Types of commercial real estate investments
Small business owners that are interested in getting started with commercial real estate (CRE) investing must first decide which type of real estate investments will work best for their long-term financing goals and current cash flow position. There are two primary types of real estate investments: debt investments and equity investments.
Debt investments are when small business profits are invested in a real estate loan that is secured with collateral, usually a fixed asset like land or buildings. Debt investments typically offer investors regular and frequent returns.
Equity investments are the more common method for individuals or businesses to invest their profits with the intention of gaining investment revenue. When investors purchase a minority ownership percentage in a real estate asset, like an office building, it is called equity investing. With this type of investment, businesses can expect consistent returns in the form of rental income.
9 reasons to invest in commercial real estate
Entrepreneurs start their own businesses for many reasons including following a passion, generating income, and carrying out or creating a family legacy. Once a business begins to generate consistent profits, though, it only makes sense for business owners to consider ways to invest those profits and generate more income. That’s where commercial real estate investing comes into play. Whether as an additional source of business income or the primary revenue stream, here are 9 reasons it makes sense to invest in commercial real estate.
- Cash flows – Commercial real estate investments generate steady cash flows for investors through quarterly or annual distributions or monthly rental income. Small businesses can include the investment income in their primary business’s flow calculations which increases net worth and working capital.
- Self-performing – Commercial property owners and commercial property occupants have a common interest in maintaining the property. Investing in retail or office buildings will likely lead to tenants that care about the appearance and upkeep of the storefront and interior space. This common interest has two benefits: proper maintenance increases the value of the real estate and self-performing lessees require less time from the landlord.
- Increased equity – Real estate values fluctuate with the Federal Funds rate, real estate market, inflationary rates, and the economy. When property values are low, investors have the opportunity to purchase the asset, perform value-add services, and sell the asset for a significant profit. When the investors sell the asset, they are able to cash in on either the appreciation or the capital gain.
- Tax benefits – An alternative to benefiting from appreciation and capital gains is to allow depreciation to increase your bottom line. As depreciation lowers the value of the building, the market value stays intact. Investors can use this to their advantage on their income tax returns by claiming a passive loss for those depreciating assets. The loss from the depreciating asset can be used to offset the business’s taxable income. Speaking with a certified public accountant (CPA) or other tax preparer is the best way to understand how real estate ownership can benefit your business at tax time.
- Higher returns – Small business investors and entrepreneurial individuals have the potential to earn more returns investing in commercial real estate than other investment vehicles, like stocks, bonds, cryptocurrency, and precious metals. Commercial real estate investment returns are measured in Cap Rates, which measure risk and potential rate of return. Low cap rates indicate a higher value asset with low risk, but high cap rates show a low price with great potential upside.
- Low risk – Investing in commercial real estate is a lower-risk investment than more volatile markets, like the stock exchange. Commercial properties are typically occupied by single tenants or multiple tenants that have long-term leases in place. The long lease terms create a consistent income source for small businesses or individual investors.
- Increasing revenue – With commercial real estate, the income is generally coming from long-term leases. Since most commercial tenants sign a five, ten, or twenty-five year lease that includes a rent escalation schedule, property owners can expect annual revenues to increase along with those escalations.
- Easy entry – Investing in stocks, bonds, and even residential real estate can be discouraging to busy entrepreneurs because there is a lot of competition in those markets. There is less competition in the commercial real estate market. Business owners that are interested in buying investment properties can work with a real estate broker and quickly find several properties to choose from.
- Tangible assets – Many entrepreneurs invest in intangible assets, like stocks, as a way to increase investment income. Adding commercial real estate to the business’s investment portfolio is a great way to diversify and stabilize its assets. Having hard assets, like real estate, can benefit a business in proving net worth to shareholders, lenders, and creditors.
How to invest in real estate as a small business owner
By now, you’ve probably realized that there are many benefits to commercial real estate investing. While the extra income is appealing, you may be wondering how to get started. Whether you are investing as an individual, as a small company, or with the intention of building a real estate business, you can get started by following the following step-by-step guide.
Choose a niche
Before jumping online to see what kind of real estate is for sale in your price range, consider choosing one profitable niche in the industry. With a little research, potential investors can explore the ins and outs of purchasing several different types of real estate. Each of the following types of real estate will have its own set of pros and cons, so joining a real estate investment group or speaking with an experienced CRE broker may be a good place to start.
- Multifamily residential – Multifamily real estate options include apartment buildings, duplex homes, and student housing opportunities. Multifamily real estate typically requires a high level of involvement from the owner when it comes to property maintenance and the revenues and lease-terms can be shorter and more volatile than other types of real estate.
- Office space– Office buildings include small suburban units, city skyscrapers, and everything in between. Investing in office buildings gives property owners an opportunity to depend on steady cash flows in the form of rents from other business entities and a lower level of maintenance involvement.
