Commercial Real Estate Guide for Beginners

Commercial real estate is its own class of real estate investing. Learn the ropes in this commercial real estate guide for beginners.

When starting a new venture, like investing in commercial real estate, a guide is helpful. Commercial real estate (CRE) has the potential to provide significant income to brokers or investors, but there's a lot to learn before diving in. Even experienced real estate professionals can benefit from a guide to commercial investing if they're new to the business.

This commercial real estate guide will break down everything you need to know about CRE, including common terms, different property types, ways to invest, and types of loans.

Types of commercial properties

Commercial real estate is a general term for several types of commercial properties. As a rule of thumb, commercial real estate properties are used for business purposes. Commercial spaces are typically categorized into five main categories:

  • Office space
  • Multifamily (e.g., apartment complexes)
  • Retail spaces (e.g., strip malls, malls, or single retail spaces)
  • Industrial (e.g., warehouses, data centers, manufacturing buildings, or self-storage)
  • Special purpose (e.g., churches, bowling alleys, daycares, hotel lodging, or health care)

CRE can be purchased by a business to be owner-occupied or as an investment for cash flow. Similar to a residential rental property, most CRE provides passive income to the owner from leasing the unit to a tenant.

Why commercial real estate?

Commercial real estate is an appealing asset class because you can invest in properties with multiple streams of income. If the tenant of a residential rental stops paying, 100% of your income is gone until you can get a new tenant into the property. If you own a multi-unit commercial property, you have additional income sources to offset any vacancies. It's a more stable investment.

You also have the potential to earn a higher income with commercial real estate. Depending on the size of the property, you could general hundreds of thousands of dollars of cash flow annually.

There are also different leases in commercial real estate than in residential. Some CRE leases put the responsibility of paying property taxes, insurance, and maintenance for the property on the tenants. Even with a single-unit rental like light industrial property, big repairs like a new roof may be the tenant's responsibility, keeping costs down.

Commercial real estate isn't the typical starting point for new investors or brokers. The larger price tag on most CRE properties can make it intimidating. The more a property costs, the more money you need for a down payment, the more difficult it may be to get a loan, and the more money is on the line.

But it's actually easier to get started in CRE than most people think. And it can provide an excellent income stream for those looking to invest passively or actively.

Terms to know

While there are dozens of terms specific to commercial real estate investing, preferred returns and equity split are two important concepts you'll see throughout this article.

  • Preferred returns: a form of return in which the sponsor pays the investor a set return, which can range from 5% to 10% or more. Preferred returns are typically paid quarterly, but can be paid monthly or annually.
  • Equity split: when a portion of the property's equity from appreciation or added value is split between the sponsor and the investor based on an agreed upon percentage.
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Passive commercial real estate investments

In passive real estate investments, the investor doesn't actively own or manage the property themselves. Passive investing typically generates income in the form of a dividend, preferred return, equity split, or a combination. 

Below is a brief overview of the various ways to passively invest in CRE. Each type of passive commercial real estate investment has benefits and risks, so conduct your own due diligence on each method before investing. 

Real estate investment trusts (REITs)

REITs are one of the easiest forms of investing in commercial real estate. A REIT pools money to purchase and professionally manage multiple commercial properties and pays dividends to investors. REITs receive special tax benefits if they pay 90% or more of their income as dividends to their investors, making them a reliable source of passive income.

There are two REIT classifications: equity REITs and mortgage REITs. You can buy shares of both types through a brokerage account (for public REITs) or from the REIT directly (for private ones). Publicly traded REITs are the most popular choice and can be purchased with as little as a few hundred dollars.

Real estate exchange-traded fund (ETF)

Rather than having to choose and purchase shares of each individual REIT, you can invest in multiple REITs with a real estate exchange-traded fund (ETF). A fund manager chooses a basket of real estate securities to invest in. This can include multiple REITs in a variety of commercial sectors.

Real estate ETFs mitigate risk by spreading your investment across multiple companies and sectors.

Crowdfunding

CRE crowdfunding is a passive investment option for accredited investors. Investors can join various crowdfunding platforms that pair them with third-party investors or developers who have an investment opportunity that requires funding. 

Most crowdfunding platforms vet the investment and sponsor before adding it to the platform, but you should conduct due diligence on the opportunity and the sponsor. 

Investors can participate in CRE crowdfunding opportunities for as little as a few thousand dollars -- though some require several hundreds of thousands. While the returns are typically higher than a REIT or real estate ETF, crowdfunding comes with less liquidity and more risk. Most crowdfunding opportunities have two- to five-year terms. During that time, the investor can't pull their funds out of the deal.

Become an equity or funding partner

Another passive option is partnering with an active CRE investor as a funding partner. You're a silent, passive partner who provides a portion of the funding for the down payment or cash purchase of the property in exchange for a preferred return, equity split, or combination of the two. This is similar to crowdfunding, but the number of partners is lower and the returns tend to be higher. But there's more risk, too.

Equity and funding partners are common in the real estate world, especially with CRE. However, these opportunities aren't publicly advertised. Most equity opportunities are found through developed relationships with active investors. It's extremely important to conduct your own due diligence on the investment and the investor. They're managing the LLC, property, and your money -- so you have to be confident in their ability to manage the investment well.

