Choosing between commercial and residential real estate is a big decision for investors. If you choose the wrong strategy, you could be in over your head and potentially lose money.
We’ve created an investing in commercial real estate for beginners guide to help you understand what it means to invest in commercial real estate and what it requires.
Understanding Commercial vs. Residential Real Estate
When you think of commercial real estate, you likely think of retail stores, office spaces, and medical facilities. It can also include properties with more than five units, such as apartment complexes and hotels.
Residential real estate refers to properties strictly for living in. This includes any buildings with fewer than five units, such as single-family homes, condos, and duplexes.
Commercial and residential real estate may both earn landlords rent and require property owners to manage and maintain them, but the similarities end there.
Knowing the key differences between residential and commercial real estate can help determine which investment strategy is right for you.
- Types of tenants: Commercial real estate tenants have specific needs. For example, you may get retail tenants, medical practitioners, or tenants needing office space. Residential real estate tenants strictly need a place to live. There is generally a larger pool of residential real estate tenants.
- Lease terms: Commercial real estate has much longer lease terms than residential leases typically have. Most residential leases are for one year or less, making the income less consistent and risking a higher vacancy rate than commercial real estate, which usually has leases ranging from three to 10 years.
- Income potential: Commercial real estate typically offers higher and more stable income because tenants sign longer leases. The risk of vacancy with residential properties makes the income more volatile, and rent prices are typically lower.
- Regulations: Commercial real estate faces much strict zoning and use guidelines. This may narrow your pool of available tenants. Residential properties have a single use: a place for tenants to reside.
- Initial investment requirement: Investors need much less capital to invest in residential real estate than in commercial real estate. This can sometimes be a barrier to entry for beginners in commercial real estate.
- Volatility: Commercial real estate is more prone to market downturns because businesses are usually the first to struggle when the economy struggles. On the other hand, everyone needs a place to live, so residential real estate isn’t as volatile.
Benefits of Investing in Commercial Real Estate
When investing in commercial real estate, it’s important to consider the benefits of choosing it. Like any investment, commercial real estate can be a solid choice when things go well.
Here are some of the benefits investors enjoy:
- Higher income: Commercial real estate rent prices are usually much higher than residential rent, so investors have higher monthly cash flow.
- Longer lease agreements: The peace of mind that comes with a commercial property lease can be worth its weight in gold. Knowing you have a tenant for the next 10 years versus one year can make investing much less stressful.
- Triple net leases: Under a triple net lease, commercial tenants pay real estate taxes, insurance, and maintenance plus rent. This lowers the investor’s costs in owning the property and increases potential profits.
- Diversification: Putting all your money into one investment is never a good idea, so diversifying into commercial real estate ensures you get the best of both markets when they do well and have each market to back up the losses when one market struggles.
Risks Associated With Commercial Real Estate
All investments have risks, and the higher the risk, the greater the potential returns. Here are some of the most common risks to be aware of before choosing to invest in commercial real estate for beginners:
- Market sensitivity: When there is a market downturn, businesses can be the first to struggle, especially those in nonessential industries. Lower sales can mean missed rent or broken leases.
- Property management challenges: Commercial real estate investments typically require hiring reputable property management companies. Hiring a deceptive property management company can cause you to lose tenants and money.
- Higher initial investment: Commercial properties require 30% to 40% down payments and have much higher price points. This can mean you need hundreds of thousands of dollars for the down payment.
- Liquidity issues: Residential real estate is much easier to sell when needed, and often at a price close to or higher than what you invested. Commercial real estate doesn’t have the same benefit. It’s often much harder to sell quickly, and you likely won’t get what you paid for it, depending on the current values and economic cycle.
Beginner Steps to Get Started With Commercial Real Estate Investing
Investing in commercial real estate for beginners requires several steps to ensure you get started on the right foot.
Before investing in commercial real estate, market research is essential, as is knowing the economic and employment health of the area. Not all commercial properties will be profitable. It depends on the health of the overall area and the demand for the type of commercial property you’re considering.
