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Do you want an investment that generates a steady passive income? Commercial real estate investment is the perfect investment that you should consider. You can reap huge benefits if you invest in commercial real estate properties. Here is a comprehensive guide that teaches you everything you need to know before you get your feet wet.
How to Invest in Commercial Real Estate: Make Money Passively
Real estate investment is one of the best forms of passive income investments. Investing in properties whether residential or commercial is a lucrative investment opportunity. However, you can achieve diversified financial returns among other benefits if you opt to invest in commercial real estate than from residential property investment.
Investing your money is all about allocation and commercial real estate has a spot for you. You don’t need significant capital in today’s age.
I track all of my asset allocations through Personal Capital. It’s the best way to take a bird’s eye view snapshot of your assets and investments. It’s completely free to use as well.
Investors of commercial real estate can make money in two ways. They can receive income through leasing the property and charging tenants rent in exchange for the use of the property and when the value of the property appreciates over time.
Commercial properties are more expensive to build or purchase than residential properties, and their maintenance costs are also higher. However, commercial real estate properties have higher dividends compared to residential properties when they are rented out.
I prefer taking an evidence-based approach to invest, which entails every last detail to make a better investment decision.
In this commercial real estate 101 step-by-step guide, we will explore how to invest in commercial real estate, different types of CRE properties and benefits of investing in commercial real estate.
This is a comprehensive guide on investing in commercial real estate for beginners. Now, before we explore that, let’s look at the meaning of CRE investing.
What is Commercial Real Estate (CRE) Investing?
Commercial real estate investing involves making investments in commercial real estate properties such as retail centers, office buildings, hotels, and multi-family housing, industrial property, medical centers, malls, farmland, apartment buildings, and warehouses and more.
Commercial real estate includes any property leased out for business and retail purposes. It also consists of any raw land that has for the development of commercial property. Here’s how you can find hotel investment opportunities.
So if you want to invest in commercial real estate, you have to target such properties.
There are five main types of commercial property that you need to know about to establish the right commercial asset to invest in. Tenants across all types of commercial real estate investment properties differ which means they have different arrangements, property management needs, as well as lease agreements.
Why consider investing in commercial real estate?
If you want to stack up investing in commercial real estate vs residential, you should evaluate several factors. I love to add potential risk mitigation to my passive income portfolio. Commercial real estate has a significantly different risk profile than residential real estate investing.
With the rise of crowdfunding platforms and commission-free investing, anyone has the ability to add commercial real estate exposure to their portfolio. Here are several considerations on why you should add commercial real estate to your investment allocation.
- Tenant Diversification
- Economies of Scale (a lot easier to put a large amount of money to work)
- Market Specific Opportunities
- Multiple Investment Strategies (see below, but commercial real estate can be dynamic by strategy)
Each of these above considerations has its own ‘cons’ or downsides. Think of your portfolio and asset allocation like a puzzle, if you have a lot of single-tenant risks, you may want to consider adding diversified tenants.
The 5 Types of Commercial Real Estate Properties
Let’s dive into the most familiar types of commercial real estate properties to invest in.
1. Office Buildings
Office Space is one of the most common types of commercial real estate. It includes cubicles and parking decks, the single-tenant, and skyscrapers and more. The buildings are defined by three categories that include Class A, Class B, or Class C.
Commercial real estate properties in Class A are typical includes the newly built or widely renovated buildings which are in a prime location within or in close range to the essential amenities. Professional real estate management companies manage these types of properties.
Commercial real estate properties in Class B include older buildings that may require the investor to spend some money on this type of investment. Albeit well-managed and maintained, Class B properties need some few minor repairs and upgrades to make it fit for investors.
Commercial real estate properties in Class C are typically properties used for redevelopment opportunities. These properties are not in prime, and they require substantial capital investments to renovate their out-of-date infrastructure.
Retail building is another common type of commercial real estate. They are located in urban areas and include strip malls, community retail centers, banks, and restaurants.
The size of these real estate properties is usually between 5,000 square feet to 350,000 square feet.
Industrial is yet another type of commercial real estate. It includes warehouse and smokestacks with suitable height specifications and availability of docking. A tenant could be a distribution or manufacturing company.
Industrial properties are in less desirable areas compared to residential and retail properties. The lease lengths of such property range from 5-10 years or more.
The typical tenant of multifamily apartment buildings is individuals or families. The lease for this type of property is shorter than for other types of commercial real estates. They include high-rise condos, apartment complexes, and smaller multifamily units.
If a property has one unit, it is generally considered to be a multifamily real estate, and if it has more than four units, then it’s a commercial property.
5. Special Purpose
The special purpose property is for a specific use, and the property cannot serve another purpose. Such properties include car wash facilities, self-storage, amusement parks, stadiums, airports, leisure & tourism, and schools.
An investor can also opt for an owner-occupied real estate in a number of the above-mentioned situations.
So, What is Owner Occupied Commercial Real Estate?
If an investor purchases a commercial real estate with intent to utilize it for their purpose, then such property is considered to be an owner-occupied commercial real estate (OOCRE).
