When people start investing in real estate, they often focus on single-family residential properties or small multifamily properties. While these residential properties can be profitable, savvy investors often transition to commercial real estate properties to earn higher returns on their money.
With the right knowledge and tools, beginning investors can also learn how to invest in commercial real estate. This guide will help to demystify commercial real estate to help you get started with your first investment.
What is commercial real estate?
Commercial real estate (CRE) is the common name for properties that are used for business activities. Many people assume that only buildings occupied by businesses are considered commercial real estate. But CRE also includes any land that is used to generate a profit, as well as larger residential rental properties.
Property types that are categorized as commercial real estate include:
- Office space
- Warehouses and other industrial spaces or buildings
- Retail spaces, storefronts, and shopping centers
- Medical buildings, healthcare facilities, and hospitals
- Storage facilities
- Apartment buildings (5+ units)
- Hotels and resorts
How commercial leases work
When a business does not own the building it is in, it must lease all or part of the space from the building’s owner. In some cases, the business owner will buy the building, then lease it back to the company. This creates an arms-length transaction to help the owner pay for the building while keeping the two entities separate in case one is sold or gets sued.
In addition to buying a building to lease it to your own business, many people purchase buildings to lease to other businesses as investment properties. In each scenario, the tenant typically signs a lease to formalize the monthly rent, who pays for what, and the duration of the lease.
There are three primary types of commercial leases:
- Gross lease. The tenant pays the landlord rent, and the landlord is responsible for paying all property expenses, such as property taxes, utilities, and maintenance.
- Net lease. Tenant pays rent, but it is responsible for fixed operating expenses, like property taxes, insurance, and common area maintenance (CAM) items. Within this category, there are single, double, triple, and absolute triple net leases.
- Modified Gross/Net Lease. This lease type allows for more negotiations between tenant and landlord related to operating expenses when determining monthly rent. The monthly rent is fixed, even as agreed upon costs increase or decrease over time.
Triple net lease is one of the most common commercial leases. With this type of lease, the tenant pays rent to the landlord and is responsible for all other expenses related to the building. These expenses include property taxes, insurance, maintenance, and other items related to operating the building. The landlord's only expense is the mortgage, if there is one, and taxes.
Monthly rent is based on the number of square feet that the tenant occupies. Prices are listed and negotiated as an annual price per square foot. This means the monthly rent is the annual price per square foot times square feet occupied divided by 12.
So if the tenant occupies 3,500 square feet of office space with a gross rent of $34.68 per square foot, the monthly rent would be $10,115 per month. (3,500 x 34.68 = 121,380 / 12 = 10,115)
Some leases may also factor in a shared cost of common areas. Common areas include bathrooms, kitchens, and elevators that are used by all tenants of the building (or those on the same floor).
How to invest in commercial real estate
When investing money in commercial real estate, there are two primary options — direct and indirect investments. Direct investment is owning a building personally or through an entity, like a partnership or real estate LLC. Indirect investment is buying shares in a company that owns properties, as you do with REIT investing or real estate crowdfunding.
Direct real estate investment
- Ultimate flexibility in choosing which property to buy
- Control day-to-day decisions about the property
- Enjoy tax benefits
- Is not a passive investment
- Requires large amounts of capital
- A relatively illiquid investment that can be costly or difficult to buy or sell
Direct real estate investment is well suited for investors who want to manage the property themselves or work with a property manager to handle day-to-day activities. These investors generally have a high net worth and want the tax benefits from the property's depreciation.
Before going big into a deal, investors may consider learning how to invest 10K into a crowdfunded deal first. Then, take that knowledge to determine how to invest 20K into the next deal. Progressively increasing your investments allows you to get closer to your investment goals while you learn the process from experienced investors.
Indirect real estate investment
- Can start with much smaller amounts of money
- A hands-off approach to the properties
- Instant diversification of your portfolio
- Investments are usually liquid
- Do not have a say on which properties are invested in
- Decisions are made without your input
- REIT income is taxed at ordinary income tax rates
The smart fit for indirect real estate investment is investors who want passive income and automatic diversification of their portfolio. Indirect investing is also suitable for smaller investors or those who want to start investing with a small percentage of their portfolio.
Indirect investing could also make it easier for you to invest in cities where you don’t live and can’t research things in person, but have active CRE markets. For example, New York, the San Francisco Bay Area, or Los Angeles.
CRE vocabulary you should know
When learning how to invest in real estate, you need to know commercial real estate industry terms. Brush up on these terms to understand the conversation and make better investing decisions:
- Net operating income (NOI): Gross rental income minus expenses.
- Cash on cash return: Annual cash flow divided by the cash you've invested into your property.
- Cap rate: NOI divided by the purchase price of the building.
- Debt coverage ratio (DCR): NOI divided by your annual debt payments.
