The commercial property asset class can be a highly profitable and productive portion of your investment portfolio. Depending on the market cycle, buying at the right time and purchase price can help real estate investors build long-term wealth. Commercial buildings fall into many categories, each with their own nuances.
There are substantial differences between buying a building in the commercial space and single-family homes. Here's an overview of what buying a commercial building looks like, the steps involved in the various types of assets under the commercial umbrella, and whether real estate investors should try to get in on the action.
How to buy a building: commercial vs. residential
Buying a building in the single-family market is significantly different from buying one in the commercial space. Here are some quick facts to consider when thinking about buying your first commercial building.
One difference between buying a commercial building and buying a single-family home is that for the latter, lending is based entirely on the creditworthiness of the individual borrower. Whereas for most commercial assets, lending underwriting is based on the underlying business. That is, the property's income and expenses (net operating income, or NOI) will dictate all aspects of lending.
Valuation and loans
The valuation for single-family residential real estate is based exclusively on comparables. Specifically, what was the purchase price of similar properties that sold recently in the same neighborhood? For commercial property, valuations are based on the income generated by that asset, not comparable sales.
Where comparable sales matter is in cap rates, which are calculated using the valuations of similar properties in your area. So if you're able to decrease a particular cost, or increase revenue, that has a direct impact -- positive or negative -- on the value of your asset.
This also means that the commercial business loan you receive depends on how you can maximize income as well as reduce expenses.
Outside of apartment buildings, tenants in commercial real estate are typically businesses rather than individuals. Offices, retail shops, restaurants, cafes, and other business types are generally the lessees of commercial property.
With commercial real estate, rental leases tend to be longer and some are categorized as a triple net lease, where tenants are responsible for the trio of property taxes, insurance, and maintenance, in addition to their monthly rent. This is not something you'd see in the residential real estate space.
There is more expense certainty in commercial real estate. For example, if you own a 12-unit apartment building compared to 12 single-family homes, with the apartment you generally only have one roof, once entrance, and one heating system to worry about. Costs are higher on the commercial side, but you have better certainty and fixed costs if managed properly.
How to buy a commercial building
Because of some of the above advantages, many investors in single-family homes graduate from the residential space to commercial. There are many types of commercial real estate: multifamily apartments, retail, restaurant, warehousing, industrial, office, and the list goes on.
Generally speaking, retail has higher cap rates in the U.S., reflecting the ongoing challenges associated with consumer behavior shifts to online commerce. Higher cap rates reflect a less expensive price point due to lower NOI and demand, whereas a lower cap rate shows high demand and higher price points.
Office buildings are the largest portion of the U.S. commercial market, at 30%, with retail coming in second at 25%. Whether looking at office, retail, or other forms of commercial real estate, here are the general steps you will need to be ready for.
Step 1: Find the right location
Real estate is hyper-local, and investors should be experts in the markets in which they operate. The biggest consideration when buying a building is looking at the right location with strong market fundamentals.
This includes positive growth projections, with high foot and vehicle traffic, and land with future residential development potential (read: future customers!). That said, with some commercial property such as data centers and warehousing, proximity to population centers and foot traffic matters very little.
Remember to consider what businesses -- your future tenants -- will think of this location when you're trying to lease up your commercial property. Can you sell the long-term viability of this specific area of your market?
Step 2: Assemble your commercial property team
As noted, residential real estate purchases are different than commercial ones, meaning your team will also have to change. You will likely need a commercial broker, appraiser, agent, manager, escrow officer, and lawyer who are all experienced in this asset class.
Step 3: Analyze a lot, purchase few
To get your footing in the commercial real estate world, be sure to analyze and conduct pro formas on a number of different properties to understand the underlying fundamentals of your commercial market. For rent projections, note that vacancy rates tend to average around 10% in the commercial space, so be sure to account for this in your analysis.
Step 4: Make commercial real estate offers
This will fall primarily on your commercial real estate agent team member. Prepare to be asked for earnest payment (a percentage of money upfront) as well as the due diligence time frame to allow you to confirm your assumptions from step 3.
Step 5: Do your due diligence in commercial real estate
With the help of your commercial investing team, this is your chance to dive deeper into the financials of this specific commercial building. This includes reviewing land title, survey, rent rolls, expenses, covenants, restrictions, and so much more.
Step 6: Get financing to buy your building
Those financing corporate buildings typically do so through a corporate structure and must come up with 20% to 30% as a down payment. Banks rely heavily on debt service coverage ratios (DSCRs) in commercial lending or for a construction loan. A DSCR represents the ability the borrower has to pay back the loan, based on the loan and income of the property.
Do your own DSCR calculations during the analysis phase by dividing your NOI by the assumed debt of the property. For instance, say the loan on an apartment building is $600,000 and the NOI is $50,000 a month, or $600,000 yearly. This would generate a DSCR of 1, meaning this asset covers its outstanding debt by 1x on a yearly basis. This applies to loans whether buying or building new on vacant land.
Step 7: Close on your commercial real estate purchase
The first step to closing on a commercial asset is to fund escrow. This typically involves an escrow agent who can ensure all funding required is accounted for before the final transaction closes. There are fewer regulations involved in the governing of commercial transactions compared to residential ones, so it's critical that your commercial lawyer is involved and present at every step of the closing process.
Typically, the buyer and their team will be required to approve a title report and sign closing documents. Following this, the deed transfer will occur along with a disbursement of the funds to finalize the commercial transaction.
The bottom line when buying a commercial building
Buying a building in the commercial space presents a number of asset diversification options: office, retail, apartment, warehousing, and so on. Further, this type of real estate investment gives investors more control of the valuation of their asset and presents some interesting economies of scale. That said, commercial deals are typically higher dollar figures and require more due diligence.
Use the above steps to be prepared for what commercial real estate has to offer. And don't forget to assemble a commercial investing team with substantial experience in this industry.