- What is Commercial Real Estate?
- Key Benefits of Commercial Real Estate Investing
- Potential Risks and Drawbacks of Commercial Real Estate
- How to Get Started With Commercial Real Estate Investment
- Direct vs. Indirect Investment in Commercial Real Estate
- Commercial Real Estate Investment Strategy and Returns
- Tips for New Commercial Real Estate Investors
- Financing Commercial Real Estate Investments
- Finding Investors for Commercial Real Estate Deals
- Conclusion
- Frequently Asked Questions
Commercial real estate (CRE) investing has long been a way for investors to diversify their portfolios and earn attractive returns. With the right strategy, commercial real estate investment can produce stable cash flow along with long-term equity growth. However, CRE investing has unique complexities and risks that beginners must understand before getting started.
This comprehensive guide provides an in-depth look at everything you need to know to successfully invest in commercial real estate as a beginner. We’ll cover the fundamentals of commercial properties, the benefits and risks, how to get started, investment strategies, financing, finding investors, and tips for new investors. Let’s get started!
What is Commercial Real Estate?
Commercial real estate (CRE) refers to any non-residential property that is used to conduct business or earn income. This includes:
Office – Office buildings are one of the core CRE property types, consisting of multi-tenant buildings leased to businesses. Major office investment markets include New York, Chicago, Los Angeles, and other major metro areas.
Retail – Retail CRE includes shopping malls, big box stores, restaurants, and more. Grocery-anchored shopping centers are a popular retail investment strategy.
Industrial – Industrial encompasses warehouses, distribution centers, manufacturing facilities, and similar properties focused on logistics and production.
Multifamily – Multifamily properties are apartment complexes or communities that offer rental housing units. They range from garden-style to high-rise apartment towers.
Hospitality – Hospitality CRE consists of hotels and other lodging properties that provide short-term accommodations.
Specialty – Specialty commercial real estate covers niche property types like self-storage, medical offices, senior housing, and more.
The total estimated value of U.S. commercial real estate is over $17 trillion. Investing in CRE allows participating in this massive asset class and diversifying beyond stocks and bonds. Now let’s explore the benefits of CRE investing.
Key Benefits of Commercial Real Estate Investing
There are many advantages that commercial real estate investment offers over other asset classes:
Higher Yields – The income-producing nature of CRE offers yields significantly higher than stocks and bonds. Cap rates typically range from 4-10% for stabilized commercial properties, generating steady cash flow.
Appreciation – Well-located CRE properties appreciate in value over the long term, averaging 1-3% annual growth on top of yearly rental income. Properties in growing markets see the strongest appreciation.
Diversification – The returns from CRE have a low to negative correlation to stocks and bonds, making it an excellent portfolio diversifier. Real estate cycles differently than the broader market.
Long Term Leases – CRE leases with business tenants are typically 3-10 years long or more, creating stable rented income for landlords over an extended period.
Inflation Hedge – During inflationary periods, CRE values and rental incomes tend to rise along with consumer prices, providing a buffer against rising costs.
Loan Paydown – Monthly mortgage payments pay down principal over time, increasing the landlord’s equity and net worth in the property.
Tax Benefits – CRE investors can realize tax savings from cost recovery deductions, mortgage interest, and deferred capital gains taxes when using tax-deferred strategies.
However, commercial real estate investing also comes with significant risks and disadvantages.
Potential Risks and Drawbacks of Commercial Real Estate
While CRE offers enticing benefits, it’s critical to also weigh these downsides before investing:
Large Capital Required – CRE properties are expensive, often requiring millions in capital. Investors must have substantial funds or financing lined up.
Specialized Expertise – Effectively operating CRE requires specialized skills like property management, leasing, and tenant relations. Learning curves can be costly.
Tenant Risks – Vacancies and tenant defaults are an ongoing risk that cuts into returns. Careful tenant vetting and diversification is crucial.
Management Oversight – Even with a property manager, CRE investors must actively oversee their assets. Remote or passive ownership often leads to underperformance.
