Summary: In this article, you’ll learn the ins and outs of commercial property investing for beginners. As you learn more about investing in commercial real estate, you’ll also learn how to choose a commercial property investment that is right for your overarching financial strategy. Read on to learn how to get started.
Commercial real estate properties typically refer to retail, industrial, office, warehouses, mixed-use, and apartment buildings. Did you know that investing in commercial real estate offers numerous advantages and potential benefits to the savvy investor? These advantages include: steady cash flow, readily available tenants, lower vacancy risks, and higher income potential.
However, before simply buying any commercial property, investors must complete due diligence, to ensure the property aligns with your investment strategy.
Fundamental #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 first understand if the potential property fits the right investment strategy for your financial needs and goals.
As its name suggests, a cash flow strategy involves understanding and managing your expectations. Before you move forward on 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, keep in mind that the strategies will be different 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).
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 important thing to remember about a value add property is that this is an active strategy. Additionally, it will have a lot of moving parts, which means that you will need to rely on your local team in order to effectively complete every stage. 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, then typically you will start to see higher cash flows, as well as a higher sale value when you decide to eventually sell the commercial property.
When you are looking at a property, you must determine what is 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 be used to generate the income needed to invest in another property.
- Commercial properties in high appreciation areas will typically be held onto, since the opportunity for increased market rents is higher.
As you look at commercial properties, consider the potential appreciation. The following types of questions will help determine how long you want to hold onto the property, before deciding to sell.
- Is there high demand for land / space to build in the local area?
- 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 types of questions can help to not only determine your holding time for a commercial property, but can also provide insights into the projected appreciation of the investment.
Fundamental #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. With this in mind, since multi-family properties are the closest to residential properties, most people tend to gravitate towards this type of building.
Cash Flow Project
A cash flow project will typically have the following features:
- This is the main driver to 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 from 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 more difficult to manage than a cash flow property.
Hold Period Project
For a hold period project, first compare cash flow to the value add potential of a property. The following types of questions can help determine if the multi-family property aligns with your cash flow needs, as well as your overall investment strategy.
- How do rents compare to the current market rental rates?
- How does the interior and exterior of the property (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?
Fundamental #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 when 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.
Fundamental #4: Understand Commercial Property Financing
Commercial property financing is typically different than 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 for commercial properties are dependent on the current prime rate, as well as an understanding of how banks actually borrow the money needed to give you a loan with a fixed or floating interest rate.
- Prime Rate. The lowest rate that money can be borrowed commercially.
- How Banks Borrow. The banks get their money by borrowing for the prime rate, loaning it to you, adding an interest rate on top of it, and then the bank makes money off the spread.
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 on a monthly basis. The shorter the AM, the higher the payment each month. As seen below, each AM period has its pros and cons.
- 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 as well as the amortization period.
Triple Net Lease / Retail Financing
Triple Net Leases and retailing financing are typically based on the following factors:
- The term of 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 is dependent on the down payment made, as well as the lease period).
Banks typically will 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.
There are several types of multi-family financing opportunities.
- Agency Lending. This type of financing occurs for properties that are valued at more than $1 million. This type of loan also 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
A single family home financing opportunity 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 the single family homes.
- It is often based on the appraisal of the home.
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 of time, and then enters into a “floating” period.
- There is a smaller secondary market, which means that the interest rates are typically higher.
- The loan is often based on the cash flow of the property, rather than its appraisal value.
Fundamental #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, as well as the operating expenses.
The gross revenue is defined as the amount of revenue that you could receive if the property was 100 percent occupied.
The vacancy is typically a percentage of gross revenue. When calculating vacancy (as well as projected vacancy rates), most investors will generate financial models based off of five percent less than the current occupancy rate.
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 see 25 – 40 percent of the gross revenue dedicated to operating expenses. The latter sum will depend on numerous factors, including whether the property is considered to be a cash flow or value add property. If it is the latter, then you will need to keep renovation and property upgrade costs in mind when reviewing operating expenses.
The debt service portion of a proforma document refers to quite literally your debt payment, without including the operating expenses.
NOI (Net Operating Income) = 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.
The CAP rate is your NOI expressed as a percentage compared to what you paid for the commercial investment property. You can 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 COC is not calculated on purchase price, but rather the down payment 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 properly “growing” with your current commercial investment property, or if there is another (stronger) investment opportunity that would lead to a higher IRR.
Fundamental #6: Understand the Triple Net Lease
As was previously mentioned, many commercial real estate investors who want to enjoy a lower risk and passive strategy will often explore the opportunities that exist 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.
- Property taxes, maintenance, and insurance are paid by the tenant.
- The expenses, fees, monthly rent, etc. are all explicitly written into the lease. Additionally it is determined 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 all you 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 be something that is going to 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 the building was built, as well as how it was built, which will result in either lower or higher expenses to the owner.
When examining the lease terms, keep the following ROI guidelines in mind:
- If the lease term is 3 years or less, then you want an 8 percent CAP or higher. The reason for the higher CAP is that there is typically a higher risk associated with a lower lease term.
- If the lease term is 3 to 5 years, then you want a 7 to 8 percent CAP.
- If the lease term is 5 to 10 years, then you want a 6.5 to 7 percent CAP.
- If the lease term is 10 years or more, then you want a 6 percent CAP.
Comps in Area (Rent and Sales)
It’s important to look at the following factors when thinking about investing in a commercial property with a triple net lease opportunity.
- Look at the rent prices, as well as 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.
Fundamental #7: Understand the Role of Property Management for Commercial Buildings
The role of property management in commercial real estate is a bit different than 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 out of a property manager, will greatly influence the rate they are paid. If the owner takes a completely hands-off or passive approach, then the cost of property management will be higher.
Fundamental #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 that you can take a more passive investment approach).
- You will gain the additional value of knowing that there are local experts on the ground, who will provide their 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 About Investing in Commercial Property
Remember that you can always speak with your investment consultant to learn more about commercial properties and help decide the best investment strategy for you.
1 – I’m interested in being a CCIM (Certified Commercial Investment Member), 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 into the commercial investing market.
2 – Can you find a commercial loan fully amortized for 20 – 25 years?
The short answer is yes. It is more likely that you will get one for 25 if it comes from a local bank.
3 – Why does NOI (Net Operating Income) 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, due to the fact that closing costs are considered a 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 a NNN. However, if you do want a property manager, then you can always hire one to manage the NNN.
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 demand within the market, then you will typically have a lower return. However, the cash flow is often higher since there is a 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 for the increase in interest rates. This will keep a steady cash flow as interest rates potentially increase.
Investing in commercial properties for beginners can be a daunting process. However, it offers a number of 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 own due diligence, you’ll be well on your way to earning passive income through commercial real estate.