it to you, add an interest rate to it, and then make money off the spread.

Amortization

Banks might stretch out the amortization (AM) period. For example, you might have a 10-year loan with an amortization period of 20 years. In the latter case, the longer the AM, the less debt you will pay monthly. The shorter the AM, the higher the payment each month. Each AM period has pros and cons, so decide what’s best for your bottom line.

Longer AM has a lower debt payment but a higher interest rate.
Shorter AM has a higher debt payment but a lower interest rate.

Length of Loan

The length of the loan typically correlates with the length of the lease. When deciding between financing options, it’s important to consider both the length of the loan and the amortization period.

Triple Net Lease / Retail Financing

Triple Net Leases and retailing financing are typically based on the following factors:

The term of the lease is examined to determine the amortization period, as well as the loan period.
The down payment is usually between 25 – 35 percent.
The interest rate is usually lower (however, it depends on the down payment and the lease period).
Banks typically refinance when the tenant renews the lease. However, the interest rate might change at this time and be higher than the average five—to six percent interest rate that is typically granted.

Multi-Family Financing

There are several types of multi-family financing opportunities.

Agency Lending. This type of financing is for properties valued at more than $1 million. It has an amortization period of 30 years and a low fixed interest rate (for a set period of time).
Traditional Lending. This type of financing has specific loan terms, usually has an interest rate between five to six percent, and often has a 25-year amortization period.

Single Family Financing vs. Commercial Financing

Single family home financing typically has the following conditions:

It is amortized evenly over the term of the loan.
It has a fixed interest rate throughout the loan period.
There is a higher demand and typically a secondary market for single-family homes.
It is often based on the appraisal of the home.

When learning about commercial property investing for beginners, you’ll find that commercial financing typically explores the following conditions:

The term of the loan typically matches the lease period.
There is usually a longer amortization period.
The fixed interest rate is typically for a set period and then enters a “floating” period.
There is a smaller secondary market, meaning the interest rates are typically higher.
The loan is often based on the property’s cash flow rather than its appraisal value.

5. Know How To Read a Commercial Rental Property Proforma

A commercial rental property proforma is essentially a financial analysis of the property. As part of this statement, you will need to review the gross revenue, vacancy rates, and operating expenses.

Gross Revenue

Gross revenue is defined as the amount of revenue that would be received if the property were 100 percent occupied.

Vacancy

The vacancy is typically a percentage of gross revenue. When calculating vacancy (and projected vacancy rates), most investors generate financial models based on five percent less than the current occupancy rate.

Operating Expenses

The operating expenses will include maintenance, utilities, property taxes, and management fees. Keep in mind that with a triple net lease property, you won’t be paying the aforementioned operating expenses.

Generally speaking, multi-family properties should dedicate 25 – 40 percent of the gross revenue to operating expenses. The latter sum will depend on numerous factors, including whether the property is considered a cash flow or value-add property. If it is the latter, you will need to consider renovation and property upgrade costs when reviewing operating expenses.

Debt Service

The debt service portion of a proforma document refers to your debt payment without including operating expenses.

Net Operating Income (NOI) = Gross Revenue – Vacancy – Operating Expenses

The NOI is calculated as the cash that you will receive before taxes are taken out, but after you have paid all of your operating expenses. It is important to note that the NOI does not include your debt service.

CAP Rate

The CAP rate is your NOI expressed as a percentage compared to what you paid for the commercial investment property. Think of it as the ROI generated before the debt service is taken out.

Cash-on-Cash (COC)

The COC is your ROI after you have taken out the debt service. It is important to note that the COC is not calculated based on the purchase price but rather the down payment you made when you purchased the commercial investment property.

Internal Rate of Return (IRR)

The IRR will show how your investment is performing. It calculates this figure by showing the value of money (made in the commercial property investment) as it would compare to a different investment. In other words, the IRR helps determine if your money is appropriately “growing” with your current commercial investment property or if there is another (stronger) investment opportunity that would lead to a higher IRR.

6. Understand the Triple Net Lease

As previously mentioned, many commercial real estate investors who want to enjoy a lower risk and passive strategy will often explore the opportunities with the triple net lease. It’s important to note that triple net leases are unique and include different criteria that must be met before going this route.

Absolute NNN (Triple Net)

An Absolute NNN will meet the following criteria:

You own the building, the tenant is paying all of the expenses.
The tenant pays property taxes, maintenance, and insurance.
The lease explicitly states the expenses, fees, monthly rent, etc., and also determines how the tenant will pay for the aforementioned expenses (i.e., will the tenant “pay you back” each month for expenses in addition to the agreed-upon monthly rent, or will the expenses be billed directly to the tenant so that each month, you will receive one rent check).

