Commercial real estate investing is attractive as a wealth-building strategy because it offers significant independent and potentially passive income streams. You can create income without becoming an active-participant landlord—or you can be a hands-on, full-service landlord and property owner.
Here’s what you need to know about getting started with commercial real estate investing.
What Is Commercial Real Estate?
Commercial properties come in a variety of types. You’ll find specific variations among each type but the six essential categories include:
- Office: Anything from skyscrapers to single-tenancy spaces
- Retail: Brick and mortar stores can be strip mall units or high-end banks and fine dining restaurants
- Industrial/manufacturing: Designed for warehousing or manufacturing goods (usually with high ceilings and docks)
- Multifamily housing: Apartment complexes, high-rise condo buildings, and smaller buildings with five or more units.
- Special purpose: Property that’s been developed for a designated purpose, making it difficult to reorient the property to a different use—e.g., a car wash facility
- Mixed use property: A property that lends itself to a mix of purposes is called a mixed-use property. Examples may include residential and retail developments, or business parks with industrial and office properties
Commercial property of almost any kind can also be owner-occupied commercial real estate (OOCRE) when the owner occupies some part of the commercial property residentially. It’s one of the major benefits of real estate investing of any kind, and can be incorporated with any of the above six categories.
The Pros and Cons of Investing in Commercial Real Estate
Why is commercial real estate investing so appealing? There are a host of benefits to consider, but there can also be some downsides. It’s important to be familiar with both the pros and cons before you commit to putting any money into an investment.
CRE investment benefits include:
- More income: In most cases, CRE has a higher potential rate of return on your investment—anywhere from 6% to 12% compared to 1–4% for residential real estate.
- Longer lease terms: Most commercial leases carry a longer term of years than residential leases. That helps reduce turnover and improve cash flow and stability of future revenue projections.
- Lower inventory (and less competition for your building): Because each prospective commercial tenant has fewer properties to consider, you’ve got a better shot of landing a good tenant.
- Better working hours: If you’re processing tenant requests, complaints, and maintenance tasks yourself, instead of hiring a management company to do it for you, you’ll enjoy the more limited work hours, since your tenants by and large keep business hours themselves.
- Less risk: Poses less risk than investing in the stock market
However, CRE investing also poses a few downsides as well. For one thing, while the overall risk is less than that of investing in the stock market, the potential returns are not necessarily as high. Additionally, CRE investing can be cash-intensive if you want to maximize your return (assuming you invest directly). Direct investment also means you can face some administrative headaches, such as tenant disputes and maintenance needs, and reduced liquidity of your assets.
The Keys to Successful Commercial Real Estate Investment
As with any investment opportunity, successful CRE investing can be elusive. That’s especially true if you’re not willing or able to put a little effort into understanding the context of the market and how to analyze potential opportunities.
It’s also helpful to be able to form relationships with professionals who are vital to putting together good development deals such as real estate agents, lawyers, architects, contractors, real estate wholesalers and brokers, and more. You should also look out for individuals with more experience who can mentor and guide you.
You’ll also need to learn the basics of investing in and operating commercial properties. It’s vital to learn how to read a real estate pro forma and evaluate the financial data you find there to ascertain whether the property is a good investment. You can learn quite a bit from CRE websites, message boards, online courses, podcasts and more.
How Are Commercial Real Estate Investments Financed?
Financing a commercial real estate investment is always a big challenge for first-time investors. With so many potential funding types, it can be challenging to choose the best path forward for a particular investment.
With a conventional, or traditional CRE loan, you’ll borrow funds from a bank or other institutional lender. Traditional loans are not backed by the U.S. federal government and typically finance between 65 to 85% of the total loan-to-value ratio for the property. That means you’ll need to find funds equivalent to between 15 and 35%.
Offered by the U.S. Small Business Administration (SBA), there are several types of 7(a) loans, each with different maximum loan amounts and other terms. There are also specialized loans designed for specific purposes or people including exporters, veterans, and small businesses with a need for short-term working capital. The SBA also offers Section 504 loans, which are long-term fixed-rate loans of up to $5 million for fixed assets necessary for expansion.
Bridge loans are designed to temporarily “bridge the gap” until long-term financing becomes available. These loans are a good way to compete against cash offer buyers, but you’ll need to refinance to a longer-term mortgage eventually.
Investors can also obtain a hard money loan from semi-institutional lenders who offer short-term loans with high interest rates. The fees can be significantly higher than traditional loans but you can get the money within a few days, as opposed to months for a traditional loan. Finally, conduit loans offer competitive fixed rates and a term of 25 to 30 years, but on the downside, you’ll need to make a balloon payment at term’s end.
How to Qualify for a Commercial Real Estate Loan
It can be overwhelming to undertake the process of securing a loan for the purpose of investing in CRE. Many factors can impact the type of lending your project can work for and what you’ll need to qualify for that loan.
Individual vs. Business Entity Applications
Decide whether you’ll invest as a person or as a business organization. Most CRE investment properties are held by business entities—a corporation or partnership, for example. Limited liability companies are a smart strategy for CRE investors as they help protect shareholders from legal exposure for personal injury and other damages.
Whether you’re investing as a business entity or an individual, lenders will want to know that you’re creditworthy. They’ll want to see evidence that you’re a good risk and that they can be reasonably assured they’ll get their money back as and when promised. Traditional lenders expect a borrower’s credit score to be over 699, whereas bridge loan applicants should have a credit score of over 680.
Commercial vs. Residential Property Loans
Lenders will consider several important financial metrics when making a decision on your loan application to acquire a specific piece of CRE property. First is the loan-to-value ratio, which describes the value of the loan as compared to the property’s value, as the name suggests. LTV ranges from between 65 to 80 percent. A lower LTV rate will typically qualify for better interest rates and terms.
Another key metric that CRE lenders want to see is the debt service coverage ratio (DSCR). This metric evaluates how well the property may service a loan by comparing its annual net operating income to the costs of servicing a mortgage’s principal, interest and fees. If the DSCR is under 1% means the property will have a negative cash flow. CRE lenders usually prefer to see DSCRs of 1.25% or greater.
Processing Times for CRE Loans
After you submit an application for a RE loan, the lender will need some time to evaluate your creditworthiness, financial projections for your proposed property acquisition, and your business plan, among other things. This process can take a varying amount of time, depending on the lender. Expect a bank to approve a traditional commercial RE loan within six weeks or so, assuming there are no material deficiencies in the application documents. Bridge and hard money loans take a week or less to reach approval.
Crowdfunded CRE Investment Platforms
Crowdfunding platforms allow you to invest in real estate passively and indirectly, without having to seek traditional funding or come up with significant down payments. These platforms are growing in popularity as they can simplify the process for new investors. They’re also a great way to start small and learn more about the commercial real estate market.
In some cases, these platforms are open to all investors who have a few hundred dollars and the desire to explore CRE investing. However, other platforms are only open to accredited investors, a special category of individuals and entities with a heightened degree of financial and investment sophistication, high net worth, and significant income.
Popular commercial real estate investing platforms such as LEX Markets work by connecting a potentially large group of investors to commercial investment deals. With some platforms you invest in REITs, whereas with others such as LEX you invest in an equity security issued by the owner of the property. Shares of the property are of that individual piece of property — instead of a pool of properties with a REIT. Other crowdfunding investment platforms include Fundrise, which is open to both accredited and non-accredited investors, and CrowdStreet, open to accredited investors.