Commercial real estate has the potential to be an excellent investment, often more so than residential properties. Yet even if you’re an experienced real estate investor, it’s crucial to understand that the process of buying a commercial property isn’t the same as buying a house to live in.
In this article, we’ll look at why you should consider buying commercial real estate, financing options available to you, and how to buy it.
Benefits of Investing in Commercial Property
Before you purchase a commercial property, it helps to know the pros and cons of this type of investment.
Real estate investing brings the opportunity to realize a profit over time, but also brings risk, as any investment does.
If you’ve been leasing property for your business, you may find it more affordable to purchase it, since your monthly mortgage payments may be less than rent.
Types of Commercial Property
If you want to invest in commercial real estate, it helps to understand the different types of commercial properties. For example, commercial properties may include:
- Apartment buildings
- Office buildings
- Retail buildings
- Multifamily apartments
- Shopping centers
- Industrial buildings
- Mixed-use buildings
How to Buy Commercial Property
Now let’s go deeper into those steps to buying commercial properties.
1. Understand your motivations for investing in commercial real estate.
Why do you want to invest in commercial real estate? It’s an important question to ask yourself before you start hunting for properties.
Do you want an apartment or office building that you can rent out to many tenants to help reduce the risk of non-payment? Are you searching for a property you can use, at least in part, for your own business?
Perhaps you’d like a larger property with the potential to appreciate and build equity over time. Maybe you’re looking to take advantage of tax benefits or scale your investment portfolio.
Whatever your motivation, it’s helpful to identify your “why” before you invest. Knowing why you want to purchase commercial property can help guide you as you search for the right investment opportunity.
2. Assess your investment options.
Looking at the list of types of commercial property above and determine which best fits your needs. Will you be running your own business out of the property or having other tenants only?
3. Look at the real estate market.
The real estate market goes up and down, so it can be a good idea to pay attention to it long before you are ready to buy. Paying attention to the ebbs and flows of the market could help you set yourself up for the opportunity to take advantage of a great price in a down market.
4. Secure financing.
Before you find a commercial property you wish to buy, it’s wise to line up your financing options in advance. Step one to securing commercial real estate financing (and other types of business financing as well) is to check your credit.
Depending upon your lender and the type of loan you apply for, your business credit scores and reports could come into play. Some lenders may check your personal credit too.
You should review your credit and make sure that the information contained in your reports is accurate. You can check your personal and business credit scores for free when you set up an account with Nav.
Once you verify that your credit information is accurate (you can dispute errors if you find them), take an honest look at the type of financing you might qualify for now. Depending on your credit, the type of property, and other factors, you might consider the financing options we discuss later in this article.
- Apartment Loans (Fannie Mae, Freddie Mac, and FHA)
- Bank Balance Sheet Loans
- Commercial Real Estate Loans
- Small business Loans
- Hard Money Loans
- Seller Financing
Be sure to compare interest rates, fees, repayment terms, and other factors as you shop for the best financing option available to you. Nav is a great resource for reviewing business financing options.
5. Partner with the right team.
Buying commercial real estate involves a lot of moving parts. In other words, it can be complicated. Even experienced investors know that it’s important to surround themselves with the right team of experts to make sure their investment has the best chance of success.
Here are some of the experts you may need to make sure your commercial real estate deal goes as smoothly as possible:
- Commercial Realtor
- Commercial real estate attorney
- Commercial real estate broker
- Tax attorney
Before you start shopping for potential properties, it’s wise to have your team already on hand. If you find the right help upfront, you’ll immediately know who to turn to when questions or problems arise. Assembling a team of pros might not be cheap, but it might save you from costly mistakes in the long run.
6. Find the right property in your market.
Once you know your “why,” you understand your investment options, you’ve secured financing, and you’ve put together a team of experts, it’s time for the fun part. You’re ready to start shopping for the right property in your market.
Your commercial real estate agent can help you locate commercial or industrial properties that meet your criteria. Pay attention to important factors, like usable square footage and location. However, don’t be distracted by a good deal if it doesn’t satisfy your reason for investing. For example, it doesn’t matter how great an office building looks on paper if you’ve decided you want to add an apartment complex to your investment portfolio.
7. Do your homework.
When you finally locate a property you may want to buy, it’s time for some heavy research. Again, your commercial realtor may be able to help you here, but it’s wise to make sure you’re personally doing your due diligence on the property as well.
Remember, you can never have too much information about a property you’re thinking about buying. Some questions you may want to ask or research include the following.
- What has the property been used for in the past? (Do you plan to continue using it for the same purpose?)
