Commercial real estate investing, or CREI for short, is the act of buying and selling properties that are used for commercial purposes. To be considered commercial the property must have 5 or more units. Here are the different types of commercial properties:
- Industrial buildings
- Apartment buildings
You can invest in a CREI by either purchasing property directly, by taking out a loan to purchase a property with the intent to sell it later at a higher price, or by purchasing shares of an investment partnership. All these options take careful consideration before committing to them as they require capital.
We all like to consider our investments as a crucial part of building our financial future. However, the investment market can be rather difficult to navigate. To help you find your way through the process, we’ve put together this guide to some of the best commercial real estate investments out there. First, let’s take a look at why you might consider commercial real estate as an investment.
Why Invest in Commercial Real Estate?
While stocks and bonds might seem like they are better investments in terms of risk-reward, they’re not necessarily as profitable over time. That’s why investing in commercial real estate, either through property purchase or rental, is such an attractive option for investors looking for more stability and long-term earning potential.
One of the most important things you should remember when investing in commercial real estate is that not every property is right for you. There are many variables that go into a property’s suitability for an investor. If you can’t imagine any of your potential investments fitting into your portfolio, then that opportunity might not be right for you.
You can be an active or passive commercial real estate investor. Commercial real estate has the potential for higher income because you’ll typically have more tenants or a larger property with higher rent.
Something else to consider is the tax advantages that come along with commercial real estate. The following are just a few of the ways commercial real estate can benefit from the tax code:
- Operating loss. If your property is used in your business and you have a loss from operations, you may be able to carry that loss forward up to three years. This can apply to all commercial properties whether they would be considered office space, retail space, industrial space, or retail condominiums. Once an expense of $5,000 has been incurred during the year, a statement must be filed describing how this expense was related to income generated or otherwise connected with your business. The IRS considers the maintenance and use of your property as part of an operating loss if you choose to do so. However, if you were in a temporary bumpy situation or just not able to maintain the property properly, a general deduction can be taken for any expenses that exceed $1,000 for personal living space.
- Deduction for interest paid. Interest paid on a loan or mortgage can be deductible. You will have to attach documentation and amend your investment account to show that you are making payments instead of interest. You must be able to see through the current use of money to your loan or mortgage when they make this deduction as the IRS needs you to prove where the additional money not being used in mortgage principal comes from.
- Deductions for allowable depreciation. Depreciation on commercial properties is a big factor that investors need to consider when buying an investment property as a means of making sure that they’re not overpaying for the property or building up a huge amount of debt that will take years to pay off with the rent they are bringing in. The IRS allows for a depreciation schedule based on the age of the property and the condition it is in. For example, for structures built before 1977, straight-line depreciation is allowed. This means that you can depreciate your building by deducting 1/27 of its assessed value over 27 years.
- Tax credits. There are several tax credits that can be applied to your tax return that pertain to commercial properties including a new markets tax credit and other local tax credits.
Now that you understand some of the reasons why someone might want to get into commercial real estate investing, let’s dive into how.
How to Invest in Commercial Real Estate
Check out 6 different ways to get into the commercial real estate market.
1. Commercial REITs
A commercial real estate investment trust (or REIT) is a company that owns, or finances income-producing commercial properties. They are similar to mutual funds in that they represent an investment for the general public, but unlike funds, they trade on an exchange like stocks do. They also have no limitations on who can purchase them which means anyone can participate in them.
A REIT can be a good investment for passive income investors or even investors that want to have more control over their investments. This is because many of them pay large dividends and distributions each year. They’re also relatively safe for the average investor and have little risk other than defaulting on the loan or properties they own. However, they do have some risks associated with them from their high leverage which can lead to huge losses if the market turns against them. Some people also like REITs because of their tax benefits and the ability to receive dividends in form of an exempt-interest distribution.
Like mutual funds, REITs are a collection of assets that are professionally managed by a team of experts. They are a favorite way for people to invest in real estate because of the ease of investment, and it removes the need for ownership of individual properties. This also makes them less liquid than individual properties or mutual funds because the investor must hold onto them until they can be sold again (just like a stock). REITs are relatively simple to understand and easy to purchase and sell.
Commercial REITs have many advantages over traditional stocks because they offer more substantial dividends and distributions. These are usually distributed quarterly or even monthly.
2. Commercial Property Crowdfunding
Crowdfunding has become a popular way to fund new and creative ideas, products, or services. Commercial real estate crowdfunding is especially exciting because it has emerged as a new and viable option for both investors and entrepreneurs eager to launch their business.
Commercial real estate crowdfunding is similar to traditional crowdfunding in that it enables people with ideas for property development or other commercial uses of properties to raise funds from others over the internet in order to finance the idea’s start-up costs (such as residential space start-up mortgages).
But unlike traditional crowdfunding, commercial real estate allows investors who have a lot of capital but not a lot of time to participate by leveraging their money into other people’s ongoing projects with minimum risk.
