by John Matheson

Investor's Guide: How To Buy Commercial Property

Do You Want to Learn How to Buy Commercial Real Estate? Start Here for the Basics.

Buying commercial property can be a fantastic investment – but it can also be a nightmare if not done properly. While there are no guarantees in the world of real estate, there are some steps you can take to greatly increase your chance of success. We've outlined the basics so you can buy with confidence.

Different Types of Commercial Properties

When we use the term "commercial property," we are referring to many different types of property that fit under this umbrella term. We are defining commercial real estate as a property that is larger than a single-family dwelling. That said, know that the official definition of "commercial property" can vary from county to county.

Some of the most common types of commercial properties people invest in include:

  • Multi-family properties
  • Office buildings
  • Industrial properties
  • Retail properties
  • Hotels
  • Mixed-Use

Each of these categories has its own pros and cons from an investment standpoint.

There Are Many Good Reasons to Invest in Commercial Property

Making an investment in commercial property is not for everyone, but there are many good reasons it is the right choice for many.

Commercial Property Investments Can Come with Big Profits

Perhaps the most common reason people choose commercial property is the fact that doing so can result in big profits. Commercial buildings generally cost more to rent and buy, which means there is a bigger potential for a return on your investment.

There Are Tax Benefits

Compared to other investment opportunities, investing in commercial real estate can have significant tax benefits. For example, depreciation allows you to deduct part of the commercial property's value from your taxable income. When it comes time to sell the property, a 1031 exchange could help you avoid paying capital gains taxes. These are just a few of the potential tax benefits.

It Can Be Less Competitive

A person who wants to invest in residential real estate is likely to see a lot of competition no matter where they live. The high cost of entry into commercial properties means less competition, which makes it a great choice for many.

You Have Lots of Options

Due to the great variety of what is considered "commercial property," there is a nearly endless list of properties a person could invest in within this category.

Lower Turnover Rates

Once again, compared to residential real estate, there is significantly less turnover in commercial property leases. In most markets, the minimum commercial lease will be three years.

These are only a few of the benefits of buying commercial property.

How To Finance An Investment Property

It is not as simple or straightforward to finance an investment property as it is to finance a home, but it can be done. One option is to look for a conventional bank loan. These are similar to the conventional mortgage most people have on their homes. To get a conventional mortgage on investment property, you should expect to come up with a down payment of at least 30% .

As is true of other types of mortgages, banks will look at your personal credit score and income to consider approval and interest rates. The lender will likely require that you can afford any residential mortgages you have along with the payments for the investment property. Note that the rental income you expect on the commercial property is not going to be included in the lender's debt-to-income calculations.

If you have equity in your home, you could use a home equity loan, cash-out refinance, or HELOC to fund your commercial property. There are pros and cons to all of these options, and they should be discussed with a financial advisor to determine if they are right for you.

It is Essential to Assemble the Right Team for Commercial Property Investment

When you go into commercial property investment, you should not do it alone. There are people who have dedicated their careers to specific parts of this process – use their expertise. You should consider working with:

  • Accountant. Ideally, you would work with a CPA who understands the specific tax implications of commercial property investment.
  • Real Estate Attorney. Working with someone who knows the ins and outs of real estate law in your area is essential. They can review contracts, complete filings, and perform other legal services.
  • Real Estate Agent. You could use a broker if you prefer, but whomever you work with should have access not just to listings but to those coveted off-market deals.
  • Appraiser. Yes, you need an appraiser to appropriately value any property you are considering buying, but the right one can also be a partner in helping you identify the best ways you can efficiently raise the value of your property.
  • Insurance Agent. Depending on where you live and the specific type of property you purchase, you will need a variety of insurance projects.
  • Property Manager. If you want to handle the day-to-day operations of your investment property, then you will not need property management. However, a good management company can more than make up for their cost by reducing your workload.