- If you wish to use the property for a different business purpose, is it appropriately zoned to support your plan?
- Can you request a change in zoning, if needed?
- How much income or rent does the property currently earn on an annual basis?
- Will the owner show you the rent rolls? Can you confirm that the units listed on the rent rolls currently have the tenants reported?
- What are the property taxes?
- Is the building in need of significant repairs now, or will it need repairs soon?
- Is the property located in a desirable area? (Ideally, you should look for locations that have less than 5% vacancy if you want to command higher rents and enjoy potentially high appreciation rates.)
- Does the deal make sense for your investment portfolio?
Buying a commercial property is quite different from purchasing residential real estate. Making a bad investment could be far more costly. If you’re new to the world of real estate investment, a wise place to begin is studying resources and real estate investment books from other successful investors.
8. Make an offer and close the deal.
When you find a property you want to purchase, it’s time to make an offer. Your commercial real estate agent will generally help you write up your offer to purchase, but it’s wise to have your attorney review it for good measure before you sign and submit it. Be prepared for the seller to ask for earnest money (potentially 1% of the purchase price, though sometimes more or less) when you go under contract.
Above all, make sure your offer has a due diligence period with an escape hatch if certain things go wrong (like zoning issues or the property failing to pass inspection). The technical term for this escape hatch is known as a contingency clause.
During your due diligence period, your lender may require an American Land Title Association survey (aka an ALTA) as a condition of closing. An ALTA survey can give you valuable information about the property, including boundary lines and the location of improvements, utility lines, and easements (if applicable).
If all goes well with your ALTA survey and the rest of your due diligence, you can continue to move forward toward closing. Your commercial realtor and real estate attorney should be able to guide you through the many complex steps involved in this process. Again, it’s crucial to set up a reliable team of experts you can count on in advance, long before you draw near the closing table.
When to Consider Buying Commercial Property
Business owners who have been leasing office space might consider purchasing a commercial space to reduce what they pay each month. Alternatively, you could purchase a commercial building so that you have your office space but can also earn income through renting out the rest.
What Happens to Commercial Real Estate in a Recession?
When looking to purchase a commercial investment property, it is important to be able to determine what happens to commercial real estate in a recession to make an educated decision regarding the most you are willing to pay without jeopardizing your financial stability. In the United States, a recession can last anywhere from eight months to a year and a half on average, and it occurs around once every six years.
At about the seven-month mark, the number of foreclosures reaches its highest point, making this a great opportunity to buy.
Is Now a Good Time to Invest in Commercial Property?
According to many experts, now is a great time to invest in commercial properties. The steady flow of revenue that is provided by rentals is among the most significant advantages of owning commercial real estate. Investments in commercial real estate can provide a steady, passive income since they are often secured by leases. This income can be counted on regardless of the market cycle.
2022 Trends in Commercial Real Estate Property Loans
Here are some commercial real estate property loan trends for 2022:
- Digital or online lenders are becoming more widely used
- Financial software development companies are using the blockchain technology
- Application Programming Interface (API) has been incorporated into applications to link banking servers
- Biometrics through fingerprinting and face recognition have become primary ways for identity verification
Financing Options for Commercial Real Estate
As promised, we’ll now cover loan options you have to pay for your commercial real estate purchase.
If you’re looking to purchase an apartment building, there are a few apartment loan programs to consider, as they specialize in multifamily occupancy properties. These include Fannie Mae, Freddie Mac, and FHA.
Commercial Real Estate Loans
There are commercial real estate loans specifically for this purpose. Because they are secured by the property you are buying, they may have lower interest rates than other types of loans.
Small Business Loans
Also consider small business loans from a bank, credit union, or online lender. You’ll need good to excellent credit to qualify for a loan from a bank, though there are some online lenders like Smartbiz that may have less strict requirements to qualify.
Hard Money Loans
If you don’t qualify for any of the above, explore hard money loans. Rather than the money being lent by a bank or other financial institution, these loans come from individuals, who may not have the same stringent criteria to qualify. Be aware: interest and fees may be higher.
If the seller is open to it, you can work directly with them to finance the property. This might look like you paying a monthly fee until the property cost is paid off.
Buying Commercial Real Estate — More Questions to Ask
Before you make a commercial real estate purchase, it’s important to gather the right information. To accomplish this goal, you need to learn the right questions to ask.
We’ve already covered a few questions you should ask above. However, there are a few more critical questions we haven’t discussed yet.
What are the different types of commercial real estate (and why does the difference matter)?
