Commercial Real Estate: Definition, Types, Companies & Best Investment Tips

Commercial Real Estate

Any type of property, whether commercial or residential, can be an excellent investment. Commercial assets often provide more financial benefit for your money than residential properties such as rental flats or single-family homes, but there are also more hazards.
Understanding the full pros and cons of investing in commercial real estate investment is critical in order to make the best investment decision for you.

Commercial Real Estate: Definition

Commercial real estate refers to asset classes that are not single-family residences. They can be multifamily (four or more connected dwellings), retail spaces or offices, industrial or factory properties, or a combination of these. Any type of property, whether commercial or residential, can be a good investment. Commercial properties typically provide more financial reward for your money than residential properties such as rental apartments or single-family homes, but there may also be more risks.

Understanding the whole advantages and cons of investing in commercial properties is critical so that you can make the best investment decision for you. or even buildable land

Because commercial properties are larger in scale, they allow you to build your portfolio faster than buying individual homes. Naturally, any real estate investment has the distinct advantage of allowing you to leverage, or mortgage, your investment.

Types of Commercial Real Estate

We’ll go over the eight different types of commercial real estate below, looking at each of the following:

  • Multifamily
  • Office
  • Industrial
  • Retail
  • Hotels / Hospitality
  • Mixed Use
  • Land
  • Special Purpose

We’ll look at several building types, property types, and land use types, as well as some examples of each asset class along the road.

#1. Multifamily

Multifamily properties serve as a bridge between residential and commercial real estate.

While they can be used primarily as a residence, the general purpose of the property type is for investment (owner-occupied or not).

The multifamily asset class includes everything from a duplex to a multi-hundred unit apartment building.

Duplex/Triplex/Quadruplex

Duplexes are two-unit rental properties, triplexes are three-unit buildings, and quadruplexes are four-unit properties. It’s quite straightforward.

The “plex” suffixed property types are found in almost every market, although they are more suitable for first-time investors and those looking to profit from their own home (by renting out other units).

Apartment buildings, on the other hand, are often classified as low, mid, or high rise based on the number of stories they have.

Garden Apartments

Suburban garden flats first appeared in the 1960s and 1970s, as young people moved from cities to the suburbs.

Garden apartments are typically 3-4 floors tall, with 50-400 units, no elevators, and surface parking. It is essentially a cluster of low-rise apartment buildings on one piece of land, some of which may share a yard or other land area.

Mid-Rise Apartments

These complexes are typically 5-12 floors tall, with 30-110 units with elevator service. These are frequently built-in urban infill sites.

High-Rise Apartments

High-rise apartments are typically located in larger markets, feature 100+ units, and are professionally managed.

The number of stories is less specific for high-rise buildings, however, once you exceed 10-12 stories, most markets will regard the building to be a high-rise.

A skyscraper is a high-rise building that has more than 40 stories and reaches a certain height.

#2. Office

Office buildings, like multifamily properties, are classified as low, mid, or high rise depending on their size.

Class A, B, and C office buildings

Office buildings are typically classified as Class A, Class B, or Class C.

These classifications are all relative and heavily influenced by contexts, such as the location of the building and the health of its surrounding market.

The Class A buildings are the best of the best in terms of construction and location.

Class B properties may have high-quality construction but are in a less desirable location.

Class C properties may be dilapidated and in an unfavorable location.

Central Business District (CBD)

Office buildings in a central business district (CBD) are in the heart of a city.

These buildings would include high rises in downtown areas in larger cities like Chicago or New York, as well as in some medium-sized cities like Orlando or Jacksonville.

Suburban Office Buildings

This type of suburban office space typically consists of mid-rise structures ranging in size from 80,000 to 400,000 square feet and located outside of a city center.

Suburban office parks, which assemble several different mid-rise buildings into a campus-like setting, are also common in cities.

#3. Industrial

The size of industrial properties can also vary significantly depending on their specific use-cases.

Heavy Manufacturing

This industrial property category is really a special use category that most large manufacturers would fall under. These properties are heavily customized with machinery for the end-user and usually require extensive renovation to re-purpose for another tenant.

Light Assembly

These structures are much simpler than heavy manufacturing properties and can usually be easily reconfigured.