Unlike Kickstarter, for example, where the entrepreneur provides the finished product to the consumer within a specified time frame (i.e. if they don’t deliver on time, the consumer gets nothing), commercial real estate crowdfunding investors are simply buying into a particular project’s expenses as they are incurred. This lowers the risk involved for these investors because there will be no out-of-pocket expenses associated with their investment in typical commercial real estate projects.
Commercial real estate crowdfunding could also change how markets are done between property owners and potential buyers in terms of marketing and pricing. Property owners, for instance, may be able to use this new method of crowdfunding to create an advanced marketing campaign that will help them sell their properties faster and for a higher price. In the past, commercial real estate owners would have to spend thousands of dollars on advertising in order to find a buyer. These costs are not always necessary now thanks to the internet, where instead of one ad placed in one newspaper or magazine, property owners can place their ad on several different websites with thousands of potential buyers who can access those websites from the comfort of their own homes.
Property developers planning to use crowdfunded money may want to include a provision that allows them to buy back shares in the investment at different prices throughout the life of the project.
3. Become a Hard Money Lender
If you have a bit of money saved up, this might be an opportunity for you. A hard money loan is a short-term loan, typically one to two years, issued with less flexible terms than traditional loans. Hard money lenders make it their business to lend in situations where the borrower lacks access to traditional financing.
If you have the capital and the flexibility you could partner with someone knowledgeable in the commercial real estate space. Using the industry knowledge paired with your upfront capital, you could work up a contract that earns you interest on the loan and a percentage of the income from the commercial investment.
This one is pretty straightforward and is for business owners or entrepreneurs. Move your small business into a commercial property and work to own it outright. If you use a loan for the property you have the option to sublease to help pay it down. You’ll likely need to put 20 – 30 percent down depending on the property, so this option does require a bit of capital.
The advantages of occupying a commercial property are numerous (see tax advantages above). Real estate fluctuates but it’s a relatively safe and not a volatile market. You can own the property for as long as you’re in business and then sell for a profit when the time is right.
5. Commercial Real Estate Mutual Funds
A commercial real estate mutual fund is a portfolio of investments in commercial real estate. It may consist of buildings, land and other property. The fund pools the collective assets of investors to purchase properties for long-term use or sale. Mutual funds are managed by professionals and offer participants an opportunity to spread their investment risk while maintaining control over their investments.
You can choose one of two types: closed or open end. A closed-end fund issues shares at a fixed price, which means that the price for an individual share remains constant over time. An open-end fund issues new shares at a variable price based on supply and demand while trying to maintain a constant share price over time. They can also be subclassified as public or private funds.
6. Buy an Office Building
In today’s digital world, the office is no longer just about where you go when you want to get some work done. Now, offices are long-term investments for many companies. The office space that a company uses is an excellent investment, and it might pay for itself many times over through rising rental rates. You might want to consider investing in a shared workspace like WeWork, or build your own version. WeWork designs and builds physical and virtual shared spaces or offices for individuals and companies.
If you’re interested in this area, there are many cities that have experienced high demand for office space in the past, like London and San Francisco. Once you find the perfect location for your investment, you can buy or build a property that will offer excellent returns during both good and bad economic times.
Bonus: Become an Accredited Investor
Many companies or projects may require you to be an accredited investor in order to invest. What’s an accredited investor? In order to become accredited your earned income must exceed $200,000 individually or $300,000 jointly annually for the past 2 years. You also must have a net worth of over $1,000,000 (individual or joint) not including your primary residence as an asset. The last thing you must have is a Series 7, 65 or 82 license. You can read more about those licenses here.
Some crowdfunding platforms like RealtyMogul and Fundrise have accredited investor-only deals. These exclusive investments often have more opportunity and income potential than if you were not accredited.
Steps to Evaluate Commercial Real Estate
Before making any investment, you should evaluate and estimate potential gains and losses based on a set of criteria. Follow these steps before committing to a commercial real estate deal.
Step 1: Observe and understand the current state of the property and area.
Observing and understanding the current state of the property is vital for proper evaluation because investors must know what property improvements are needed in order to make it more attractive. Some initial questions to ask yourself:
- What are some things to consider when observing and understanding commercial real estate property?
- How can you evaluate whether or not your building has good access?
- How do you evaluate traffic flow within a building?
- What impact does access have on overall commercial real estate investment performance? (ex. improve access to parking)
- What is your property’s physical appearance? What do you see when you look at the front of a building? How does the facade of a building affect its value?
- What type of zoning is in effect for what area? How will zoning affect current or future value?
- What are some common problems facing the building, and what would make it more successful in your eyes? For example, plumbing issues may be a problem. Some buildings may need cosmetic changes such as painting, landscaping, or upgrading pipes.
- What services are available in the area? Which are lacking?
Step 2: Evaluate the potential future state of the property.
What do you envision for the property if it were to be improved? According to commercial real estate appraisers, your vision must be realistic. Be careful not to overstate your case. You can, however, use a general vision and adjust it as you learn more about the property and its surrounding area.
