How to Invest in Commercial Real Estate: Guide to CRE Investing for Beginners

In order to diversify their assets and manage their risk, increasing numbers of investors are considering investments in commercial real estate.

But is commercial real estate a good investment for you? Every investment vehicle has its own particular set of risks and mitigants, benefits, and concerns. Investors should be aware of their risk tolerance and invest accordingly.

An examination of the risks and advantages of commercial property investment will help you find your investment “sweet spot”.

Pros and Cons of Investing in Commercial Real Estate

7 Pros of Investing in Commercial Property

1. Commercial real estate can provide a steady income stream, what some people call “mailbox income”.
2. In addition to the income, the asset (the commercial property) should appreciate in value over time.
3. With this type of investment, you can leverage your cash with debt for the purchase. As rental income is used to make loan payments, your tenants are buying the property for you.
4. Tax rules let you depreciate the value of the property every year. This helps to offset your rental income and lessen your tax bill. (Learn more about commercial and industrial property taxation and commercial property tax reduction methods).
5. 1031 Exchange rules give commercial property owners more flexibility when they need to reallocate assets. If you replace the sold property with another investment property according to the exchange rules, you can put off paying taxes on the transaction.
6. Long-term leases with good tenants can provide stability during economic downturns.
7. Commercial properties have fewer regulations to follow than residential real estate. Fair Housing Laws do not apply to most commercial leases.

5 Cons of Investing in Commercial Property

1. You may need professional help with the management of your commercial property. Management fees will increase your expenses.
2. The minimum investment required to purchase commercial real estate is higher than some other investments such as stocks.
3. Asset appreciation is not guaranteed.
4. Properties can turn into non-performing assets if you have trouble replacing departing tenants.
5. A long-term investment like commercial real estate will tie up your funds for the life of the investment.

Why Invest in Commercial Real Estate?

Commercial real estate ownership is a long-term investment that creates an income stream plus asset appreciation. These assets aren’t subject to the short-term volatility that affects other types of investments.

The asset can be used:

• As a hedge against inflation
• To take advantage of tax benefits
• To balance portfolio risk

If you have the minimum cash required, and you can leave it in an investment for a prolonged period of time, commercial real estate can provide you with a stable and growing investment.

Most professionals consider the categories of commercial investment properties to include:

• Industrial
• Office
• Retail
• Multifamily, and
• Special Purpose.

There are also different types of property within those categories. How does that impact the property’s desirability as an investment?

Industrial

This property type can include both large warehouses and manufacturing plants, and small flex spaces housing “Mom and Pop” businesses.

The industrial category of commercial real estate is benefitting from the shift to eCommerce. The way to put an online order into the customer’s hands within 24 hours is to have the most popular items stored nearby.

eCommerce retailers need warehouses placed around the country to give them quick access to their customers. Warehouses and fulfillment centers are strong performers as investments in almost any economic cycle.

Industrial rent can be charged as some form of triple net (NNN) or Industrial Gross (IG). With NNN, the tenant is responsible for the upkeep of the property. A partial net lease, such as a double net (NN) arrangement may exist where the landlord is responsible for the structure or the roof, or both.

The tenant is also responsible for the landlord’s property tax, insurance, and common area maintenance (CAM) charges. These are called additional rent, or pass-throughs. The tenant is billed for base rent and additional rent (pass-throughs) separately.

With an IG lease, the pass-throughs are added into the base rent for one rent factor. Instead of paying additional rent separately, it’s included in the base rent.

Either way, the lease will provide for periodic increases as needed. Industrial properties can be steady performers for patient real estate investors.

Office

As far back as the ’90s, office space has been undergoing changes in how it is used. This has impacted the amount of square footage needed by tenants. In some cases, this means less room per employee than with previous office designs.

While some businesses may not need as many employees to work in the office, the amount of space per employee appears to be increasing. This is due to health and safety standards and the philosophy of creating a more relaxed work environment.

An equally important question is where should these properties be located? Office developers report that tenants are asking for space away from the dense metropolitan areas.

Most office leases are gross leases or full-service leases. The tenant pays base rent and possibly common area expenses. The landlord will pay the property taxes and insurance which is calculated into the base rent.

Sometimes the space is separately metered for water and/or electricity and the tenant pays for those expenses. Otherwise, the landlord pays the utilities. In some markets, Class A office tenants expect the landlord to pay for cleaning and trash removal services.

The office segment of the commercial real estate world is perhaps the biggest unknown in the industry. You should carefully research potential office property investments. This may not be the place for inexperienced investors.

Retail

There are different types of retail properties. They include:

• neighborhood (or strip) centers
• grocery anchored centers
• lifestyle centers (mixed-use with retail and apartments)
• power centers (big box anchors like home improvement stores)
• malls
• single-tenant (banks, drug stores, restaurants)

A lot has been made of the impact on retail business by online commerce. It’s estimated that since 2015, over 200 retailers have filed for bankruptcy.

