Real estate investment, like any other type of investing, comes in a variety of flavors. When people consider becoming a landlord, they are usually thinking of renting out a single family home or another type of residential property (condo, townhouse, etc.). Although rentals of this nature make up the vast majority of investment properties owned by independent investors, the flashiest real estate investors in the world (think Donald Trump) cash in on commercial properties. Read on for a look at the pros and cons of investing in commercial properties. (To learn more about real estate, read Smart Real Estate Transactions and Tax Deductions For Rental Property Owners.)
What are commercial properties?
Loosely speaking, commercial properties are properties that are leased out to provide a workspace rather than a living space. Commercial real estate includes office buildings, strip malls, restaurants and shops (both in the shopping and industrial sense).
In most cases, properties are sold by the building - one office building, one restaurant, one factory, etc. However, if a developer wants more capital to expand a project or wishes to see the returns more quickly, the project will be broken down into smaller units rather than sold as a whole. (To read more about commercial properties, check out our Exploring Real Estate Investments tutorial.)
Advantages to Commercial Real Estate
One of the biggest advantages of commercial real estate is the attractive leasing rates. In areas where the amount of new construction is either limited by land or law, commercial real estate can have impressive returns and considerable monthly cash flow.
Rental rates are usually calculated as price per square foot. For example, the U.S. national average in 2007 for a grade A office hovered around $22 per square foot. Prices in downtown Tokyo, where further development is all but impossible, are about $130 per square foot. Industrial buildings generally rent at a lower rate, but they also have lower overhead costs compared to an office tower.
Commercial real estate also benefits from comparably longer lease contracts with its tenants than residential real estate. Typically, residential leases are for short-term periods - often as short as three or six months. However, it is not unheard of that some commercial leases last for 10 years or more, and are usually at least one year long. This gives the commercial real estate holder a considerable amount of cash flow stability as long as the building is occupied by long-term tenants. (For related reading, see Tips For The Prospective Landlord.)
Disadvantages to Commercial Real Estate
Rules and regulations are the primary deterrent for most people wanting to invest in commercial real estate. The taxes, mechanics of purchase and maintenance responsibilities for commercial properties are buried in layers of legalese that shift according to state, county, industry, size, zoning and many other designations. Most investors in commercial real estate either have specialized knowledge or a payroll of people who do.
Another hurdle is the increased risk brought with tenant turnover. A house is a place where people eat, sleep and watch TV - the requirements of a given tenant are almost the same as any previous or future tenant. With a commercial property, an office for example, each tenant may have very different needs that require costly refurbishing. For example, a newspaper's office and a chiropractor's office may only have a reception desk in common. The building owner then has to adapt the space to accommodate each tenant's specialized trade. A commercial property with low vacancy but high tenant turnover may still lose money due to the cost of renovations for incoming tenants.
Who should invest in commercial real estate?
People best suited for investing in commercial real estate are those who either have a considerable amount of knowledge about the industry or have a payroll of people who do. You may have guessed that such an investor is likely to already be quite wealthy to begin with.
That said, there is a wide range of commercial properties - from mega malls and office towers to small warehouses and single shop buildings - so you don't necessarily need to be Donald Trump. Just make sure that you can handle the time and costs associated with an investment in commercial real estate.
Another type of investor who would benefit from commercial properties is someone who owns a business. Just like residential properties, it can be financially beneficial to own your own workspace rather than rent it.
Evaluating Commercial Real Estate
When looking at commercial properties purely as an investment rather than as a partial-use property for business owners, the most important factor is supply and demand. The ideal property is located in an area where vacancy is low and the space available for new developments is limited. Low supply and high demand means favorable rental rates as well as the hedge of a higher rate of appreciation. The strength of the local economy of the area will also affect the value of your purchase, so you will want to check employment rates via the Bureau of Labor Statistics (MLS) along with other economic growth and strength metrics. (To find out more about employment rates, see Surveying The Employment Report.)
In addition to checking the BLS website, you will also want to check out the rate at which building permits have been issued over the past few years. This will give you an idea of how the supply will be affected by new developments. Commercial real estate listings will, of course, be your most valuable source. If too many buildings are on the market, either for purchase or rent, then you may need to reconsider the purchase because an increase of supply will have a dilutive effect in the market and lower overall rates.
Investing in commercial properties is a high-risk, high-reward type of real estate investing that will appeal to sophisticated investors looking for a challenge. If, however, you don't have the capital to invest in commercial properties, but you still want the challenge, you do have an option.
Real estate investment trusts (REITs) offer small-scale investors the chance to enjoy the profits of commercial investing. The managers of REITs handle all the details of purchase, maintenance, tenants, and so on, and the investor buys a share of the REIT just like a stock. This can be done without a real estate broker and REITs are more liquid than actually owning a commercial property. In fact, you can even hold most REITs inside your retirement account.
Whether you choose to invest in commercial real estate directly or indirectly depends on how much of a challenge you want.
Keep reading about REITs in What Are REITs?, Basic Valuation Of A Real Estate Investment Trust (REIT) and Investing In Real Estate.