The Good and Bad of Commercial Real Estate
What to Know Before You Invest
Technically speaking, commercial real estate can be any of the following: an office building, industrial/ warehouse facility, retail property (Walmart, CVS, Strip Center), and apartment buildings greater than 4 units. It surrounds us throughout our everyday lives. We need commercial real estate to facilitate business, supply chain, housing, and many other aspects of modern society.
From an investment standpoint, the industry has rapidly accelerated over the past decade. With money pouring into the industry from large institutions and technology granting access to investors that would have never otherwise had the opportunity, you don’t have to look far to find someone that has made money in the industry. But what’s the catch? Why not stick to a 401k or invest with traditional financial advisor? Below as I highlight some of the pros and cons of investing in commercial real estate.
The Pros:
Cash Flow- This is probably the most important and attractive aspect of commercial real estate investing. This is what every investor wants: a positive balance after all expenses are deducted from a property’s gross revenue. Cashflow simplified: An investor takes out a loan to purchase a commercial property. The investor leases that property to a tenant or tenants who pays a set amount of rent. The rental income from the tenant pays for the investors mortgage, taxes, insurance, and all expenses associated with the operation of the property. This ultimately yields a profit to the investor which they weigh against the amount of capital they have invested into the property in order to assess their ROI.
Depreciation- The tax code recognizes the wear and tear a property can incur over time and allows the individual to deduct a portion of the property’s value from the total taxable income produced by the property each year. In short, you can reduce your tax liability over the course of the property’s useful life, which is determined by the IRS.
Appreciation- It seems counterintuitive that to say that two benefits of commercial real estate investing are depreciation and appreciation, but it’s true! While depreciation is beneficial when deducting against the cashflow of the property, appreciation generally occurs as properties gain value over time. It is important to note that appreciation is not necessarily a given. There are a variety of factors that can affect market conditions and cause fluctuations in value. However, a diligent investor can remain profitable regardless of market cycles.
Tax breaks- The IRS allows for several tax breaks for real estate investors. The most popular is the 1031 exchange. This code has arguably led to the greatest level of wealth creation from real estate investors across the board. Upon the sale of an investment property, the 1031 exchange allows the capital gains to be deferred by reinvesting those profits into another similar like-kind property. This has proven to be a great wealth building tool for value-add investors, as they are able to trade into larger properties and increase their returns on each trade.
The Cons
High Capital requirement for direct investment- Unfortunately, the cost of entry into the commercial space is often significantly higher than that of a residential home. In addition to the high purchase price, there is also a higher cost of capital. In commercial transactions, lenders will typically loan 65%-75% loan to value compared to personal residential properties where once can get 90%-95% loan to value. This means there is a significantly higher initial capital requirement to acquire a property as you need to produce larger down payments to close on a property.
Subject to regulation- Commercial real estate is highly regulated from the national level all the way down to the local municipality. This can make it cumbersome and time consuming to purchase or lease a property as you are subject to zoning, permitting, ordinances, and other local governing bodies that get to have a say in how your property operates. The level of restrictiveness varies by market. For example, when the 2020 pandemic lockdowns began, the federal government mandated stay at home orders, which meant many businesses could not open. Therefore, tenants could not pay rent and many landlords were forced into forbearance or default.
It is an Illiquid Investment- Real estate is usually a long-term investment. Investors and operators typically can expect to have their capital tied up for 5-10 years in the property depending on their investment strategy. With that said, it can be difficult to get out of an investment quickly as commercial real estate transactions can take months or even years to close. Even a passive investor may be tied to the investment until they can find someone to buy out their shares.
Management Intensive – Often what ends up making or breaking a commercial property is the management team. Without a strong plan for management, the property can quickly find itself upside down with poor tenants, low rental income, and high operating expenses. At the same time, a strong management team can seize opportunities where others can’t by increasing operating efficiency, maximizing rental income, and improving the tenant experience. The key to successful management is having a competent team that is intimately familiar with the market and has a strategic plan in place prior to the acquisition of the property.
Overall, investing in commercial real estate can be a lucrative addition to anyone’s portfolio.
How does one invest in commercial real estate?
Despite high barriers to entry on an individual basis, there are ways to invest passively and still realize the tax benefits of commercial real estate ownership. This is done through syndication. In real estate, syndication is the pooling of capital from investors to purchase and operate a property for profit. This allows investors who do not have the time or money to acquire and manage a property themselves, to invest through a sponsor, who is responsible for the acquisition and management of the property. The sponsor receives a portion of the equity in the property in exchange for acquiring and managing the property, while the investors receive equity in exchange for bringing the capital.
In conclusion, the daunting task of investing in commercial real estate may not be as daunting as you think. Now, more than ever before, there is access to sponsors and educational material to help make an informed decision prior to investing. Over the course of the next few months, I will be breaking down specific property types, investment strategies, and companies to facilitate your knowledge of commercial real estate investing.