Understanding Commercial Real Estate
What exactly is commercial real estate? Think of it as non-residential property that can generate profits through rental income or capital gain. There is a distinct difference between investments in residential and commercial properties. With commercial real estate, the investment and income potential can be larger, and you can’t live in the property.
Types of Commercial Real Estate
Commercial Real Estate is generally classified into five major types:
This is for stores and restaurants. They are multi-tenant, lead tenant, or anchor. They can also be standalone for single use. Single-use stores are usually big-box like Target, Best Buy, Kohls, and Walmart.
Office buildings are a common type of commercial real estate. There are also two types within this subset – suburban or urban and ranked by Class A, B, and C.
Suburban office buildings can be found in office parks and generally have a smaller footprint than urban properties. Urban office buildings on the other hand are located in major cities and could be high-rises and skyscrapers. Many companies and company offices are located in these buildings.
Class A is for premier offices and commands a higher premium. Class B is for fair to good buildings and finishes and is for the general market. Class C is for those who need space to conduct business. The rents are usually below average.
Industrial buildings are usually right outside urban areas and are located on major routes of transportation. You can find them in office parks or standalone. These have four types: heavy manufacturing, light assembly, bulk warehouse, and flex industrial. Research and Development buildings (R&D) are also typically lumped under the industrial umbrella, but are highly specialized.
Multifamily commercial real estate includes buildings that house multiple families such as co-ops, apartments, townhomes, and condos. They also fall under the classification of A, B, and C.
Special purpose buildings are commercial buildings that serve specific purposes. Examples include casinos, self-storage, bowling alleys, amusement parks, and churches.
Why Commercial Real Estate
Generally, investors will consider a commercial real estate investment for its potential ability to provide long-term, consistent income. This is because commercial properties typically generate regular cash flows from lease payments. Compared to residential real estate, commercial real estate will generally have longer lease contracts with tenants – helping to improve the predictability of cash flows.
Passive vs Active
There are two primary ways to access commercial real estate investing: passive and active.
Passive investment options, include Real Estate Investment Trusts (REITs) and real estate funds.
If you’ve seen people “flip houses” or have development or renovation projects in motion, these are examples of active investing. The investor is very involved and has dedicated time and money. There is a significant level of risk involved and it requires dedication from the investor.
Real estate investment trusts (REITS) are popular in commercial real estate investing because they are easy to access. Individuals may buy shares in a REIT like a regular stock on a major stock exchange. These companies finance or own multiple properties across property types while paying dividends to their investors.
There are certain qualifications to meet in order to be classified as a REIT. In order to qualify as a REIT, the company must be prepared to invest 75% of its total real estate assets, with 75% off its gross income from real property rent, mortgage interest when financing real property or from real estate sales. It also must pay 90% or more of the income generated to its investors.The company must also be taxable as a corporation managed by trustees or a board of directors. No more than 50% of the shares can be held by five or fewer and there must be a minimum of 100 shareholders.
A REIT ETF is a fund of REIT stocks. These ETFs passively invest by tracking the indexes of publicly traded real-estate owners. Most of the investment in these exchange-traded funds are assets in equity REIT securities and other similar derivatives.
Investors who want to invest in real estate who choose a REIT ETF may do so in order to invest in diverse properties with a low investment. The advantage is that ETFs operate like shares of stock on the market and can be bought and sold intraday.
There are pros and cons to REIT ETFs. While your exposure is diversified due to widespread real estate holdings, they are usually only tied to one or two types of properties. ETFs could also have additional costs and fees that could lessen the income received from investing in a REIT.
This is a popular solution for investors looking to get in the business, allowing developers to merge different investments from a larger group of investors with the objective of funding a project or venture. This helps raise money quickly. In most cases, these are REITs that have their own set of regulations but this is a great option for a diverse group of investors.
A real estate limited partnership (RELP) is a group of investors merging funds to invest in the purchase, development, and leasing of property. This method is typically used when funding for larger products is needed.
Active commercial real estate investing can include directly investing in properties. For that type of investing, there are a few typical stages to the process. Some of those phases are explored below.
Commercial real estate investors will look for investment opportunities through various sourcing sites like Loopnet, Crexi, Craigslist, and others. These platforms are online marketplaces that list commercial properties for sale and lease.
In commercial real estate, every transaction may have a due diligence period. This is when the purchaser visits the site to examine and inspect all aspects of the property. Some people choose to call it the investigative period. During this time, the purchaser may review the title and survey, and inspect the property in its physical, ecological, and environmental states. They may also do physical inspections of every structure attached to the sale, and all the mechanical systems to ensure everything is in working condition. The purchaser is usually responsible for any expenses during this inspection period.
Much like a residential sale, the due diligence process occurs either before or after signing the purchase contract. Every situation is different. In most cases, the due diligence period is about 30 to 60 days, with additional or less time adjusted as needed.
With commercial real estate, this can be a tedious process, as there might need to be confirmation of governmental approvals, permits, zoning, and more. At the onset of the deal, the purchaser could negotiate their right to cancel the contract during the due diligence period if the property is not up to par. Experts advise to work with a commercial real estate attorney to ensure the due diligence process is thorough and complete.
Commercial real estate investors may need to secure funding after they have executed a binding contract. In most cases, a commercial loan is the first option, but there are alternatives:
Repayment may be short or long-term with repayment from two years to 30 years.
SBA504 loans and SBA7a loans are backed by the government and are between 10 and 25 years.
There are a few forms of owner financing that someone might consider. One such is a hard money loan which is short -term at a high-interest rate based on the perceived value of the property. Another option is the online marketplace loan, which can also be called a soft money loan. The interest rates are high, but the objective is to match a borrower to investors. The third option is a joint venture loan where the investor is unable to get financing or does not want to take on all the risk on their own. In this case, two or more entities apply for financing in a joint venture where they equally share the risks and returns of the commercial property.
In a commercial inspection, an engineer or architect is usually involved. They may understand unique aspects of commercial properties and may find something that was overlooked by a general building inspector. If this route is taken, the fees associated with this inspection may be very high. The next option would be to hire a commercial building inspector who specializes in commercial inspections and understands the logistics of commercial properties. During the inspection, five major systems are typically evaluated: the roof, the integrity of the structure, the electrical systems, the plumbing, and the heating, ventilation, and air conditioning (HVAC).
This post is provided for informational and educational purposes only. It is not intended to be investment advice and should not form the basis of an investment decision.