Although my primary rental property investment focus is 2-4 unit multifamily residential properties, I have dabbled in commercial real estate in the past. Commercial property can be extremely lucrative, but it is certainly not for the faint of heart. What follows are some of the key differences when investing in commercial properties compared to traditional residential properties.
WHAT IS COMMERCIAL REAL ESTATE?
First, let’s define the 9 key commercial real estate niches available. They are large apartment buildings, self storage facilities, mobile home parks, retail spaces, office buildings, warehouses & manufacturing facilities, land development, hotels / resorts and health care outfits. These types of investments differ from traditional residential real estate in several ways.
DIFFERENCES BETWEEN RESIDENTIAL AND COMMERCIAL PROPERTY
The first major difference relates to the determination of property value. For a residential investment property, this valuation primarily encompasses the land and the building itself – what kind of shape it is in, the appliances, the updates, etc. For commercial properties, the income potential is the primary determination of value. The rent for commercial property is based on dollar per square foot per unit, and this number can change with swings in supply and demand. Thus, if the situation is high demand, low supply, the income potential of the property will be substantially greater and hence it’ll be worth more.
Banks are hoping that the incentive payments will cut out resistance from homeowners and offer up the best solution for all. It is a win-win for the banks, particularly because they skip out on a potentially long legal battle on the one hand, and take advantage of making a better deal through a short sale on the other.
Another major difference relates to the financing. Of course, your down payment amount will be greater at the commercial level because the value of the underlying asset is always going to be greater than that of a traditional residential real estate investment. Plus, the standard down payment amount for commercial real estate can be up to 30% of the sale price. Also, you can expect the rate on a commercial loan to be a little higher compared to residential real estate. On the plus side, seller financing is generally easier to find at the commercial level, which can be beneficial because this eliminates the need to go through a bank.
Another difference relates to the typical rental terms and leases. At the residential level, a typical tenancy agreement will cover 1 year, and as such the month-to-month vacancy rates can hurt your numbers. For commercial properties, your lease terms are longer – generally 3-20 years – and there is usually a provision in the lease for annual rent increases. Plus, commercial real estate caters to business tenants, so the overall quality of the tenants tends to be better. And as an added bonus, commercial property is subject to triple net, which means that the tenants are on the hook for paying property tax, insurance and property maintenance.
Commercial property management is another consideration. At the residential level, typically you are the property manager. This is time consuming and, to be honest, being a landlord is really not that much fun. At the commercial level, property management fees are typically already included in the property’s valuation. This means you can hire a professional commercial property management company and remove yourself from the day to day management of the property.
BENEFITS OF COMMERCIAL PROPERTIES
Banks are hoping that the incentive payments will cut out resistance from homeowners and offer up the best solution for all. It is a win-win for the banks, particularly because they skip out on a potentially long legal battle on the one hand, and take advantage of making a better deal through a short sale on the other.
As you can see, there are a ton of benefits of commercial real estate investing. For one, the income potential is much greater. Also, the cost per unit is generally lower at the commercial level compared to the residential level. Simply put, having 20 units under the same roof is less expensive than having 20 roofs. Another benefit is the higher quality tenant base, coupled with the longer lease terms and the built-in annual rent escalation clauses. Yet another benefit is that you do not have to manage the property yourself – you can simply hire the commercial property management. And of course, with any real estate investment you’ll be able to enjoy a plethora of tax benefits.
DISADVANTAGES OF COMMERCIAL REAL ESTATE
Obviously the main downside is that there is a lot of incremental risk compared to traditional rental properties. The learning curve is greater (state legalities, deal complexity, etc.), and more of your capital will be tied up in the acquisition of the asset because you’ll need various inspections, an attorney, etc. Similarly, economic problems can have a greater impact on the tenants of commercial property compared to a residential property.
CONCLUSION
Commercial real estate is a great investment if you have access to a lot of capital, have some spare time, and you have experienced people on your team to help you navigate the complexity of these deals. Yes the risks are higher with commercial properties, but so is the potential payoff. Just learn as much as you can, and tread carefully when evaluating any commercial property deal, and you’ll do just fine.