Frequently we have prospects who approach us about investing in commercial real estate. With financial institutions paying historically low interest on savings accounts, potential investors are looking for more profitable ways to grow their savings.
Investors are seeking an alternative investment to diversify their portfolio. For some, the volatility of the stock market is intimidating. Recently, whether you are a new investor or seasoned contributor to the stock market, news stories about economic bubbles, overvalued price to earnings ratios and the value of the US dollar have people seeking alternatives for their surplus cash. The popularity of TV shows displaying how much one can make buying, fixing and leasing or reselling homes has also had its impact on investors wanting to get into real estate.
Benefits of owning a commercial building compared with a rental house include lower vacancy risk with multiple tenants, longer term leases and higher potential earnings. Some key differences between owning commercial property and owning a rental house are initial cost, ability to attract tenants, location and the effects of the economy.
While there are many investors in single tenant buildings, one of the best things about commercial property investment is having multiple tenants helping to pay your mortgage and put dollars in your pocket. If you have a house for lease, and it takes you three months to rent it, you are out 100 percent of the income for that period. Compared with a multi-tenant warehouse, office, retail or apartment building, if one or two of the tenants leave, the remaining tenants are there helping to pay the bills and provide funds for maintaining the property.
A second benefit is the stability provided by longer term leases. House rentals are typically six months to a year in length, in stark contrast to the common three to five-year terms in commercial real estate. Trying to increase rents annually for homeowners is a frequent cause of tenant turnover, whereas in commercial real estate passing along the increased cost of living each year typically results in rents escalating annually by 3 percent or more. These increases are normal, customary and tend to be understood by business people whose costs generally increase as well.
As the property size increases, some costs per square foot tend to decrease. If you landscape a 1,500-square-foot rental home with one-half acre of grass and trees, you pay a fixed cost for that maintenance. If you landscape a one-half acre of grass and trees on a 20,000-square-foot industrial property, the contractor’s charges may be roughly the same as for the house. Lower total maintenance costs per square foot equate to more net income for the investor. On top of these cost savings, many commercial leases place the responsibility for interior maintenance and repairs on the tenants, uncommon with house rentals in the area.
It is obvious that buying a larger property will usually result in a higher cost. Since the cost of commercial property tends to be higher, buying a commercial property requires a larger amount of money down, and more money to maintain it. This barrier to entry tends to keep many new investors away as they simply can’t afford it.
A couple of less obvious costs of commercial investing relate to the loan process. While we have seen loan rates reach amazing lows in the last few years, what novices aren’t aware of is that commercial loan rates tend to be higher, often one or two percentage points higher. This results in a larger monthly payment. If you recently got a 4 percent home loan, you shouldn’t expect to go to your lender for a commercial investment and get the same rate.
Another component is the amount of money you have to put down on a commercial investment tends to be substantially higher than for a house. Part of this is due to the sheer volume of houses compared with the number of commercial buildings. In the residential housing market, there are loan programs backed by the federal government as a way to encourage home ownership, such as FHA and VA that require as little as 3.5 percent down to get a loan. Most of those programs are not available for investors in commercial buildings. Another part of the equation is, without government backing, lenders will protect themselves by requiring the investor to cover more of the upfront cost. It is not uncommon to see commercial lenders requiring down payments from 20 to 40 percent, so a $500,000 purchase may require you to come up with $200,000 up front at closing in addition to your other closing costs.
One solution to jumping into commercial investing is for a group of like-minded people to come together, form a limited liability company or a partnership and buy a building together. Hopefully at least one of them has purchased, leased and managed commercial real estate before and has the expertise necessary to avoid the pitfalls. An investor in Tennessee has dubbed this the DIY or “do it yourself” method of investing.
A second possibility is to find a commercial real estate syndication to join which pools together several investors’ assets to purchase a building or buildings larger than any one of them could buy on their own. Typically the syndicator, general partner or managing member is an experienced real estate investor working with a professional leasing and management company, with knowledge and experience to maximize the earnings of properties throughout the period owned and sold.
In summary, commercial real estate investing has several benefits and can be available to new and experienced investors. It is a fantastic way to get more return from your excess savings than current interest rates and can create generations of income and wealth.