Is commercial real estate (CRE) a good investment for entrepreneurs? There’s no one-size-fits-all answer. While CRE can provide investors with better returns than residential properties (an average of six percent to 12 percent annually versus one percent to four percent in residential properties), they also require more of an initial cash outlay.
Entrepreneurs need to know the facts about commercial real estate before deciding whether it’s a good investment for them. Here are nine things to consider.
- What Are Your Goals?
This one is key to every financial decision, and it’s no less true of CRE. Are your goals to buy and hold for annual return? To buy and sell in a few years to realize profit? For each, how much return or profit are you seeking? Are you looking at CRE to enhance your tax picture? Do you want to own a single property? Redevelop a property for more future income? Own a portfolio of properties?
A disciplined plan needs this bedrock analysis of your own investment goals.
- What Is the Outlook for the CRE Market?
The robustness of CRE real estate markets, like residential real estate, varies greatly by region and city in the US. Some places, such as Las Vegas, have suffered downturns both in rents and in vacancies. Others, such as the San Francisco Bay Area, have high rents and few vacancies. The fortunes of commercial real estate often reflect those of the overall economy in the area.
Do research to determine the current and past economic performance, as well as the forecast for the future.
- What Are Your Investment Parameters?
While CRE might offer a higher annual return, it also requires a higher annual investment. Robust real estate markets might offer low vacancy rates, but they are also more likely to be higher-priced. Assess how much of an investment you are prepared to make. How much of a return are you aiming for?
The answers to these questions will tell you the number of buildings, type and market that suit your investment profile.
- What Type of CRE Do You Want to Invest In?
CRE covers a wide range of property types. Office parks, warehouses, industrial buildings and malls are all CRE properties. So are large apartment buildings and mixed-use buildings that combine, say, offices with a residential tenant. Each of these types have a profile for the amount of involvement required of an investor and the investment picture.
There are also CRE Real Estate Investment Trusts (REITs), which allow investors to purchase a portfolio of properties managed by asset managers. In this case, investors are not themselves managers of the CRE and do not directly engage with the physical property.
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- What Are the Financial Parameters of Potential Properties?
There is no substitute for a detailed financial analysis of the properties you are thinking about. At a minimum, you should know net income (income less expenses), expected return on investment (the cash flow less any investment costs), the cash flow (net income minus any debt financing payments), the capitalization rate, the total return on investment (cash flow, accrual of equity, appreciation of the property and taxes), and the cash-on-cash return.
- What Is Your Risk-Reward Profile?
Before placing your investment capital into CRE, think about your risk-reward profile for all your investments and how CRE contribute to your overall portfolio. For example, many investors want to move into real estate investments because other types of investments are getting low returns and/or they want to diversify their investments. US bond yields, for example, have been very low. The stock market fluctuates, and an individual investor might see real estate as more stable.
In periods of rapid real estate price appreciation, CRE investments can return handsomely. However, if real estate depreciates, or the economy affects prices and vacancy rates, CRE investments can also fall.
Another factor is ease of selling the investment. Real estate in general is not as liquid as bonds or stocks, which can be sold on an open market relatively quickly. REITs, on the other hand, trade as stocks with real estate as the underlying investment. As a result, REITs are as liquid as stocks. Investors need to consider their comfort with physical CRE versus REITs.
- What Do Your Tenants Contribute to the Investment?
As investors are thinking through the type of CRE to invest in, they need to consider the tenants and how they contribute to the investment. Small business tenants who are open to the public, for example, have a vested interest in the upkeep and maintenance of the property. A better-maintained property will draw more clients and customers.
A factory or warehouse, in contrast, may have less incentive to maintain and upkeep the properties. That may place more responsibility for upkeep and maintenance on the property owner.
- Are You Comfortable With Landlord Responsibilities?
CRE landlords often have fewer responsibilities than residential ones. Most CRE property is maintained by a professional organization, for example, so CRE landlords are not called upon to fix a broken water heater themselves. However, business CRE can have more risk simply from the variety of people entering the business property — far more than would enter the average business property.
That’s more opportunity for broken windows and damaged displays. Assess whether you would be comfortable responding to this in your own property.
- What Variety of Leases Are Available?
Some tenants would prefer to hold a type of lease known as a triple net. They pay the property expenses themselves (including taxes), rather than paying rent to a CRE landlord who then pays the expenses. In these cases, the CRE property holder pays only the mortgage. Why would a tenant prefer these? Many large chains, such a Starbucks and CVS, want to maintain the property to reflect their brand. Via being responsible for the expenses, they can set up things like signage and frontage to their specifications.
These types of leases can be very advantageous to a landlord, because it reduces the outlay. However, it may also reduce the tax advantages of property ownership.
Making sure you know the answers to these questions will ensure success as a CRE investor. Take the time to know the answers to each.
9 Questions Entrepreneurs Should Ask Before Investing in Commercial Real Estate