Storage, product assembly, and office space are all common applications.

Flex Warehouse

This is an industrial property that can be easily converted and typically includes a mix of industrial and office space.

Flex space can also be considered mixed-use, which we’ll go over in more detail below.

Bulk Warehouse

These properties are typically very large, ranging from 50,000 to 1,000,000 square feet.

These properties are frequently used for the regional distribution of products. They also require easy access by trucks entering and exiting highway systems.

#4. Retail

Strip / Shopping Center

Strip centers are smaller retail properties that may or may not have anchor tenants. An anchor tenant is simply a larger retail tenant that serves to draw customers into the property.

Anchor tenants include Wal-Mart, Publix, and Home Depot. Strip malls typically house a mix of small retail stores such as Chinese restaurants, dry cleaners, nail salons, and so on.

Community Retail Center

Community retail centers typically range in size from 150,000 to 350,000 square feet.

They are occupied by a number of anchors, such as grocery stores and drug stores. Furthermore, it is common to find one or more restaurants in a community retail center.

Power Center

A power center typically has several smaller, inline retail stores, but it is distinguished by the presence of a few major box retailers, such as Wal-Mart, Lowes, Staples, Best Buy, and so on.

Each big box retailer typically occupies between 30,000 and 200,000 square feet, and these retail centers typically contain several out parcels.

Regional Mall

Malls range in size from 400,000 to 2,000,000 square feet and typically have a few anchor tenants such as department stores or big-box retailers such as Barnes & Noble or Best Buy.

Out Parcel

Most larger retail centers have one or more out parcels, which are plots of land set aside for specific tenants such as fast-food restaurants or banks.

#5. Hotels

Full-Service Hotels

Full-service hotels are typically located in central business districts or tourist areas and include well-known brands such as Four Seasons, Marriott, and Ritz Carlton.

Hotels with Limited Service

Hotels in the limited-service category are typically boutique properties. These hotels are typically smaller and do not offer amenities such as room service, on-site restaurants, or convention space.

Extended Stay Hotels

These hotels have larger rooms, small kitchens, and are intended for people staying for a week or more.

#6. Mixed Use

Mixed-use properties, while distinct in their own right, can actually be a combination of any of the aforementioned types of commercial property. Retail/restaurant properties with offices or residences atop are the most common type of mixed-use property, particularly in cities.

Consider a typical downtown high-rise building; chances are, the asset is mixed-use. Mixed-use properties are typically some combination of office, residential/multifamily, retail, and/or industrial.

#7. Land

Greenfield / Agricultural Land

Greenfield land is undeveloped land, such as a farm or pasture. This category would also include various types of agricultural land, such as orchards, animal farms, ranches, and more.

Infill Land

Infill land is located in a city that has already been developed but is now vacant. It is solely associated with the development of real estate in urban areas.

Brownfield Land

Brownfields are parcels of land that were previously used for industrial or commercial purposes but are now available for re-use.

These properties are generally environmentally harmed or are suspected of being so, as a result of previous commercial uses.

#8. Special-Purpose

The above real estate categories cover the most common types of commercial real estate. However, there are numerous other types of commercial real estate that investors construct and own.

This is where the concept of “special purpose” property comes into play. It is, in essence, the CRE miscellaneous classification. Amusement parks, bowling alleys, parking lots, stadiums, theaters, zoos, and many other special-purpose properties are examples.

Basic Terms In Commercial Real Estate

While there are dozens of words unique to commercial real estate investing, preferred returns and equity split are two key ideas that will be discussed throughout this study.

Preferred returns:

This is a type of return in which the sponsor pays the investor a fixed rate of return that might range from 5% to 10% or more. Preferred returns are usually paid quarterly, but they can also be paid monthly or annually.

Equity Split:

When a portion of the property’s equity from appreciation or increased value is split between the sponsor and the investor based on an agreed-upon percentage, this is referred to as an equity split.

Passive Commercial Real Estate Investments

The investor does not actively own or manage the property in passive real estate investments. Passive investment often produces income in the form of a dividend, preferred return, equity split, or a mix of the three.