- Hospitality – Hospitality buildings include motels, vacation homes, and hotels. The hospitality niche experiences a lot of turnover, so investors should expect fluctuating revenues.
- Retail – Retail buildings, like strip malls and small storefront units, provide investors with a dependable passive income source and a moderate demand for maintenance. Most investors with retail buildings depend on a property management company to handle day-to-day maintenance issues.
- Industrial – Investing in industrial space, like warehouses and distribution centers, can be a very profitable niche because industrial units offer long lease terms, established tenants, and a low level of landlord participation.
Choose a strategy
Once you’ve narrowed your investment goals down by a niche, you must also research the different investment strategies to take. Focusing on one investment strategy at a time allows new business owners and first-time investors to become experts in the specific industry and tailor their marketing and acquisition strategies to their end goal.
- Land Banking – buying one or several parcels of land that will be valuable to an upcoming development plan.
- Development – buying land with the intent of holding it, building on it, leasing it up, and selling it for profit.
- Value-add– Sometimes called flipping, or fix-and-flip, buying a property with the intention of increasing the value through lease administration, repairs, or renovations.
- Owner-occupied – purchasing existing real estate where the investor’s primary business is operating.
- Passive income– buying real estate to hold long-term and collect passive rental income.
- Wholesaling – buying properties that are below market price and selling them to investors.
Understand the financial aspect
Before jumping into commercial real estate investing, take some time to understand how these transactions work. The term underwriting is one real estate investors when they are performing due diligence on a property or applying for a business loan. Generally, the process of underwriting results in a financial projection of future cash flows. With loans, underwriting will include checking the creditworthiness of the borrower to evaluate the lender’s risk. Specific to commercial real estate, the underwriting process also includes analyzing the purchasing and selling cap rates, occupancy sensitivity (the potential impact of vacant units on investment income), and required capital investment.
Depending on an entrepreneurs’ industry experience, it may make sense to build an investment team. Consulting with or hiring the following professionals can allow business owners to make more informed decisions and also save time on due diligence.
- Commercial real estate attorney
- Commercial real estate broker
- General contractor
- Commercial property management company
- Business lenders
Small business loans for commercial real estate investors
There are several types of business financing options to consider with commercial real estate investing. Loans can be used to purchase land or buildings, cover construction and development costs, or as capital to make repairs and cover the costs of tenant improvements. Some investors also consider small business loans to offset fluctuating cash flows or losses in revenue. Business loans come from traditional lenders, like banks and credit unions, and also online lenders, like Biz2Credit.
Commercial real estate loans
Commercial real estate loans are the most common type of small business funding option for investors. There are several different types of loan programs that can be used for CRE, including traditional bank loans and government-backed loan options.
- SBA Loans – SBA loans are lower interest, commercial loans that are partially guaranteed by the S. Small Business Administration. The SBA 7(a) loan program approves borrowers for up to $5 million which can be used for land, buildings, and renovations. The SBA 7(a) loans have strict eligibility requirements requiring borrowers to have a good credit score and be able to prove they intend to occupy the property. The SBA 504 loan program, or CDC (Certified Development Company) loans can also be used to purchase owner-occupied real estate.
- Traditional commercial mortgages – Like traditional bank loans, traditional commercial mortgages are a popular way to fund CRE. The loan terms typically offer interest rates between 5 percent and 7 percent, with closing costs ranging from 2 percent to 5 percent. Repayment terms could be as short as five yearsor as long as 20 years, with full amortization over the life of the loan.
- Specialty loans – Investors with unique financing needs can also use specialty loans to fund the purchase or renovation of commercial real estate. Bridge loans are ashort-term form of funding that loan can close a gap that exists between the capital a business owner requires right now and a longer-term answer to financing. Hard money loans are a similar type of loan with higher interest rates and down payments than bridge loans.
Working capital loans
Working capital loans describe any type of small business loan that provides smaller amounts of capital quickly. Loans that are in response to business needs involving a large purchase or unforeseen expense are often categorized as working capital loans.
- Short-term loans – A business short-term loan is a traditional type of financing where the borrower receives a lump sum payment upfront and is obligated to pay the funds back with regular monthly payments, according to the repayment terms presented to the borrower at the loan closingTerm loans can be secured, where an asset is used as collateral or a personal guarantee is required, or unsecured, where the borrower’s creditworthiness secures the loan.
- Working capital lines of credit – A business line of credit is a type of revolving credit that can be thought of as a cross between a loan and a business credit card. Working capital lines of credit are a great way for new business owners to build credit history which leads to more financing options in the future.
Investing in commercial real estate is a smart way for small business owners to generate passive income in addition to their primary business’s ordinary operating income. Commercial real estate offers tax benefits, high returns, consistent revenues, and is very low risk. To get started earning from commercial real estate investments, consider speaking with a real estate broker or small business lender, like Biz2Credit, who helped TJ Shah, owner of Georgia-based Shah Realty, fund his dream of owning rental properties.