Commercial Real Estate (CRE)
Commercial real estate (CRE) refers to property that is specifically used for business purposes or to provide workspaces, rather than being utilized as a residential space as in the case of residential real estate. The primary usage of commercial real estate is to lease it to tenants for conducting activities that generate income. This extensive category of real estate encompasses a range of options, from individual storefronts to large-scale shopping centers.
Commercial real estate encompasses a wide range of options that include office buildings, residential duplexes, as well as establishments like restaurants, coffee shops, and warehouses. Both individuals and corporate entities have the opportunity to generate income from commercial real estate through leasing or holding the property for eventual resale.
Commercial real estate encompasses various categories, including office space, hotels and resorts, strip malls, restaurants, and healthcare facilities, among others.
Understanding Commercial Real Estate (CRE)
There are two main categories of real estate property, which are commercial real estate and residential real estate.
Residential properties are designated for human habitation exclusively, excluding any commercial or industrial purposes. Commercial real estate, as the name suggests, is utilized within business transactions, and multiunit rental properties intended for tenants’ residency are considered commercial engagements for the property owner.
Depending on its function, commercial real estate is typically classified into four different classes.
- Office space
- Industrial use
- Multifamily rental
- Retail
Different types of retail real estate can be further classified into individual categories.
- Hotels and resorts
- Strip malls
- Restaurants
- Healthcare facilities
Office space is often classified into different subtypes referred to as class A, class B, or class C.
- Class A represents the best buildings in terms of aesthetics, age, quality of infrastructure, and location.
- Class B buildings are usually older and not as competitive—price-wise—as class A buildings. Investors often target these buildings for restoration.
- Class C buildings are the oldest, usually more than 20 years of age, located in less attractive areas, and in need of maintenance.
Most zoning and licensing authorities classify industrial properties as a subset of commercial real estate, although some authorities may distinguish them separately as sites primarily utilized for manufacturing and producing goods, particularly heavy goods.
Commercial Leases
In some cases, businesses possess the buildings they use, but it is more common for commercial properties to be rented. Typically, a building is owned by an investor or a group of investors who receive rent payments from the businesses operating within it.
Commercial lease rates are typically presented as annual rental dollars per square foot, while residential real estate rates are expressed as either an annual sum or a monthly rent.
Commercial leases usually have a duration of one year to 10 years or even longer, whereas office and retail spaces usually have leases that last between five and ten years. In comparison, residential leases tend to be more short-term, such as yearly or month-to-month agreements.
The landlord and the tenant are required to take on different levels of responsibility depending on the four primary types of commercial property leases.
- A single net lease makes the tenant responsible for paying property taxes.
- A double net (NN) lease makes the tenant responsible for paying property taxes and insurance.
- A triple net (NNN) lease makes the tenant responsible for paying property taxes, insurance, and maintenance.
- Under a gross lease, the tenant pays only rent, and the landlord pays for the building’s property taxes, insurance, and maintenance.
Managing Commercial Real Estate
For proper ownership and maintenance of leased commercial real estate, constant management is necessary from the owner’s side. To accomplish this, property owners might consider hiring a commercial real estate management firm. This firm would assist in tasks such as tenant search, management, and retention, supervision of leases and financing choices, as well as the coordination of property maintenance and promotion.
A commercial real estate management company’s specialized knowledge is beneficial due to the different rules and regulations that apply to such properties, depending on factors like state, county, municipality, industry, and size.
The landlord has to find a balance between renting out properties at the highest possible rates and reducing the number of empty spaces and turnover from tenants. The turnover can be expensive for commercial real estate owners because they have to make changes to the space to suit the unique requirements of new tenants, such as when a restaurant moves into a property previously occupied by a yoga studio.
How To Invest In Commercial Real Estate
In order to succeed in the field of commercial real estate, it is crucial to perform thorough research and exercise diligence, regardless of the specific sector or niche you are involved in. Hence, the answer to the question of how to invest in commercial real estate lies solely in conducting due diligence.
If you are ready to start your first commercial endeavor, make sure to understand the commercial real estate market and how it can differ from the residential real estate market, in addition to learning the details of commercial investing. Abide by the following tips alongside your venture.
1. Understand How Commercial Real Estate Is Different
To begin, it is important for a commercial investor to comprehend that the valuation of commercial real estate differs from that of residential properties.
When comparing residential and commercial real estate, the revenue generated from commercial properties is usually tied to the usable square footage. Another notable difference is that commercial leases generally have longer durations compared to residential leases. These two factors demonstrate why investors in commercial real estate have a greater opportunity to achieve higher earnings.
According to Matt Woodley of Mover Focus, it is recommended to begin by conducting thorough research. It is important to have a clear understanding of the potential risks and rewards associated with investing in commercial real estate. Additionally, individuals should be prepared to make a substantial upfront financial investment and be willing to endure challenging market conditions.