The following is a basic overview of the numerous ways to invest in commercial real estate passively. Each type of passive commercial real estate investment has advantages and disadvantages, so do your research before investing.

Real Estate Investment Trusts (REITs)

REITs are one of the most straightforward ways to invest in commercial real estate. A real estate investment trust (REIT) pools money to buy and manage several commercial buildings effectively, and it pays dividends to investors. REITs are eligible for special tax breaks if they send out 90% or more of their earnings as dividends to their shareholders, making them a solid source of passive income.

There are two types of REITs: Equity REITs and mortgage REITs. Shares of both types can be purchased through a brokerage account (for public REITs) or directly from the REIT (for private ones). The most popular option is publicly-traded REITs, which may be purchased for as little as a few hundred dollars.

Real Estate Exchange-traded Fund (ETF)

Rather than selecting and purchasing individual REIT shares, you can participate in several REITs through a real estate exchange-traded fund (ETF). A fund manager selects a portfolio of real estate securities to invest in. This can comprise a number of REITs in various commercial areas.

Real estate exchange-traded funds (ETFs) reduce risk by spreading your investment across several firms and sectors.

Crowdfunding

For approved investors, CRE crowdfunding is a passive investment alternative. Investors can use crowdfunding platforms to connect with third-party investors or developers that have an investment opportunity that needs funding. Most crowdfunding platforms evaluate the investment and the sponsor before adding them to the platform, but you should do your own research on the opportunity and the sponsor.

CRE crowdfunding options can be accessed by investors for as little as a few thousand dollars, however, others demand hundreds of thousands. While the returns are often better than those of a REIT or real estate ETF, there is less liquidity and more risk with crowdsourcing. The majority of crowdfunding possibilities have maturities ranging from two to five years. During such time, the investor is unable to withdraw their funds from the transaction.

Participate as an equity or financing partner.

Another passive alternative is to collaborate as a financial partner with an active CRE investor. You are a silent, passive partner who contributes to the down payment or cash purchase of the property in exchange for a preferred return, equity share, or a combination of the two. This is similar to crowdfunding, except that the number of partners is smaller and the returns are bigger. But there is also a greater risk.

Equity and financial partners are popular in the real estate industry, particularly in CRE. These changes, however, are not well-publicized. The majority of equity opportunities are discovered through established contacts with active investors. It is critical that you undertake your own due diligence on the investment and the investor. They are in charge of the LLC, the property, and your money, so you must have faith in their abilities to manage the investment successfully.

Active Commercial Real Estate Investments

Active real estate investments are those in which the investor actively manages the investment. This often entails owning a piece of the investment as well as bearing some or all of the risk and obligation. While this is not always the case, active investing typically outperforms passive investing. Active investments generate revenue in two ways:

  • Rental income and cash flow
  • Property appreciation is the process of increasing the value of a property.

How to Buy and Manage a Commercial Real Estate Property on Your Own

If you actively invest in commercial real estate, you are responsible for finding, funding, acquiring, managing, and disposing of the property. While you may have financial partners, investors, a third-party management business, or a team of individuals on your side, you are ultimately accountable for the investment’s success or failure.

Most active CRE investors specialize in a specific industry. They may exclusively purchase multifamily residences or concentrate on office complexes. Determine the following before purchasing a commercial property:

  • The type of commercial real estate property you wish to own,
  • The availability and demand for that type of CRE in your real estate market, and
  • how to correctly invest in that CRE industry

Here’s how to start actively investing in commercial real estate.

#1. Evaluate potential investment opportunities

Once you’ve decided on a sector and a location, you’ll want to look for investment opportunities to explore. Loopnet, Crexi, Craigslist, and your own direct mail campaign are all good places to look for properties offered for sale through a commercial real estate broker.

If the property is listed with a broker, the broker would normally submit an offering memorandum (OM) outlining the property’s present performance as well as its pro forma, or the prospective revenue the property can earn when managed and leased efficiently. While this information is helpful, it is your responsibility to confirm the projections and current spending.

The majority of offers are based on the property’s net operating income (NOI) and cap rate.