However, a lot of those were Chapter 11 filings that allowed the retailer to reorganize and stay open. Some of these brands were able to renegotiate their leases during bankruptcy and cut their costs. That was good for them, but not for their landlords.

Like most other real estate types, the future outlook for retail depends on where you are. Relocation within the US hasn’t slowed down in recent years. If anything, it’s sped up. Retail properties in parts of the country where people are moving are still good investments.

Multi-tenant properties can help you spread your risk among tenants. A good mix of tenants is critical for success.

National chains sometimes called “credit tenants” are great tenants. Their lease is often guaranteed by their parent company. Well-known stores are good traffic generators that will attract other tenants.

A lot of times national name-brand stores are actually franchise stores. Franchise leases aren’t guaranteed by the parent company, but the larger entity usually has the right to take over operations if the tenant underperforms.

Many franchisees are themselves great tenants who have honored their leases during weak economic cycles. Grocery stores are stable tenants who are excellent traffic generators.

Retail leases are triple-net (NNN) leases. This means that the tenants pay their rent plus their share of the owner’s property taxes, insurance, and common area maintenance. In a true or absolute NNN lease, the tenant is responsible for all maintenance on the property. Retail tenants are responsible for their utilities too.

NNN leases are highly valued by investors.

Multifamily

Multifamily properties can be either large or small. Duplexes and 4 unit properties have been the starting place for many investors. Large apartment complexes have been excellent long-term investments for partnerships and corporate entities.

The lingering housing shortage in the US continues to grow, providing a source of renters for multifamily properties. Lenders, trade associations, and developers all predict good growth conditions for multifamily investors.

Investors in properties with 12 or more units want to see a combination of differently sized units in the property. A combination of studio apartments, 1, 2, and 3 bedroom units will help to spread the owners’ risk and better manage the property’s vacancy rate.

Multifamily property leases are typically for one year. A residential lease will sometimes allow the tenant to stay over on a month-to-month basis at the end of the lease. That option should be at the landlord’s discretion.

Tenants may or may not be responsible for their utilities.

Leasing residential commercial properties like apartments are subject to federal Fair Housing laws. Your state will also have rules regarding a landlord’s obligations to provide suitable living conditions.

Other regulations that multifamily investors should be aware of include rules for properly maintaining trust accounts for deposits. You should also be familiar with the landlord’s options for dealing with tenants who default on their lease.

Multifamily commercial properties are an excellent investment choice for small investors. With some patience, suitable entry-level properties can be found in good markets. Another option for small investors is to partner with experienced investors on larger properties.

Special Purpose

According to the SBA, a special purpose property is, “a limited market property with a unique physical design, special construction materials, or a layout that restricts its utility to the specific use for which it was built”.

Special purpose properties include:

• bowling alleys
• car washes
• golf courses and driving ranges
• hotels/Motels
• marinas
• medical (hospitals, urgent care, surgery centers, assisted living centers)
• theaters

The lease form for these properties can run the gamut from NNN to Gross Leases to Ground Leases.

A ground lease is just what it sounds like. The tenant leases the dirt from the landlord. In this case, the tenant builds the improvements on the property. When the lease is up, the landlord owns the improvements. Ground leases usually have a longer-term than other lease types.

Many Special Purpose properties are sold with an existing tenant in place. With any property that has existing tenants, you should carefully examine the financial strength of the tenant(s) and the terms of the existing lease.

Make sure that you research the nature of the tenant’s or intended tenant’s business. How easily can you backfill the space when the lease is over or the tenant defaults?

Special Purpose properties can be good investments, but they are not usually the first purchase that a real estate investor makes.

Your risk tolerance will dictate the type of commercial real estate investing with which you are comfortable. You might have heard that the average return on commercial real estate investment is 9.5% throughout the U.S. But you should remember that it changes depending on the strategy and the deal.

There is a saying: “return follows risk”. The higher the returns you expect, the higher the risk level with that investment. If you want a more conservative investment, you should expect lower returns.

The best commercial real estate investment for you will depend on your risk tolerance and the time you have to devote to the investment.

Passive Investing

The IRS defines passive income as “income from a business in which the taxpayer does not materially participate”. If you don’t want to materially participate in the management of the property, you should look into passive real estate investing strategies.

If you are using funds from a self-directed IRA, you are prohibited from being an active investor.

Investment Type

Passive investors usually look for good-performing properties that need few, if any, improvements. They’ll probably hire a property management company to handle the operation of the property. That includes:

• Leasing the space(s)
• Vetting prospective tenants
• Collecting rent
• Paying bills
• Handling operating and reserve accounts
• Handling all documentation including storage
• Engaging and managing maintenance vendors
• Engaging and managing repair vendors
• Handling bookkeeping and financial records maintenance.

