Buying Commercial Property for Beginners
Source: Ashley Kilroy, contributor for Rocket Mortgage
New investment opportunities pop up every day for bright entrepreneurs. For those who want to invest in something tangible with the potential for growth or passive income, you may want to consider buying commercial real estate. Here’s how you begin.
What Is Commercial Real Estate?
Residential property only includes single-family homes or those with up to four units. Usually, only families or individuals lease them. But commercial real estate (CRE) is generally for business purposes, including five or more units. You can break commercial real estate into five main categories:
- Multifamily: Essentially, multifamily homes are residential properties with more than one unit, like duplexes, garden apartments or assisted living facilities.
- Office space: They’re designated as low-, mid- or high-rise based on size, and allow for multiple tenants. Examples include medical offices and suburban office buildings.
- Retail: This type of real estate is designated for businesses that sell goods or services to consumers. They’re usually located in places conveniently accessible, like regional malls and strip shopping centers.
- Industrial: These properties range in size, like office spaces, and they host industrial operations, such as heavy manufacturing or light assembly.
- Hospitality: This covers establishments that service travelers, whether for meals, accommodations or entertainment, like hotels and short-term rentals.
Commercial office properties face further classification and are broken into three class gradings:
- Class A: Represents the highest-quality buildings available. They’re typically newer with top-tier construction, situated in the best location.
- Class B: Can still be high-quality properties, but usually older and lower-priced compared to Class A. Many investors flip or restore these.
- Class C: Are generally distressed and older. Class C properties require maintenance and lack an attractive location.
How To Get Into Commercial Real Estate
Figuring out how to buy commercial property isn't exactly like buying a single-family home. The experiences differ in more ways than one. The costs, for example, can be steep with commercial real estate , and it may be harder to secure funding. In addition, if you don't already have tenants, then it's up to you to cover expenses during lengthy periods when the properties are unoccupied.
Additionally, valuation for commercial property is often difficult. It's generally hard to find comparable properties for commercial real estate than residential. Because of these differences, investors should be careful before purchasing.
If you think you're ready to buy or invest in commercial real estate, there are a few steps you can take to prepare for the investment and purchase the right property to achieve your business or personal goals.
1. Define Your Motivation
It's important to reflect on your reasons behind buying commercial property. What are your long-term and short-term goals and what would it take for the investment to yield a successful return? Also, what do you plan to do with the property? Commercial buyers generally do one of the following:
Buying Commercial Property For Personal Use
Sometimes, investors benefit from real estate in more ways than just financially. One method is the owner-occupied commercial real estate (OOCRE) investment strategy. In this, the owner uses the property to conduct business operations. OOCRE affords you tax advantages, like the ability to depreciate and deduct annual interest on the loan. In addition, owning the property allows you to build equity, which you can sell for more later. Or, you can continue using the property as an income stream through leasing. It’s also much easier to manage the property on-site and control the tenant selection. However, there are some stumbling blocks. More costs may fall in your lap, such as property repairs and routine maintenance. Conflicts of interest can also arise, making it difficult to collect rent.
Buying Commercial Property For Investment Purposes
Buying a commercial building as an investment property comes with its perks. According to Bank of America, commercial property returns range between 6 – 12% annually; that’s higher than the average on single-family residential properties (which is typically around 1 – 4%). There are also tax advantages, cash flow opportunities and equity appreciation when you buy your commercial property.
Investors employ a variety of tactics depending on things like financial goals and the overall timeline. Here are some of the most common real estate investing stratgies they use:
Land banking: The process of purchasing and holding land. Investors do this to protect and grow their money, since it gets tied to a physical and fixed asset. They may sell the land or develop it in the future.
Development: An investor buys raw land to build on, sometimes after waiting for its value to grow. The direction of development, like condominiums versus commercial, depends on zoning laws.
Fix and flip: This strategy involves buying property, renovating it and then reselling it for a profit. Investors usually purchase poorly maintained land at a discount.
Wholesaling: A short-term real estate investing strategy where the wholesaler buys a contract from a property seller, typically below market value. Then, the wholesaler sells or assigns the contract to an interested buyer.
BRRRR: This acronym stands for Buy, Rehab, Rent, Refinance, Repeat. Essentially, it’s a passive income strategy that involves flipping a property to rent out to tenants. Once the owner pays the mortgage and builds equity, they can refinance the property to fund future real estate investments.
Passive investing: This strategy is for investors who don’t want to be directly involved. Instead, they put capital into a real estate deal through the stock market, crowdfunding or partnering with a more active investor.
2. Secure Financing From A Lender
Finding a lender for your commercial property early on is essential. Compare several lenders before you settle on one, though. While you want to secure financing, you should ensure your lender promises what you need. They should offer options according to your credit score range and at an affordable interest rate. Also, ask them about possible fees and penalties so that you know ahead of time. Look out for the loan-to-value (LTV) ratio, or how much they're willing to loan, and whether they ask for collateral as well. A recourse loan lets the lender go after additional personal assets if you default, whereas a nonrecourse loan only gives them the option to seize agreement-specific collateral.
3. Hire A Team Of Trusted Professionals
Everyone has to start somewhere, but first-time investors shouldn’t begin alone. It’s better to have people with experience and knowledge on your side. That way, the process moves smoothly and efficiently, which will save money in the long run. Some professionals you may want to think about hiring include a
- REALTOR: helps with responsibilities such as researching potential properties or negotiating terms for their clients
- Attorney: protects your interests during negotiations, help you understand applicable laws, get better pricing and ensure the agreement is legitimate
- Accountant: handles the financial side of things, preparing budgets, creating monthly reports and generating any necessary statements for tax purposes
- Mortgage broker: matches you with the best lender for your needs. They can submit multiple loan applications, increasing your approval chances, and track down agreeable pricing
- Contractor: oversees the site, materials, and more during the course of the project
- Property manager: supervises they property and ensures it has tenants who contribute to the real estate's value. They also facilitate or address repairs for on-site issues in the building, collect rent, hire contractors, and meet with potential clients.
4. Find The Perfect Opportunity
Numerous factors play into a commercial property’s value to an investor. But it also needs to be desirable to your potential tenants who will lease it. Some things you may want to think about while searching:
- Economic and industry trends
- Networking potential through tenants, business owners and commercial brokers
- Affordable leasing
- Zoning laws and land use
- The property’s design
- Potential for growth
- Market data like rental rates, vacancy rates and construction costs
5. Run The Numbers
Due diligence plays a crucial role in real estate investing. Essentially, this entails taking steps to ensure you meet all legal requirements while purchasing or selling the property. That involves fact-checking and assessing the property:
- Evaluating the location, real estate market and comparing multiple properties.
- Assessing the condition of the property.
There are a few formulas and tools you can use to estimate a property’s value. If you are new to commercial real estate, seek the guidance of the team you have put together to look at the risks and benefits from multiple angles.
6. Make An Attractive Offer
After calculating potential costs and profit, you can make an offer. You can negotiate broad terms using a Letter of Intent (LOI) and more specific terms with a Purchase and Sale Agreement. An attorney can help you review your terms before finalization. You may also want to think about asking an accountant for help. They’ll review your terms as well and explain the tax consequences. A back-and-forth may ensue. Meeting in person may help you resolve any problems, but always follow up with written confirmation of any changes or agreements. Our team has experience working through the process of purchasing and selling commercial property and can guide you