Investing in commercial real estate (CRE) can be a powerful strategy for wealth creation, often presenting greater financial rewards than residential property investments. However, this higher potential comes with a unique set of risks that demand thorough understanding before making a commitment. This comprehensive overview delves into the pros and cons of investing in commercial real estate, helping you determine if it’s the right move for your investment portfolio.
What Is “Commercial Real Estate”?
In the realm of real estate, “commercial real estate” broadly refers to any property that is not residential and comprises more than four units. This distinction sets it apart from single-family homes, duplexes, triplexes, and four-unit buildings, all of which fall under the residential category. The commercial real estate industry often uses the acronym “CRE” to refer to this sector.
Types of commercial real estate are diverse and include:
- Retail buildings: This broad category encompasses everything from inline strip centers and neighborhood centers to large power centers, standalone buildings, and even shopping malls.
- Restaurants: Properties specifically designed and utilized for food service establishments.
- Hospitality properties: Hotels, motels, bed and breakfasts, and other lodging facilities.
- Office buildings: Ranging from multi-tenant complexes to single-tenant corporate headquarters.
- Medical Offices: Specialized facilities designed for healthcare providers.
- Warehouses / Industrial buildings: Including facilities for cold storage, high-bay storage, food-grade operations, properties with rail access, or those equipped with cranes.
- Apartment buildings: Specifically those with more than four units, or a portfolio of smaller residential properties managed as a commercial entity.
- “Mixed-use” buildings: Properties that integrate multiple functions, such as ground-floor retail with office space and apartments above.
Managing each of these property types involves distinct considerations and complexities. Being fully prepared for the demands of successful commercial real estate investment is crucial.
Pros When Investing in Commercial Real Estate
- Income Potential: The most significant advantage of commercial real estate is its superior earning potential compared to residential properties. Commercial properties typically generate an annual rate of return on the purchase price in the range of 6-12%. This is substantially higher than the 1-4% annual return commonly seen with single-family homes, at best.
- Professional Relationship Interactions: As a commercial property owner, you will often operate under an LLC, fostering a more business-to-business dynamic with your tenants. Commercial tenants, being business owners themselves, tend to approach interactions with a professional mindset. While difficult commercial tenants can exist, they are generally less common than in residential settings.
- Public Image: Tenants in retail or office spaces have a strong incentive to maintain their storefront and interior space, as its appearance directly impacts their business. This alignment of interests ensures that the property’s quality is maintained, which in turn helps preserve and enhance the value of your investment.
- Work Is Held During Business Hours: Commercial tenants typically “go home” when their businesses close for the day. This often translates to fewer late-night emergency calls for property owners, allowing for more predictable work hours. Additionally, commercial properties are more likely to have security services, which handle initial responses to after-hours incidents and immediately notify authorities.
- Objective Property Price Evaluations: Valuing commercial real estate is often more objective. You can request the current owner’s income statement to help determine a fair price. A commercial real estate broker can also provide a lease comparable analysis to verify that existing tenant leases align with current market rates. Residential properties, conversely, tend to be subject to more emotional pricing and closely follow overall market cycles, making differentiation between similar properties challenging.
- Triple Net Leases (NNN): A powerful advantage, the triple net lease is a concept where the property owner is largely absolved of property expenses. The “three Ns” typically stand for Property Insurance, Real Estate Taxes, and Common Area Maintenance (CAM). Under an NNN lease, the lessee directly covers all these property expenses, meaning your primary expense as the commercial real estate owner is often just the mortgage. Large corporations frequently sign NNN leases because they want to maintain brand-consistent aesthetics and manage related costs. This makes NNN properties some of the lowest-maintenance income producers for investors. While you may still manage the arrangements for services like snow removal, lawn care, and property insurance, a key benefit of an NNN lease is the ability to pass these expenses directly to your tenant(s), including your property management fee if you manage it yourself. For a truly hands-off experience, you can hire a commercial property management company to handle all logistics.
