Should You Invest In Commercial Real Estate?

I've spoken with several investors over the years that want to make the transition from residential investments into commercial. For the sake of this blog post, when I refer to commercial real estate I'm not talking about multifamily properties. Instead, I'm going to be discussing properties such as office, retail, and industrial/warehouse. 

There are a lot of reasons people want to invest in commercial real estate; they see higher returns, less headache from commercial tenants, and the perceived status from owning commercial real estate. While all of these things can be true, they also come with a price. 

When investors come to me wanting to make their first commercial real estate investment, I have a few key points I discuss with them first, to make sure they're actually ready to make the commercial real estate leap. 

Vacancy

In most markets, vacancies in commercial real estate aren't as easy to fill as with residential properties. While a vacant apartment or SFR can usually be filled fairly quickly, a vacant office space, retail space, or warehouse can take several months, even years, to fill. 

Commercial tenants have very specific requirements as far as the size space they need, the layout, and location. For these reasons, investors often have to be able to find a very specific user to fill their space.  As an investor, you have to be able to cover the cost of these vacancies until you can fill the space again. While a fully occupied commercial property can cash flow incredibly well, you have to be able to weather the periods of vacancy. 

Cost to Acquire a New Tenant

While a residential property can usually be rented without paying a real estate commission, or at least a fairly low commission, commercial real estate leases usually involve the use of an agent. The real estate commission is typically based on the full value of the lease. So if you have a five year lease, at $2,000/ month, you're looking at a $120,000 deal you're going to be paying a commission on. 

Commercial spaces also often require a significant amount of work on the investor's part to prepare a space for a new tenant. Depending on how competitive you have to be to get a new tenant, you may have to agree to providing certain tenant improvements. These tenant improvements can cost tens of thousands, and even hundreds of thousands in some cases, before you ever start collecting rent from the tenant.

Commercial leases are also more complex, and specific to a tenant or space. This often requires hiring an attorney to draft a lease for each deal, since the lease terms are often different from one tenant to the next. 

Between the commission, tenant improvements, and legal fees, you can have quite a bit of money invested into the deal. In many cases, it can take two years of rent payments to cover the cost of acquiring a new tenant. 

Market Changes

15 years ago, who would have ever thought that a retail strip center anchored by a Blockbuster Video would ever have trouble staying leased? However, many investors got left with a large vacancy in their properties that weren't easy to fill. Not only did that large vacancy hurt, the reduction in traffic to the center also had a negative effect on the other tenants in the space. This may not have caused all of these smaller tenants to close, but it did affect the lease rate tenants were able to pay to be in their space. 

Blockbuster is just one example. As different industries encounter major changes, it has a huge impact on the commercial real estate market. Predicting what will happen in the next decade is nearly impossible, so any investor with commercial real estate holdings can get left with a vacant building that's extremely difficult to lease. 

Not all market changes are a death sentence to the affected properties. A few years ago, office vacancies were increasing as working remotely was an increasingly popular trend. However, as many companies have been calling these workers back, office demand has been increasing again. Many vacant big box stores are now being repurposed or redeveloped for other users. If you can afford to hang onto your property, a new user for it will usually show up eventually. 

Exit

Getting out of your commercial property can take quite a bit longer than a SFR or multifamily property, since there are fewer commercial real estate investors out there. The time it takes to exit your commercial property is very dependent on the leases you have in place. Long-term leases with high-credit tenants, like national chains and franchises, are a lot more attractive to other investors. Short-term leases with smaller businesses are a lot riskier, and aren't as attractive. 

Financing

Many commercial real estate investors find that getting financing for their commercial deals can be tough. Many lenders only like to finance owner occupied properties, which require the owner of the property to run their own business out of at least 51% of the property. While there are many lenders out there that finance commercial investment properties, your options will be more limited, so lenders don't have to be as competitive to get your business. 

Investing in commercial real estate isn't all bad, I just wanted to point out some of the important factors to consider before deciding if you're up for the risk of making the leap. 

Commercial real estate has many advantages. Because of the risk, the ROI is often higher. Commercial tenants are often less needy than residential tenants, and the landlord's responsibility is typically less for a leased space. Many retail and industrial leases are NNN (triple net) leases, which means the tenants covers their prorated share of the property taxes, insurance, and maintenance. This also usually means they are responsible for most, if not all, of their maintenance and repairs. Since commercial leases usually have a longer term, you aren't turning over spaces as often and have more stability during periods of high occupancy. 

As with any real estate investment, be sure to do your homework before jumping in. Having a thorough understanding of the market you plan to invest in is extremely important. Talk with the planning department to find out what their master plan for the area is and what developments may be coming. Look at what businesses have been moving in, and which ones have been closing. Plan your investments right, and you can control many of the risks.