A passive investor can periodically review the records and tour the property to assess the performance of the management company.

Ownership Type

It’s possible to be part of the ownership of a higher-risk investment property and still be a passive investor.

By their nature, higher risk/return properties require some work in order to realize their investment potential. These properties are usually in need of repair or renovation. This work has to be overseen by the ownership in some way.

You can have a partner(s) that handles the active management of the property, while you remain a passive investor who does not participate. If necessary, this can be memorialized in the operating agreement of the partnership.

Active Investing

If you have time to spend on your investment property, active investing can be fulfilling. You will learn a great deal that will help you with future investments by actively participating in the management of your investment properties.

Short Term Investments

Some investors prefer to turn their funds repeatedly by buying, fixing, and selling commercial properties. The best-known method of distressed commercial real estate investing is “house flipping”. This can be also done with commercial real estate.

The keys to successful short-term investing are knowing how to accurately evaluate a property’s physical condition, and having enough cash to handle unforeseen issues. Investors with a construction background can manage the rehab process and even participate in some of the work.

Short-term investors are encouraged to get their broker’s license so that they can more effectively market the rehabbed property for themselves. This will avoid listing agents’ fees.

Long Term Investments

Being an active investor in long-term investments means managing the ongoing condition of the property and your tenant relationships. It could also mean adding value to the property by way of improvements or renovations.

Depending on the number of tenants involved, an active investor might still hire a property management company to assist them. Otherwise, they collect their own rents and pay all the bills.

An active investor regularly visits their property to keep up with its condition. If the property needs work or updating, the investor will budget and schedule the work and oversee its completion.

They’ll hire and pay regular service providers such as landscapers, HVAC service companies, and plumbers. They will also schedule and order periodic capital improvements such as roof replacement.

Let’s consider how to get started in commercial real estate investing. The first thing that you should do is examine your personal financial situation. How much cash do you have to invest? This will determine the type of commercial property investing that you can consider.

How much income do you have outside of rental income? You shouldn’t count on receiving any distributions from your CRE investment right away. This is especially true if you are the sole owner of small residential real estate.

Next, research the different types of commercial real estate in your market. National averages can be misleading. You need to target your search to the market(s) where you will invest.

As you learn about the different property types, ask yourself:

• How much cash is needed?
• Will I have to guarantee any debt?
• How long will my investment be tied up?
• How quickly can I get money out if needed?
• What is the current and future need for this property type (demand)?
• What is the current and likely future inventory of this property type (supply)?

You should talk to your local planning department. They can give you a good picture of the future needs for your intended property type.

While you’re doing your research, select one of your top-rated commercial local mortgage lenders to work with and schedule an appointment. Sit down with them and tell them your plans. Ask them what you will have to do to qualify for a multifamily or another commercial loan.

Ask them to look at your financial information and tell you how much you are able to borrow. This amount plus your cash is your maximum purchase amount if you’re working alone.

Most real estate investors begin by investing in small residential rental properties. They learn the business and build up an investment fund as they move up to larger investments.

If you are willing to live in one of the units, rental properties up to 4 units can be purchased with FHA, VA, or conventional mortgage loans. This is a great way to get started in real estate investing.

Properties like these that are strictly investments can still be financed with conventional loans. The terms of the loan will be based on commercial investment standards which are not as desirable as residential mortgage loans.

Other ways to start investing without a lot of cash are REITs and Crowdfunding. A REIT (Real Estate Investment Trust) is a publicly-traded corporation that owns commercial real estate. Individuals can buy shares in the REIT. Profits from the operation of the properties go to the investors. REIT shares can be traded like other stocks.

It’s easier to get your funds out with a REIT than with Crowdfunding. Crowdfunding companies are private, not public. Investors can start crowdfunding investing with as little as $1,000. Crowdfunding often has fewer fees than REITs, but your investment will have to stay in place longer than with a REIT.

With Crowdfunding, you will have to meet the Security and Exchange (SEC) requirements for being a qualified investor. Their rules will determine how much you are allowed to invest.

Another way to begin your real estate investing is to invest directly with one of your local commercial real estate developers. This isn’t always available for everyone. However, if you can find a reputable developer to partner with, it can be a good way to learn the business. Commercial real estate attorneys, CPAs, or financial planners may be able to refer you to a suitable partner.

You should have an attorney who specializes in real estate represent you in your business dealings. They should examine all partnership documents before you sign anything.

Investors should thoroughly investigate any potential investment vehicle such as REITs, Crowdfunding companies, and development partners.