Investors can choose to occupy the commercial real estate that they have purchased which is an added advantage.
If you are wondering how to get started, then here are some of the common ways to invest in commercial real estate properties/
Different Ways to Invest in Commercial Real Estate
There are a number of different ways for you to participate in commercial real estate investments.
1. Outright Ownership of the Property
Purchasing the property outright is one of the best ways that investors can acquire and operate a commercial real estate property. If you can afford to purchase a property of your own, then you need to go for it. A commercial real estate is one of the best investments that guarantee regular income as well as capital appreciation.
If you want to purchase a property, then you must be able and willing to manage your investment. To acquire outright ownership of a property, you must contribute 20% to 30% of the purchase price.
You need to be patient with this kind of investment and have a higher risk tolerance. Also, you need a general knowledge to help you understand your financing options, cash flow and the tax implications that go hand in hand with this type of property ownership.
2. Traditional Direct Investing
Making a direct investment is another way investors can invest in commercial real estate property. Traditional direct investing is an investment that involves buying debt or an equity stake in commercial real estate property.
Traditional direct real estate investing usually consists of pooling your funds in a limited liability company (LLC). This form of investment is also a bit expensive but far much cheap compared to buying a property outright.
In this type of investment, the general partner manages the property, sources the investment, obtains financing, and makes leasing among other decisions.
The limited partner, on the other hand, provides the equity capital and owns a portion of the deal. Both receive a percentage of the cash flow as well as a percentage of the proceeds once they sell the property.
Two to ten investors can form this type of partnership. If you can tolerate a higher degree of risk but don’t want to be actively involved in the management of the investment, then you can consider this kind of commercial real estate investment.
3. Publicly Traded or Private REITs
Buying publicly traded REIT is yet another viable way to dive into commercial real estate investing industry. In this form of investment, investors own a variety of income-producing commercial real estate properties. The investor then starts to earn a constant portion of the earnings that the particular property generates.
REITs are affordable since they are far much cheaper than the other two options discussed above. They are very liquid and thus are an ideal way for investors to diversify their portfolios.
However, their performance could be very volatile, and the investors have no direct control of the properties the REIT invests in.
REITs can specialize in one asset class. For example, a REITs can own shopping centers or a multi-family project.
REITs aren’t taxable as long as they distribute 90% of their earnings in the form of dividends to the shareholders.
I like using a platform such as M1 Finance to build portfolios of REITs that can help increase my income passively. It’s completely free to use and they automatically invest your money.
Read more about M1 Finance in our review of the platform.
4. Online Direct Investing/Real Estate Crowdfunding
Online direct investing also known as real estate crowdfunding also comes in handy for investors looking for viable options to get into the CRE investing. With this form of investment, the investor has an opportunity to hand-pick the individual real estate projects they prefer. It helps them easily align their financial goals with their values alongside a pool of other investors.
Investors from different regions have a chance to own a stake in this kind of investment. A real estate crowdfunding minimum investment amount can be as little as $500. My favorite platforms for investing in commercial real estate are:
- Fundrise: Fundrise is a great platform for both accredited and non-accredited investors. They offer best in breed fees and investment opportunities. Read more about it in our Fundrise review.
- CrowdStreet: CrowdStreet is one of my favorite platforms due to the sheer types of investment opportunities and structures. You can invest in some very attractive returning crowdfunding investment opportunities. Read more about it in our CrowdStreet review.
- RealtyMogul: RealtyMogul gives you instant access to institutional quality investments in commercial real estate. The platform was developed due to the findings of the wealthiest individuals were predominately invested in real estate and focused on passive cash flow.
Summary of Best Real Estate Crowdfunding Options
These are the three best real estate crowdfunding option that you should consider.
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Real estate crowdfunding is quite an affordable way for investors to diversify. Real estate crowdfunding also comes with some possible tax advantages depending on the type of investments and the personal tax position of the investor.
Also, LLCs allow for other deductions including “pass-through” of depreciation, interest expense, etc.
Why invest in commercial real estate properties?
Common Benefits of Investing in Commercial Real Estate Properties
Investing in commercial real estate can be very rewarding for any investor. Different investors who invest in commercial real estate properties have different investment and financial goals. Here are some of the reasons why investors dive into CRE investing:
1. Portfolio Diversification
Historically, CRE investments have had a low correlation with the stock market securities such as stocks or bonds. If there is a decline in the equity market, CRE investments are rarely affected by it.
Additionally, research shows that illiquid assets can provide higher returns since they’re not subject to the so-called liquidity discount which is present in liquid assets such as bonds and equities.
Therefore, CRE investing is a perfect way to add diversification in your portfolio.
Investors also diversify within the commercial real estate investment portfolio since there are varying demand drivers for different commercial property types. Diversification is an excellent way to mitigate risks exposed to various investments.
2. Lower Levels of Volatility
Commercial real estate investments are less volatile compared to other forms of investments such as stocks. Since commercial real estates are not traded in a public stock exchange, they are less affected by short-term news, events and even declarations which can help in smooth valuations.
