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Unlike some of the other alt assets we’ve featured, commercial real estate isn’t the easiest to get into. Like residential real estate, it often requires a large sum of up front cash to get started and so, unless you’re already flushed with cash waiting to invest in real estate, many first timers will have to borrow a lot to get started.

For this reason alone, commercial real estate isn’t for the faint hearted - and it’s not something you can easily “dabble” in (as you might do with stocks or other assets).

As always, this article is purely for educational purposes and if you are interested in getting started in commercial real estate, consulting a finance professional who specialises in this is key.

So with that, let’s take a look at some of the essential things you need to know.

Coming up:

• What is commercial real estate?
• How is it different from investing in residential real estate?
• The upsides and downsides to be aware of
• How to get started in investing in commercial real estate

What exactly is commercial real estate?

Commercial real estate refers to properties used for business purposes rather than residential living.

These properties are designed to generate profit through rental income or capital appreciation. Commercial real estate (CRE) involves a wide range of property types, including:

• Office Buildings: Ranging from small professional buildings to large skyscrapers.
• Retail Spaces: Such as shopping centers, strip malls, and standalone stores.
• Industrial Properties: Including warehouses, factories, and distribution centers.
• Multifamily Housing: Apartment complexes and other residential buildings with multiple units.
• Special Purpose Properties: Hotels, healthcare facilities, and educational institutions

Some investors might specialise in just office builders, others in retail spaces for example but other investors might decide to invest in a variety of all of these.

How is it different from investing in residential real estate?

The fundamentals are similar between residential investing and commercial real estate investing in many ways. The basic premise is to buy property which can appreciate in value and potentially act as a source of recurring revenue. But despite the similarities,  there are some key differences to be aware of.

Here’s a snapshot of some of the most important differences between investing in commercial real estate and residential real estate.

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Some of these differences are self explanatory but others are differences you might not have considered before.

For example, lease terms tend to be much longer than residential real estate and the management overheads of commercial real estate is typically far greater than residential properties. Tenant needs tend to be far more complex (since if it’s a business for example, each business has different needs). Health and safety regulations can also be incredibly complex, depending on the nature of the commercial real estate.

It’s fair to say then, that getting started in commercial real estate isn’t straightforward - but most investors know this beforehand. Are the returns worth it?

What are the potential returns?

Commercial real estate, like residential real estate is an illiquid asset. This means that it isn’t easily converted into cash like stocks. Given the illiquidity, the need for active management, legislation, and high capital costs, one might expect a significant premium over stock market investments but that’s not always the case.

Unfortunately, like most questions in real estate, the answer to this is not cut and dry. Commercial real estate returns vary depending on a wide variety of factors, and a “good” ROI for one property might not be “good” for another.

Recent estimates suggest that the ROI on a commercial real estate portfolio is likely to grow over the next few years but potentially start to decline slightly later this decade. Analysis varies but some reports suggest that the ROI on commercial real estate will float around the 7-8% mark. It ultimately depends on so many variables including the industry, location, demand by tenants, building quality, interiors, exteriors, market conditions.

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How to calculate the performance of commercial real estate investments

Here’s some of the ways commercial real estate investors analyse their portfolios. If you’re considering getting into commercial real estate, these should come in handy:

Capitalization Rate: A property’s cap rate is the annual, debt-free rate of return from a property, based on its annual net operating income and current property value.

Internal Rate of Return: IRR measures the annual ROI over a particular time period, rather than over the total time of ownership

Cash-on-Cash Return: This calculation compares the annual pre-tax cash flow from a property to the total amount of cash invested.

An example

Let's imagine a scenario where an investor is considering purchasing an industrial property, given its high average ROI of 12%. We'll use the following the Capitalization Rate, Internal Rate of Return (IRR), and Cash-on-Cash Return metrics to assess the potential of this investment.

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Here’s a breakdown of the property details

• Property Type: Industrial
• Purchase Price: $1,000,000
• Annual Net Operating Income (NOI): $120,000 (based on a 12% cap rate)
• Loan Amount: $700,000 (70% of purchase price)
• Investor's Cash Investment: $300,000
• Annual Debt Service: $50,000

The cap rate is calculated as the ratio of the property's NOI to its current market value. In this case, the net operating income (NOI) is $120,000 / $1m which gives us a 12% capitalization rate (cap rate).

The IRR measures the annual ROI over a particular period. For simplicity, let's assume the property is held for 5 years and sold at the same cap rate, with no change in property value.

• Yearly Cash Flow: $70,000 (NOI - Debt Service)
• Sale Price after 5 years: $1,000,000
• Total Cash Inflows over 5 years: $350,000 (Yearly Cash Flow) + $300,000 (Return of initial investment upon sale)

The IRR would be calculated using these cash flows, but for simplicity, let's assume an IRR of approximately 15%, considering typical market conditions for industrial properties.

Finally, Cash-on-Cash return highlights the potential profitability of investing in industrial properties, with strong cash flow and attractive returns. However, it's essential to consider factors such as market conditions, property management, and potential risks when making investment decisions.

In this case, this would be annual cash flow ($70,000) / cash invested ($300,000) = 23.3%

And so to summarize, in this scenario, this is what each of those metrics would equate to:

• Cap Rate: 12%
• IRR: Approximately 15%
• Cash-on-Cash Return: 23.3%

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How to get started in investing in commercial real estate

As we mentioned earlier, getting started in real estate typically involves a substantial up front investment and isn’t something a new investor without deeper pockets and domain expertise can lightly dip their toes into!

There are some funding options available for potential investors, though and here’s a summary of the most common:

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For folks who want to get started, there are tools and marketplaces that potential investors can use to buy their first commercial real estate properties.

Loopnet is one of the most well known commercial real estate websites and offers a series of listings across different asset types. Here’s a selection of some other websites and tools to help you get started too:

• Brevitas - nationwide marketplace that offers a number of tools for finding private, open, and off market commercial real estate, both in the United States and abroad
• Crexi - marketplace and property related analytical tools for potential commercial real estate investors
• RealNex - a tool which allows investors to howcase properties and development opportunities in relation to transportation, landmarks and key points of interest.

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Hope this was a helpful deep dive!

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Jason

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DISCLAIMER: None of this is financial advice. Finbrain is strictly for educational purposes.