The Pros and Cons of Investing in Commercial Real Estate
My kids love to play Monopoly. I, on the other hand, am not a huge fan, primarily because the game takes so freaking long to play. No matter how fast we try to speed the game up, we never seem able to bankrupt each other in one sitting. Mind you, I do have six kids, all under age 12, so it takes us about 10 minutes to get through all of our turns.
The real-life Monopoly game seems much the same. I coach a lot of investors who have their five-year financial freedom goal clearly mapped out in their minds, but life happens, and then their journey proves to be tougher than expected. And just like the game, it ends up taking far longer, even 10 years or more. Some give up altogether and never even finish the game.
Unless you’re a surgeon or you’re about to turn 60, you must have a long-term perspective on wealth creation. According to ancient Hebrew wisdom literature, “Wealth from get-rich-quick schemes quickly disappears; wealth from hard work grows over time.”
There’s a reason why most people in our culture don’t achieve their wealth creation goals. It’s because they don’t want to do the hard work of learning to overcome their fears of using investment strategies that the masses shy away from, and commercial real estate is a prime example.
If you want to be wealthy, it’s usually a good idea to see what wealthy people do. The fact is, wealthy people tend to own commercial real estate.
Steve McKnight recently shared in his book, From 0 to Financial Freedom, how this realization dawned on him while playing Monopoly.
He noticed how the game is essentially about going from buy and hold in the form of collecting rent, to developing, as in those little green houses, and then to the big red hotels, or commercial property. You can read more by picking up a free copy here.
This was an “ah-ha moment” for him. From that revelation, coupled with his own experience, came his conviction that you should focus on residential property for growth returns, and commercial property for income. Thus, he recommends debt-free commercial property as the asset of choice to fund your passive retirement income.
Commercial real estate has value for different reasons than residential real estate does. I wrote about eight of those sources of value for commercial property here. But herein lies the very reasons that, at some point when you switch to an income focus, commercial property may be your best vehicle.
As with any strategy, there are pitfalls to be aware of, so, before you step into the realm of commercial real estate, or any property investing strategy for that matter, educate yourself.
Commercial Real Estate Pros
Here are some of the many advantages of investing in commercial real estate:
1. Commercial Real Estate Offers Greater Income Profitability
If it’s passive income that you’re after, you’ll likely get more bang for your buck in commercial real estate. Because of the significant capital growth we’ve seen in residential real estate, and the degree to which it has outpaced inflation in rental prices, the yields are quite low.
Unless you buy in a regional area, good luck getting greater than a three or four percent yield on a residential rental property.
Residential property grows faster because its value is driven by lifestyle factors. People primarily decide where to live for emotional reasons. They want to be close to work, or close to the people they want to associate with, like family. Certain suburbs have greater appeal to people who have money. This makes the houses in those areas worth more.
Commercial property values are based purely on investment or business decisions. When someone assesses the value of commercial real estate, it’s all about how much income that asset spins off each month. Yield is the expression of this income as a percentage of the property’s value.
Yield = (gross annual rent / purchase price) x 100
Commercial property usually offers a higher yield, somewhere in the seven to 10 percent range. Because it’s strictly business, and investors demand higher returns, we have seen less capital growth in commercial property, and therefore higher yields.
2. Commercial Property Transactions Are Unemotional
Intertwined with the first point is about the unemotional nature of commercial real estate. Because it’s based on business principles and return on investment, this can make commercial real estate a more attractive opportunity.
This business nature of the transaction can simplify the relationship between landlord and tenant, making management of the property much more hassle-free. When your goal is passive income, worry-free property is a major bonus.
3. Commercial Property Outgoings Are Usually Paid By The Tenant
Outgoings is simply a term that describes the expenses related to the use of the property. These include rates, utilities, insurance, land tax, repairs and maintenance.
You may have heard this saying, “A dollar of commercial income is worth more than a dollar of residential income.” This is because once your residential tenant pays their rent, you still need to pay for the costs of owning the property. Not only are commercial yields higher, you get to keep more of the rent money that comes in.
4. Commercial Property Leases Tend To Favour The Landlord
- They Last Longer. It’s easier and it costs less for a family to move house than for most businesses to move premises. Therefore, commercial leases tend to run much longer. While the typical residential lease may only be 12 months, commercial leases are generally in the two to five year range.
- They Usually Have Built In Renewal Options. It’s therefore not uncommon for a commercial tenant to stick around for a decade or even longer.
- Commercial Leases Usually Contain Automatic Rent Increases. This may either be a flat percentage increase of perhaps three to five percent per year, or it could be an automatic increase pegged to inflation. Either way, commercial real estate helps investors secure the buying power of their future income.
Commercial Real Estate Cons
Here are some of the downsides of investing in commercial real estate:
1. Commercial Property Carries A Greater Vacancy Risk
People will always need a place to live, but people may not always need a place to do business. This makes vacancy a much greater concern for investors in this space.
Vacancy periods can also be much longer in the commercial market. This means residential vacancies could last weeks, while commercial vacancies could last for months, or even years.
This risk is multiplied if the building on the property is purpose-built for a particular type of tenant, or if the area has restrictive zoning.
In the town that I live in, one large commercial property in the central business district has sat vacant for about five years now. It was a nightclub, and although the location is prime, the fit-out and size of the facility leaves fewer other options for businesses.
Of course, vacancy risk intensifies in weaker economic times, which brings us to the next point.
2. Commercial Property Is More Exposed to Economic Factors
Commercial tenants are engaged in business, and the longevity of most businesses are dependent on the strength of the broader economy. If you’re a commercial real estate investor and the economy takes a dive, so could your income.
For this reason, commercial property investors tend to prefer some industries over others. For example, some investors see retail space as less desirable than office or industrial complexes, because the retail industry is more prone to economic problems.
However, some blue chip retail tenants are more desirable. As you might expect, commercial property investors place a huge value on government tenants.
In general, higher risk properties will command a greater yield from investors in order to compensate them for the greater vacancy risk.
3. Commercial Property Tends To Be More Expensive
Most businesses produce more income than families do, so it would stand to reason that commercial properties tend to be more expensive than homes. This presents a barrier of entry into the market for many investors.
Before you can make a move into the commercial real estate market, you may need at least two million dollars or more, especially if you hope to buy multiple properties and diversify your vacancy risk.
4. Commercial Property Comes With Some Finance Barriers
Because the primary benefit of owning commercial property is income and not growth, it’s generally best to pay cash for commercial property.
Even if you do seek finance to purchase commercial property, it’s important to understand that commercial loan terms are much less attractive than residential loans.
Some people choose to redraw the equity on their residential loans to buy commercial property. For instance, commercial financiers will typically only lend up to 70 percent of the purchase price of a property. This means you’ll need to put up more cash than you would for a residential property.
You can also expect higher interest rates and fees,but shorter loan terms in the world of commercial finance. Expect to pay as much as three percentage points more in interest on a loan term of only 10 to 15 years.
In Steve McKnight’s Property Apprenticeship course, we devote an entire session to exploring the nuances of commercial real estate. In fact, this is one of Steve’s areas of expertise. Through the Passive Income Fund, he devotes a great deal of his time to purchasing and improving commercial real estate.
No matter where you are in your investing journey, education is crucial. Whether it’s our course or someone else’s, seek out training that supports you while you learn. Make sure it also offers some degree of accountability to ensure you maintain the motivation to go the distance and take the necessary action steps toward your goal along the way.
Whatever You Do, Don’t Try To Go It Alone.