Becoming a commercial real estate investor involves investing in any non-residential real estate that is used for business purposes only. Commercial real estate includes retail properties, office buildings, shopping centers, warehouses, hotels, etc. As with most investments, investing in commercial property comes with risks and rewards. Nevertheless, becoming a commercial real estate investor can be a good way to diversify your investment portfolio.
However, before taking the plunge, beginner real estate investors need to have a good understanding of this investment strategy so that they can make an informed decision. There are some aspects of commercial real estate investing that you should consider before going down this path. Here are 4 truths about becoming a commercial real estate investor.
1. Requires a Large Initial Investment
Becoming a commercial real estate investor can be a more expensive venture than becoming a residential real estate investor due to the large initial capital requirement. It may involve large loans requiring personal and recourse guarantees. Therefore, it is usually necessary to have more capital up front when buying commercial real estate than when buying residential real estate in the same area. Even so, getting funds from banks can be easier for a high performing commercial real estate property.
Moreover, once you have acquired commercial real estate, you can expect some huge capital expenditures to follow. Since there are more facilities to maintain, the costs will be more. This makes investing in shopping centers and office buildings a major endeavor for most investors.
Many real estate investors fail to enter the market because of this. So the advantage to the hefty financial requirements is that there is less competition.
2. Has a Higher Return on Investment
Generally speaking, although becoming a commercial real estate investor has greater risks, it guarantees a higher return on investment compared to residential property investing. The yield on commercial property is generally higher, both on an investment and a per square foot basis. This is particularly true if you decide to rent or lease a multi-unit commercial property. Having more space translates to more tenants which translates to more income generated. While the average return on investment of commercial real estate ranges from 6-12%, that of residential properties is often between 1-4%. Nonetheless, the return on investment will also vary depending on property type, location, property management costs, vacancy rate, and other factors.
Commercial real estate leases are also typically longer than residential leases. Most commercial leases are at least three years. This allows a commercial real estate investor to easily predict annual cash flow, have lower turnover costs, and lower vacancy rates. The downside to longer lease terms is that it is harder for a commercial real estate investor to break a long-term lease if they are unhappy with a tenant.
3. Comes with More Risks
Whether you are investing in commercial or residential property, it is important to keep your risks to a minimum. However, becoming a commercial real estate investor is riskier than investing in residential property. Apart from the fact that it requires a larger cash outlay, you will be putting all your eggs in one basket if one commercial property is all you can afford. Putting all your funds into a single commercial property is riskier than spreading the risk across multiple residential properties. If you miss your mark with a single-family home, it won’t be as big a financial setback as missing your mark with commercial property. It is easier to diversify and spread out your risk across multiple types of residential properties that are in different locations.
Moreover, risks of real estate investing for a commercial real estate investor will vary greatly depending on the type of investment property. The risks linked to two commercial buildings in the same location would vary independently. On the other hand, residential properties that are adjacent to each other would show the risk. It is vital to understand the range of risk associated with your prospective investment.
4. Vulnerable to Economic Volatility
The housing market is quite unpredictable and is always changing. However, commercial real estate is typically more vulnerable to economic busts and slumps than residential real estate. This makes becoming a commercial real estate investor even riskier.
In case of an economic downturn, people may close their businesses, search for other jobs, or even work from home. Residential properties will always have a relatively high demand even when the housing market is bad. People will always need somewhere to live regardless of the economic situation. Residential properties, therefore, perform more consistently than commercial real estate during economic downturns.
Moreover, it is hard for a commercial real estate investor to get a commercial loan in a bad economy. This makes the buying or selling of commercial property incredibly difficult. A commercial real estate investor may be forced to rent or sell an investment property for far less money.
Making money in real estate is possible whether you choose commercial properties or residential properties. However, these property investment strategies are very different and serve different purposes. Each strategy has its own set of benefits and challenges.
Some say that being a commercial real estate investor is a great option. However, most experienced real estate investors agree that investing in residential real estate is the best investment strategy. For most real estate investors, especially beginners, investing in residential real estate is much more beneficial than being a commercial real estate investor. It takes a lot of money, time and experience to fully understand and be successful in the commercial real estate market. While commercial investing may offer more return, it is costlier, riskier and demands a more logistical engagement.
Nonetheless, investors should research and take time to think about what their short and long-term goals are before deciding on which option to go for.
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