Pay Attention to These Factors When Deciding if You Should Invest in a Particular Property

When you buy commercial real estate, there are a few factors you should be sure to consider. Of course, the specifics will vary based on the type of property you are investing in – for example, buying an office building will require considering different factors than if you are buying a warehouse – but there are some general factors you should consider when weighing your decision:

  • Location
  • The condition of the property and any improvements you will need to make immediately
  • Market value
  • Zoning
  • Parking
  • Adjacent properties and the effect they could have on your property
  • Accessibility
  • Future expansion potential
  • Extra fees that might be required

Due Diligence For Commercial Real Estate Begins with Knowing What to Research

No one would walk into a commercial property transaction without feeling as though they have done their due diligence. That said, it can be difficult to even know what you should research.

First, look into the seller of the property. Do they have a good or bad reputation? Do you feel you can trust their assessments? Ask for tax returns pertaining to the property, their loan documents, any past litigation against the property, service contracts, and other paperwork that can help you get to the facts about how the property actually runs.

Second, research the zoning and ADA compliance of the property. Know that it does not necessarily matter what the current property owner is doing with the property – you need to be sure that it is legally zoned for appropriate use. Likewise, make sure that it is compliant with the latest Americans with Disabilities Act (ADA) regulations.

Finally, if the commercial property comes with tenants, do your research into them. Have they been paying their rent on time? Do they create noise or other issues in the neighborhood? How long are their leases?

How to Make an Offer on a Commercial Property

By the time you have found a commercial property to invest in, you likely have a broker working with you who can help you make an offer. In most cases, the first step will be a basic Letter of Intent (LOI). This is a non-binding document that outlines your offer.

Remember that with commercial property acquisition, there are many more factors to negotiate compared to a residential transaction.

Investment Strategies for Commercial Real Estate

Many people who invest in commercial real estate do not plan to hold the asset for decades. There are many potential strategies for investing in commercial real estate:

  • Fix and Flip. This involves finding an undervalued property that needs significant improvements. You buy the property, make the improvements, and then sell the property for significantly more than you bought it.
  • Lease the Space. You might purchase a commercial real estate property and then lease it directly to tenants.
  • Development. The sky is the limit when it comes to developing a property.
  • Occupy the Space. Some people invest in commercial real estate so that they can rent out part of the space and occupy the rest. This works well for multi-family residences, mixed-use spaces, and other types of commercial property.
  • Long- or Short-Term Holds. If you know that a particular area of your city is about to see a huge renovation, it can be wise to buy up lower-priced commercial properties, hold them until the renovations are complete, and then take advantage of the increase in prices by selling.

These are only a few of the ways you can invest in commercial real estate.

Important Terms to Know When Investing in Commercial Real Estate

Before you can get serious about the process of investing in commercial real estate, it is important to get to know the vocabulary. Some of the most important terms you should know are as follows:

  • Net Operating Income. Also known as NOI, this is the income a property generates on a yearly basis, minus property expenses.
  • Return on Investment. Also known as ROI, return on investment is the benefit of an investment (i.e., the return) divided by the cost of the investment.
  • Cash on Cash Return. Also known as CoC, this metric measures the ratio between the annual cash flow of a property related to the required down payment. It is generally calculated pre-tax.
  • Debt Coverage Ratio. Also known as DCR, this refers to the comparison of an investment property's NOI with its debt. This is the ratio a lender will use to determine if a property is likely to generate the necessary income to cover debts.
  • Capitalization Rate. Also known as the cap rate, this refers to the NOI divided by the lower of its current market value or its asking price. This ratio is used to determine a potential return on investment before mortgage financing.
  • Loan to Value Ratio. Also known as LTV, this is determined by the percentage of an asset's sales price (or value) is taken up in its financing. For example, if a property is worth $100,000 and the owner has an $80,000 loan, then its loan to value ratio would be 0.8.
  • Real Estate Investment Trust. Better known as a REIT, this refers to a company that owns or finances income property. A REIT sells shares of investment properties, which are purchased by investors who then receive dividends on the rent payments.

As you can see, there are many acronyms and short-hand used in commercial real estate. The good news is that once you have the language mastered, you'll be one step closer to being ready to invest. If you're ready to take the next step and want to see what you pre-qualify for before chatting with a lender, check out Leverage.

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