Investing in real estate can offer big returns, but it often comes with big risks, especially for investors getting started in the industry. When buying a commercial real estate (CRE) for steady rental property income, it is important to do research before making an offer.
Assessing value and income potential accurately requires a multi-step process that is much more complex than estimating the value and expenses of a single-family home. The added complexity of commercial real estate pays off.
While annual profits from residential real estate average 4 percent, commercial real estate easily gives investors 10 percent to 15 percent. Before a first CRE investment, professionals recommend research to build an understanding of the various types of CRE investments and choosing the one(s) that best suit your financial situation, time constraints, risk tolerance and knowledge base.
CRE consists of four main categories:
- Direct investment.
- Real estate investment groups.
- The sharing economy.
Direct investment involves owning the property directly. Direct investment includes apartment buildings, industrial real estate like warehouses, retail space, strip malls, office buildings and more. Direct investment CRE includes the purchase of any space a tenant uses to make a profit.
Expect an initial investment in the five figures. Direct investment CRE investors also need an emergency fund to handle maintenance and repairs.
Real estate investment trusts (REITs) offer great returns and low minimum investments. Expect an initial investment from $1,000 to $7,000, though many REIT investors make much larger investments. There are many advantages to REITs for investing in real estate for beginners, such as:
- Professionally managed assets.
- Low transaction fees (purchase on the stock market).
- Low time commitment.
- High dividends.
With annual yields often exceeding 10 percent, REITs offer some of the highest dividend rates on Wall Street. The reason: By law, REITs must pay 90 percent of profits to investors as dividends. As a result, they tend toward low volatility. Each REIT owns multiple CRE and residential properties, providing a steady cash flow.
REITs concentrate on one sector, such as apartment buildings or office space. If investing a small amount like $1,000, it’s impractical to purchase multiple REITs to gain diversification. Diversification can be attained by buying a REIT ETF, which includes a basket of REITs in a variety of sectors.
Real Estate Investment Groups
These groups provide a less risky option for a first CRE investment versus direct investment but entail a higher risk than REITs. It’s possible to join an existing group that already has a property under management and relevant research completed.
Since the group has already purchased and maintains the property, there is much less potential for rookie mistakes.
The sharing economy has ushered in the opportunity for the average person to become a landlord. Applications like Airbnb allow individual investors to rent residential space that competes with expensive hotels.
Guests like the cost savings, and access to a kitchen saves cost on meals. In areas with high tourist traffic, vacancy rates remain low. Whichever CRE investment you choose, all have several advantages in common:
- Positive cash flows.
- Leverage increases profit margins.
- Tax benefits.
- High equity building opportunities.
- Excellent inflation hedges.
As with all investments, due diligence makes the difference between high profits with controlled risks and meager profits with unmitigated downside factors. Here are several key CRE research strategies that help investors choose investments with strong cash flow and appreciation potential:
Research The Rental Property Restrictions In The Area
Make sure you research things such as rent control, short-term (under 30 days) rentals and any HOA rules. New CRE investors often make the mistake of only taking a cursory glance at restrictions and misunderstanding their impact.
Rent control not only holds down cash flow, but it can also inhibit appreciation because buildings are worth less to buyers when rents are lower. Investors interested in short-term rentals need to understand restrictions put in place by cities or developers.
As popular as Airbnb has become, a backlash has prompted cities to restrict the practice and many apartment and condo management companies to ban it altogether. A condo can make a great rental property, provided the HOA doesn’t become a problem. Some HOAs ban rentals.
The same may be true for townhome communities and covenant-restricted subdivisions. The financial condition of the HOA and the potential for big maintenance items on the horizon also matter. A sudden increase in dues or a giant special assessment can suck the profit right out of the investment.
Get To Know Your Tenants Ahead Of Time
See if the previous owner kept good records on their payment habits, job changes, and other factors that would indicate potential future problems. Apartment buildings for CRE investment provide excellent potential for big cash flow, but due diligence and research takes some well-invested time when buying rental property.
Careful analysis of the profit & loss (P&L) statement reveals if the cash flow claimed by the seller stands up to scrutiny. Checking expenses for accuracy and estimating future additional expenses like deferred maintenance shows if the property is really a good deal at the asking price.
The rent roll shows the tenants, the rents and the sizes of the various apartments. Take a careful look at payment history and lease terms. Are too many tenants struggling to make rent? Are many tenants moving out soon? An increase in vacancies may mean cash flow estimates are too optimistic.
If the rental property is vacant, check out other vacancies and rentals in the area to see the likelihood of renting it out, for how much, and the like. If buying a building with vacant apartments, it’s better not to assume that they will rent for the same as previous tenants paid.
A comparison of similar apartments in the area provides a better estimation tool. When buying a vacant house, condo or townhouse as a rental property, the same rule applies.
Make Sure There Are Adequate Cash Cushions For Taxes And Unexpected Maintenance
This rookie mistake results from underestimating expenses. Maintenance costs frequently require landlords to dig into their pockets. Major disasters, like burst pipes or a fire, should be included in insurance policies.
Both of these emergencies can quickly result in thousands and tens of thousands in damages. Other costs to consider include:
- Closing costs.
- Carrying costs.
Properly estimating income and expenses allows investors to calculate an accurate cap rate.
Sales price divided by net operating income equals the cap rate.Calculating cap rates for various properties allows investors to choose the most advantageous deals, but cap rates based off of bad assumptions can be misleading.
CRE investors earn some of the highest returns but also take risks. Finding the most profitable deals with reasonable risk factors requires due diligence that provides accurate income and expense estimates. Every property is a goldmine at one price and a money pit at another.
Interested in learning the techniques that allow CRE investors to choose the best investment? The real estate pros at LCI Realty show new investors the path to success in the Phoenix area real estate market. We’ll have you valuing properties for maximum profit. Contact us now for more information.
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