On top of that, tenants of commercial real estate sign lease contracts that go up to five years or even more. This guarantees ongoing rental income which mitigates risks linked to broader economic meltdowns.
3. Better Returns
Commercial real estate offers income to the investor in the present time as well as a potential of a return associated with the future appreciation of the asset. Investors receive all or a significant portion of their total investment return from the current rental income cash flows. Earning passive income is one of the main reasons why investors invest in commercial real estate properties.
Commercial real estate properties leases are longer compared to the residential real estate’s lease. Therefore, it means that there is a far less tenant turnover in commercial real estate properties compared to that of residential properties.
Commercial real estate properties have a lower vacancy risk since they have more available spaces than residential properties. A commercial building can have more units which mean that one vacant unit in an office building impacts the investor finances less than one vacant unit in a residential duplex.
4. Investment in a Hard Asset
Since real estate investment is a hard asset, it has intrinsic value in both the property and the land. Land can appreciate due to various reasons. So, CRE investments offer potential returns at present as well as potential return depending on the appreciation of the asset in the future.
5. Hedge Against Inflation
Increase in the prices of the goods and services in the broader economy generally increases the amount of that property. This is because it increases wages and profits which increases the amount charged for the use of the space or what the tenants can afford to pay.
6. Tax Benefits
CRE investors also receive tax benefits. You can claim deductions to interest income, depreciation, among other items that can help defer the taxes on cash distributions. For instance, the IRS lets the CRE investors deduct a part of the depreciated value of the property to account for the maintenance and upkeep costs.
7. Ability to Co-Invest with Professionals
Investors in passive commercial real estate investing get to choose partners with proven track record before they invest. It offers investors a chance to mitigate some risk exposure since they join experienced professionals.
3 Vital Metrics to Know Before you Invest in Commercial Real Estate
Commercial real estate investing involves several vital calculations and financial ratios that every player in commercial real estate should know. The most important basic financial metrics you should know for investing in CRE are below.
1. Net Operating Income
Net Operating Income (NOI) is a calculation that equals all revenue minus costs from a particular property. The ratio provides the figure that an investor will make from an investment after subtracting all the necessary operating expenses.
The operating costs include insurance, utilities, repairs, property management fees, janitorial fees, and property tax and more.
2. Cap Rate
Cap rate which is short for capitalization rate is used to calculate the value of income-producing properties will give investors with a projection of future profits or cash flow. In addition, cap rate is usually the ratio of net operating income (NOI) to property asset value.
Cash on cash offers investors a return rate on their CRE transactions. Investors who rely on financing to purchase their properties can utilize this rate.
It measures the return on out-of-pocket cash an investor makes relative to the financed percentage and offers a precise analysis of the performance of the investment.
Key Commercial Real Estate Investing Strategies
There are several strategies for commercial real estate investing that highlight your risk and return expectations. The end goal for any professional investor is to achieve a high return for as little risk as possible.
1. Core Real Estate Investing
Core real estate investing is the lowest risk and lowest return. With core real estate investing, you are simply investing for cash flow and yield.
Returns for this type of real estate investing are generally in the 6-9% IRR.
2. Core Plus Real Estate Investing
With core plus real estate investing, the investor seeks to find investment opportunities that pose the ability for improvement in cash flow. The investor provides an added approach to improving the property, which in-turn improves revenue and potential sale value.
Returns for this type of investments are generally in the 9-13% IRR. This approach is a hybrid between income and growth oriented investing.
3. Value-Add Real Estate Investing
With value-add real estate investing, an investor seeks to grow the property and improve both operations and sale value. Think of value-add real estate investing like investing in growth opportunities in the stock market.
These investors are typically more capital appreciation oriented than income. Returns for this type of real estate investing are generally in the 13-19% IRR.
4. Opportunistic Real Estate Investing
Opportunistic real estate investing is a speculative/turnaround approach. With this investment strategy, investors look for the long forgotten assets that are underappreciated and misunderstood. Their sole focus with this style of investing is capital appreciation.
Think of investing in a property that no one wants, but you see something extra special. You buy the property at such a cheap valuation that it’s almost hard to lose.
At the same time, you can lose money on it at any given point. Thus, making opportunistic real estate investing one of the riskiest forms of commercial real estate. Returns for this type of commercial real estate investing are generally 20-30% IRRs. There are even times where these assets return more than 30% on an IRR basis.
You can find attractive opportunistic real estate opportunities by using CrowdStreet.
Conclusion on How to Invest in Commercial Real Estate
One of the reasons why investors invest in commercial real estate properties is to generate passive income. It’s vital to be patient, do due diligence and understand the market before you embark on the CRE investing journey. Read these books about real estate investing to continually improve your knowledge and become a better investor.
Also, consider your risk tolerance and the available financing options that you have. Finally, if you want to be successful, you must choose your partners wisely and adequately keep the record of all your finances.
Do you think this commercial real estate investing guide is useful? Let us know in the comments below. We’d love to hear from you.
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