CRE offers consistent returns, passive income, and growth potential, making it a very attractive investment class. Real estate investing in this sector is gaining popularity as an alternative investment. Commercial real estate does have the potential to be profitable, but not all commercial investments are the same. Commercial real estate investment success or failure depends on knowing when, what, and how to invest.
Understanding commercial real estate’s common pitfalls, mistakes, and risks are also essential to prepare for them before you buy. Here are six things you need to know before investing in commercial real estate.
1. Not all types of properties are the same
Commercial real estate consists of a wide variety of assets. In addition to the five main CRE segments; industrial, office, retail, multifamily, and special purpose, there are a number of other types of properties such as self-storage, medical, elder care, and land. Various factors affect the supply and demand, yield, and overall profitability of each sector.
Depending on the supply and demand in the location of the asset, some property types perform better than others. However, even on a macro level, some sectors perform better than others. The ability to identify the asset types that are most profitable or offer the greatest opportunity in the current economy is crucial.
NCREIF Property Index returns
A great illustration of how the performance and returns of different CRE sectors vary.
The industrial sector is currently the best-performing CRE asset class, while retail is the worst. With the rise of online shopping, the retail space is struggling to compete, resulting in a decline in growth and a shortfall in returns. It is important to consider that some sectors of commercial real estate tend to have higher vacancy rates because they may only have a single tenant — such as a warehouse or office space. Investing in sectors or properties that have multiple tenants, such as multi-family apartments, lowers the potential risk profile.
Study the performance of each asset class in the current economy, determine the viability of that sector as an investment, and then choose which type of CRE property you wish to invest in.
2. Know the market area and supply and demand
The most important thing to remember before investing in commercial real estate is that each market is different. Investing involves investing in a geographic area that has its own unique supply and demand. You may find that certain types of properties are doing well on a macro level, but there is an oversupply in your city, or vice versa. Often, investors fail to conduct adequate market research to determine if the market is saturated.
Research the market supply within your immediate area, taking into account both the current profitable square footage and any additional square footage that will result from upcoming construction and future developments.
If you have identified an undersupplied real estate type in your specific market, you can get a feasibility study to analyze its growth potential and likelihood of success. These resources include Realtor.com, Deloitte, CBRE, and Mordor Intelligence.
3. Understand market cycles
It is impossible for something to last forever. Commercial real estate profitability is directly correlated with the health of the economy, unemployment rate, and GDP. You can avoid buying at the peak of the market and being forced to sell when the market is low if you understand how real estate market cycles work.
It will also be easier to make more informed investment decisions by knowing specific indicators of the various market cycles.
4. Do thorough due diligence
Due diligence refers to the period in which a prospective buyer can conduct thorough research on the investment opportunity. Reviewing financial records, documents, tax returns, profit and loss statements from the previous owner, as well as conducting surveys, property inspections, a feasibility study, or any other research needed.
New real estate investors are prone to get so excited about the first commercial investment that they overlook something during their due diligence. You can avoid potentially making very costly mistakes by knowing what should be investigated, carefully analyzed, and inspected before you buy.
By establishing a thorough and comprehensive due diligence checklist for your CRE property type, you can ensure no item is overlooked. The following items should be considered:
- Confirm that using the property as intended is permitted by the zoning before you develop vacant land.
- Look at how many additional units a market can accommodate before expanding an existing building or building a new one.
- Learn about the permitting process and costs with the city or municipality where the property is located
Whenever you invest in commercial real estate that is more passive, such as REITs, crowdfunding, partnerships, or private funds, it is vital that you thoroughly vet the company or person handling your investment.
It is unfortunate that not everyone in the investment world follows the same set of standards. It is equally important to conduct due diligence on the asset as it is on the person, fund, or company with whom you are investing.
- Ask for recommendations from other participants who have invested in past properties.
- For a sense of their track record, review past offerings and actual returns on closed investments.
- Ask about their due diligence process. See how they determine which REITs or investments to invest in or how they vet each investment opportunity.
- Do a background check if it’s your first time working with someone in the private sector, even if it’s not necessary with a large investment firm. Even though this may seem severe, it is not uncommon in larger CRE deals.
5. Establish a contingency and capital reserve fund
Any investment entails some level of uncertainty. Regardless of the amount of research, verification, or preparation you do, there will always be unknown factors affecting your overall outcome. You can mitigate this uncertainty by considering the costs of unexpected events.
Contingencies are money you set aside from your initial acquisition costs to help pay for unexpected expenses that occur during lease-ups, rent increases, management changes, renovations, and rezones. Until your property is stabilized, you can use them to help pay your debt service. It is especially helpful if there will be a negative cash flow while you improve the property’s overall performance. Standard contingency budgets in commercial real estate range from 5%-15%, depending on the asset and its performance.
Creating a capital reserve fund or replacement reserve fund is also a best practice in real estate.
Capital reserves are funds or accounts established to handle long-term improvements or unexpected expenses beyond the initial capital improvements. This is the money you set aside before netting any positive cash flow, typically between 3-5% of gross rents. As you run your analysis of the investment, take into account these two factors to increase the chances of being profitable and to have the funds available when unexpected events occur.
6. Be prepared for delays and setbacks
Timing is also subject to uncertainty, just like costs. People set unrealistic deadlines for building, renovating, fully leasing, or reaching market rents for their commercial real estate investments. Construction, renovations, increasing rents, changing management, and introducing new systems all take time. Progress is almost always slowed by challenges and setbacks. You should try to identify the potential obstacles as part of your due diligence period and prepare for them as part of your contingency costs or with a plan of action in case delays occur.
Make sure your timelines and return expectations are flexible when investing in commercial real estate through a passive vehicle like a REIT, crowdfunding, partnership, or fund.
Due to economic factors, market cycles, or challenges that arise after an acquisition, asset performances can fluctuate. Ultimately, it’s the fund manager’s job to inform you of this, but it’s also good to be aware of it on your own.
You should know these six things before investing in commercial real estate so that you can identify profitable investments as well as guard against some potential downsides, risks, and setbacks.