  • The net operating income (NOI) is the money generated by a property after all annual expenses, excluding debt payment, have been deducted.
  • The cap rate is the property’s valuation based on its net operating income, or NOI. The better the return, the higher the cap rate. The lower the cap rate, the less of a deal you will get.

#2. Submit a Letter of Intent (LOI)

If the investment appears to be viable, the next step is to submit a letter of intent (LOI). This is a one- or two-page paper that summarizes:

  • what you intend to buy, and
  • the purchase terms, such as the purchase price, down payment, inspection time, and any other stipulations or contingencies

An LOI is not legally binding, but it continues the buyer and seller’s due diligence process on temporary terms. After the buyer has completed their due diligence, they will be able to engage in a formal contract. Consult with an attorney before signing any contract to ensure that it contains all of the relevant provisions and conditions and effectively protects both parties.

An LOI is not legally binding, but it continues the buyer and seller’s due diligence process on temporary terms. After the buyer has completed their due diligence, they will be able to engage in a formal contract. Consult with an attorney before signing any contract to ensure that it contains all of the relevant provisions and conditions and effectively protects both parties.

#3. Obtain funds

You should arrange funds as soon as the contract is signed. There are a variety of commercial real estate loan options available:

  • Conventional loans require a down payment of at least 20% of the buying price. There are both short- and long-term options available, so you can acquire money with repayment terms ranging from two to thirty years. There are fixed-rate mortgages and adjustable-rate mortgages; some short-term loans also involve balloon payments.
  • Government Loans Small Business Administration (SBA7a) or Certified Development Company (SBA504) loans are government-backed and range from 15 to 25 years in length. Adjustable and fixed-rate loans can be obtained with as low as a 10% down payment.
  • Syndication: You combine funds from investors to buy the property in cash, paying a preferred return, equity share, or a combination of the two.
  • Owner financing: When the seller of a property carries financing at a defined rate and terms, this is referred to as owner financing.

When approving loans, most banks consider two factors:

  • The loan-to-value (LTV) ratio, which is the loan amount in relation to the property’s worth.
  • The annual income generated by the property in comparison to the annual debt service on the property. This is referred to as the debt service coverage ratio (DSCR).

While the property is the most important factor in the loan, banks also look at the investor’s business plan, creditworthiness, experience, and net worth to determine whether or not they are qualified to repay the loan.

It is not uncommon for CRE loans to require the investor to be a personal guarantor, assign a life insurance policy, or use other property as collateral, such as a primary residence.

#4. Conduct a thorough inspection and due diligence

Commercial real estate, like residential real estate, has an examination period. This term, which can be negotiated to be as short as 15 to 60 days, allows the buyer to conduct inspections and undertake due diligence on the property.

Buyers can order a variety of reports:

  • Report on Property Inspection
  • Environmental survey, Phase I
  • Survey of boundaries

The lender is the one who orders the majority of inspections. As a result, before ordering any surveys or inspections, you should look into financing options. This is also the time when the buyer verifies information on the property’s operation, such as income deposits, rental rates, vacancies, preceding tax returns, and so on.

During the inspection time, the buyer has the option to renegotiate or cancel the contract, often without penalty.

#5. Complete the transaction and begin managing the investment.

The property will be closed with a title firm or attorney once funding is received and the inspection period has expired. It is then the investor’s responsibility to manage the property. This can involve things like

  • supervising or employing an on-site manager.
  • enlisting the services of a third-party property management business,
  • To handle the rental units, property management software is used.
  • social media marketing and advertising for the property
  • launching eviction proceedings against defaulting tenants,
  • constructing significant improvements, and
  • additional responsibilities

Owning a CRE property frequently necessitates a significant amount of work and constant supervision. However, it can result in a large reward.

Commercial Real Estate and Taxes

Depending on the type of investment, income from commercial real estate is taxed differently. Once you’ve decided on the best way to invest in CRE for you, look into how that investment is taxed and consult with a tax advisor.

Benefits of Commercial Real Estate

One of the most significant advantages of commercial real estate is the low cost of leasing. Commercial real estate can have remarkable returns and significant monthly cash flows in places where the quantity of new construction is either limited by land or by law. Industrial buildings typically have cheaper rents than office towers, but they also have lower overhead expenditures.

