Beginner’s guidelines for investing in the commercial real estate sector
Everyone in the nation right now knows about investments and their values. Especially the youth. Investments are more profitable than keeping the money in banks. We all know about mutual funds, stocks, and all of those traditional assets.
Investing in the real estate sector has been booming. Especially in the commercial real estate (CRE) sector. According to a 2017 report by Knight Frank, global real estate has delivered an unleveraged return of 6.3% over the past 10 years.
Being a new market for investment, not a lot of people know it inside out. It requires a more strategic investment procedure. But once you get to know the basics of CRE investments, it upholds tremendous profit opportunities.
Why invest in CRE?
CRE is a multi-billion dollar market, and any investor missing out on this sector is missing out on huge market potential. Some of its perks are:
- Higher Returns: Higher risks bring you higher returns. Investing in CRE is risky, but if done the right way, it can be beneficial for the investors. The ROIs on commercial properties easily cross double digits and are stable throughout the market.
- Less Competition: There are fewer investors in the sector because of the anticipated difficulties compared to the other investment options. This gives a greater chance to tap the opportunity.
- Cash Flow: CRE includes large commercial buildings. So naturally, the investments are higher. Also, the lease duration is longer which increases the overall cash flow.
- Ease of Protocol: All the units under a single roof can be operated through a single set of guidelines, which makes the scaling-up process easier.
- Triple net leases: In a triple-net (NNN) lease, the tenant pays the property taxes, insurance, and maintenance. So, the owner only has to pay for the mortgage.
How to start investing in the CRE?
CBRE officials say that the first commercial investment is very crucial as it involves many different variables. The investor needs to understand the factors associated with it for a long-term beneficial investment. It requires the investor’s due diligence before diving into the process.
- Determine your investment requirements
The investor must know whether the CRE investment fits his investment strategy, financial needs, and return goals. Since CRE investment is for the long lease term, one must understand the risk associated with it. The most important factor to consider here is the cash flow, the return they are aiming for, and how urgently does he need it.
It is important to know the market trends and long-term impacts. Being updated with the current trends, like managed office spaces in office rentals can be a major boost for the investment. “This will enable investors to fine-tune their commercial real estate investments and diversify their portfolio”, says Juan Zaragoza of Exan Capital LLC.
- Understanding the CRE investment basics
As this process involves multiple variables, one needs to be familiar with them before getting into it. Some of the general terminologies every investor should learn are:
- Single Net Lease - In a single-net lease, the tenant pays the property taxes along with the building rent. The landlord covers the repairs, maintenance, insurance, etc.
- Double-Net (NN) Lease - In a double-net (NN) lease, the tenant pays property taxes and insurance, and the rent. The landlord covers the repairs and maintenance.
- Triple-Net (NNN) Lease - A triple-net (NNN) lease requires the tenant to pay the property taxes, insurance, and maintenance for the property.
- Cap Rate: The capitalization rate is the ratio of net operating income to the property asset value. It is helpful in evaluating the value of income-producing properties.
- Cash on Cash: It is the measure of the annual return the investor receives on the property w.r.t. the amount of mortgage paid during that year.
There are several other formulae for investment and return calculations. The investor should know these formulae or should have someone’s expertise to guide them through the process to avoid the chances of any risks.
- Property comparables
Also known as ‘comps’, this refers to the price of the recently sold properties in the same location, or of similar size and style. This helps in determining the price of the property. A standard rule is to consider those properties for reference whose land area (square footage) is within ±10% of the property being evaluated. This will help to get the best possible market value.
- Property location
Once the investor gets to know the technicalities of CRE investment, the first thing that has to be done is to identify the property and its location. Today investing in properties is all about their location. Prime locations attract more people due to good visibility and brand recognition which results in better ROIs.
This is where the demand vs supply rule applies. Higher space demands with a shortage in supply are going to be profitable. So, it’s better to look for such locations. Apart from this, it is also necessary to assess the target renters and leases. It is imperative for the investor to consider demographics and trends for the area.
- Lease structure
Commercial leases are structured as 3+3+3 (for 9 years) or 5+5+5 (for 15 years). The lease escalates every 3 or 5 years. The tenants can vacate the place anytime during the lease while the investor cannot force them to leave. There is also a lock-in period (normally 3 years) during which the tenants cannot vacate the place. Hence, the investor should know the lease structure beforehand to avoid any risks and misunderstandings later.
- Property fundamentals
According to Herron Todd White associate director Edward Cox, understanding the property’s core fundamental need is the key. Different property types may have a different fundamental niche that the investor needs to identify.
For instance, for office spaces, being close to all the amenities, transport networks, and having better outside views, interiors, adequate parking space, etc. play an important role in decision making for the renter.
Some common mistakes to avoid
As the saying goes, it is more important to know what not to do than knowing what to do. While investing in the CRE, investors might make some errors or take avoidable risks. It is better to be a step ahead and be aware of such risks.
- No due diligence
CRE investments are huge and slightly complex. Hence, everyone needs to do a little research of their own before deciding anything. A poorly chosen property is never going to give a good ROI. Hence, it is always better to lose a deal than a bad investment. It is recommended that the investors learn as much about the property as possible before coming to a conclusion.
- Incorrect evaluation
It is the most common mistake one can make. This is where the due diligence of the investor’s comes into play. Knowing all the technicalities and ‘DOs’ and ‘DON’Ts’ can help to reach the correct property value. An improper evaluation may impact every step ahead of it and may ultimately lead to a significant investment difference than what it is meant to be.
- Ignorance of the details
Failing to understand the financial details and the basic process can be detrimental to the investor. Commercial deals are very different from residential ones. If not all, the investor should be able to calculate the basic formulae mentioned above to know where and how the cash flow is going to be.
- Playing solo
It is of utmost importance to hire an investment team. The team may cost the investor a bit. But it is always better to have a team than working alone. This team has experience and expertise in the field and knows where to cut costs and where to invest better. It will save time, energy, and money. The investors should hire a competent team to do the job because they know the process inside out.
Investing in commercial real estate may seem lucrative and intimidating. While the returns are higher, they have their own risks. A proper business plan helps in determining the perfect property. One needs to understand the market, trends, their audience, the purpose, their investment needs, etc. before deciding to invest.
It also requires thorough research and understanding from the investor’s side. Being a part of every step is important for the investor to understand the whole process. The experience of the team is a ‘must’ to account for the financial calculations and risks. Missing out on any small detail can be detrimental to the whole process. Nevertheless, the future of CRE is optimistic. According to a Deloitte research of 750 CRE executives, 85% of them believe that the transaction activity and capital availability will grow.