Commercial Real Estate Investments – Why They Are Better Than Its Residential Alternatives
Many real estate investors leave commercial real estate opportunities aside. The sheer thought of empty office buildings and old warehouses residential architects in Palm Springs with faded ‘For Sale’ signs on dark and deserted industry parks is often more than enough to scare them off. Commercial real estate investment is often perceived as too risky due to the hardships in securing and keeping good tenants for commercial property and because of the difficulty in getting commercial real estate investment opportunities properly financed. Then, what is the reason that I often favor commercial property as an investment vehicle? Where do I believe that commercial real estate investment can stand out from its residential counterpart?
I am excited about commercial real estate above residential opportunities for several reasons which I will share with you in this article. Vacant commercial buildings do not scare me off. I will show how to make commercial real estate investments work in ways that most often do not work with residential real estate opportunities. The perceived drawback of not being able to properly finance commercial real estate investment deals due to bad loan-to-value ratios can be tackled. Getting and keeping good tenants for commercial properties might not be as hard as often perceived.
There are three reasons why I prefer commercial real estate. The first reason is that commercial property is valued in a different way from residential property. The value of residential property is dictated primarily by the market. Not so for the value of commercial real estate as I will soon explain.
The second reason is that commercial leases work in your favor in several ways. Finally, with commercial property I am often not bound to the many laws and regulations associated with residential income-producing real estate investments. This is especially true here in Europe where tenants of residential houses are protected in several ways by law.
Commercial property valuation
Commercial property is valued in a different way from the way residential houses are. The buying price of residential houses is for most part dictated by the market. The market also determines the rent you can ask for your residential property. If you as a landlord charge too much, tenants will leave for other similar properties at a cheaper rent.
You might find a house at a bargain price, but in general you will have to pay around market prices for your residential property. Since both the rental income from the property and price you have to pay for the house are primarily dominated by the market, the return you can expect to get is determined for a large part by the market and not easily manipulated and improved.
When investing in residential properties, the return on investment (ROI) you make on the investment is measured by taking the rental income you receive from the property and then to divide this income by the purchase price you paid for the property. If, for example, the house was bought for 250.000 euro and the rental income is 15.000 euro per annum, the ROI is 6 percent (15.000 euro/250.000 euro).
Commercial property valuation works entirely different. The value of commercial property is less related to the buying price of the property but depends much more on the rental and other incomes it produces. Its value is defined as the rental income divided by the capitalization rate. Defining the capitalization rate, also called cap rate, is outside the scope of this article.
The cap rate is a measure of a property’s performance used by most commercial real estate investors. It is perhaps easy to calculate and a good tool to compare the performance of a specific property with similar properties. Data about prevailing cap rates is often readily available for a specific type of property in a given location.
What is important to remember is that also the cap rate is mostly defined by the market, but that the income that can be produced from commercial property is not as stiff as rents received from residential income.
This income can many times be increased in several ways. You could, for example, add mobile phone antennas to the rooftop of your building or increase the rental rate by taking some simple measures such as putting in a good alarm system and digital locks. You might be able to charge extra for allowing a large ad or a neon sign with a company name on the wall of your building facing a busy intersection in town or you could dedicate part of the empty lot next to your premises to install more car parking spaces thereby increasing the price per square meters you can ask for the office space.
Improvements made to commercial property tend to have a more direct influence on the value of the property whereby in the case of residential property this relationship between improvements and the rent you can ask is rather stiff. With a little creativity you often can increase the income produced from your commercial property thereby increasing directly the value of the property as well.
With additional value added to your balance sheet the moment you increase the income stream from your commercial property, you can use this added value to help you close the deal and get it properly financed or at some time refinance and pull the added value out of the property for other purposes.
Commercial leases work in your favor
Residential tenancy is operated most often on a monthly basis where tenants rent the house but have no direct interest in the well being of your property. They will call you when repairs are needed. With residential property you are dealing primarily with people. Commercial tenants use your premises to run their business and they earn their income on your premises. The business owner will often improve your building in order to attract more customers to his office. When these tenants have goodwill build up and intend to sell off their business, they often are interested in securing a longer lease term.
It is common for tenants of commercial property to pay for all or most of the outgoings such as property taxes, insurance premiums and even maintenance. The returns on these leases are often net returns with less management overhead compared to managing residential real estate. When you deal with residential property you work mostly in solving people problems, but with commercial property you deal more with contracts. Commercial leases tend to move upward only and the rents are more easily collected. If the rents move upward, the value of the commercial property moves up at the same time increasing the value of the property.
Commercial income-producing property involves less regulatory laws
In most of Western Europe tenants of residential property are well protected by law. The rents and its increases can be strictly regulated. Tenants are protected from landlords wanting to take action against them when they fail to pay their rent in time. Having said all that, when dealing with commercial real estate, there are not that many rules in place protecting the tenant. Commercial property gives you more room to work on creative deals.
Then how do you overcome the disadvantages of commercial real estate?
Successful commercial real estate investors have mastered the art of attracting tenants. Most landlords simply place advertisements or list their property with a commercial real estate broker and sit and wait for potential tenants to show up. Taking an active and creative approach to finding and keeping tenants can quickly pay off and help you beat the odds in the industry. After all, you only need one tenant for your property to sign the lease contract. Maybe you need to adjust or improve your property a little to attract a tenant.
To be able to finance your commercial property deal you could search for empty commercial property, find a tenant thereby increasing the value of the property and then finance the deal based on the new valuated property value and not on the price you have to pay for getting the empty office building. Banks often offer loans on commercial real estate plans with a lower loan-to-value (LTV) ratio of perhaps 50 to 70 percent as compared to LTV ratios of 90 or even 100 percent offered on loans with residential property as collateral. But with a new tenant in place your property value instantly increases and can be used as a basis for financing the property. Commercial property can be seen as creative finance and with your creativity and active approach you can beat the odds, have some fun along the way and make some money as well.
Sjoerd Jan ter Welle lives with his family right in the centre of the small medieval city of Doesburg in the eastern part of the Netherlands. As a commercial real estate deal maker his interest is in property investments in former communist but emerging markets in Eastern Europe. His special interest goes to the city of Timisoara, Romania. Sjoerd Jan is CEO of Bright55 ([http://www.bright55.com]). Bright55 provides BPM and project management solutions. Bright55 also has an office in Timisoara from where software is developed for the BPM market.