Thinking about investing in commercial real estate? This sector is a totally different animal than residential investments and comes with a distinct set of rules and strategies you will need to apply in order to be successful. Commercial property owners get to enjoy higher payoffs, open playing fields, reliable managers, beneficial economies of scale, and larger cash flow.
Yet, how can you be sure that you’ll receive the same benefits as you start investing? Well, success in this area comes with a good education. Whether you’re an experienced investor who’s focused on residential real estate, or just a beginner trying his luck at owning a commercial property, here are seven things you’ll need to know about commercial real estate.
The Definition and Classification of Commercial Real Estate
Commercial real estates are basically everything that isn’t a residential real estate or vacant land. They include things like factories, warehouses, retail stores, and offices and have three different classes – retail, industrial and office. Industrial includes factories and warehouses, while retail includes properties such as restaurants and stores. Every commercial real estate can also be classified into one of three distinct categories:
- Class A buildings include the newest properties built with the highest quality and in the best location, which in turn gives them the biggest rental income and the ability to attract exceptional tenants.
- Class B properties aren’t as good but still have some nice qualities. They are usually targeted by value-added investors since a well-located class B real estate can be transformed into a class A building. The goal is to find a class B building located in a class A neighborhood and renovate it to receive class A rents.
- Class C property has the lowest quality and the biggest odor. They were built in the 80s or even before, and are often subsidized buildings. Since they require extensive renovations, they shouldn’t even be considered.
Related: Everything You Need to Know About Property Classes
Investing in Commercial Real Estate
Commercial property is valued differently than a residential one. Although comps from the neighboring houses are what determines residential real estate value, commercial real estate is valued based on its cash flow, or how much income it can produce.
It is advisable to invest, rather than accumulate. Of course, you will invest money into something so you can turn profits. This means that if you purchased a commercial property that doesn’t generate income, you are basically acquiring a real estate rather than investing. Remember this when you’re sifting through market listings.
It is also advisable to concentrate on one type of investment at a time. When new to investing, it is best to focus on a single type – whether it is an office, retail or industrial. Since each transaction needs your undivided attention, this will ensure that you always find the best possible deal.
The Trend of On-Demand Warehouses
As a part of the bigger commercial real estate sector, on-demand warehouses involve short-term rents of various durations and sizes – as much space as the client needs, when they need it, in a convenient location. Prologis analyzed the DCs industrial real estate market and found that e-commerce comprises about 20 percent of new leasing for DCs.
The reason for this growth is that online retailers need 1.2 million square feet per billions of dollars of online sales on average, which is three times the distribution space needed for traditional retailers. In short, retailers need supply chain strategies that keep warehouse shelves stocked cost-effectively while meeting the increased service demands of e-commerce.
Logistics specialists responded to this demand – for instance, CartonCloud offers integrated transport management systems and warehouse management systems that reduce pick errors and automates allocation, while last year, UPS developed a subsidiary named Ware2Go, a platform that matches businesses in need of space with space providers. It finds warehouses for investors, giving them the ability to keep up with new e-commerce growth.
Within the next decade, on-demand warehousing services will start to be an alternative to traditional leasing. Although they won’t dominate the industry, they will grow to fill in a niche in the market.
For starters, securing tenants for commercial properties is a bit more challenging. Although everyone needs a place to live in, not everyone needs a property for their business. Business owners also typically have very distinct spacing demands for their company, so if your commercial real estate doesn’t offer what they need, they will probably look elsewhere.
However, once you do find tenants for your real estate, you likely have them for a while, since leases here tend to be longer and moving a company is generally much harder than moving to a new house. Most business owners avoid it. Although this still doesn’t mean you won’t have problems since tenants can still leave your property. In this case, you will need to have enough cash reserves to cover your mortgage if the property is empty for months at a time.
Rental Returns and NOI
As with all investments, returns are different depending on the surrounding circumstances. However, where residential investment properties typically return somewhere around 4% or 5% a year, the returns for commercial real estate investment can be bigger – depending on the location, market conditions, and trends, as well as the quality of the building.
Net operating income (NOI) is a calculation investors use to analyze the profitability of property investments that generate income, such as the aforementioned rental income. Net operating income is calculated as all revenue from the property minus all reasonably required operating expenses. As a before-tax figure, NOI excludes interest and principal payment on debts, depreciation, capital expenditures, and amortization.
The operating costs calculated in the NOI metric can be modified if a real estate investor accelerates or defers particular expense items or income.
What Will the NOI Tell You?
Net operating income will serve you like a valuation method to determine how income-producing your commercial real estate is. Other than rent, your commercial property might also generate revenue from parking and services fees, such as laundry or vending machines.
Operating expenses consist of the costs of running and maintaining the real estate and its surrounding grounds, such as property management fees, insurance, utilities, legal fees, repairs, property taxes, and janitorial fees. Capital expenditures, such as the cost of a new ventilation system for the entire building, are not a part of the NOI calculation.
Net operating income will help you as a potential or current owner of retail properties, warehouses or office buildings, calculate several helpful ratios. For instance, NOI is utilized for determining the capitalization rate, which in turn helps you determine the real estate’s value and compare different buildings you are considering to purchase or sell. Ultimately, NOI is also used to calculate the cash return on investment, net income multiplier, and total return on investment.
Debt Coverage Ratio – DCR
When finance is in question, NOI is also used in the debt coverage ratio, which tells investors and lenders whether a real estate’s income covers its operating expenses and debt payments. The DCR term is used more frequently with your lenders. When you think of commercial property and also about financing, at the core of those two terms stands the DCR.
Defined by the amount of cash flow available to pay your mortgage, all commercial lenders use DCR to see if you’ll be able to pay the mortgage and still have something left over. It is a crucial number for your lenders since they will first check the DCR to view whether the deal is lendable. By the way, they typically want to see a debt coverage ratio of at least 1.2 or more.
In short, the DCR formula goes like this: Your NOI divided by your annual debt service. Debt service includes your annual mortgage payments. If it comes up to 1.0, it means you don’t have excess cash flow – in other words, your NOI equals your mortgage. When it goes over 1.0, that means you have cash flow.
Commercial real estate isn’t for the faint of heart. It requires a lot of effort which is necessary for buying this type of real estate, and you will have plenty more to do after the deal goes through. However, the payoff is much bigger, making the whole experience a worthwhile investment, not to mention a very profitable one. The point here is that although you may be an experienced residential property investor, that doesn’t mean that you’ll be ready to take on a commercial property. If you wish to go with this type of investing, it’s fundamental that you put in the research and learn all you can about commercial real estate investing before going for any kind of a deal.
This article has been contributed by Amelia Atkins.