Commercial real estate also benefits from tenant lease terms that are far longer than those in residential real estate. As long as long-term tenants occupy the building, this extended lease period provides the commercial real estate holder with significant cash flow stability.

Commercial real estate, in addition to providing a consistent and lucrative source of income, has the potential for capital appreciation as long as the property is well-maintained and kept up to date. And, like all types of real estate, it is a distinct asset class that can provide an effective diversification alternative for a well-diversified portfolio.

Commercial Real Estate Disadvantages

Most people who desire to invest in commercial real estate directly are put off by rules and regulations. Commercial property taxes, purchase mechanics, and maintenance responsibilities are hidden beneath layers of legalese. These standards differ depending on the state, county, industry, size, zoning, and a variety of other factors. Most commercial real estate investors have specialized knowledge or a team of people that do.

Another impediment is the heightened risk that comes with tenant turnover, which is especially important in an economy where unexpected retail closures leave properties vacant with little warning.

When it comes to dwellings, one tenant’s facility needs frequently mirror those of prior or prospective occupants. In the case of a commercial property, however, each renter may have quite diverse needs that necessitate significant renovations. The building owner must then modify the area to meet the particular trade of each tenant. Due to the cost of improvements for incoming tenants, a commercial property with a low vacancy but high tenant turnover may nevertheless lose money.

Buying a commercial property is a significantly more expensive proposition for those wishing to invest directly than buying a residential home. Furthermore, while real estate, in general, is one of the more illiquid asset classes, transactions for commercial buildings proceed at an exceptionally slow pace.

Forecasts for Commercial Real Estate

The commercial real estate industry in the United States suffered greatly during the 2008-2009 crisis, but it has been experiencing annual improvements since 2010. These gains have contributed to the recovery of nearly all recession-era losses.

Other signs, however, suggest that the commercial property market has peaked in the post-recession expansion cycle. According to Ten-X Growth, a California real estate agency, commercial property prices closed in 2018 up just 1% from 2017.

In Ten-X analysis, the 2018 final total for commercial properties matches their opinion of late economic cycle pricing. According to the firm’s data, vacancies are increasing, rent growth is slowing, and market interest rates are rising.

According to Forbes, the retail sector, in particular, has been a source of concern in the broader commercial property market, with widespread store closures intensifying in 2017 and continuing into 2018. For example, popular mall REIT Westfield Corporation had its stock price drop almost 30% between mid-2016 and late 2017, before rebounding some of those losses in January 2018. Unibail-Rodamco SE paid $15.8 billion for Westfield, forming Unibail-Rodamco-Westfield (URW).

Most organizations, on the other hand, believe that the property market is still in good shape overall. It is worth noting that the worldwide events of 2020 did not significantly reduce real estate values, and property values have stayed stable or even climbed, much like the stock market, which recovered from its stunning loss in Q2 2020 with an equally dramatic rally that has lasted through Q2 2021. This is a significant difference between the economic consequences in 2020 and what occurred a decade ago. What is unknown is whether the mandatory remote work environment for most Americans, which began in 2020, will have any long-term influence on corporate office demands.

Evaluating Commercial Real Estate Transactions

While the residential property is normally valued for the end-user based on square footage and comparable property sales in the neighborhood, commercial property is appraised differently.

Real estate professionals utilize a set of comps, or comparisons, to analyze and compare similar properties, but they are not entirely based on sales price, as is usual in residential real estate.

Commercial properties are also not included on standard residential sales websites such as Realtor.com, Zillow.com, or Trulia.com. Loopnet.com, which is owned by the commercial real estate database CoStar, is the largest listing site for commercial real estate. You may also locate commercial property leasing comps and listings here.

Comparing a commercial property’s capitalization rate (also known as cap rate) to that of similar properties is a standard method of evaluating it. This is derived by dividing the sale price of the property by the net operating income. Consider what your annual rate of return would be if you purchased the property in cash.

