Pros and Cons of Commercial Real Estate Investing
Adding real estate to your investment portfolio in order to diversify and reduce overall risk has been considered a smart investment option since time immemorial. Commercial properties tend to fare better in terms of returns as compared to residential. Higher returns also bring with them their own set of risks to deal with.
Let us take a deep dive into commercial property and understand the rewards and risks associated with the same.
What comes under Commercial Property?
- Retail outlets and structures
- Office Buildings
- Industrial factories used for manufacturing and production
- Apartment buildings
- Warehouses and storage rooms
- Malls or multi-use buildings which comprise offices, retail outlets, and other commercial centres
Classification of Commercial Real Estates
- Class A – The best and the most updated properties in terms of infrastructure, designing, aesthetics, age, location, and technology.
- Class B – Older and not as competitive in pricing as Class A. Normally, these structures are used for revamping or restoration by Class A
- Class C – Usually more than 20 years old, these buildings are the oldest, with not a very attractive location and need thorough maintenance.
Investing in Commercial Real Estate
Investing in commercial real estate is a boon as a long-term investment that gives ample and timely returns. Money is multiplied not only by an appreciation of the value of the property if the investor wants to sell it, but also maximum returns are generated from the tenant rents. It is a highly lucrative return on investment, which serves as a hedge against the instability of the stock market. Investors can make money through property appreciation when they sell, but most returns come from tenant rents.
Two kinds of investments are made towards buying CREs:
Any investor with a considerable amount of know-how about the estate industry or who can employ firms to do so, can indulge in direct investing wherein they become the landlords after owning the property. This is high risk but a high reward investment for which the investor needs to be a high net worth stakeholder with a substantial amount of capital.
The other way is to avoid being the landlord of the commercial property; instead, the investor invests in REITS – Real Estate Investment Trusts, companies who deal in Commercial Real Estate, exchange-traded funds, banks, and realtors, etc.
Pros and Cons of Commercial Real Estate
Now that we know what comprises commercial real estate, let’s delve into the pros and cons of investing in one.
Pros of Investing in Commercial Real Estate
- Attractive Leasing Rates And Objective Price Evaluations Of The Property – Even in restricted areas, commercial real estate can still have attractive leasing rates, appreciable returns, objective and reasonable price evaluations of the CRE, and considerable monthly cash flows. Industrial buildings generally rent at a lower rate
- Cash Flow Stability – Commercial real estates also benefit from tenants as the long lease length gives the investor an appreciable amount of cash flow if the long-term tenants occupy the CRE
- Excellent Capital Appreciation – A rich source of capital appreciation, as long as the property is well maintained and kept up to date
- More Tenants, Less Risk – In a multiple-occupancy building, there are many tenants covering the operating costs as opposed to vacancies on a single-family residential, which equals a hundred percent income loss
- Security Advantage – Unlike stock, bonds, and other forms of investments, commercial real estate promises value both the land itself and its improvements, such as structures, infrastructure, and landscaping
- Pride Of Ownership – The investor is the proud owner of the Commercial real estate, and the value is one of the highest among all asset classes
- Tax Benefits – The government offers a good percentage of tax exemption on keeping real estate for more than three years and considering it as a long-term gain
- Superior Hedge Against Inflation – There is ever-increasing volatility in the stock market, and it is better to invest in CREs than considering other long term investments which have lesser fluctuations as compared to other sources
- Public Eye And Enhances Credibility And Goodwill – Possessing a CRE is surely a good score on the individual credit ranking of the investor and with the help of a team of experts, due diligence and proper investigation, the investor can enjoy the smooth maintenance of a credible CRE
- Limited Hours Of Operation – If an excellent team of managers and heads is employed, the investor himself does not have to invest a lot of time in the upkeep of the CRE
- Triple Net Leases – The lessee handles all property expenses directly, including real estate taxes
- Flexible Lease Options – Commercial real estate investments have the highest correlation to inflation compared to other asset classes such as treasuries and corporate bonds
- Less Competition – Due to their more significant structures, competition can be expected to be less in the commercial real estate market, and it offers a great variety of different establishments
- Conscientious Clients And Professional Relationship Maintained – Clients are also business owners; therefore, more professionalism can be expected from them. Also, since most of them are establishments that offer products and services, they will be concerned about maintaining their image and will surely try hard to keep the premises as clean and well-kept as possible
- Equity Portfolio – Commercial real estate often moves in the direction opposite to that of the stock market, thereby making it an effective diversification option to equities in a portfolio
Cons of Investing in Commercial Real Estate
- Time Commitment And Investment – To invest in CRE is a highly time-consuming process. So, the inconvenience of time and money spent on a thorough lookout for the CRE property is quite a lot
- Professional Help Required – It is not like buying a home, wherein the family looks at the residential property, and things are settled. Instead, this is for commercial purposes which means a number of legal, personal, professional, administrative, and infrastructural causes need to be verified and investigated which needs professional help and the burden of it is carried by the investor
- Bigger Initial Investment – by the buyer for which he either needs to partner with many other investors or avail feasible loans and other finance options, which increases his debt.
- Risky – As compared to buying general property, buying a Commercial Real Estate is quite risky as it is not for private but for public use. It will be professionally carried out, so the costs and risks pertaining to the structure are much higher
- Difficulty Finding Tenants – CRE’s attract long terms lease contracts compared to residential properties. Finding tenants willing to commit to such contracts can be a tricky situation to be in. Moreover, in times of non occupancy, owners are responsible for bearing the costs associated with the property along with maintenance, if any.
- Susceptible To Economy – In a healthy economy CRE is much in demand. With increase in demand the market value of such spaces also tends to rise. However during an economic slump, the opposite situation becomes the reality. Vulnerable businesses might shut shop, decreasing demand and reducing prices of retail spaces.
Investing in commercial real estate is a huge undertaking that comes with a lot of investment of capital, time, effort, and convenience. It also offers a lot of benefits and surely comes with a few downsides as well. It is a long-term investment with a faster rate of investment and with fewer risks. It is not difficult to triple the value of the investment by applying strategic techniques and advanced tweaks.
Pros & Cons of CRE FAQs:
Absolute Net means that the tenant who uses the commercial real estate pays for all the incurred expenses. In such a situation, the gross value of the CRE will be the same as the absolute value of the CRE, which is termed as ‘Absolute Net’.
The interest rate increase and inflation will be directly compensated with the escalations in the rent of the commercial real estate. This will adjust with the steady flow of cash and income and thus save the investor from any losses and the potential increase in the rates of interest.
If the investor has available and ready money and if he has the option to invest in both, residential and commercial with his amount of investment, then taking ROI – Return of investment ratio, lower vacancy rates, steady opportunities of cash flow, high-grade tenants and much higher income potential into consideration, one must invest in commercial real estate.
A triple-Net or NNN is a lease agreement wherein the tenant promises to pay all the expenses of the property, including building insurance, real estate taxes, and maintenance. These payments are in addition to rent and utilities, and in the absence of a triple net lease, all payments are typically the responsibility of the landlord.
Various strategies can be used to find the value of ROI like:
- Debt Service
- Internal rate of return
- Capitalization rate
- Net operating rate