What Type of Commercial Real Estate Investment is Right for You?

I often get asked how I first started investing in commercial real estate (“CRE”), and of course the next follow up question: “How do I start investing?”   

I think the most important facet to begin investing in CRE is to identify what your goals are.  How much do you want to invest and why do you want to invest, is it to build equity; for cash flow purpose; or are you looking for larger future appreciation?  CRE can provide an avenue of long-lasting income; it can help diversify your portfolio, it can offer tax benefits, and by using properly selected real estate strategies, it can produce the potential for appreciation, in addition to cash flow.

Many first time investors in CRE immediately go to multi-family apartment buildings.  Any multi-family building with 5 units or more is considered a commercial property.   There is a comfort level for most people in that they are familiar with the leases, how they operate, and what a tenant might expect of a landlord.  This asset class however, is one where the investor is typically very hands on with the investment.  There tends to be higher turnover of the units (advertising for new tenants), make-ready of the apartment once someone has moved out, and maintenance issues (emergency calls in the middle of the night).  An area many first time investors overlook is the budgeting for capital expenditures (roof or water heater replacement, repairs, etc...)

I often get asked how I first started investing in commercial real estate (CRE), and of course the next follow up question: “How do I start investing?” I think the most important facet to begin investing in CRE is to identify what your goals are. Example questions to ask yourself would be: How much do you want to invest and why do you want to invest, is it to build equity, for cash flow purposes, or are you looking for larger future appreciation? CRE can provide an avenue of long-lasting income – it can help diversify your portfolio, it can offer tax benefits, and by using properly selected real estate strategies, it can produce the potential for appreciation, in addition to cash flow.

Once you’ve identified your initial reasons for investing, the next step is to identify your tolerance for risk. Other questions to keep in mind: are you willing to trade safety for the potential of a higher return?  Do you want the investment to be passive, or will you be actively involved?  Once you’ve recognized your goals for investing, and your tolerance for risk, you now need to identify what asset class would be best suited for your investment.

Many first time investors in CRE immediately think of multi-family apartment buildings.  There is somewhat of a comfort level in that most people are familiar with the leases, how they operate, and what a tenant might expect of a landlord.  This asset class, however, is one where the investor is typically very active in the investment.  There tends to be higher turnover of the units (which means having to advertise for new tenants), make-ready of the apartment once someone has moved out, and maintenance issues (emergency calls in the middle of the night, as well as everyday maintenance issues), and budgeting for capital expenditures (roof replacement, repairs, etc...). Even with a property management company to oversee much of the day-to-day operations, a multi-family apartment building can still take up a lot of an investor’s time.

An alternative to an apartment building is either an office or retail building.  The differences can vary widely.  Office leases can be similar to apartment leases in that the majority are either Full Service Gross, or Modified Gross leases.  Positives for an office lease are that the leases are typically 3-5 years long, and a tenant is typically responsible for the increase in the expenses over their base (initial) year.  This of course reduces some of the risk.  Negatives for an office is that in a gross lease (the majority of cases) the landlord also pays for the utilities, and janitorial (offset somewhat by the tenant paying for increases from the base year) and that the make-ready or tenant improvement costs are typically substantially more than for an apartment building.

Retail leases are typically drafted under a Triple Net (NNN) format, whereby the tenant is responsible for all costs associated with the space, including reimbursements for taxes, insurance, and repairs; and are also typically longer, from 5-20 years in length.  This may offset some of the risks associated with rising costs, but retail buildings also have some negatives, in that if you are leasing to new businesses, they tend to have a higher rate of failure, potentially leaving you with a vacant building.  You can offset these risks by leasing to established businesses, with corporate guarantees, and proven track records.

Another option for investing is the Single Tenant NNN building.  This is a single building, occupied by only one tenant.  An example of these would be most fast food restaurants, banks, drug stores, and grocery stores.  Many times, these leases are structured with initial lease terms that are 10-20 years in length, with rental increases built in, and with multiple option periods.  With a strong corporate tenant, and guarantee, this type of property can truly allow for a much lower, long-term investment risk. 

Typically speaking, CRE properties need a minimum of a 35% down payment, with other factors coming into play on the investment, such as the debt service coverage ratio (a ratio of the Net Operating Income vs. the loan payments).   An alternative to just jumping in feet first, is to capitalize off of the experience of another investor, possibly through a Real Estate Syndication.  This is where a syndicator (typically one with previous experience in investing in real estate) sponsors a transaction.  The syndicator typically puts in between 5-10% of the required equity, and offers the balance to other investors.  This method allows an investor to invest in larger commercial real estate properties, in better locations, and with higher quality tenants than they might typically be able to afford on their own.  The key to choosing a good syndicator and/or deal is to look at their previous track record, and ask the following top five questions:

1)    How much of your own funds will you be putting into the purchase?  (If less than 5%, then consider another sponsor, you want to have a managing partner that has some “skin in the game.”)

2)    What is the anticipated hold period for the investment, and what is the exit strategy? If they don’t have a definite term and exit strategy, or if it does not match your investment strategy then this investment may not be for you.

3)    What has been their previous track record for returns?

4)    How have the returns compared to what was anticipated?

5)    How many transactions have they completed from acquisition, holding, and disposition? (Some syndicators may be newer, and have not sold any of the investments they’ve acquired.)

Ultimately, syndications can be a very effective means of getting started investing in real estate – you are leveraging the experience of the syndication, as well as their network of management.  It really allows for a more passive investment, while still reaping the benefits from real estate investments (i.e., potential to offset capital gains, receive depreciation benefits, having “real property” backing up your investment, receive appreciation,  having strong corporate guarantees to leases, etc…

Image © Phillip Taylor | Creative Commons License

An alternative to an apartment building is either an office or retail building.  The differences can vary widely.  Office leases can be similar to apartment leases, in that the majority of the leases are either Full Service Gross, or Modified Gross.  A Full Service Gross lease essentially  means that everything is included in the lease; utilities, maintenance, even janitorial; while a Modified Gross lease is very similar to a residential lease, where typically the tenant must also pay for utilities and janitorial.  Positives for an office lease are that the leases are typically 3-5 years long, and a tenant is typically responsible for the increase in the expenses over their base (initial) year.  This of course reduces some of the risk.  .

Retail leases are typically drafted under a Triple Net (“NNN) format, whereby the tenant is responsible for all costs associated with the space, including reimbursements for taxes, insurance, and repairs; and are also typically longer, from 5-20 years in length.  This may offset some of the risks associated with rising costs, but retail buildings also have some negatives.  You can offset these risks by leasing to established businesses, with corporate guarantees, and proven track records.  Retail properties typically are the easiest to manage for an investor. 

The easiest management option is the Single Tenant NNN building.  This is a single building, occupied by only one tenant.  An example of these would be most fast food restaurants, banks, drug stores, and grocery stores.  Many times, these leases are structured with initial lease terms that are 10-20 years in length, with rental increases built in, and with multiple option periods.  With a strong corporate tenant, and guarantee, this type of property can truly allow for a much lower, long-term investment risk.  Due to the nature of these types of leases, you are able to easily invest out of the area to maximize your cash flow.

Ultimately, there are many options for a CRE investor, the right type of property for you is one that meets all of your goals and risk comfort levels.  To find the best ones, make sure you utilize a good agent familiar with the asset class, which can help you identify the right property for you.