Commercial real estate can be an excellent investment opportunity.
Typically, commercial properties offer more financial reward than residential properties. However in some scenarios, the risks can outnumber the rewards. Understanding the commercial real estate pros and cons is important for any investor no matter if the property was acquired by a sale or inherited. Having the ability to understand the investment and having the knowledge to make a decision if ownership or sale is the best option is crucial.
Commercial properties may refer to retail buildings, office buildings, warehouses, industrial buildings, apartment buildings and mixed use buildings. Mixed use properties feature both residential and commercial tenants in the same building.
Armed with the different types of properties available, let’s take a brief look at some of the pros and cons of owning commercial properties.
Income potential. Commercial properties generally have an annual return off the purchase price between 6% and 12%. Residential properties usually have a return averaging between 1% to 4%.
Tenant Relationship. Business owners generally take pride in their businesses and it is in their best interest to be successful and keep their business viable. A commercial property is also operated as a business, thus giving the landlord and tenant a common goal. The business-business customer relationship helps foster interactions that are professional and courteous.
Public Image. Retail tenants have a vested interest in maintaining their store and storefront, because this affects their image as well as the landlord’s. For this reason, commercial tenants and property owner interests are aligned, which helps the owner maintain the quality of the property, and ultimately, the value of their investment.
Standard Business Hours of Operation. Businesses that typically operate in a commercial setting are open during normal weekday business hours of 8am-5pm. This allows for the commercial property owner to not have late night issues or deal with tenants after hours. Typical calls are for true emergencies or a monitoring service on the building.
More objective price evaluations. Financial information is easier to acquire for commercial properties so that an evaluation of the property price is based on the current owner’s income statement. The seller should be using an experienced broker so the asking price is set where an investor can earn the area’s prevailing cap rate for the commercial property type they are looking at (retail, office, industrial, etc.).
Triple Net Leases. There are variations to triple net leases, but the general concept is that the property owner does not have to pay any expenses on the property. The lessee handles all property expenses directly, including real estate taxes. The only expense the investor handles is the mortgage payment.
More flexibility in lease terms. Fewer consumer protection laws govern commercial leases, unlike the dozens of state laws, such as security deposit limits and termination rules that cover residential real estate.
Time commitment. Owning a commercial building with numerous tenants or even just 2-3 tenants, there is more to manage than one would with a residential property investment. Ownership can’t be an absentee landlord and maximize the return on the investment. With commercial properties, there are multiple leases, annual Common Area Maintenance (CAM) adjustments, day to day maintenance issues, as well as potential safety concerns with customers and the general public accessing the property.
Property Management and Hiring Vendors. Some commercial property owners try a self-managed approach, but a more ideal situation is hiring a property management company as the best scenario for both the investor and their tenants. Licensed vendors to handle problems and issues at the building is a smart investment as well. This is an added cost which doesn’t seem ideal but these expenses can be budgeted into the building’s expenses and is well worth the cost. Property management companies can charge between 5-10% of rent revenues for their services, which include lease administration. Once a property is purchased, the investor will need to decide if they will be handling the leasing responsibilities or hiring out a broker to handle those responsibilities. If hiring a broker, be sure to budget in paying out commissions to not only the broker the investor has hired, but if potential tenants are being represented by a broker as well.
Bigger initial investment. Purchasing a commercial property typically requires more up front capital compared to a residential property. Once an investor has acquired a commercial property, they can expect some large capital expenditures to follow. Everything can be running smooth for a few months and then the roof starts leaking and now there is a $20,000 bill to address the repairs. With more customers there are more spaces to maintain and therefore more costs. For an investor, a top concern is that the increases in revenue outweigh the gains in costs, to support purchasing a commercial property.
More risks. Properties intended for commercial use have more public visitors and therefore have more people on the property each day. The more visitors that visit, the greater the chance that someone can get hurt or do something to damage the property. There are a variety of things that make commercial buildings risky such as snow removal (ice for slip and falls), vandals of all types including graffiti or damage to exteriors or landscape, and a variety of other situations. The building must have the proper insurance that can cover a potential lawsuit or building damage is very important so that there are limited responsibilities and out of pocket costs.
If looking for an investment opportunity, commercial property is a great avenue to pursue as long as one is aware of the pros and cons to make educated decisions.