Commercial Real Estate Investing: Everything You Need To Know

Most people know what residential properties are but wonder, “what makes something a commercial property?” Commercial real estate is defined as a property that is leased to tenants who generate income with business and retail activities. Vacant land zoned by a local municipality for commercial purposes is also considered commercial real estate.

This is different from residential real estate, which includes single-family homes used as primary residences and rental properties with less than four individual units. There are five main categories of commercial real estate:

Read on to learn about these commercial real estate categories and think about which type of commercial real estate properties might work for you.

Retail

Commercial properties with tenants that sell products or services to consumers are retail commercial real estate properties. This includes individual retail stores, malls, restaurants, and banks, just to name a few.

The size of retail properties can vary greatly. For example, a mall can be upwards of 300,000 square feet, and a small bakery can be under 2,000 square feet.  Retail commercial real estate investments can be profitable if the tenants have thriving businesses. That means they can afford high rents and pay them on time.

If the retail sector slows down (like during a pandemic), retail commercial real estate investments become less valuable. If the businesses aren’t making money, they won't be able to afford their rent.

Cities or towns with a vibrant, bustling downtown area are good places to look for retail commercial real estate. Steady population growth and a higher than average median income are good indicators of a location where retail real estate properties thrive.

Office

Perhaps the image most people think of when contemplating commercial real estate is a big high rise office building. This is the most common form of commercial real estate in the country, and the types of office buildings can range from a single office to a skyscraper with a hundred or more offices. 

Areas with high population growth and a robust job market are good places to invest in office buildings. After all, the more people working, the more office space they will need.

Offices are divided into three main categories: Class A, Class B, and Class C, as follows:

Industrial

Commercial real estate used by manufacturing and distribution companies is usually considered industrial property. Industrial buildings are often warehouses or manufacturing plants making products. An automobile factory is an excellent example of a commercial real estate industrial property. 

Industrial real estate can be expensive, as there are often many unique requirements like the height of loading areas to accompany semi-trucks. They are also usually quite large, making land acquisition and construction costs higher than other types of commercial real estate.

Multifamily

Apartment buildings, condominiums, and other commercial real estate with many residents are referred to as multi-family properties. Multifamily apartment buildings in heavily populated areas with high home prices are excellent commercial real estate investment opportunities. Many people are forced to rent when home prices are high, creating a large pool of potential tenants for apartment building owners. 

However, residential tenants usually are in their apartments for a shorter period than retail tenants. This means there is more turnover and vacancies, resulting in a loss of rental income while you search for a new tenant.

Special Purpose

Commercial real estate properties that are designed for a specific use and could not be easily converted to a different use are considered special purpose properties. Gas stations, schools, and car washes are examples of special purpose commercial properties. 

Tourism is an industry where many special purpose commercial real estate properties can be found as well. Hotels, airports, and theme parks fall in this category. In addition, mixed-use developments that combine apartments, retail, and offices all in one building are also often considered special purpose commercial properties.

Owner-occupied commercial real estate (OOCRE) refers to any of the aforementioned properties that the owner occupies all or part of. For example, you might have a company that needs office space. If you purchase an office building and use all or part of it for your company, that would be an example of OOCRE. 

This is akin to renting out part of your house to help cover your home mortgage in residential real estate. If you have other tenants in your office building besides your company, you can offset the cost of paying the commercial loan you used to buy the property.

Commercial real estate investing can be an excellent way to grow your investment portfolio and achieve financial freedom. It can also be enriching from an educational and professional development standpoint. The skills you learn can apply to any business, and the income streams you create from commercial investing can help you lead the life you want. Read on to learn about some of the many benefits of investing in the commercial real estate sector.

Passive Income

Buying a commercial property or investing in commercial real estate stocks are just a few of the many ways (more on that later) you can create passive income through commercial real estate investing. Most of us are familiar with active income, the traditional work model where we go to work each day and receive a paycheck every two weeks. On the other hand, passive income means we do some work on an initial investment and then watch the money roll in each month without working from 9 to 5 each day.

Good Risk/Reward

Someone once said that real estate was a good investment because it's the only thing they aren't making any more of. Commercial real estate holds to this adage because the rewards often outweigh the risks.

The rewards can be substantial if you understand the steps for successful commercial real estate investing (we will go over those later). Any investment comes with risk, but the historical track record of commercial investing shows that the risk compared to other investment strategies is relatively low.

Reliable Income Streams

Commercial leases provide a few key benefits over residential leases regarding real estate investing. First of all, commercial tenants usually have much longer leases, so you don’t have to worry about a high tenant turnover rate. 

In addition, contracts with business tenants are often more desirable for the property owner. For example, most commercial real estate tenants sign a triple net lease. This means their company pays for all of the expenses associated with the property, including taxes, insurance, and maintenance. This is something you won’t find in residential real estate investing.

No 24- Hour Work Days

Owning a residential investment property means being on call 24/7 for your tenants. From toilets clogging to basement flooding and everything in between, you never know when you might need to spring into action.

As a commercial real estate investor, you only need to be ready to help your clients during regular business hours. If you prefer to protect leisure time in the evenings and weekends, commercial real estate investing can help.

Now that you know the why let’s cover the how. Commercial real estate investing can take both active and passive forms. Let’s start with how to invest in real estate without buying property, for those of you who are looking to invest in real estate without being a landlord. Then, we will cover the more active approaches that involve purchasing commercial property.

