Investing in Commercial Real Estate – What You Need to Know
Real estate is a lucrative investment. Unlike other asset classes the value of real estate rarely falls, so it is considered to be a “safe" investme
16:20 05 June 2017
In time, your asset will appreciate in value, which is always good news, but what sets real estate investment apart from other asset classes is that you can also generate a regular income from your properties.
Different Types of Real Estate Investment
There are two types of real estate investment: residential and commercial.
· A residential real estate investor buys homes and lets them out to tenants. You either take on the management of your portfolio or leave it to an agent.
· Commercial real estate investors focus on business properties. This type of real estate can be anything from a parking lot to a factory. Multi-use buildings with four or more units are also classed as commercial.
Is Previous Experience Necessary?
Investing in commercial property does not require previous experience, but it is helpful. Seasoned residential investors are familiar with the ins and outs of financing, so they know which lenders to approach. However, if you want to jump right in, it is worth considering the advantages and disadvantages first.
Pros of Commercial Real Estate Investment
· Higher return on investment – Rental yields on commercial properties are usually higher than residential properties. You can expect to earn between 8% and 10%, whereas a residential real estate will only yield around 5%. However, rental yields are subject to a number of variables, so it is essential that you conduct some research before investing.
· Fewer expenses – A commercial real estate owner has very few building related expenses. Once a tenant signs up for a triple-net lease, they are responsible for utilities, building maintenance, property refits, and other expenses, subject to the terms of the lease of course, in addition to their rental payments.
· Better working hours – Residential real estate owners are often on-call 24/7. If a tenant has lost their key or a pipe has burst, they will have no qualms about calling you up at midnight. Commercial tenants typically operate during normal working hours, so you won’t have to deal with problems outside of these hours (unless there is an emergency).
· Ease of financing – Commercial real estate owners can access more flexible financing deals. Unlike a residential real estate owner, you will be able to apply for 100% financing. It is much easier to make large-scale investments with very little of your own cash.
· Longer leases – Residential leases are usually around 12 months, but commercial tenants need greater security. For example, if a retail client has spent tens of thousands of dollars fitting out a store, they will not want the expense of moving out after two years. Accordingly, leases are usually three, five, or ten years in length, with break clauses written in for extra flexibility for both parties.
Cons of Commercial Real Estate Investment
· Commercial real estate financing can be more expensive – Lenders usually charge higher rates of interest on loans for commercial real estate. Lending terms are more restrictive and you may need to provide a larger down payment.
· Zoning – Commercial properties are categorized in zones for a specific use. For example, if you want to change the use of a building from retail to manufacturing, you will need to make a special application, which can be costly.
· Taxes – Commercial real estate owners are taxed on the value of their properties. A significant rise in real estate values will increase your tax bill. You could pass on your costs to your tenants, but this will cause a higher tenant turnover and you may end up with void periods.
· It takes longer to find tenants – Void periods tend to be longer with commercial properties. It is harder to find suitable tenants for niche properties such as manufacturing premises or retail units in less desirable locations. One way to minimize a loss of income is to invest in mixed-use retail/office units. Even so, it is common for void periods to last for several months or longer, and with no tenants, you have no income.
· The value of properties can fall – Commercial properties are subject to steeper fluctuations in value. If a geographic area goes into decline, this will have a greater effect on commercial real estate values. People still need homes, but businesses are less likely to move into a low rent area.
· Demand can fall - Commercial real estate values are affected by the state of the economy. When times are tough, businesses fail and demand for commercial real estate is lower. However, when the economy grows, demand rises, so there is a balance in the long-term.
· Commercial real estate is subject to changes in local infrastructure – if a new road directs traffic away from a commercial area, businesses will move away and properties will fall vacant.
Managing Commercial Real Estate
Many commercial real estate owners pay a management company to manage their properties. However, not all management companies are equal and the success or failure of your investment is heavily dependent on the quality of the management company you use.
There are many different variances in commercial real estate investment, but if you are looking for a passive investment, it’s a good choice. However, as with any other type of investment, you should never jump in feet first without considering the many pros and cons.
Take professional advice and speak to local realtors and management companies to find out which asset classes are most in demand. Targeting a growth sector in the right location is the best way to see a significant increase in the value of your investment. For example, if you buy a mixed-use commercial unit in an up-and-coming area with a proposed new transport link in the pipeline, you are on to a winner, but if you buy a retail unit in an area where the local retail stores are struggling, it is hard to think of many positive reasons why this would be a smart investment.
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