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Active commercial real estate investments

Active real estate investments are ones in which the investor manages the investment themselves. This typically means owning a portion of the investment and carrying a part or all of the risk and liability. While not always the case, active investing typically produces a higher return than passive investing. Active investments earn income in two ways:

  • cash flow from rental income and
  • appreciation, or adding value to the property.

How to buy and manage a CRE property yourself

If you actively invest in commercial real estate, you're doing the work to find, fund, acquire, manage, and dispose of the property. While you may have funding partners, investors, a third-party management company, or a team of people helping you, you're ultimately responsible for the success or failure of the investment.

Most active CRE investors choose a sector to specialize in. They might buy only multifamily homes or focus on office buildings. Before purchasing a commercial property, determine:

  • the type of CRE property you want to own,
  • the supply and demand of that CRE type in your real estate market, and
  • how to invest properly in that CRE sector.

Here's how to get involved in active commercial real estate investing.

1. Evaluate investment opportunities

Once you've identified the sector you want to target and an ideal location, you'll want to find investment opportunities to pursue. You can search for properties listed for sale with a commercial real estate broker on Loopnet, Crexi, Craigslist, or through your own direct mail campaign.

If the property is listed with a broker, they'll typically send an offering memorandum (OM) that outlines the current performance of the property and its pro forma, or the potential income the property can produce when managed and leased optimally. While this information is useful, it's up to you to confirm the estimates and current expenses.

Most offers are based on the net operating income (NOI) of the property and its cap rate.

  • The NOI is the income the property produces after accounting for all annual expenses before debt service.
  • The cap rate is the value of the property based on the income it produces, or the NOI. The higher the cap rate, the better the return. The lower the cap rate, the less of a deal you're getting.

2. Submit a letter of intent (LOI)

If the investment looks promising, the next step is to submit a letter of intent (LOI). This is a one- or two-page document outlining:

  • what you intend to purchase, and
  • the terms of the purchase, including purchase price, down payment, inspection period, and other clauses or contingencies.

An LOI isn't binding, but continues the due diligence process for the buyer and seller based on temporary terms. After the buyer continues their due diligence, they can enter into a formal contract. Have your attorney review any contract to ensure it outlines the necessary clauses and conditions and adequately protects both parties.

An LOI isn't binding, but continues the due diligence process for the buyer and seller based on temporary terms. After the buyer continues their due diligence, they can enter into a formal contract. Have your attorney review any contract to ensure it outlines the necessary clauses and conditions and adequately protects both parties.

3. Secure funding

Immediately after the contract is executed, you should secure funding. There are a number of loan options available specific to commercial real estate:

  • Conventional loans: These require at least 20% of the purchase price as a down payment. There are both short- and long-term options, so you can get funding with a repayment term of anywhere from two to 30 years. There are fixed- and adjustable-rate mortgages -- some short-term loans require balloon payments, as well.
  • Government loans: Small Business Administration (SBA7a) or Certified Development Company SBA504 loans are government-backed and offer loans of 15 to 25 years. Adjustable- and fixed-rate loans require as little as 10% down.
  • Syndication: You pool money from investors to purchase the property in cash, paying a preferred return, equity split, or combination of both.
  • Owner financing: The seller of the property carries financing at a specified rate and terms.

Most banks look at two factors when approving loans:

  • The loan-to-value (LTV) ratio, which is the loan you're requesting in relation to the value of the property.
  • The annual income the property produces in relation to the annual debt service on the property. This is called the debt service coverage ratio (DSCR).

While the property is the most important factor in the loan, banks also review the investor's business plan, creditworthiness, experience, and net worth to see if they're qualified enough to repay the loan.

It's not uncommon for CRE loans to require the investor to be a personal guarantor, assign a life insurance policy, or use other property, such as a primary residence as additional collateral.

4. Inspect and conduct due diligence

Like residential real estate, commercial real estate has an inspection period. This period can be negotiated to as little as 15 to 60 days and allows the buyer to conduct inspections and continue due diligence that may pertain to the property.

Buyers may commission a variety of reports:

  • Property inspection report
  • Phase I environmental survey 
  • Boundary survey

Most inspections are ordered by the lender directly. For this reason, you should pursue financing before ordering any surveys or inspections. This is also the period in which the buyer verifies information relating to the operation of the property, including deposits of income, rental rates, vacancy, prior tax returns, and so forth.

The buyer can renegotiate or cancel the contract, often without penalty, during the inspection period.

5. Close on the property and begin managing the investment

Once funding is secured and the inspection period has passed, the property will close with a title company or attorney. From there, it's the investor's job to manage the property. This can include:

  • overseeing or hiring an on-site manager,
  • hiring a third-party property management company,
  • using online software to manage the rental units,
  • marketing on social media and advertising the property,
  • starting evictions on delinquent tenants,
  • making capital improvements, and
  • other responsibilities.

Owning a CRE property often requires substantial work and consistent monitoring. But it can result in a big payoff.

Commercial real estate and taxes

Income earned from commercial real estate is taxed differently based on the type of investment. Once you've determined the best method of investing in CRE for you, research how that investment is taxed and talk with a tax professional.

Take the first steps to investing in commercial real estate

Investing in commercial real estate doesn't have to be intimidating, nor do you need hundreds of thousands of dollars to start. With the number of investment options available, you just need to determine which method of investing is right for you.

As with any investment, it's imperative you conduct thorough due diligence and understand the risks and benefits before investing.

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