Commercial Real Estate Stocks And Mutual Funds

Perhaps the easiest way for investors familiar with traditional stock and mutual fund investments is to target these types of financial instruments that deal with commercial real estate. You’ve probably heard the phrase “buy low and sell high” regarding good stock market investing. Achieving this can be tricky with volatile markets like cryptocurrency. 

With prices rising and appreciation steady over the last few decades, commercial real estate stocks and mutual funds often have a significant rate of return. There are risks with any stocks and mutual funds, but choosing ones that focus on a booming industry (like the real estate industry) is a pretty safe bet.

REITs

Real estate investment trusts (REITs) pool money from various investors to purchase, manage and sell real estate. Commercial REITs focus on properties zoned for commercial purposes. 

REITs make money in two primary ways for their investors. First, they make money by managing properties they purchase by collecting rent from tenants each month. Second, they sell properties once they have appreciated enough to garner a healthy return. 

ETF

If you want to invest in multiple REITs simultaneously, consider a real estate exchange-traded fund (ETF). With this investment model, a fund manager selects several real estate securities to invest in. This can include many different REITs and other commercial real estate stocks. 

ETFs appeal to investors because they can mitigate risk by spreading their money across several different companies and industries.

Commercial Real Estate Crowdfunding

You can become a commercial real estate investor using a real estate crowdfunding investment platform for as little as a few thousand bucks. These platforms have a vetting process before opportunities can be listed on their site, but you should do your own research as well.

Crowdfunding real estate investment opportunities often have a two or 5-year window during which your funds are tied up in the investment. That means they aren't great for liquidity, but their returns are usually higher than REITs and ETFs.

Commercial Real Estate Funding Partner

You can be even more passive as a real estate investor by backing a funding partner. You simply act as a silent partner and let the other person or group handle all the commercial real estate investing decisions. Simply write a check upfront and wait for the income to roll in (as long as you choose the right partner, of course).

Consider purchasing a commercial property for a more active approach to commercial real estate investing. This can provide healthy monthly rental income and a significant ROI when you sell after the property has appreciated over time. To be successful, you will need to know the proper steps.

Know The Differences Between Commercial And Residential Real Estate

Commercial and residential real estate are very different beasts. Commercial leases often last much longer than residential leases, which is appealing to commercial real estate investors. Conversely, it usually takes longer to find a commercial tenant than a residential one, so extended vacancies must be accounted for.

The type of tenant needs to be more carefully scrutinized for a commercial lease. Does the area support the kind of business moving in? Is it sustainable long term? For example, a retail store is much more likely to prosper in a bustling city center than on the outskirts of town. These are issues that don't come up with residential renters. If they qualify financially, that’s all you need to know.

Evaluate Opportunities

Researching and evaluating commercial property purchase opportunities starts with finding comparable recent sales. Find commercial properties with similar features, size and location and see what they sold for. 

If there are no recent sales that compare to the property you are researching, you may need to make some adjustments. For example, if a commercial building around the corner sold for $1,200,000 but is twice as big as the property you are looking at, your offer may be more in the $500,000-$600,00 range. As a general rule, if the square footage difference between the property you are thinking of purchasing and a comparable is less than 10 percent, it’s a good comparison. 

Once you have good comparables, think about the property's area. Is it suited for the type of business? Have the businesses occupying the property been successful for an extended period? The better the track record of success is, the less risk you take.

Next, look at the condition of the building. Is it going to need significant repairs or improvements to be profitable? If so, is the investment you will need to make to bring it up to snuff worth the potential leasing income?

Define Success

You can’t enjoy financial success if you don’t know it when you see it. Think about what you want to accomplish before getting into commercial investing to make sure you get what you want out of it. A few different success metrics to consider are net operating income, cap rate and cash on cash. 

These can be defined as follows:

All three of these metrics are essential to successful commercial real estate investing. Still, some might be more important to you than others, depending on your specific financial circumstances and goals.

LOI

Once you have found a property that you want to make an offer on, it’s time to draft a letter of intent (LOI). This includes the property address, the amount you are willing to pay, and other purchase terms like the inspection period and other contingencies.

This isn't a legally binding contract like a purchase agreement, but it allows the buyer and seller to evaluate the deal with preliminary terms. If the general framework of the LOI appeals to both the buyer and seller, then a formal contract can be written up and signed.

It’s important to note that you should have a commercial real estate attorney review any LOIs or contracts before signing on the dotted line.

Commercial Real Estate Financing

The next step is figuring out how you will pay for your new commercial property. If you are paying cash, it’s pretty simple. If you will use a loan, it’s essential to do your research and select the best option for your situation.

Commercial Real Estate Inspection

Once you have secured financing and signed a contract to purchase commercial real estate, it’s time to do a formal inspection of the property. Commercial real estate inspections are much longer than residential inspections. They can take anywhere from two weeks to two months. 

During this period, a professional commercial property inspector will review every part of the property. This might also include a property boundary survey and an environmental survey. Your lender usually orders this inspection if you use a loan to purchase the property. 

Once the inspection report is complete, you can renegotiate the terms of the deal with the seller or walk away from the deal.

Commercial Real Estate Closing And Managing

Once you are through the inspection period and your loan is approved, it’s time to close on the property and begin managing it. Closing involves simply signing a few documents and making sure the money is wired. Managing the property is a little more complicated.