Owning commercial real estate can be an exciting way to build your investment portfolio. The commercial market offers the potential for higher growth and greater rewards down the road. Buying commercial property is also far more complex then purchasing residential real estate, and there are more risks involved.
Those investing in commercial real estate for the first time can find the process complicated and confusing. There are numerous potential pitfalls, and the experience could be very costly if you are not thoroughly prepared. Here are 5 important steps that first time commercial real estate investors should take before entering the market:
Assemble your team of experts to assist you with the purchase
There are many ‘moving parts’ involved in a commercial real estate transaction, and you should plan on the process taking significantly longer than the purchase of a typical residential property. During this process, you will need experts to help you with various steps that must be completed. At a minimum, you will need an experienced commercial real estate lawyer, commercial realtor, accountant, and a mortgage lender. Depending on the complexity of the property you are considering, you may also need to bring in appraisers, engineers, environmental specialists, and other specialists.
Determine the purpose of the investment
The first thing you need to get clear on as a new commercial real estate investor is why you want to get into this business, and which type of commercial property is most appealing to you. For example, is this a short-term play where you plan to fix up and sell the property for a quick profit? If so, you should be aware of the risks going in, and the fact that expenses to repair a commercial property could end up being much higher then you originally projected. On the other hand, you may be looking at an investment that you want to provide long term cash flow. Decide before going in the purpose of your investment, what do you plan to do with the property, and your exit strategy (i.e., how you plan to eventually recoup your investment).
Determine the type of property you want to purchase
There are numerous different types of commercial real estate properties you could invest in. Examples include apartment complexes, office buildings, shopping and retail centers, medical facilities, warehouses, industrial property, hotels, or even farmland. Each type of commercial property has its own unique set of risks and potential rewards. Consider which property you are most passionate about, and which one is most likely to yield a good return on investment. It is also important to look at market factors that may present a risk for various types of property. For example, consumers have been trending toward online purchases in recent years, and this has hurt the retail industry. This is something do you definitely want to take into account if you were looking at purchasing a retail property (such as a strip mall).
Understand your local market
Macroeconomic trends are important when considering which commercial real estate property to invest in, and equally important are the trends within your local area. Look at the demographic trends. Is the population growing or declining? Is it a younger or older population? You should also understand something about how your local municipalities operate. There is a very good chance you will need permits and approvals from the city or town to make certain alterations to the property and bring in certain types of merchants. Find out the time frame and what it takes to secure various types of approvals from your local municipalities. This is one of many areas in which your commercial real estate attorney will be able to provide invaluable assistance.
Figure out your financing
One of the most critical pieces to the commercial real estate investing puzzle is the financing. Most investors do not have the ability to pay cash for their first commercial property, so you will need to find the most favorable financing options. First of all, you should not plan on borrowing too much. A bank or private lender would not finance 100% of the purchase of a commercial property anyway; but even if they did, this would most likely put you in a difficult financial position. There are various factors that lenders will look at depending on the type of property you are purchasing and the purpose of your investment. Assuming you are purchasing a property from which you plan to collect rent to cover the loan payments, a lender will generally want to see a break-even ratio (BER) of 85% or less. The break-even ratio is (operating expenses + debt service payments)/gross operating income. If your BER is less than 85%, this means that operating income (e.g., rents) could drop by as much as 15%, and you would still break even on the property. This allows for vacancies in the event that some of your tenants fall on hard times.