Regardless of your investing niche, location plays a crucial role, especially in commercial investing. However, in commercial investments, investors should also focus on their tenant type. When determining demand, the location and intended tenant type are closely intertwined factors.
Analyzing recent comparables can provide a better indication of how a property of interest might perform, especially when considering factors like the intended use of space. For instance, a corporate office space is more likely to thrive in an urban center rather than a primarily residential neighborhood.
2. Analyze Comparables
The subsequent procedure involves examining comparables in the vicinity and investigating upcoming developments. Also referred to as “comps,” these assets signify the prices paid for recently sold properties that are akin in location, size, and style. Evaluating comps will assist in ascertaining the present market value of a property.
When choosing comparables, it is generally recommended to select a property with square footage that is within a range of 10 percent higher or lower than the property being evaluated. This will result in the most precise comparable sales. Further advice on obtaining the most accurate comparables can be found by referring to additional information.
3. Use The Right Success Metric
In order to participate in commercial real estate investing, it is necessary to possess a broad range of calculations and a comprehension of real estate finance. It is also essential to be familiar with various formulas related to this field.
Net Operating Income refers to the sum of the revenue and costs associated with a specific property, calculated prior to taxes. This figure provides investors with an estimation of their potential earnings from an investment, deducting all essential operating expenses. These expenses typically include insurance, property management fees, utilities, repairs, janitorial fees, and property tax.
The “cap rate,” which is short for capitalization rate, is used to determine the worth of income-generating properties. It offers investors an approximation of potential future profits or cash flow by representing the ratio between net operating income and the property asset value.
Cash on Cash is a metric used by investors who finance their commercial real estate transactions to determine the rate of return. It calculates the return on the amount of money paid out-of-pocket compared to the amount that was financed, which accurately assesses the investment’s performance.
The aforementioned formulas act as an initial overview for our comprehensive manual on real estate calculators which are essential for every investor to be familiar with.
4. Reserve Cost Contingencies
Cost contingencies refer to funds that are put aside to cover unforeseen expenses that may arise during an acquisition.
You can utilize this part of your budget to compensate for reduced cash flow resulting from early vacancies, renovations, and other initial expenses. For instance, you may have to rezone the property or employ a new property manager, which often leads to costs incurred prior to achieving a steady cash flow.
To guarantee that you have enough funds to cover these expenses, it is important to incorporate cost contingencies into your budget from the beginning. In commercial investing, a typical cost contingency budget ranges from 5 to 15 percent.
When determining the appropriate amount for your investment, you should first analyze the expected cash flow in the initial months. Will this amount be sufficient to cover early loan expenses? Additionally, consider any potential expenses related to property modifications. Even if you anticipate the cash flow to be sustainable initially, it is advisable to have additional funds as a precautionary measure.
Many investors will allocate a capital reserves fund alongside cost contingencies, serving a similar purpose in the future. These funds are intended for unforeseen expenses and are incorporated into the operating budget.
When it comes to commercial investing, it is crucial to include cost contingencies and cash reserves throughout the investment process to prevent situations where you lack sufficient funds.
5. Commercial Real Estate Investing Mistakes To Avoid
Mitigating risk is the most crucial action a real estate entrepreneur can take for the success of their business. As a commercial real estate investor, it is equally important to understand what actions to avoid, just like knowing what actions to take. The best investors of today have grasped this concept, and it is about time you did as well.
In order to increase the probability of success, it is crucial to mitigate the exposure to risks. With that being said, provided below is a compilation of common errors that commercial real estate investors should refrain from.
When it comes to valuing commercial properties, it is crucial for investors to consider the distinct characteristics that each asset possesses. Neglecting to account for all the intricacies involved in valuing an asset may result in severe financial consequences.
Consequently, it is crucial for commercial real estate investors to have a complete understanding of the property they are purchasing and its corresponding price. Failing to accurately assess the property’s true value will have repercussions throughout the subsequent stages, underscoring the significance of ensuring correctness during the acquisition.
Failing to comprehend the financial complexities of investing in commercial real estate can have disastrous consequences. Primarily, it should be understood that commercial deals differ from residential ones. Investors must educate themselves on the distinctions, especially relating to loan-to-value (LTV) or debt service coverage ratio (DSCR).
In order to make informed decisions, it is crucial to consider due diligence even in a fast-paced market. It is preferable to let someone else secure a deal rather than investing in a property without adequate preparation. Consequently, it is essential for investors to dedicate sufficient time to thoroughly understand a property before making a purchase.
Many investors prefer to work alone in order to save money, but it is unquestionably more advantageous to work with a team. Despite the apparent cost savings, working alone often results in the loss of both money and time.
When considering your actions, make sure to match your services with a skilled team and have faith in their ability to carry out the tasks you hired them for. It is highly likely that they possess greater knowledge about each process compared to you.