Even if a prospective property appears to be a good buy based on the cap rate, you should compare it to a couple of other valuation methods. This can include things like:

  • Net operating income (NOI): The amount of money generated by an asset after deducting all operating expenses, including vacancy and loss, and before paying the mortgage. This is the amount utilized to calculate the capitalization rate of the property.
  • Cash flow is the net amount of money in your pocket after all costs and mortgage payments are deducted.
  • Cash-on-cash return: Calculated by dividing the amount of money you put down on a property by the annual cash flow it generates. It is yet another indicator of your return on investment.
  • Gross income: The whole amount of money earned by a property before expenses.

Setting yourself up for success

There is more to commercial real estate evaluation than just the numbers. Before you even sit at the negotiating table, you must have a lot of things in place. Regardless of the asset class you choose, keep the following in mind during the purchasing process:

Is it possible for you to obtain financing for this property?

If you want to get financing for a multifamily or other commercial property, it must pass a commercial assessment and valuation by your bank. Banks, unlike single-family, owner-occupied properties, evaluate commercial properties on their own merits, with the operator-owners serving as personal guarantors. That means both you and the property’s numbers must be accurate.

If you invest in a four-unit or fewer multifamily property, you can live in one of the units and take advantage of owner-occupied financing terms, which typically require lower down payments and lower interest rates. It also makes it easy to manage the property yourself if you like. This strategy can be extremely beneficial for new real estate investors, but the unit you reside in will definitely limit your total cash flow. Still, you may stay in the house for a year or two before moving on to the next.

Make use of a commercial broker.

Residential real estate professionals who are used to assisting clients in purchasing single-family homes are not always the best persons to assist you in evaluating the commercial property. You’ll need a commercial broker or salesperson that understands how capitalization rates, cash-on-cash returns, and income are used to determine the worth of a property. They can assist you in understanding the subtleties of finalizing and negotiating a deal that may involve inheriting tenants or requiring odd or creative arrangements. Commercial transactions can quickly fall apart, and it requires an experienced professional to bring them to a successful conclusion. Skilled agents can also use their connections to assist you to find off-market deals. Loopnet.com provides a commercial real estate agent search to help you locate a specialist in your area.

Do you want to find out if that agent is any good? Inquire how many deals they have closed in the last year or two, and request three referrals from former clients and other agents with whom they have worked to close a deal. Because your commercial agent’s competency and negotiation abilities can make or break a transaction, you’ll want to hear from the horse’s mouth how smoothly and quickly he or she has been able to work in the past, particularly with similar properties to yours.

Request that the seller provide you with each piece of paper.

Unlike in a standard single-family detached transaction, you should ask the seller for a rent roll of current tenants, service contracts, and maintenance documents, as well as income and expense, accounts for current and previous years. Inquire with neighbors and present tenants about any potential issues, and determine how much of the property has been vacant, for how long, and why.

Obtain confirmation of payments from renters in the form of an estoppel certificate, which is essentially an oath that confirms their payments and terms, as well as copies of all leases. Use an online checklist to help you cover all of your bases.

Have a backup.

The larger the facility, the more expenses there will be, and these may not always be monetary. There will almost certainly be some vacancies and defaults, and you must be prepared for this. Allow for 10% of your annual estimated income.

Once you understand how to evaluate any piece of commercial real estate using these criteria, you can pick which asset class best complements your portfolio goals and how to evaluate the nuances of that asset class.

Commercial Real Estate FAQ’s

How profitable is commercial real estate?

Commercial properties typically have an annual return on investment of between 6% and 12%, depending on the area, present economy, and external factors (such as a pandemic). That is a significantly wider range than is typically found for single-family home properties (1 percent to 4 percent at best).

What is the 50% rule in real estate?

According to the 50 percent rule, real estate investors should expect a property’s operating expenses to be around half of its gross income. This excludes any mortgage payments (if applicable), but does include property taxes, insurance, vacancy losses, repairs, maintenance expenses, and owner-paid utilities.

What is the 70 percent rule?

The 70 percent rule in house flipping argues that you should not spend more than 70% of the After Repair Value (ARV) minus the cost of repairs for an investment property.

Should you tip your realtor?

In any case, you should not tip your Realtor. It is neither expected nor accepted as a regular practice. In fact, several real estate brokers claim that receiving gifts or bonuses makes them uneasy. Tips can actually cause them to work harder to ensure they stay inside the law and meet their licensing requirements.

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