Commercial real estate investment is highly profitable for new investors

Commercial real estate investment is highly profitable. Time and again real estate investors have been eyeing the sector as an alternative to residential and single-family investments. Depending on individual goals and market trends, the commercial property asset class generates increased returns on investment. In this article, we discuss a detailed guide for new investors to invest in commercial real estate.

What is commercial real estate?

Commercial real estate encompasses any property that investors use for business operations and income generation. Furthermore, unlike residential properties, commercial properties provide a workspace and not a living space. The end goal of a commercial real estate building or land is to reap profits. The commercialization of a real estate property has implications on its financing, law applications, and tax treatments.

The four main classes of commercial real estate include office spaces, industrial, multifamily, hospitality, and retail. Malls, grocery stores, office buildings, storage facilities, hotels, etc are parts of commercial real estate.

Types of commercial real estate

1. Office properties

Commercial real estate office properties include single-tenant or multi-tenant buildings and other small professional buildings and high-rises. They are typically classified into urban and suburban properties. Urban office properties are located in metropolitan areas and include skyscrapers. On the other hand, suburban office properties, include mid-rises and are located outside the core centers of a city. Hence, they are also often grouped in office parks.

Furthermore, the office buildings are further categorized into three tiers- Class A, Class B, and Class C. 

2. Industrial properties

Industrial spaces include warehouses, factories, plants and other large to heavy manufacturing sites. These properties are used for manufacturing and distributing purposes. Hence, they are located in suburban areas, alongside major transportation routes. These properties often have height specifications and house single tenants. In 2020, the rise of e-commerce led to a boom in the demand for industrial properties.

Industrial properties are classified into four types:

3. Multifamily

Multifamily properties comprise apartment fourplexes and larger buildings. Apartment complexes, high-rise condo units, co-ops and townhomes, and smaller multi-family rental units are examples of multifamily properties. 

Multifamily properties, like office spaces, are classified into Class A, B, and C tiers as well. There are broadly six types of multifamily properties, that include:

4. Retail

Retail properties house retailers who sell products and services directly to the consumers. They can have single or multiple tenants or standalone buildings. There are several types of retail centers: 

A step by step guide for new investors to purchase their first commercial real estate asset

 1. Set your goals

The first step to building a portfolio is to determine the purpose and financial goals before. An investor must have a clear vision of what they want to achieve from a particular investment.

Investors must know whether they want a steady flow of monthly income or long-term capital appreciation. Do they want to focus on investing in office properties? Or are industrial properties more up their sleeve? Having a clear idea of whether they want to be an active or passive investor or if their end goal is to reach financial freedom, equips them with a foolproof investment strategy. Some of the strategies include:

Depending on the investor’s long-term and short-term goals, they must select a suitable investment strategy.

2. Determine your commercial real estate asset strategy

Commercial real estate investment is divided into four main strategies: core, core-plus, value-add, and opportunistic. These strategies depend on the risk tolerance and the return targets of the investors.

1. Core assets

Buyers consider commercial real estate investment in core assets as the safest bet. These assets are in fairly good condition in prime locations and are almost never vacant. Hence, core assets are stable assets because it generates steady income flow in the form of market rents. In core assets, investors adopt a buy-and-hold strategy as they involve little or no risks. Here, investors aim for capital preservation and reliable cash flow rather than asset appreciation. Core assets deliver around 7-10% of returns on investment.

2. Core plus assets

A Core plus asset is in similar condition as core assets, but it requires a certain degree of renovation. These offer a steady income for the investors who are willing to tolerate moderate risks to reap more returns after redevelopments. Since these properties are adequately good quality, they witness generous occupancy rates. Moreover, after renovations, investors can renew the leases of the existing tenants and even raise the rents and increase income. Core plus assets deliver around 9-12% of returns on investment.

3. Value add assets

Value add properties are higher up in the risk-returns scale as such assets require extensive renovations and repositioning. These properties are not fully occupied and witness low demand and a decent amount of vacancies. After investing in value-added assets, investors seek to not only generate income but significant value appreciation. Post renovations, investors increase rents and the net operating income of the property. As a result, the value of the property thoroughly improves. Hence, value-added assets are a combination of risks and returns. Value add assets deliver around 12-18% of the returns on investment.

4. Opportunistic assets

Opportunistic assets offer the highest risk-reward investment strategy. Such properties require massive or complete renovations. Hence, these assets are also called distressere3d assets. Moreover, they include repositioning a building from one use to another.

Furthermore, these properties are located in developing markets. As a result, opportunistic assets witness high vacancy rates notwithstanding their market potential. 