- Flexibility: Unlike residential properties, which are typically restricted to their intended residential use, commercial real estate offers a wider variety of potential uses. It’s common for suite sizes and configurations to change significantly when new tenants arrive. Additionally, commercial tenants often bear the cost of their own remodels. In instances where the owner pays for a remodel, it’s typically backed by a strong commercial-grade credit guarantee on the lease, providing security for any associated commercial loans.
- Property Appreciation: Well-located commercial properties have significant potential for appreciation over time. This can be driven by:
- Planned new developments: Nearby projects can increase property value.
- New traffic corridors: Directing more traffic and visibility to your property.
- Growing businesses: Moving into the area, generating increased demand for both housing and retail space.
- Underutilized land: Vacant portions of the commercial property that could be developed.
- Subdivision potential: The ability to split the property into multiple parcels.
- Below-market lease rates: Opportunities to increase lease rates to market levels upon lease expiration.
These creative strategies for value creation are generally less prevalent in residential real estate.
- Tax Advantages: Commercial property ownership offers substantial long-term tax benefits. You can potentially deduct mortgage interest, real estate taxes, and claim depreciation on the building. Costs associated with maintaining the property may also be deductible.
Cons When Investing in Commercial Real Estate
While the advantages of commercial real estate are compelling, it’s crucial to consider the potential downsides before investing.
- Time Commitment: Owning a commercial retail building with multiple tenants necessitates a much greater time commitment than managing a single-family residential rental. Being an absentee landlord often prevents maximizing your return on investment. You’ll likely deal with multiple leases, each with unique start and end dates, more frequent repair issues, and increased public safety concerns. While a good commercial property management company can alleviate many of these time commitments, you’ll still want to be the lead negotiator for all your leases, as they directly impact your cash flow and Net Operating Income (NOI), which maximizes your property’s value.
- Professional Help Needed: Unless you are licensed and skilled in various trades, you will likely need to hire professionals for maintenance issues, emergencies, and repairs. This additional cost must be factored into your expenses. While some property management expenses can be passed through to tenants in a NNN investment, be cautious that excessively high expenses don’t price your space out of the market, potentially leading to tenant vacancies. Commercial property management companies typically charge between 5-10% of rent revenues for services like lease and contractor administration. Carefully evaluate whether you prefer to manage leasing and tenant relationships personally or outsource these responsibilities.
- Larger Initial Investment: Acquiring a commercial property generally requires significantly more upfront capital than a residential rental, making market entry more challenging for individual investors. Furthermore, you can anticipate substantial capital expenditures post-acquisition, such as a major bill for a roof replacement or a new furnace. More customer traffic implies more facilities to maintain, leading to potentially higher unforeseen costs. The goal is for revenue gains to outweigh these increased costs. Additionally, obtaining a commercial loan can be more expensive and prohibitive, requiring careful evaluation of financing options.
- Increased Risks: Commercial properties, due to higher public foot traffic, face increased risks of personal injury claims or property damage. Incidents like vandalism, car accidents in parking lots, or slips and falls on ice are more probable. These risks can be mitigated by owning the property through a business entity like an LLC, maintaining robust insurance coverage, promptly addressing safety hazards (e.g., snow and ice removal), and ensuring all property work adheres to code, using bonded and insured contractors.
- May Have Better Ways to Spend the Money: The substantial capital required for a commercial property investment might be better utilized to address cash-flow needs in an existing business or to invest in alternative opportunities that are more aligned with your financial comfort zone or expertise.
- May Not Be Cost-Effective If Moving Your Business: If you plan to locate your own business within the commercial property, it’s crucial to assess your long-term commitment to that specific location. If your business is likely to relocate in the near future, investing in the property may not be the most cost-effective use of capital. Your business operations and the commercial real estate market cycle operate independently and may not always align, making long-term financial planning challenging.
It is always prudent to seek professional advice from real estate attorneys and brokers when considering commercial real estate investments. Their market insights can provide an accurate assessment of market conditions and help determine the viability of your investment, including the time horizon for recouping high initial costs.