Commercial Investing: How to Get Started
Investing in commercial real estate can provide higher returns than its residential counterpart. There is also less volatility, as longer-term leases are the norm. The tax benefits are significant. Still, a considerable learning curve exists when it comes to commercial investing. Here’s some advice when getting started and basic tips.
Before starting commercial investing, understand exactly what constitutes a commercial property.
Commercial properties include:
- Industrial buildings
- Office buildings
- Retail buildings
- Shopping centers
- Strip malls
- Storage facilities
Apartment buildings are also considered commercial properties for investment purposes.
Commercial Investing Pros
Commercial investing provides various advantages. These include:
- Depreciation: Commercial properties are usually depreciated over 39 years. That means you can deduct 1/39 of the building as well as improvement costs over that period.
- Tax benefits: One of the great strengths of commercial investing involves tax breaks. Besides mortgage interest and property tax, property owners can deduct the costs of repairs, maintenance, some property management expenses, and certain operating expenses.
- Triple net lease: This is one of the most common leases in commercial real estate. A triple net lease puts the burden of paying rent, property taxes and insurance on the tenant. The tenant is also responsible for certain maintenance costs. In return, the base rent is generally lower.
In addition, commercial tenants tend to keep the premises in better condition than residential tenants. That’s because a lack of maintenance or cleanliness reflects on their business. The overall relationship between the tenant and the landlord is generally more professional. This is because both are operating businesses.
Commercial Investing Cons
There are also downsides to investing in commercial real estate. Commercial investing generally involves a large amount of capital. More so than in most residential real estate investing.
If you’re a small commercial landlord, expect to put a great deal of time into your investment. Commercial investing differs from residential investing in many ways. But overall management is more demanding.
In addition, there’s less of a DIY aspect in commercial investing as compared to investing in smaller residential properties. You’ll almost certainly have to hire a property manager to maintain the premises. And this can cost up to 10 percent of your rent revenue. If you are a licensed professional, you may prove able to handle commercial property repairs. But otherwise, you’ll need to hire licensed contractors and the like.
Many types of commercial properties are open to the public. And due to this, the liability risk is much higher than with residential properties. The odds of facing a lawsuit for slips and falls and other situations is much greater.
Larger capital expenditures occur than with residential investments. Regular maintenance is costly but cheaper than waiting until an emergency occurs. For instance, if the HVAC system breaks down in the middle of winter or in the midst of a sweltering summer, it requires immediate, and expensive attention.
Commercial Investing in REITs
For those just starting out with commercial investing, Real Estate Investment Trusts (REITs) make sense. Similar to mutual funds, REITs focusing on commercial properties pool investor monies to purchase real estate. Investor do not have to buy such real estate on their own. REITS operate much like mutual funds. And investors can get started buying shares with relatively little money.
Along with publicly-traded REITS, there are also private REITs. The latter are not regulated by the SEC or traded on stock exchanges. In contrast to publicly-traded REITS, private REITS may have little public performance data for investors. Because they are not traded publicly, private REITs are illiquid.
Only institutional investors, those holding a Series 7, 65 or 82 financial professional license and accredited investors may purchase private REITs. As per the SEC, accredited investors are those who “earned income that exceeded $200,000 (or $300,000 together with a spouse or spousal equivalent) in each of the prior two years. And reasonably expects the same for the current year, OR has a net worth over $1 million, either alone or together with a spouse or spousal equivalent.” That value excludes that of the person’s primary residence.
Commercial Investing and LLCs
The owners of most commercial properties form Limited Liability Companies(LLCs). They do this rather than owning the property in their individual names. All LLCs must register in the state in which it conducts business. An LLC helps commercial real estate owners avoid personal liability if someone is injured on the property. Your personal assets are not at risk should a third party obtain a monetary judgment. The third party could obtain a monetary judgment from the court. However, this does not mean the property must be sold right away to pay the creditor. Instead, a lien is placed on the property. And this requires payment if and when the property changes hands.
Gross Rent Multiplier
If you plan to invest in commercial property on your own or with partners, remember that investing in commercial real estate means you must find the best deals quickly. That entails an efficient method to analyze and compare potential properties. That’s where the gross rent multiplier (GRM) can help. The GRM is the metric used by commercial real estate investors to compare properties based on market value and rental income.
While not the definitive property value indicator, it’s one of the most effective screening tools. The GRM indicates the price-to-rent ratio. Once you’ve determined these figures, you can ascertain whether a property is worth further investigation.
Calculate GRM by dividing the purchase price by the annual rental income. Just consider the gross rental income. And leave property taxes, insurance, management etc, all out of the equation. However, do include all sources of rental income. For instance, a property may have non-tenant income, such as parking lot rental.
As an example, if a $1 million property generates $100,000 in annual gross rental income, it has a GRM of 10. It also means it would take 10 years for the property to pay for itself.
Acceptable GRM numbers are generally between four and seven. Keep in mind a GRM number only makes sense when comparing similar properties. Don’t compare the GRM of an office building with that of a strip mall. As with anything real-estate-related, location is another prime factor.
Commercial Investing Considerations
Commercial investing requires a great deal of due diligence and effort. If you have several tenants on your property, that means dealing with multiple leases. Expect management to take up a great deal of time. Still, the potential rewards of commercial investing are substantial. Make sure to find a lawyer and accountant specializing in this field to help guide you.