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Commercial Real Estate Investment – Basics
Commercial real estate investment is the natural progression from residential property investment. Experienced property investors tend to move into commercial real estate sooner than later – and for very good reasons.
Once your portfolio grows you will find it very difficult to manage your investments if a large portion of them is tied in residential properties. Imagine if you have $15 million worth of residential properties. That will be a lot of homes and tenants to take care of.
On the other hand $15 million will buy only a very small number of commercial properties that will be comparatively easy to manage with much lesser overheads.
Commercial properties include offices, industrial sheds, free standing retail shop, bulk retail, block of shops, medical centers, service stations, motels, hotels, back packers, health clubs, churches, funeral parlors, child care centers, car yards, convenience stores, shopping malls, to name just a few. Each type of commercial real estate investment has its own peculiarities, strengths, problems, rewards and risks.
The return on investment in commercial real estate is much higher than residential property.The income is net and not gross because the tenant pays all the out going expenses. The income is also more stable because of the long leases.
It is typical to have returns of around 10% net for a commercial real estate investment and any where from 7% to 9% net return for a prime property.
The value of a commercial real estate to a great extent is determined by the quality of the lease. In general the value is determined by taking net contractual rental being paid and use of a capitalization rate to arrive at a value. The value is also determined by the quality of the tenant and length of the lease.
The value of a commercial property can drop substantially if it becomes vacant. I have seen commercial properties being sold at less than half their value if they are difficult to lease.
Commercial property management is also much simpler because tenants have a strong vested interest to maintain the property to a high standard. Tenants usually derive their income from the property. They have to keep the property looking good and maintain functionality to impress their clients.
I have seen tenants spend hundreds of thousands of dollars to make improvements to the property. Most of these improvements stay with the property long after the tenant has left the property.
Real estate law is more flexible towards commercial lease contracts. You can virtually word and add any clause that is agreeable to the contracted parties. It is common to charge penalty interest on the out standing rent or lock the premises on continued default of rent.
By far the biggest risk in commercial real estate investment is finding a new tenant in case of a vacancy. In commercial real estate the requirement of each tenant in terms of size, location, use and rent payment capacity is so different that it is very difficult to get the right tenant for the right property.
For the reasons mentioned above it is also difficult to sell a commercial property investment. Higher the value of property there are lesser number of investors to buy the property. A commercial property investment is less liquid than other investments because there are very few players in the market. For a residential house there will be hundreds of potential buyers which is not the case with commercial properties.
Commercial real estate investments are generally sold on capitalization rates and rarely on replacement value. It is therefore possible to purchase a poorly rented commercial property well below its market value. You can also increase the value of your commercial real estate simply by raising the rents during rent reviews or re-negotiating the lease terms when it come up for renewal.