Leverage Risks – While lending allows purchasing larger properties, it also compounds risks. Declining property values can prompt lenders to foreclose.
Lack of Liquidity – Commercial properties take significant time and fees to sell, especially compared to stocks or bonds. Accessing invested equity can be difficult.
Susceptible to Economic Cycles – Recessions that reduce business activity risk higher vacancies and lower rents, directly impacting CRE incomes.
Regulation and Zoning – Local zoning changes or new regulations could restrict uses for a property and potentially hurt value.
Now that we’ve weighed both the pros and cons, let’s turn to how beginners can actually get started in commercial real estate.
How to Get Started With Commercial Real Estate Investment
Launching your commercial real estate investing endeavors takes preparation and strategic planning. Here are the key steps:
Mindset and Setting Investment Goals – Adopting a business mindset is essential. Determine your targeted asset classes, markets, expected returns, and timelines for holding periods and exit strategies. Set realistic goals before investing significantly.
Choosing a CRE Investment Strategy – Study the core investment strategies – core, value-add, and opportunistic – and decide which matches your risk tolerance, experience, and financial capacity. Identify target property types and locations. Assess potential barriers to entry in your chosen niches.
Selecting a Business Structure – Will you purchase CRE investments under your own name, jointly with partners, or through entities like an LLC or corporation? Consult with financial and legal specialists to determine suitable structures for liability protection, tax considerations, and facilitating partnerships.
Building a Team of Experts – A trustworthy real estate lawyer, tax accountant, lender, property inspector, and leasing agents are crucial when starting out. Lean on specialists to avoid costly rookie mistakes.
Understanding Commercial Real Estate Financing – Speak to both local banks and national lenders to educate yourself on CRE loan products, down payment requirements, interest rates, and loan underwriting criteria. Determine if partnerships or creative financing strategies will be needed to fund your deals.
Conducting Thorough Market Research and Analysis – Demographic and rental market data will reveal a market’s investment fundamentals and help you spot promising opportunities. Focus your efforts where CRE fundamentals are strong and align with your strategy.
Finding Deals and Lead Sources – Lean on commercial brokers, MLS listings, Loopnet, auction sites, wholesalers, distressed sellers, networking, and driving for dollars to find deals. Let brokers represent and educate you as a rookie investor.
Evaluating Deals and Due Diligence – Follow a consistent due diligence process for assessing CRE opportunities, including financial modeling, tenant credit checks, SWOT analysis, site visits, and inspections to avoid lemons. Work the math and run comparable data.
Making Offers and Negotiating the Purchase – Learn techniques to value CRE properties based on market comps, cap rates, and discounted cash flow. Submit credible offers with contingencies to allow proper due diligence. Use proven strategies to negotiate a fair purchase price and terms favorable to you as the buyer.
Ongoing Property Management Best Practices – Even with a property manager overseeing day-to-day operations, investors must regularly inspect their properties, monitor financials, handle capital projects, evaluate leasing decisions, and implement their investment strategy. Assume an active investor role to maximize returns.
While hands-on direct ownership of brick-and-mortar properties is ideal for total control, passive and indirect options exist too.
Direct vs. Indirect Investment in Commercial Real Estate
Beyond direct property ownership, indirect options allow investing in commercial real estate without the hands-on role.
Direct Ownership – Directly owning physical CRE properties provides the greatest potential returns through active management. But you must have considerable capital and expertise.
REITs – Investing in real estate investment trusts (REITs) offers exposure to large-scale commercial real estate portfolios. Publicly traded REITs offer greater liquidity but less upside than private REITs open to accredited investors only.
Funds and Syndications – Joining CRE investment funds or syndications led by experienced sponsors allows investing alongside other private investors. Look for strong alignment of interests through sponsor equity investment.
Crowdfunding – Real estate crowdfunding online has opened up CRE investing to more individuals. But due diligence on sponsors is still essential, and liquidity typically remains limited until properties are sold.
Now that we’ve covered various CRE investing structures, let’s examine the critical element of returns and performance.