Once you’ve evaluated the current state of the property, determine what would be ideal or possible improvements that would make this property more valuable. Think about how you see this type of commercial real estate investment performing in comparison to other investments you’ve made in the past. (Example: Can this be a retirement investment? Can you get a higher return than your local bank account? Would this be a good stable investment?)
Figure out the ideal tenant profile for the property. For instance, the building may require office activity during the day and have parking available after hours.
Future-focused questions will help you weed out the potential bad investments.
Step 3: Analyze demand, location, and access to capital.
Because most real estate investments are considered long-term, commercial real estate investors must think about factors such as demand, location and access to capital. Demand is the number of people who need what you are offering compared to how much supply is available. Does the property you are evaluating have enough demand for reasonable rental and/or investment income?
Location is another important factor. Where are the local offices? What kind of buildings and divisions are nearby? What type of commercial real estate would be appropriate in this location?
Access to capital is necessary to consider because it can help you select better tenants, buy larger buildings, or make other investments.
Step 4: Evaluate return on investment (ROI).
Once you evaluate your property’s potential future state, you need to execute a plan that will help you determine how well the property is performing financially. Estimate economic feasibility based on how much income you can generate and the expenses that you’ll incur. Look at things like operating expenses, debt service, and taxes. Quantifying financial performance is an important part of evaluating commercial real estate. You will need to create a financial statement that estimates cash flow (income minus expenses), profit or loss, working capital, investments and other financial information. This will provide future estimates for the project’s earnings and assets while helping you determine which investment strategy is best.
Step 5: Develop a commercial real estate business plan.
A business plan is helpful when you’re exploring real estate investment possibilities. As a commercial real estate investor, you should develop as much of a business plan as possible based on private and personal financial information. This is also helpful for investors who want to get financed and get the attention of lending institutions by setting out your goals and keeping them abreast of changes in your investment strategy. Read more about how to make a business plan.
Step 6: Determine economic feasibility, property value, and financial performance.
Once you have gone through all these steps, you are ready to review your results with other real estate appraisers in order to decide whether or not this property is worth investing in. Economic feasibility is the first evaluation criterion. How much income can be generated? What expenses will be incurred?
Commercial real estate property value is the second evaluation criterion. What do you see as the property’s potential value to a buyer?
Financial performance is the next evaluation criterion. How much income and profit are generated? What level of expenses? How much will be used to pay off debt? How much is left after you’ve invested your own money?
Once you have evaluated the property’s potential future state, you can decide if this investment will benefit your goals. This is another reason why it is important to develop a business plan before making any real estate investment decisions.
Is Commercial Real Estate Investing Right for You?
After you have invested in a commercial real estate project, it’s important to monitor the improvement of its performance on a monthly and annual basis. From there you can make adjustments to your strategy and continue to invest in other properties.
Commercial real estate investment strategies are like a marathon race: Marathon training allows you to be in top condition when the race begins and then it is up to you to work hard during the race.
Frequently Asked Questions
Q: How much money do you need to invest in commercial real estate?
A: Commercial real estate deals often involve large sums of investment capital but investments are never one-size-fits-all. How much money you need initially depends on a few different factors. One of the most important things you’ll want to consider is your current financial situation and the amount of risk you’re comfortable with taking on.
A general rule for assessing your financial stability is that if you’re not willing to risk at least 25% of your total assets, then it’s probably best to not enter into a commercial property deal. One of the most common types of financing used in commercial real estate deals is a hard money loan. A hard money loan is a type of loan that’s provided by private investors or institutions that are not as regulated as traditional lending institutions. The purpose of these loans is to help a borrower meet immediate funding needs after they’ve exhausted other sources.
If you’re planning on purchasing a commercial income property, such as an apartment complex, you’ll want to ensure that your down payment is enough to cover the costs for both closing costs and property maintenance.
Q: What are the best commercial real estate investments?
A: When you buy a property as an investment, you plan to get your money back through either ownership of the property or rent that you collect from tenants. The best commercial real estate investments are those that will offer the most stability and safety for your investment. Compared to investing in stocks and bonds, commercial real estate offers you the opportunity to earn a profit on your investment every year as long as there are no existing loans. Commercial real estate may not go up or down as much in value, but that doesn’t mean it can’t increase over time. This type of investment also allows for the possibility of keeping the property for years, which can be crucial during a recession or other economic downturns.
Q: How do commercial real estate investors make money?
A: Commercial real estate investors are the ones who actually invest in property for leasing to tenants. They’re looking for a return on their investment, either through an annual return or to sell the property if it has appreciated in value. The other kind of investor is a speculator: they buy properties hoping that they’ll be able to resell them for higher prices in the future, with little regard for its standing as an income-producing property.
When a commercial real estate investor buys a property, there’s not usually just one way they make money off it. Typically these investors will be trying to maximize revenue from renting out various parts of the building or flipping and selling it at some point down the line if it has gone up in value.
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