- Zoning: Regulations determine what type of building can be built within an area or what type of business can be operated.
- Building classification: Grades A through D represent the quality and location of your building, with A having the highest quality.
- Build-to-suit: Property that is developed specifically to meet the needs of the tenant.
- Triple net: A lease where the tenant pays rent to the landlord and covers all normal operating expenses of the building, such as utilities, property taxes, insurance, and maintenance.
- Common area maintenance: The costs associated with operating the building, including shared spaces. These costs are typically allocated to tenants proportionately based on how much square footage they are leasing.
- Parking ratio: The total rental square footage of the building is divided by the number of parking spaces. Many leases state how many parking spaces will be available for each tenant. This is particularly common for office properties.
To learn even more CRE terms and concepts, it helps to hang out in real estate investing forums. By reading posts from the community, these terms and concepts will make more sense. Plus, there will be additional possibilities to learn about opportunities, network with other investors, and get feedback on your deals.
Alternatively, you can dive into real estate investing books, podcasts, and courses. Everyone learns differently. These resources can provide valuable insights into the minds of other real estate investors, which could help you refine your strategy.
CRE people you should have in your network
Part of being a successful commercial real estate investor is surrounding yourself with the right team. These teammates handle certain tasks, provide invaluable advice, and make sure you are compliant with all federal, state, and local regulations.
- Commercial real estate agent: An agent from a commercial real estate firm will help you find potential properties that match your investment criteria and keep you updated on local trends related to your property. Some agents may also be able to help find tenants for your building.
- Property management company: Property managers handle the day-to-day interactions with your tenants, help negotiate leases, and collect rent payments.
- Lenders or mortgage brokers: Lenders and brokers enable investors to borrow money to fund a building's purchase or to borrow money against their equity. The lender may also help you refinance to reduce your rate or renew for a new term when your loan matures.
- Insurance agent: Insurance protects you and your property against risks from damage, lawsuits, and other covered events.
- Contractor or handyman: This is an essential person to perform rehab or repairs when you first buy the building, when tenants move out, and as necessary throughout a tenant's lease.
- Attorney: An attorney reviews contracts, responds to lawsuits, and provides a sounding board when difficult situations arise.
Should you invest in commercial real estate?
Investing in commercial real estate can be a profitable way to diversify your investments and income streams. Traditional commercial real estate investing is best suited for investors who have a larger sum of cash and are okay with concentrating their investment into a single building.
New investing apps, REITs, and ETFs make it easier for beginning investors or those with a small portfolio to start investing as little as $500 into commercial real estate as you continue to grow your assets.
Here are a few tips on how to know if commercial real estate investing is right for your goals:
- A larger initial investment may be required to purchase a commercial building. Though, smaller investors might be able to get started through ETFs and investing apps.
- There is less competition for commercial real estate properties because many investors don't have the capital or know-how to buy and operate a commercial property.
- A commercial property has less turnover and more consistent income with long-term leases in a commercial property.
- More objective price evaluations that are based on your tenants, not what a neighboring home recently sold for.
- Triple-net leases reduce landlord headaches and expenses since tenants are responsible for taking care of the building.
- Commercial real estate allows more flexibility with lease terms and evictions over residential real estate.
- Professional help is typically required because buildings are larger and more complex.
CBRE is one of the industry's leading commercial real estate brokers. They offer numerous CRE reports that help investors understand the latest real estate market trends.
What are examples of commercial real estate?
There are a variety of properties that are classified as commercial real estate. These include apartment buildings, office leasing, hospitals, storage facilities, industrial properties, and retail shopping malls.
Which makes more money: commercial or residential real estate?
Commercial real estate generally provides higher potential earnings for real estate investors. The average CRE investor earns 6% to 12% annually, while the typical residential real estate investor earns 1% to 4%. CRE properties usually have a diversified income stream from multiple tenants with long-term leases at a price per square foot that is higher than residential real estate.
How much capital do you need to invest in commercial real estate?
The amount of money needed to invest in commercial real estate varies based on the strategy you want to use. Purchasing a commercial building typically requires a 30% down payment. However, you can invest in real estate with $500 on several different online investing platforms. Additionally, many brokerage accounts allow investing in commercial real estate REITs and ETFs with relatively small amounts of money.
Real estate is a popular investing category for those looking to diversify their portfolios. But potential real estate investors might consider commercial real estate over single-family residence rentals. Commercial real estate offers many advantages, including longer-term leases, less turnover, and more flexibility in negotiating lease contracts. CRE also includes a wide variety of opportunities, from office buildings to retail spaces to industrial properties.
While traditional commercial real estate investments require significant capital, there are more opportunities than ever for smaller investors to participate. In some cases, you can start investing in real estate with $500 or less.
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