Commercial Real Estate Investment Strategy and Returns
Smart investors approach CRE with a strategic, numbers-focused frame of mind. Here are key facets of successful strategies:
Capitalization Rates, Cash Flow, and Appreciation – Learn to accurately calculate cap rates, analyze operating cash flow, and assess appreciation potential to confidently evaluate opportunities. Model your return projections conservatively.
Investment Time Horizons – Target appropriate hold periods of 5-10+ years to allow for value appreciation. Don’t invest funds needed in the short term.
Impact of Leverage – Leverage amplifies returns if property values rise but also compounds losses in a down market. Model scenarios of potential loan defaults.
Geographic and Property Sector Considerations – Weigh the pros and cons of each sector and metro market. Focus your efforts where fundamentals align with your investing strategy and expertise.
Active vs. Passive Investment Strategies – Research indicates hands-on active investors consistently outperform passive absentee owners. Manage your properties proactively, even if you hire a property manager.
Market Timing Risks – Commercial real estate operates in market cycles, but downturns are hard to predict. Pursue a long-term buy and hold strategy rather than betting on short-term plays.
Building a Diversified CRE Portfolio – Mitigate risk through diversifying across multiple metros, property types, and tenants. Too much concentration in one sector or deal is dangerous.
Setting Return Expectations and Benchmarks – Realistic expectations based on market benchmarks help investors evaluate opportunities objectively rather than relying on enthusiasm. Target deals that exceed these return thresholds.
Now that we’ve covered core commercial real estate investment fundamentals and strategy, let’s discuss tips to put this into practice as a beginner.
Tips for New Commercial Real Estate Investors
Follow these tips to maximize your chances of success as a new CRE investor:
Partner with Experienced Investors – Find a mentor or sponsor open to partnering with a rookie investor. Leverage their expertise to mitigate risk on your first ventures. Offer to add value through sweat equity and smaller capital contributions.
Start Small and Get Your Feet Wet – Don’t attempt to swing for the fences on your first deal. Begin with a smaller property of 2-4 units or requiring less than a few hundred thousand in capital.
Make Sure to Run the Numbers – Avoid solely relying on “gut feel” or emotions when evaluating deals. Follow a consistent financial modeling process and make data-driven decisions.
Don’t Underestimate Expenses – Budget for the inevitable capital expenditures, maintenance costs, vacancies, and management fees of CRE ownership. Leave room in your models for expense overruns.
Be Prepared to Invest Time and Effort – Successful CRE investing isn’t passive. Especially early on, commit to regular property visits, oversight of managers, and continuing education.
Don’t Expect Overnight Success – Remain patient in the first few years as you build up your portfolio. Commercial real estate rewards long-term disciplined commitment, not risky get-rich-quick schemes.
Have Realistic Return Expectations – Base your return goals on actual market benchmarks rather than rumor or exaggerated projections. Factoring in all costs and work required is vital.
Keep Learning and Evolving Your Approach – Read books, listen to podcasts, and network with other investors to continuously improve. The most successful investors never stop acquiring new knowledge.
The next critical step is learning how to finance commercial real estate purchases, so let’s examine that process next.
Financing Commercial Real Estate Investments
CRE investments require sizable capital for down payments and closing costs. Financing covers the remainder of the purchase price.
Debt Financing Options
Commercial Mortgages – Traditional commercial mortgages from banks are a common financing method. Expect a down payment of 20-25% and strong personal credit.
Commercial Real Estate Loans – Hard money and bridge lenders offer CRE financing for riskier deals with lower down payments, but at higher interest rates.
Equity Financing Sources
Self-Funding – Paying all cash obviously avoids financing costs but requires major capital. High net worth investors often self-fund.
Partners – Combining equity with trusted partners allows pooling capital to buy larger properties. But make sure your partnership aligns on objectives.
Private Investors – Accredited private lenders are an option. Offer attractive interest rates and collateral to incentivize them.
Crowdfunding – Real estate crowdfunding pools capital from multiple smaller investors. But substantial track records are often required to attract investment.
