Buying 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 buying a commercial property isn’t the same as buying a house.
Before you purchase a commercial property, it helps to know the pros and cons of this type of investment. It’s also important to understand that with the chance for more reward often comes a higher purchase price and more risk.
7 Key Steps for Buying a Commercial Real Estate Property
- Understand your motivations for investing in commercial real estate.
- Assess your investment options.
- Secure financing.
- Partner with the right team.
- Find the right property in your market.
- Do your homework.
- Make an offer and close the deal.
How to Buy a Commercial Property: An In-Depth Review
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.
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
- Industrial Buildings
- Mixed-Use Buildings
As you can see, commercial properties are used for business purposes.
3. 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 one of the following financing options:
- Apartment Loans (Fannie Mae, Freddie Mac, and FHA)
- Bank Balance Sheet Loans
- Commercial Real Estate Loans
- 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. The Nav Marketplace is a great resource for reviewing business financing choices.
4. 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 Lender or Mortgage 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.
5. 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 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.
6. 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.
7. 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.
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 in “7 Keys for Buying a Commercial Real Estate Property.” 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 buildings, 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 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 appealing.
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.
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 it’s 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: Buying a Commercial Property
Most real estate investors start out small and work their way up to commercial listings. 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.
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.