In this scenario, the investors undertake the buy and flip strategy with the goal of generating maximum returns. The aim to generate immediate rental income is not the priority of investors. Here, the investors buy a distressed asset, add value to it, and wait for anywhere around t-7 years till the property reaches its desired appreciation. After the property reaches its required potential, the investors ‘flip’ or sell the property at a much higher price. Opportunistic assets generate around 15%+ returns on investment.

Passive commercial real estate investment

This strategy is an example of active commercial real estate investment. In these scenarios, the buyers need to invest their capital, time, and risk tolerance. As opposed to active investments, passive investments in commercial real estate are also gaining popularity among investors.

Passive investment is a strategy where the investors generate passive incomes through commercial real estate. Some of the modes of passive investments include Real estate investment trusts (REITs) and crowdfunding.

Crowdfunding in commercial real estate is a way of accumulating small sums of money from multiple investors to fund large commercial real estate projects. In exchange for financing a big-budget commercial project, each investor receives great returns. Furthermore, crowdfunding enables investors to diversify their portfolios and make several short-term investments.

Read more about Lilypads’ article on REITs here.

3. Build a reliable partnership

Investing in commercial real estate for the first time can be daunting. So it is ideal to partner with experts and seasoned professionals to secure the investment and get maximum returns.

Collaborating with a reputed commercial real estate sponsor mitigates potential issues in the investment. This is because the right sponsor makes smart decisions. They have experience in relevant niches and know how to operate a property, build its value and maximize ROI. Based on the specific investment parameters, institutional sponsors and private equity real estate sponsors, as well as real estate investment platforms, are particularly helpful. Such platforms identify the end goals and risk tolerance of the investors and determine appropriate exit strategies for them.

However, it is wise to conduct extensive research on the partners before entering into a partnership with them. Investors should look for a few things before associating with them:

4. Run the numbers that matter

It is important to underwrite a commercial real estate investment to evaluate the deal. Crunching the metrics helps investors to understand how a potential investment will perform in the future and determine the areas of improvement. Some of the important metrics for a commercial real estate deal include:

1. Internal Rate of return (IRR)

IRR measures a project’s profitability. It is the annual rate of return on investment. This metric takes into account initial investment costs, cash flow, and property sale proceeds. A property’s internal rate of return estimates the value of the property in the holding period. Hence, a property projecting a higher IRR is more profitable for investment. IRR is expressed as a percentage.

2. Equity Multiple

Equity multiple measures the ratio of total cash returns to the paid-in capital over the entire time span of an investment.

For instance, an investor puts $200,000 into a property and receives $400,000 from distribution and sale proceeds over the total hold period. Here, the investor will receive a 2x equity multiple. This is because the returns of $400,000 divided by the invested amount of $200,000 equal 2.0. 

Equity multiple is also referred to as return on equity or multiple on invested capital.

3. Cash on cash return

The cash on cash return denotes the ratio of annual pre-tax operating net cash flow to the total amount of cash (equity) invested in the deal. The annual pre-tax cash flow is divided by total cash investment to get cash on cash returns of a property for that year. It is also represented as a percentage. 

Cash on cash returns helps investors to understand how a potential investment will perform in the current as well as a future market scenario. It also helps investors to determine the future income profitability against their initial investment.

4. Net operating income (NOI)

NOI in a commercial real estate investment is the total income a property generates, minus the total amount spent on its capital expenditures. A commercial property produces income from various sources including potential rental income, vending machines, parking fees, and so on. On the contrary, the property incurs operating expenses in the form of vacancies, utilities and maintenance charges, property taxes, etc.

Read our article to know more about the net operating income (NOI) of a commercial real estate asset.

5. Never underestimate the power of due diligence

Before acquiring commercial real estate, investors need to conduct intensive due diligence. Such an intricate background check helps in unearthing details about the property that are not readily available. This information helps in determining the value of the property. Furthermore, with due diligence, investors uncover financial demerits of a property that can make an investment a costly mistake.

Prospective buyers must carefully scrutinize the fundamentals of the property. These include the financials, compliance obligations, risk assessments, and other liabilities. For this reason, it is beneficial to partner with an experienced real estate sponsor. Their expertise in studying the resources to evaluate the value of a property or a portfolio limits the emergence of post-purchase risks.

In summary

Purchasing one’s first commercial real estate is certainly profitable and a great way to diversify one’s portfolio. However, identifying one’s investment goals and strategy, and partnering with experts and extensive due diligence will lead the way to the best ROI vehicle.