Debt vs. Equity Tradeoffs – Weigh the pros and cons of debt leverage versus bringing on equity partners. Factor in debt service ability and acceptable leverage levels.
Loan Underwriting – Commercial lenders scrutinize property financials, location, tenancy, borrower experience, credit, and LTV ratios. Prepare your case thoroughly to secure financing.
LTVs and Down Payments – Aim for maximum LTVs of 80% for conventional loans or 75% for riskier deals. Have larger down payments available to improve terms.
Creative Financing Strategies – Seller financing, delayed financing, debt assumption, and equity partnerships can help buy properties with limited capital.
Finding good CRE deals is only half the battle. Securing financing is equally critical but surmountable through preparation and creativity.
But beyond your own capital, sometimes turning to outside equity investors is the best or only way to fund larger commercial real estate projects.
Finding Investors for Commercial Real Estate Deals
Adding equity partners expands the capital pool available for acquisitions and development:
Why Syndication Is Beneficial – The capital required to buy larger properties exceeds most individuals’ capacity. Syndicating with multiple investors allows buying larger assets while diversifying risk.
Types of CRE Investors – Common capital sources include high net worth individuals, family offices, institutions, pension funds, foreign investors, and developers.
Marketing Strategies to Find Investors – Create professional marketing decks touting your business plan and track record. Leverage brokers, lead lists, digital outreach, events, and referrals to build relationships.
Vetting and Evaluating Investors – Screen potential investors for experience, CRE understanding, investing criteria, and ability to deliver on equity commitments.
Structuring Win-Win Deals – Offer incentives like above-market preferred returns and favorable waterfall distributions that reward major capital partners. Provide escalation clauses and other protections investors seek.
Ongoing Investor Relations – Keep partners updated through frequent communications and reporting transparency. Make investors feel valued, informed, and aligned with deal sponsors.
Assembling the right investor group takes effort but multiplies your buying power. Arm yourself with capital and expertise before pursuing large-scale CRE projects.
Conclusion
Commercial real estate remains a rewarding asset class for diversification and attractive risk-adjusted returns. But prudent underwriting, active management, and knowledgeable partnerships are vital, especially for new investors. By following the strategies outlined in this guide, beginners can position themselves for CRE investing success over time.
The key is approaching CRE investing as an ongoing learning journey. Gain hands-on experience with smaller deals, continually expand your knowledge, build your resources and network, and stick to a data-driven disciplined approach. The patient, persistent, and proactive reap the greatest rewards in commercial real estate.
What questions do you still have on getting started in commercial real estate investing? Let me know and I’m happy to discuss further and elaborate on any concepts you need explained in more detail. I aimed to provide a comprehensive overview of the intricacies of CRE investing specifically for beginners in this guide. Feel free to provide any additional feedback to improve the content.
Frequently Asked Questions
Yes, commercial real estate can be highly rewarding for investors who are strategic and proactive. The income, appreciation, and diversification benefits make it worth considering.
Experienced commercial real estate investors target internal rates of return (IRR) of 12-20% or higher. Property location, asset class, leverage, and strategy impact ROI.
Investors profit from commercial real estate through rental income, appreciation over time, loan paydown leading to equity buildup, and tax advantages from depreciation.
Multifamily, industrial, and warehouse properties tend to provide favorable risk-adjusted returns. Well-located Class A office and retail can also be highly profitable.
Pros include portfolio diversification, passive income, long-term equity growth, and leveraged returns. Cons include large capital requirements, illiquidity, specialized expertise required, and tenant risk.
It depends on your goals and criteria. Multifamily and industrial offer stability. Office and retail have higher upside but more risk. Analyze market fundamentals to identify ideal asset classes.
Commercial buildings typically have useful lives of 30-50 years. Properties require periodic capital improvements and renovations to maintain viability beyond this period.
It can be, if you buy at the right point in the cycle at discounted prices. Be selective and patient deploying capital gradually in a downturn for long-term holds.