Assemble a team of experts
Investing in commercial real estate requires a solid team of experts who are there for you every step of the process. This team includes real estate agents, lenders, accountants, property managers, contractors, and lawyers. The right team will oversee purchasing and managing commercial real estate to help you earn profits.
Financial analysis and budgeting
A property financial analysis is the key to ensuring you make a solid commercial real estate investment. Like residential real estate, consider the rent history, property management expenses, taxes, and insurance. But you must also consider the number of units, vacancy history, zoning regulations, the property’s net operating income, and cash flow.
You must also determine your personal budget and if you’ll qualify for financing. This requires an extensive down payment and the ongoing funds to operate and manage the property.
Securing financing for commercial properties differs from residential investment financing. As mentioned, you’ll need a larger down payment, but you must also show you have the experience and knowledge to manage a profitable commercial real estate investment.
In addition to standard financial documents required for residential real estate investments, you must prove you have the experience necessary to run a commercial real estate investment with documented proof, such as profit & loss statements.
Research is the key to successfully investing in commercial real estate. Consider the property’s cap rate, cash-on-cash return, and net operating income. Compare these numbers to your overall investment plan to see how they fit.
Common Strategies for Investing in Commercial Real Estate
Investing in commercial real estate for beginners offers many options, from direct investment to crowdfunding; there are opportunities at every income level.
Most people think of direct investment when investing in commercial real estate. This means purchasing a commercial property and renting it to tenants. This requires large down payments, qualifying for financing, and understanding how to manage the property for the duration of ownership.
Real estate investment trusts (REITs) are real estate holding companies that purchase commercial real estate properties and sell shares of their companies to investors. The investors become real estate investors by default and earn a prorated amount of the portfolio’s return. This is a hands-off approach to real estate investing.
Real estate syndication
If investing in commercial real estate alone seems overwhelming, you can join a real estate syndication, a group of real estate investors who pool their assets and resources to invest in real estate properties. This gives you more power than investing in REITs and decreases the capital required and your overall risk. The profits, appreciation, and ownership percentages directly correlate to the size of your investment.
Crowdfunding real estate platforms make commercial real estate investing possible for more investors. Some crowdfunding platforms have low investment requirements—as low as $100. This commercial real estate investment strategy is 100% passive, meaning you don’t have to do any work to manage the property. You invest money and collect your portion of the profits as they occur.
Managing Your Commercial Real Estate Investment
A major component of investing in commercial real estate is managing it. Consider these factors when deciding if commercial real estate investments are right for you.
When investing in commercial real estate, you must determine whether to manage the property yourself or hire a professional property manager.
Property management includes running the day-to-day operations of owning commercial real estate, managing the property’s maintenance plan, tenant management, handling vacancies, collecting rent, and budgeting and reporting.
Hiring a property management company increases your expenses but decreases the time and effort you must use to manage the property.
Improving and upgrading properties
Improvements and upgrades can help you save money in the long run and earn higher rents. Tenants are always looking for upgraded spaces with the latest amenities. Upgrading commercial spaces also decreases repair costs and makes the property last longer.
Handling tenant relations
The most significant part of commercial real estate investing is developing tenant relationships. You’ll negotiate lease and lease renewals, collect rent, discuss rent increases as allowed in the lease agreement, and handle any tenant needs within the lease agreement.
Legal & Tax Considerations
Taxes and legal considerations are significant in commercial or residential real estate investing.
Generally, residential real estate properties have lower property tax rates than commercial, but commercial real estate properties have shorter depreciation periods than residential properties (27.5 years versus 39 years).
It’s vital to have a powerful real estate team to ensure you understand your legal and tax requirements, both before choosing a real estate investment and while owning it.
Investing in commercial real estate for beginners requires a strategic plan, due diligence, and a solid real estate team. With the right people by your side and adequate research, you can diversify your real estate investment portfolio to include residential and commercial real estate investments.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.