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.
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
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
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.