One way to make money as an investor is to look into real estate. Commercial real estate investing offers the opportunity to diversify beyond stocks and bonds with the potential for high risk-adjusted returns.
Here’s what you need to know as you decide if commercial real estate is a good investment for you.
What is commercial real estate investing?
Commercial real estate investing focuses on property that generates revenue. Common types of commercial real estate include:
- Retail stores
- Industrial parks and warehouses
- Storage units
- Healthcare parks and facilities
- Multi-family apartment complexes
- Office buildings
- Mixed-use complexes and buildings that include living, working, and retail spaces
If you want to invest in commercial real estate, there are plenty of asset types to choose from.
Is investing in commercial property a good idea?
When trying to decide if commercial real estate is a good investment, you should understand the pros and cons — and consider your own investing and financial goals.
Pros of investing in commercial real estate
- Ongoing income potential. Commercial real estate investing comes with the potential for regular income from operations. Commercial properties operate like a mini business. They receive revenue from rents they charge tenants and must pay all the expenses to operate the property. If revenue exceeds expenses, there is a profit, which can flow to the owners as income.
- Potential tax benefits. Depending on the situation, you might be able to take advantage of tax benefits that can help you improve your tax liability and shelter the passive income you generate from the asset.
- Strong risk-adjusted returns. Commercial Real Estate investments often outperform returns generated from a traditional stock and bond portfolio. In fact, institutional investors have long understood the merits of holding private real estate in their portfolios. Today, most endowments, pension funds, and asset managers allocate a significant portion of their investment portfolio to real estate to bolster returns over what they can achieve in the stock market.
Cons of investing in commercial real estate
- Higher initial investment. You normally need a higher initial amount for commercial real estate investing than what you’d need to start investing in stocks. For some investors, this can be a challenge.
- Illiquid Investment. You can’t trade in and out of real estate like you can a publically traded stock. Buying and selling assets takes significant time, and there is no ready-made public market that will be at the ready to buy your real estate at the price you want for it.
- Professional Expertise Required. Owning and operating commercial real estate is not a trivial exercise. Successful real estate companies employ experienced professionals to plan and execute their operating strategies. Even deciding to buy a duplex means you have to meet the demands of being a landlord, which is often seen as a full time job.
Can you make a lot of money in commercial real estate?
As with any investment, there are risks and you have the potential to make or lose a lot of money. However, when you work with good partners and have a clear set of goals and objectives, you can potentially see solid returns from commercial real estate investments that exceed what you typically see from the stock market.
One of the advantages of commercial real estate investing is that you have the potential to see returns in the form of profits from operations, as well as capital appreciation. It’s possible that, by the time you decide to sell your commercial property, you will have already made a substantial cash on cash return from regular operating profits even before you capture the appreciation in the asset’s value when you sell.
What is a good ROI on commercial real estate?
Calculating ROI on commercial real estate can be tricky, since there are many different methods of determining your return. However, ROI isn’t the same thing as a profit. With ROI, you’re trying to figure out your percentage gain on the investment.
One method of determining ROI is the cost method, which just takes into account what you bought the property for, how much you put into it, and the new value. For example, if you buy a property for $3 million, and then spend $1 million to upgrade it, you’ve now put $4 million into the property. However, if the property is worth $5.5 million after you finish, you have $1.5 million in equity, making your ROI $1.5 million divided by $4 million, or 0.375 — 37.5%.
Things get more complicated when you use the out-of-pocket method, which focuses on the capital you put down for your loan, how much you spend to rehab the property, and other factors. You might get a higher overall ROI with this approach because you’re basing your calculations on what you’ve actually spent out of your pocket, rather than the costs. You typically see an inflated ROI due to leverage.
Rather than doing a straight calculation, though, you can also look at potential annual ROI. In general, you can expect between 6% and 12% in terms of an annual return off the capital invested in many commercial properties. How much you actually end up with depends on the location of the property, the type of property, and economic and market factors.
There are real risks to investing in commercial real estate. While returns can often exceed what you might expect to make in the stock market, there is also the potential to incur significant losses if you fall short of your revenue goals or are otherwise not able to operate the property to a profit.
How do you invest in commercial real estate?
There are different ways to get involved with commercial real estate investing. If you don’t have the ability (or desire) to purchase the property on your own, you can buy the property yourself or you can invest with a sponsor. You can also get indirect exposure to real estate by purchasing shares in real estate investment trusts that specialize in commercial property.
A great way to begin making investments in commercial real estate is to use a program