Commercial real estate is defined as a property that’s used solely for business purposes. In addition to the different types of commercial properties listed above (e.g., apartment complexes, office buildings, retail space, etc.), there are different classes of commercial properties as well.
Office and apartment buildings are often classified as follows:
- Class A properties are high-quality and generally represent lower risk. They’re often newer, demand higher rent, and tend to require few repairs or renovations (outside of routine maintenance). Class A properties may be managed by a professional property management company and can be easier to resell.
- Class B properties may be older and have lower rents compared with Class A buildings. They may have some deferred maintenance that requires attention as well. Class B properties are usually seen as higher risk and, therefore, might be available for a lower price.
- Class C properties feature the biggest risk for commercial real estate investors. As a result, they can usually be purchased for a much lower investment. They’re often 20+ years old and may be in need of heavy renovation. Class C properties often bring in significantly lower rent than Class A and B properties.
Other types of commercial properties, such as industrial buildings, hotels, or retail stores, have different designations. Depending on the type of commercial property you intend to buy, it’s important to understand the different building classifications and what they mean for you as an investor. Understanding the difference in commercial real estate classifications can help you better grasp the level of risk involved with a potential investment.
Why is the owner selling?
Once you find a property you like, it’s important to discover why the owner wants to sell it in the first place. Here are a few common reasons why owners sell their investment properties.
- The market is strong, and the owner thinks he or she can fetch a good price.
- The owner wants to cash out funds for another investment.
- There are tax advantages to selling.
- Rental income has stalled or isn’t performing as hoped.
- Long-term tenants are ending their lease.
- The owner has a balloon payment coming due soon.
The reason an owner wants to sell isn’t necessarily sinister. Nonetheless, knowing why the current owner wants to take the exit ramp could help you when it’s time to negotiate a purchase price.
Is investing in commercial real estate better than investing in single-family homes?
Becoming a landlord of single-family homes is a great way to get your feet wet when it comes to real estate investment. But if you want to grow your investment portfolio and potentially boost your cash flow, a larger commercial property may be a good investment.
According to Matt Larson, President of Cricket Realty Advisors, commercial real estate has an average annual return of 6-12% above the purchase price. Larson, writing for Nolo.com, says single-family homes average 1-4% by comparison. Of course, no real estate investment is a sure thing, whether it’s a commercial property or otherwise.
What is a Good Rate of Return on Commercial Real Estate in the Post Pandemic World?
The yearly return on the purchase price of commercial properties is normally between 6% and 12%, depending on the region, the economy, and one of the biggest factors, the pandemic. Currently, a good rate of return on commercial real estate post-pandemic is in the area of 5%.
Important Terms to Learn
The world of real estate is full of terms and acronyms most people don’t come across in their day-to-day lives. As a potential investor, it helps to have a grasp of these terms to guide you.
Ad Valorem: A form of taxation based on the official valuation of a piece of property.
Capitalization Rate (Cap Rate): The rate of return a property generates divided by its total value. It’s calculated using the following formula.
Cap Rate = Net Operating Income ÷ Appraised Property Value
Cash on Cash: Cash on cash is a measurement that applies to investors who buy real estate with financing. The term describes a property’s annual income over how much cash you actually invested. For example, the amount invested might be equal to the amount of your down payment.
Debt Service Coverage Ratio (DSCR): A measurement of a property’s annual net operating income compared with its annual debt payments (aka debt service). It’s calculated using the following formula.
DSCR = Annual Net Operating Income ÷ Total Debt Service
Loan-to-Value (LTV): A measurement of how much money you wish to borrow compared with the total value of the property you want to purchase. The formula for calculating the LTV ratio is as follows.
LTV = Loan Amount ÷ Appraised Property Value
Rentable Square Feet: The total area a tenant occupies from wall to wall, plus a portion of the common areas (e.g., hallways, stairwells, bathrooms, etc.).
Usable Square Feet: The total area a tenant occupies, not including shared space.
Vacancy Rate: The percentage of available units in a rental property that are unoccupied.
Final Word: Purchasing Commercial Real Estate
Most real estate entrepreneurs start out small and work their way up to commercial listings as their investment strategy. However, that’s not always the case. Regardless of your past experience, a commercial property might represent a sound investment opportunity, if you take time and learn the ropes first. Nav offers various financial resources that can help you identify which small business loans or business credit cards are best for your business — depending on your business credit scores.
Of course, any investment — commercial real estate included — comes with risk. This risk is magnified if you try to jump into buying a commercial property without a solid plan in place. For this reason, it’s important to consult with professionals, assemble a trustworthy team, and do everything you can to protect your assets in the event of a problem.