NN (Double Net)

In an NN, the following conditions are usually set:

All expenses are billed to the tenant with the exception of roof, structure, and parking expenses.
The expenses associated with the roof will vary. Typically, in this situation, the roof will last 20 to 30 years and thus will not usually provide high expenses during the term of the lease.
The structure will depend on when and how the building was built, which will result in either lower or higher expenses for the owner.

Lease Terms

When examining the lease terms, keep the following ROI guidelines in mind:

If the lease term is 3 years or less, you want an 8 percent CAP or higher. The reason for the higher CAP is that a higher risk is typically associated with a lower lease term.
If the lease term is 3 to 5 years, you want a 7 to 8 percent CAP.
If the lease term is 5 to 10 years, you want a 6.5 to 7 percent CAP.
If the lease term is 10 years or more, you want a 6 percent CAP.

Comps in Area (Rent and Sales)

It’s important to consider the following factors when investing in a commercial property with a triple net lease opportunity.

Look at the rent prices and common lease terms for similar buildings in the area.
Look at what a similar tenant is paying in rent (for a similar type of space in the area).
Examine the recent sales in the area.
What is the CAP for similar types of buildings that have recently sold in the area?

Grade of Tenant

The grade of the tenant should be evaluated when considering a triple net lease. To calculate the grade of the tenant you should ask the follow types of questions.

What is their creditworthiness?
Is the tenant trustworthy?
Are they backed by a public company?

Generally, the higher the tenant grade, the lower the CAP. However, while the CAP might be lower, higher grade tenants are often lower risk.

7. Understand the Role of Property Management for Commercial Buildings

The role of property management in commercial real estate is slightly different from residential property management. A commercial property manager will have different responsibilities depending on the type of property. For example, an owner will usually not have a property manager for triple net leases.

Additionally, how much is expected of a property manager, which will greatly influence the rate at which they are paid. If the owner takes an entirely hands-off or passive approach, then the cost of property management will be higher.

8. Determine if Investor Assistance or Asset Management is Needed

Investor assistance is provided by an industry expert, as well as their property teams, to actively explore other real estate market opportunities.

Some commercial investments will also offer property team asset management opportunities (so you can take a more passive investment approach).
You will gain the additional value of knowing that local experts on the ground will provide direct input and apply their expertise to your commercial investment.
Leverage the knowledge of an experienced investor when choosing a commercial real estate property.

When Should I Use an Asset Manager?

An asset manager is often used when purchasing a multi-tenant property. An asset manager can be especially beneficial when investors are trying to get a multi-tenant or multi-unit financed, and the process is more complex.

Asset managers are experts in their field, have extensive experience purchasing and managing these types of assets, and can guide you throughout the entire process. If you’re a beginner, asset managers can be very helpful.

10 FAQs: Commercial Property for Beginners

Remember that you can always speak with your investment consultant to learn more about commercial properties and help decide your best investment strategy.

1) I’m interested in becoming a Certified Commercial Investment Member (CCIM). Where do I go for that?

Go to CCIM.com and take at least an introduction class or the 101 class. These continuing education classes will provide a great introduction to the commercial investing market.

2) Can you find a commercial loan fully amortized for 20 – 25 years?

The short answer is yes. If it comes from a local bank, you are more likely to get one for 25.

3) Why does NOI not include debt service?

The short answer is that “it simply doesn’t.” The longer answer is that getting loans is a biased process, whereas cash is not, which is why NOI doesn’t include debt service.

4) What is absolute net?

Absolute net means that the tenant pays all of the expenses. In this case, the gross value will be the same as the absolute net.

5) Would a higher grade tenant result in a lower interest rate from the lender?

Yes, it will, because the risk will be reduced to both you and your lender.

6) Are closing costs included in CAP rate NOI calculations?

The short answer is yes, as closing costs are considered part of the initial investment and expenses and are thus included within the NOI calculation.

8) Who manages a Triple Net Lease (NNN)?

Typically, you, the owner, will manage an NNN. However, if you want a property manager, you can always hire one.

9) What is the typical return for multi-family or retail property?

The return will depend on the demand within the market. For example, if there is high market demand, you will typically have a lower return. However, the cash flow is often higher due to high demand. In other words, the strategy, market, and risk will directly impact the return of a multi-family or retail property.

10) What about interest rates rising? How will that affect my cash flow when the rate adjusts?

You will typically have rent escalations within the lease to accommodate the interest rate increase. This will keep a steady cash flow as interest rates potentially increase.

Final Thoughts

Investing in commercial properties for beginners can be a daunting process. However, it offers several advantages, including higher income potential, lower vacancy rates, steady cash flow opportunities, and high-grade tenants. With the help of an expert and performing your due diligence, you’ll be well on your way to earning passive income through commercial real estate.