3 Reasons Why Commercial Real Estate Investing Might Be Your Next Step

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Wondering how I got started in commercial real estate investing?

Almost 10 years ago now, I was at a crossroads with my investing career. At that point, after investing in residential real estate units for approximately 15 years, I started to ponder the idea of going into the commercial real estate investing arena. It just seemed like the next logical step, I had always done single-family units for the most part but I did buy a six unit building once and had three duplexes and some commercial garages that I had built. I had been a realtor, rehabber and painting contractor throughout these first 15 years and now I was thinking bigger. After all, in my opinion it’s just more zeros, right?

How I Got Started with Commercial Real Estate Investing

When I was thinking about getting into commercial real estate investing, I started to try to find some places that were available in the Philadelphia area and I was struggling.  There just wasn’t much available at the time where the numbers seemed to work.  Everything just seemed too expensive. Personally, I preferred something over 100 units because in my mind it could justify an on-site manager and an on-site maintenance man. Then by chance, something happened.

At the time of my conundrum, I ran a Real Estate Investor networking group and a company from New Jersey came to speak about commercial real estate. I was floored by their presentation, it just made sense. With experience raising private money, I was able to join their team assisting this company with the fundraising of private capital. What I learned next was that by using private placements these owners were purchasing $30 million worth of commercial property and a storage center with none of their own money.

We went on to raise $8 million for down payments and improvements and they proceeded to get some form of owner financing. Private placements also insulated the owners from most of the liability if anything went wrong. Their goals at the time was to turn the parks around within five years, raise lot rents, refinance and pay back their private investors. Now the $30 million worth of commercial property would be all theirs. Here’s the best part, they had no previous experience other than taking a Scott Scheel course! What they learned and taught me was really why it makes sense to invest in commercial property.

Three Reasons Why Commercial Real Estate Just Makes Sense

Economy of Scale

To put it simply, you can manage a lot more apartments, mobile home parks, and offices than you can manage residential homes. Did I say a lot? Because I mean A LOT more, like 100’s of units more. If you have enough units to justify an onsite manager and maintenance person, you can give them a free apartment and/or a small salary and you’re out of the property management game. Plus if they live there, this person will most likely be on call 24 hours a day – this gives your place a better reputation, makes people happy, and it keeps the property up to date and in good shape.

Plus you don’t really have to hire too many outside contractors; some maintenance departments even paint and cut grass. And the contractors that do come in will usually give a discount since with large apartment complexes they’re getting quantity work, that’s usually steady as well. I know because I used to be a contractor for places like these and they were my most consistent jobs every month. Also owning a large commercial property usually simplifies the maintenance and upkeep of the units by having all the same carpet, paint, furnishings, etc.,

Valuation

Market comps and replacement value do play a part in valuing commercial property, but the TRUE value is found by determining the NOI (Net Operating Income). Net Operating Income is Gross Income minus operating expenses (and it doesn’t include debt services).  There’s a great example in one of Scheel’s articles called How Commercial Property is Valued that simplifies the process greatly, “Let’s say a commercial property generates $100,000 in NOI.  Investors in most parts of the country would gladly pay $1 Million to buy a property with a $100,000 annual income stream (a 10% return).  This desired return on investment is also known as a ‘cap rate’.

Thus, as a (very general) rule of thumb, you can take the NOI of a property and divide by 10% (or an appropriate CAP rate for the market you are evaluating) to determine the value of the property.  If you were able to find a way to increase the NOI on that same property from $100,000 to $150,000 [(by say raising the rent, lowering vacancies, etc.)], the property would rise in value from $1 Million to $1.5 Million (based on a 10% cap rate).” And this of course is a major concept with commercial real estate investing. Much like residential, you don’t make the most money with a property that’s in great shape, you make the most money with a property that needs work or that could have it’s value raised.

Creative Financing

Probably my favorite of the three reasons is that you can purchase multi-unit properties with little or no money down through private money partners.  Commercial loans are often more lenient and flexible than residential loans. You can also use a combination of financing.  For example, if you were buying a $10 million commercial building, the bank may lend you $7.5-8 million and the balance may be raised with a combination of owner financing and private money.  The seller may hold a 2nd mortgage of a million dollars, interest only for 5 or 7 years.   The remaining million dollars along with closing costs and renovation capital could be raised through a private placement.

In this example, the managing partners would be Class A members with at least 51% ownership (to maintain control) and would oversee day-to-day operations and could not be voted out under normal conditions.  The remaining investors would be Class B members and would own shares of whatever the company owned whether they’re units, equipment, rental bank accounts, etc.  Keep in mind the buyers will be receiving all security deposits and often times are allotted repair credits from pre-purchase property inspections or seller assists towards closing costs when negotiating the purchase of the property.

I have seen cases where buyers walk away from closing with cash. For example, I had a guy from my local commercial group who walked away with cash in his pocket at a recent closing from doing what is called a lease-back. A lease-back is an arrangement where the seller of an asset leases back a portion of the same asset from the purchaser. This enables the seller to lease back some vacant space in the current building, paying for it in advance at closing, and allowing the buyer to get better financing from the bank by raising the value of the property through the increased NOI.

So Now What?

Today, I’m still involved in several commercial deals. I still utilize many of the skills I’ve learned, especially those involving fund-raising through private placements, with a variety of new projects today. I’m currently working on a 12,000 square ft. office building deal (and it looks like the sellers are willing to hold some paper too!). So when are you going to jump in the commercial pool and take action? Go out and join a commercial real estate group, ask questions, read books, and get started today!

Would you consider commercial real estate investing? Why or why not?

Be sure to leave a comment below, and let’s talk!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.