Important Rules for Commercial Real Estate Investing

Investing in commercial real estate assets can appear intimidating. But, that misconception shouldn’t stop you. By adhering to the long term investment rules, you stand to make higher returns compared to many other debt instruments. The rules covered in this article, can help you down the path to smart CRE investing.

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1. Location, Location, Location
This first rule might not surprise you. Location is everything in real estate. One of the ways you earn a return on CRE investing is through capital appreciation. The other way is through rental income. Both capital appreciation and rental income are dependent on the asset’s location. As a general rule of thumb, look for locations with a vacancy rate of less than 5%. This is a measure of ensuring supply is stable and tenants are less likely to vacate and negotiate a new, lower rental amount.

2. Quality of the Property Matters
Besides selecting a great location, the building should be of great quality. The quality of the building tends to attract the same quality of tenant. When the building is of high quality, you can charge a premium, expect a better retention rate, and of course, a higher capital appreciation. As you search for a property, look for certifications such as LEED, gold, or platinum ratings. Other attributes to look for include an attractive and inviting lobby, enough elevators, high ceilings, and lots of windows with nice views. Owning a high quality building can make it easier to sell when that time comes.

3. Study the Demand vs. Supply
Before making the commitment to buying a property, you should carefully analyze supply and demand. Each city has a micro-market and each micro-market has a stock and upcoming supply. Stock in this context is the amount of space completed and leased. If projected annual supply exceeds historical demand over the next two to three years, both rents and prices will go down. In this scenario, with a disproportionate supply in the market, rents will decrease as tenants have more options.

4. Look at Market-Rent
Although complex, this concept helps investors foresee the amount of risk that’s involved in the property. Let’s look at an example together of this concept. Assume three available properties are around the same location for similar prices, but with a tenant paying different rental amounts.

Building 1 has a tenant paying $1,000 and the sales price is $10,000
Building 2 has tenant paying $1,100 and the sales price is $10,500
Building 3 has tenant paying $900 and the sales price is $9,500

At first glance, you might say Building 2 is the best option with a rental return of 10.5%. Yet, a seasoned investor would be more interested in finding out the current rental rate in the market today. If the market rate is $900, then Building 3 is the safest investment. That tenant is paying rent at market price and therefore is not likely to vacate.

5. Quality of the Tenant Also Matters
When you find a great tenant, you can generally expect them to pay rent on-time, put down a higher deposit, stay longer, and help increase the property’s value. As a word to the wise, look for tenants who have well-established companies, rather than finding a smaller, unknown company or start-up.

6. Consider Interior Finishings
As an investor, ask who has completed the interior fit-outs on the property. An interior fit-out relates to the flooring, wiring, air conditioning, conference room build out, etc. Some tenants prefer to do the fit-outs on their own. But, others ask the developer to do them and in turn agree to pay a higher rental amount to cover those costs. So, tenants who perform their own fit-out tend to stay longer on the lease to recover the amount spent.

7. Carefully Examine the Lease Structure
The way commercial leases are structured, vary widely when compared to residential leases. For instance, a commercial lease has terms of 3+3+3 or 5+5+5. This means that in the 9-year (3+3+3) or 15-year (5+5+5) lease period, escalations will occur every 3 or 5 years. Even more, commercial leases are one-sided. So, a tenant can vacate anytime, but a landlord cannot ask a tenant to leave during the lease period. Conversely, some leases include a lock-in period (generally for 3 years) where the tenant cannot vacate. As you can see, it’s important to understand the lease terms and the inherent risks involved with the investment.

8. Security Deposit
In commercial real estate, leases often require a tenant to pay a deposit in the amount of 10 to 12 months rent. If a prospective tenant offers to put down an amount equal to six months rent, take caution. They could have potential cash flow issues or could want a short-term lease arrangement.

9. Diversification is Key
As with any investment, creating a diverse investment portfolio helps to reduce your overall risk. If you put all your money into one property and your main tenant vacates, you’re still on the hook for maintenance, property taxes and so forth. Rather, by investing in a few properties in different cities, you can reduce the variance in rental income. And this keeps the risk at the property level diversified.

Ryan Gravel
Ryan Gravel

Ryan Gravel is an American real estate broker and developer. He began his career at a young age working for his family owned construction company.
After graduating college at the University of Central Florida with a degree in business, Ryan set out to find untapped prolific markets around the world. His search landed him in Playa del Carmen, Mexico where he founded Virgin Realty Mexico and co-founded the Saatal Development Group one of the fastest growing development companies in the Riviera Maya.
With extensive market knowledge, professionalism, etiquette, innovation and integrity Ryan is known as one of the most highly respected real estate advisors in the region.

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