First Time Investor | Spillar Properties

Commercial real estate is a fantastic launchpad for building generational wealth and financial independence. It’s easy to see why commercial real estate is attractive for investors. It can provide some of the highest income streams and requires little oversight or involvement. You don’t have to worry about taking care of things like toilets or AC units—your tenants are responsible for that!

Commercial real estate is a great place to begin building your portfolio. This guide will walk you through the five main types of commercial real estate, considerations for getting started, what to avoid, and key definitions for common industry terms.

Commercial real estate is a property that is typically leased out for business and retail purposes. Investing in commercial real estate involves purchasing and/or developing properties that have been designed with the intent of housing commercial tenants, such as medical providers or local businesses. Unlike a residential real estate investor, commercial real estate investors lease out and collect rent from the businesses that occupy their properties rather than from residential tenants. Raw land purchased for commercial property developments is also included in this definition.

The most common commercial real estate type is office space. These buildings, which can range from single-tenant offices to skyscrapers, are defined by one of three categories: Class A, Class B, or Class C.

Class A commercial real estate properties are typically new or extensively renovated buildings in excellent areas with easy access to major amenities. These are typically managed by professional real estate management companies.
Class B commercial real estate properties are often older buildings requiring capital investment. Although they’re well-maintained and managed, these properties require minor repairs and upgrades, making them a popular target for investors.
Class C commercial real estate properties are typically used for redevelopment opportunities. They are generally poorly located and require major capital investments to improve out-of-date infrastructure. Their vacancy rates are much higher than Class A or B buildings.

Multifamily properties include apartment complexes, high-rise condominium units, and smaller multifamily units. Property is qualified as multifamily real estate any time it has more than one unit, but can also be considered a commercial property if it has more than four units. Many residential investors get their start in commercial properties by expanding into larger multifamily properties. Residential tenants tend to have shorter lease terms than office and retail tenants, so tenant turnover is a factor that should be considered.

In general, special-purpose properties are designed for a specific use, so much so that it would be difficult to repurpose the property for another use. Car washes, self-storage facilities, and schools are all examples of special-purpose properties. The leisure and tourism industries represent a large proportion of special-purpose real estate as well. Common examples within the industry include hotels, airports, sports stadiums, and amusement parks. Mixed-use development properties are also prevalent in the commercial real estate sector and continue to grow in demand. These properties represent different uses, such as residential, retail, and the public sector. A mixed-use building could have shopping and services on the first floor with apartment units on the upper floors.

Class A commercial real estate properties are typically new or extensively renovated buildings in excellent areas with easy access to major amenities. These are typically managed by professional real estate management companies.
Class B commercial real estate properties are often older buildings requiring capital investment. Although they’re well-maintained and managed, these properties require minor repairs and upgrades, making them a popular target for investors.
Class C commercial real estate properties are typically used for redevelopment opportunities. They are generally poorly located and require major capital investments to improve out-of-date infrastructure. Their vacancy rates are much higher than Class A or B buildings.

The question of ‘how to invest in commercial real estate’ has only one answer: due diligence.

Regardless of what sector or niche you’re in, doing your homework and minding your due diligence is critical in ensuring your success in real estate. Besides learning the ins and outs of commercial investing, make sure you understand the commercial real estate market and how it differs from the residential real estate market. If you’re ready to embark on your first commercial endeavor, stick closely to the following tips!

The first step as a commercial investor is understanding that commercial real estate is valued differently than residential properties. Unlike residential real estate, the income from commercial real estate is typically related to usable square footage. Also, commercial property leases generally last longer than residential leases. These two factors help illustrate why commercial real estate can generate higher income for investors.

Location is an important factor regardless of your niche, and commercial investing is no exception. However, commercial investors must also pay close attention to their tenant type. The location and intended tenant type are two factors that intersect closely when determining demand.

For example, a space intended for corporate offices will likely perform better in an urban center than in a primarily residential neighborhood. Analyzing recent comparables can provide you with a better clue of how your property of interest might perform.

The next step is to analyze comparables in the area and research future developments. Otherwise known as “comps,” these assets refer to prices paid for recently sold properties that are similar in location, size, and style.

Analyzing comps will help you determine the current market value of a property. When determining comps, a general rule of thumb is choosing a property where the square footage does not exceed 10 percent higher or lower than the evaluated property. This will allow for the most accurate comparable possible.

Commercial real estate investing involves various calculations and an understanding of real estate finance. To become a successful player in commercial real estate, you should know several formulas.

Net Operating Income: This calculation equals all revenue and costs from a particular property. Configured before taxes, this number gives investors an idea of how much they’ll make from an investment minus all necessary operating expenses. Operating costs typically include insurance, property management fees, utilities, repairs, janitorial fees, and property tax.  
Cap Rate: Used to calculate the value of income-producing properties, the capitalization rate (“cap rate”) will provide investors with an estimate of future profits or cash flow. This is essentially the ratio of net operating income to the property asset value.  
Cash On Cash: Cash on cash is a metric that provides investors with a rate of return on their commercial real estate transactions. It’s typically used by investors who rely on financing to purchase their properties. Cash on cash measures the return on out-of-pocket cash invested relative to the portion that was financed. This will provide an accurate analysis of an investment’s performance.

Cost contingencies are rainy-day funds set aside to cover unexpected acquisition expenses. This portion of your budget can cover lost cash flow due to early vacancies, renovations, and other upfront costs. For example, the property may need to be rezoned or you may need to hire a new property manager. These costs can often be incurred before you have a stable cash flow.

A typical cost contingency budget in commercial investing is between 5 and 15 percent. To determine the right number for your investment, analyze your expected cash flow in the first few months. Will that number cover early loan expenses? What about changes to the property? Even if you expect cash flow to be sustainable early on, it is always a good idea to have extra funds just in case.

