Investing in real estate can be very lucrative and commercial real estate, especially, has the capacity to provide very high-income streams. If you’ve been growing your portfolio in residential real estate, maybe you’ve expanded into multifamily properties and you have started wondering how to get into commercial real estate investing. In this installment of our Commercial Real Estate Investing 101, we provide some basic information about how to get started in commercial real estate.
Commercial Real Estate Investing 101: How to Get into Commercial Real Estate Investing
Before getting involved in any type of investing, it’s important to do your due diligence. To start, you will want to do some research about the commercial real estate market in general as well as your local market. What are current commercial real estate trends? What are the local opportunities and challenges? If you have experience in residential real estate investing it will be important to learn how commercial real estate investing differs from residential.
Here are some steps to get you on the path to becoming a successful commercial real estate investor:
- Learn the differences between residential real estate and commercial real estate
If you already have experience as a residential real estate investor or you’re new to the real estate investing game altogether, it’s very important to understand that commercial real estate is valued differently from residential properties. There are three major differences between residential and commercial real estate investing: 1. Commercial real estate is typically valued by usable square footage and the amount of income the property brings in to the owner, 2. Commercial property leases are usually longer than residential leases (from one to 10 years), and 3. Commercial real estate loans are typically five to 20 years (instead of 15-30).
- Understand the risks and rewards
While commercial real estate has a high potential for return on investment, investors must be prepared to invest a substantial amount of money up front and be able and willing to weather some tough market conditions.
- Determine demand: Understand the connection between location and tenant type
Location is important for both commercial and real estate investing but commercial investors will also need to identify the appropriate tenant type for each building to determine demand. For example, offices are going to attract corporate clients and will do better if they are located in an urban center or business park vs a residential neighborhood. Retail stores, on the other hand, attract shoppers and could do very well in mixed-use buildings or in a downtown location among other retail shops.
- Analyze comparables to determine current market value
Analyze current comparable properties in the area and for upcoming developments. This is known as “comps”, and describes what was paid for recently sold properties that are similar in location, size, and style. Because square footage is an important part of valuing commercial properties, you would generally want to look at prices for properties that don’t go beyond 10 percent higher or lower than the square footage of the property you are evaluating.
- Set aside cost contingencies and capital reserves
Any type of investment comes with the potential for unexpected costs. Cost contingencies are funds set aside to cover unexpected expenses that accrue before you have had a chance to establish a stable cash flow. For commercial investing, a cost contingency budget of five to 15 percent is ideal. Capital reserves are also meant to cover unexpected expenses but those that come up later on after cash flow has been established. Capital reserve funds are built into the operating budget.
- Consider working with a team
Sometimes investors try to save money by doing everything themselves, or maybe they don’t realize how beneficial it can be to work with a team. Working with a team can save time and money and provide insights into the investment process that you didn’t even know you needed.
- Organize financing
If you will be financing your commercial investment, it’s important to know your loan options and what information you will need to provide in order to get approved. Each type of loan has specific eligibility requirements and varying terms so you will need to decide which type of loan makes the most sense for you. Lenders will typically make their decisions based on an investor’s financial and credit history.
Here are some basics for getting a commercial real estate loan:
- Decide if you will be financing a commercial property as an individual or as a business entity such as a corporation, developer, or business partnership.
- You will need a favorable loan-to-value (LTV) ratio for approval. The LTV ranges from 65 to 80 percent for commercial loans, with lower LTVs qualifying for more favorable financing rates.
- You will need a favorable Debt Service Coverage Ratio (DSCR) that shows the property’s ability to service debt. Commercial lenders are usually looking for DSCRs of at least 1.25 to ensure proper cash flow; anything less than one percent reveals a negative cash flow.
Here are some different types of commercial loans to consider:
- Conventional loan
- Commercial bridge loan
- Certified Development Company (CDC) / SBA 504 loan
- Hard money loan
- Small Business Administration (SBA) 7(a) loan
- Conduit loan
Once you have done your research and secured financing, you’re ready to start investing!
- Know how to calculate success
There are a few options for calculating real estate investing success:
- Cap rate. The cap rate (or capitalization rate) is used to calculate the ratio of net operating income to the property asset value. This is helpful because it provides investors with an estimate of future profits or cash flow.
- Net operating income. The net operating income is used to calculate the pre-tax amount of revenue from the investment minus all operating expenses such as insurance, utilities, repairs, property management fees, janitorial fees, and property taxes.
- Cash on cash. Cash on cash is a metric used by investors who financed their purchase. It is used to calculate the rate of return on commercial real estate transactions. Specifically, it measures the return on out-of-pocket cash invested, relative to the portion that was financed.
Turn to Windermere for real estate done exuberantly right.
For 50 years, Windermere has used our extensive knowledge of local markets to offer a full range of services that match your commercial real estate needs. Whether you’re a business looking to buy or lease space, or an investor interested in private capital or institutional properties, you’ll benefit from our experience in all phases of commercial real estate, including leasing, business development, brokerage, property management, and consulting.
You can depend on our powerful network
Windermere Commercial has established connections with highly reputable brokers throughout the nation. We also have the benefit of being affiliated with Windermere Real Estate, so you aren’t simply hiring a broker; you’re hiring an entire company with an extensive team of dedicated professionals whose highest priority is to help you reach your commercial real estate goals.
Are you interested in owning commercial real estate property? Connect with our people today.