Commercial real estate is a property that holds five or more units. There are five types of commercial property — retail space, offices, industrial buildings, apartment complexes, and warehouses.
How Is Commercial Property Evaluated?
There are three key ways to evaluate the profitability of commercial real estate.
Net Operating Income
Net Operating Income (NOI) for a commercial property is calculated by subtracting the operating expenses (including taxes, insurance, utilities, management fees, etc.) for the year from the total gross income. Positive NOI means you have positive cash flow and, at the very least, your property isn’t losing you money.
Return on Investment
Return on Investment (ROI) determines how well your piece of real estate is performing. It’s your annual return divided by your total initial investment. The average ROI on commercial real estate is around 9.5%.
Cap — or capitalization — rate is the most popular way to measure a property’s profitability and return potential. It can help you compare apples to apples among different properties. The most common way to calculate the cap rate is by dividing the NOI by the current market value. Generally, 4% to 12% per year is a reasonable cap rate range.
Cap Rate is the percentage you would make on your money over a year if you paid cash for the property, while ROI is your percentage when factoring in financing. If selling a property, a lower cap rate is good because the value of your property will be higher. If purchasing a property, a higher cap rate is good because it means your initial investment will be lower.
If an investor has purchased a property through financing, the cash-on-cash formula is another great way to compare properties. Cash-on-cash is calculated by dividing the NOI by your initial cash investment, including down payment, lender fees, and closing costs.
Like cap rate, cash-on-cash is shown as a percentage and helps you gauge if your commercial real estate investment is more profitable than other ways you could have invested the same amount of money.
Which to Use?
Typically cap rate is used on commercial buildings and apartment buildings. Investors will also use cash-on-cash returns to evaluate the cash flow and it generally provides a better picture of a property’s performance than ROI.
Reasons to Invest
Commercial property typically has higher income potential than residential real estate. Since the commercial property has five units or more, this means a greater economy of scale and more gross income than a single family residential rental. Since business owners typically pay their most, if not all, of their own utilities, you’ll also likely have less fixed costs. Many companies that are part of a larger chain (like CVS, etc.) like to pay their own bills so they can maintain the look and feel of the national brand.
Since there can be a larger initial investment and its perceived difficulty, fewer people invest in commercial real estate. This means you’ll likely experience less competition when looking for a good deal.
Commercial properties are often leased to fellow business owners who tend to maintain a clean, well-maintained space to impress potential clients and customers. You could say their livelihood and reputation depends on being good tenants. Also, since most businesses operate during the day, you’ll likely receive most of your calls during normal business hours, unlike residential property.
Easier Price Evaluation
It can be easier to determine the value of commercial property by using the current owner’s income statement. Commercial investors typically keep better records of income and expenses and you can use the numbers to determine the cap rate of multiple properties to apples to apples.
There are fewer laws governing commercial property since no one is actually living in the space. This is especially true with commercial leases – there are less strict rules regarding security deposit limits and termination rules. Plus, one of the biggest perks to commercial investing is that leases are typically three years or longer so you may spend less time searching for tenants.
Risks to Consider
More Upfront Cash
Unlike a typical mortgage on a residential property that only requires a 20% or less down payment, most lenders of commercial property financing require 30% down. This means you’ll either need more cash upfront or need to get creative on how you find that initial investment money.
With residential properties, you can get by completing much of the maintenance on your own. But given the scare and nature of commercial property, you’ll want to be prepared to pay a licensed professional to complete maintenance tasks, especially if you’re dealing with a national chain as a tenant.
Since commercial properties see more foot traffic from public visitors, this comes with a higher liability risk. The more people on the property each day brings greater potential for someone to trip and fall, vandalize, damage the property, or injure others. This can be reduced through good property management but is always a possibility. You’ll want to make sure you have excellent liability coverage before investing in commercial property.
If you’re looking to enter the world commercial real estate market, be sure to find a trusted real estate agent experienced in working with this type of investment property. They can help you find profitable commercial property in the area and may even be able to pinpoint properties likely to appreciate in the future or find whole portfolios in which to invest. A real estate agent familiar with the local market is key to your success and is a great person to keep on your investment team.