Ask any real estate professional about the benefits of investing in commercial property, and you'll likely trigger a monologue on how such properties are a better deal than residential real estate. Commercial property owners love the additional cash flow, the beneficial economies of scale, the relatively open playing field, the abundant market for good, affordable property managers, and the chance for a potentially bigger payoff from commercial real estate.
But how do you evaluate the best properties? And what separates the great deals from the duds?
- Like most investments, success in commercial real estate holdings start with a good blueprint.
- Get familiar with the commercial real estate market and how it differs from residential properties and what aspects are similar.
- Use a multi-pronged approach to help find available properties and score the best deals.
1. Learn What the Insiders Know
To be a player in commercial real estate, learn to think like a professional. For example, know that commercial property is valued differently than residential property. Income on commercial real estate is directly related to its usable square footage. That's not the case with individual homes. You'll also see a bigger cash flow with commercial property. The math is simple: you'll earn more income on multifamily dwellings, for instance, than on a single-family home. Know also that commercial property leases are longer than on single-family residences. That paves the way for greater cash flow. Lastly, if you're in a tighter credit environment, make sure to come knocking with cash in hand. Commercial property lenders like to see at least 30% down before they'll give a loan the green light.
2. Map Out a Plan of Action
Setting parameters is a top priority in a commercial real estate deal. For example, ask yourself how much can you afford to pay and then shop around for mortgages to get a sense of how much you will pay over the life of the mortgage. Using tools like mortgage calculators can help you develop good estimates of the total cost of your home.
Other key questions to ask yourself include: How much do you expect to make on the deal? Who are the key players? How many tenants are already on board and paying rent? How much rental space do you need to fill?
3. Learn to Recognize a Good Deal
The top real estate pros know a good deal when they see one. What's their secret? First, they have an exit strategy: The best deals are the ones you know you can walk away from. It helps to have a sharp, landowner's eye—always be looking for damage that requires repairs, know how to assess risk, and make sure to break out the calculator to ensure that the property meets your financial goals.
4. Get Familiar With Key Commercial Real Estate Metrics
The common key metrics to use when assessing real estate include:
- Net Operating Income (NOI): The NOI of a commercial real estate property is calculated by evaluating the property's first-year gross operating income and then subtracting the operating expenses for the first year. You want to have positive NOI.
- Cap Rate: A real estate property's "cap"–or capitalization—rate is used to calculate the value of income-producing properties. For example, an apartment complex of five units or more, commercial office buildings, and smaller strip malls are all good candidates for a cap rate determination. Cap rates are used to estimate the net present value of future profits or cash flow; the process is also called capitalization of earnings.
- Cash on Cash: Commercial real estate investors who rely on financing to purchase their properties often adhere to the cash-on-cash formula to compare the first-year performance of competing properties. Cash-on-cash takes the fact that the investor in question doesn't require 100% cash to buy the property into account, but also accounts for the fact that the investor will not keep all of the NOI because they must use some of it to make mortgage payments. To uncover cash on cash, real estate investors must determine the amount required to invest to purchase the property or their initial investment.
5. Look for Motivated Sellers
Like any business, customers drive real estate. Your job is to find them—specifically those who are ready and eager to sell below market value. The fact is that nothing happens or even matters in real estate until you find a deal, which is usually accompanied by a motivated seller. This is someone with a pressing reason to sell below market value. If your seller isn't motivated, they won't be as willing to negotiate.
6. Discover the Fine Art of Neighborhood "Farming"
An excellent way to evaluate a commercial property is to study the neighborhood it's located in by going to open houses, talking to other neighborhood owners, and looking for vacancies.
7. Use a "Three-Pronged" Approach to Evaluate Properties
Be adaptable when searching for great deals. Use the internet, read the classified ads, and hire bird dogs to find you the best properties. Real estate bird dogs can help you find valuable investment leads in exchange for a referral fee.
The Bottom Line
By and large, finding and evaluating commercial properties is not just about farming neighborhoods, getting a great price, or sending out smoke signals to bring sellers to you. At the heart of taking action is basic human communication. It's about building relationships and rapport with property owners, so they feel comfortable talking about the good deals –and doing business with you.