A business plan is both a blueprint and a measuring stick. It tells the reader where you are going and how you plan to get there. As you conduct business, it also serves as a guide to how well you are meeting your budgetary goals.

Your plan will be used internally and externally. You will refer to it regularly as you manage your investments. It will also become part of your loan application package or presentation to potential partners.

A company or team profile is needed to describe you and anyone involved in your business. Anything about you that highlights your ability to perform as agreed should be included in the profile.

Short and long-term business goals come next. Be careful about assigning a specific timeframe to your goals. Make your goals attainable and reasonably within your control.

The next section should describe your preferred investments and market(s). Go into detail about how you arrived at these conclusions. Give a thorough analysis of the market(s) and all data that could impact your investment.

The financial section will be the most detailed part of your plan. Often a lender or potential partner will skip to this section first. Your financials should include:

• Business budget: this will look like a P&L with line items for sources of income and expenses. You should have separate columns for budgeted amounts and actual amounts for comparison.
• Capital Sources & Uses: show the source of your required investment funds and how they will be spent.
• Profit & Loss (P&L): interim in-house P&Ls can be generated monthly. A reviewed P&L should be prepared by your CPA after the end of your fiscal year.
• Cash Flow Statement: this shows all funds that come into and go out of your business. This statement is an indication of how well you manage your cash flow and your expenses.
• Balance Sheet: once you’ve begun investing, an updated Balance Sheet should be created in-house every 6 months and a reviewed Balance Sheet prepared by your CPA annually.

And finally, review your plan and analyze your strengths and weaknesses. Investors call this the SWOT assessment: Strengths, Weaknesses, Opportunities, and Threats. Honestly spell out the strengths and weaknesses of your team and your investments. Lenders call these the “risks and mitigants”.

Then describe possible opportunities such as value-added work that can increase the value of the property or the income stream. And finally, go over any competition or harmful market conditions that could pop up during the term of your investment.

First of all, consider one of the most reputable online platforms for commercial property listings — PropertyCashin Commercial Real Estate Marketplace. Unlike most popular real estate listing websites, PropertyCashin’s detailed interface provides the most extensive information to help you decide whether a property is worth further examination.

Apart from broker-assisted deals, the platform also offers a wide selection of distressed “for sale by owner” properties available at discounted prices.

When you find a property that you’re interested in, you can easily contact the seller through the site. Additionally, the platform shows you local reputable lenders available to finance the deal.

If you can’t find a property that suits your needs right now, join our preferred buyers list. This way you will get notified as soon as a property matching your criteria and location appears on the marketplace.

There are also other online listing services that provide information about properties for sale and for rent. You can usually access these sites for free. However, premium versions of the site that contain needed material may require a paid membership.

In larger markets, there are commercial real estate exchanges where properties are listed for sale. You may have to be a licensed broker to become a member. Sometimes, however, they will include you on an email list for properties that come on the market. You can also find the most active commercial listing brokers in the market and ask to be included in their email blasts.

There are several things to keep in mind when you’re buying commercial property for investment.

Every business owner should have a team of professionals to advise them. Your team should include a real estate attorney, a CPA, a commercial real estate broker, and a commercial lender. Not only will they help you in their area of expertise, but they should also be good referral sources within the industry.

To find the best specialists serving your location, browse our directory of commercial real estate professionals.

As you prepare to make your first commercial property investment, remember this crucial piece of advice: don’t fall in love with the real estate. Go by the numbers. You should be making your decision based on actual details of the property, the market, and your risk tolerance. Period.

Inexperienced investors should engage the services of good local commercial real estate brokers. Make sure that they are recommended by someone you trust (like your professional team) and that they will put your needs first.

An experienced broker can quickly teach you about the market and the players. They can give you options and provide comparables to help determine values.

When negotiating on a price, set a “walk away” number and stick to it. If you’ve determined that you can’t pay more than a certain amount for a property, don’t change your mind. Go with your analysis.

Give yourself time in the contract to do all your diligence. Your professional team can tell you how long it’s taking for things like inspections, appraisals, surveys, and loan underwriting to be done. If a particular feature of the property concerns you, you can make the contract contingent on a satisfactory inspection of that area. You can obtain it from local commercial real estate inspectors.

As for appraising a commercial property, we have an entire guide: How to Value Commercial Real Estate (3 Property Appraisal Methods). It will help you read appraisal reports provided by your local professional commercial real estate appraisers.

Sometimes sellers and buyers like to use a Letter of Intent (LOI) before going to contract. Once they’ve agreed on the business points of the deal in the LOI, the attorneys will go to work on the legal language.

Make sure that the LOI specifies the diligence documents that the seller will provide and when they are due. They’re usually due 3 to 5 days after signing the contract. Diligence documents should include full financial statements on the operation of the property.