In addition to cost contingencies, many investors will set aside a capital reserves fund that serves the same purpose later on. These funds can be used for unexpected expenses and are built into the operating budget.

When it comes to commercial investing, cost contingencies and cash reserves are a crucial component of the process. By planning for unexpected costs throughout the investment process, you can avoid situations where you are strapped for cash.

As a commercial real estate investor, it’s just as important to know what not to do as it is to know what to do. Today’s best investors already know it, and it’s about time you did too: mitigating risk is the single greatest thing a real estate entrepreneur can do for the success of their business. Mitigating risk exposure is the best way to increase the likelihood of success. That said, here’s a list of some of the most common mistakes commercial real estate investors should avoid:

Improper Valuations: Every single commercial property is unique, and investors need to be able to account for variances that may be found in each asset. Failure to account for every detail in an asset’s valuation could lead to financial ruin. The inability to account for the true value of a property will impact nearly every step moving forward, so it’s important to get things right at the time of acquisition.
Financial Ignorance: Failing to understand the financial intricacies of commercial real estate investing can be devastating. Investors will need to learn the differences between commercial and residential real estate deals, not the least of which include the loan-to-value (LTV) or debt service coverage ratio (DSCR).
Neglecting Due Diligence: While today’s market requires decisive decision making, it’s important to mind due diligence. It’s better to lose a deal to someone else than to buy into a deal you aren’t prepared for. As a result, more investors need to take the appropriate time to learn as much about a property as they can before they buy it.
Working Alone: Far too many investors want to save money by doing everything themselves. However, working with a team is unequivocally better than working alone. While you may appear to save money on the surface, chances are you are losing both money and time by working alone. That said, align your services with a competent team and trust them to do the job you hired them for. There’s a good chance they know more about every process than you do.

Ask yourself the following questions as you consider leaping into commercial real estate.

Do I have the ability to think big?

Investing in commercial real estate requires big-picture thinking and having an open mind. When investing in residential real estate, the properties under consideration are much smaller in scale. With a commercial property, you must visualize a finished product even in the beginning stages of redevelopment. If you are debating whether to purchase a five-unit apartment versus a property with 10 or more units, it is probably more beneficial to choose the 10. If the five-unit complex requires nearly the same commercial financing as the 10, it makes sense to think big and do what it takes to boost your bottom line.

Are you an expert relationship builder?

Networking and building relationships as a residential real estate investor are important, but it is an absolute must for commercial investors. The biggest reason to build relationships with other commercial investors and private lenders is for financing purposes. When facing a million-dollar or more purchase price, you’ll probably need funding. What better way to find capital than to contact one of your personal private lenders? Once you’ve built a network, you can rely on others who have made and learned from their mistakes.

Can you successfully execute your due diligence?

Arguably the most important task for beginner investors is their due diligence. After you’ve chosen your niche, you must research everything you can regarding that specific sector. Ask questions from like-minded individuals, find information online about different types of financing options, and reach out to private lenders in advance. That way, you’ll know exactly what information to present when the time comes. Once you’ve carried out thorough due diligence, you will be ready to successfully embark on your first commercial real estate deal.

Commercial real estate investing may initially seem intimidating, but know that the core skills and competencies required are the same as residential property investing. They include minding due diligence, having a proper business plan to understand financing options, and building a robust network.

Any type of investing is associated with some risk, and it’s up to you to find ways to mitigate that risk. If you use the systems that brought you success with residential real estate and seamlessly implement them into your commercial strategy, you’ll be able to find your footing. And by working with an experienced team that’s invested in your success, you’ll quickly find that commercial real estate investing really is right for you!

Commercial real estate investing involves various calculations and an understanding of real estate finance. To become a successful player in commercial real estate, you should know several formulas.

Net Operating Income: This calculation equals all revenue and costs from a particular property. Configured before taxes, this number gives investors an idea of how much they’ll make from an investment minus all necessary operating expenses. Operating costs typically include insurance, property management fees, utilities, repairs, janitorial fees, and property tax.  
Cap Rate: Used to calculate the value of income-producing properties, the capitalization rate (“cap rate”) will provide investors with an estimate of future profits or cash flow. This is essentially the ratio of net operating income to the property asset value.  
Cash On Cash: Cash on cash is a metric that provides investors with a rate of return on their commercial real estate transactions. It’s typically used by investors who rely on financing to purchase their properties. Cash on cash measures the return on out-of-pocket cash invested relative to the portion that was financed. This will provide an accurate analysis of an investment’s performance.

Improper Valuations: Every single commercial property is unique, and investors need to be able to account for variances that may be found in each asset. Failure to account for every detail in an asset’s valuation could lead to financial ruin. The inability to account for the true value of a property will impact nearly every step moving forward, so it’s important to get things right at the time of acquisition.
Financial Ignorance: Failing to understand the financial intricacies of commercial real estate investing can be devastating. Investors will need to learn the differences between commercial and residential real estate deals, not the least of which include the loan-to-value (LTV) or debt service coverage ratio (DSCR).
Neglecting Due Diligence: While today’s market requires decisive decision making, it’s important to mind due diligence. It’s better to lose a deal to someone else than to buy into a deal you aren’t prepared for. As a result, more investors need to take the appropriate time to learn as much about a property as they can before they buy it.
Working Alone: Far too many investors want to save money by doing everything themselves. However, working with a team is unequivocally better than working alone. While you may appear to save money on the surface, chances are you are losing both money and time by working alone. That said, align your services with a competent team and trust them to do the job you hired them for. There’s a good chance they know more about every process than you do.