Why should you invest in commercial real estate? Commercial real estate refers to property used specifically and exclusively for business purposes or otherwise providing a space for work.
Residential properties are used as living spaces and it is a common type of investment that can feel much more accessible than commercial real estate. Everyone needs a place to live, sleep, and put their belongings. Not everyone runs a business or necessarily wants to own office space.
Commercial properties typically include offices, industrial spaces, and retail environments, like storefronts or strip malls. Commercial real estate also includes certain multi-family units, like large apartment complexes and duplexes.
As intimidating or confusing as commercial real estate can be, commercial property can be an excellent real estate investment for beginners and veteran investors alike. Read on to learn more.
One of the main reasons for just about any investment, commercial properties offer a high potential for income. Obviously, your actual income amounts can vary based on the current market and tons of other factors, and things can always go wrong. However, commercial real estate tends to offer higher income than other forms of real estate investing, even residential real estate.
Commercial real estate investments tend to come with higher rents, which naturally means a high regular cash flow. Commercial property investors also keep their tenants for much longer as lease contracts tend to have longer periods. Residential properties usually have leases that run for 12 months. Commercial leases have terms lasting about three years typically, though it’s not uncommon to have terms lasting five to 10 years. That builds stability in your income, and with fewer vacancies and less turnover, you can generally maintain that high monthly cash flow.
Taxes on any property or asset can leave you feeling like you’re paying more than you’re actually making. Commercial real estate comes with some natural tax benefits. The first of these is known as depreciation. Commercial real estate is considered a physical asset that degrades (or depreciates) over time. To compensate, the IRS allows you to depreciate the property value, which involves deducting part of the property’s value from your taxable income. Depreciation deductions can help reduce the overall tax burden, and over time, it can lead to some significant savings. The exact depreciation amount depends on the age of the property and its type.
Along with depreciation, you may also use 1031 exchanges to offset capital gains taxes if or when you eventually sell your property. Also known as like-kind exchanges, 1031 exchanges essentially involve swapping out one property for one of “like-kind,” which then allows you to defer any capital gains taxes. The rules of “like-kind” are surprisingly flexible. You can ostensibly exchange a large apartment complex for a piece of raw land or a ranch for a large storefront.
All told, these tax benefits can help you maintain the profits gained from your investment property. However, it may be worth consulting with a tax expert to understand your tax liabilities regarding owning commercial real estate fully.
Many early investors tend to put all their eggs into one basket, investing all of their money into a single property or a single type of property. That can be potentially fruitful, but more often, it can increase your risk if the market goes south.
The good news about when you invest in commercial real estate is that it is exceptionally easy to diversify your portfolio and mitigate that risk. When you buy commercial property, you have many different options. Office spaces are the most common offering, but beyond that, you have a whole host of retail properties, including shopping centers, malls, big-box anchor stores, and individual storefronts. You can invest in industrial property as well, like manufacturing and distribution centers and warehouses.
Each type of property comes with its own quirks and nuances, but spreading your money over several lucrative investments can diversify your risk, balance out your portfolio, and allow for more opportunities to make money.
It may be obvious to say, but when you invest commercial real estate, it is a physical, tangible asset. Unlike stocks or bonds, a piece of property has a physicality to it, which means it will always have some value attributed to it because of the land and the structures on it. Even if property values go up or down, that piece of property will always be there.
That physicality also means that the asset can be changed. It has an inherent mutability. You can remodel your office space or restructure the building, which then affects the value of that property.
Property values with residential and commercial real estate are completely different. With residential properties, value largely depends on comparable properties in the local area, which often comes down to basic, raw factors. For example, a two-bedroom, two-bathroom home with the most updated appliances will likely be the same value as a two-bedroom, two-bathroom home with updated appliances in the neighborhood. While you can potentially increase that value with minor additions and changes, it primarily comes down to the local housing market.
Local comps still factor into commercial properties, but the market value for commercial real estate is actually more about the amount of revenue generated by the property. It’s extremely straightforward. The higher the cash flow of a commercial property, the higher the property value. That means that the smallest, most inexpensive improvement to the property could pay massive dividends as long as it increases the revenue that the property generates. If you have the right tenants, your value could increase at a truly unprecedented rate.
Property management and taking care of your tenants’ needs still require plenty of work, but with commercial real estate, businesses usually go home at night. It’s a typical 9-to-5 job, meaning that you work when they work. You may still have to take care of some after-hours errands, and there’s always the potential for an emergency. More often, your hours are limited to the day, leaving you with plenty of flexibility in your day-to-day operations. Even in the event of an emergency, most commercial investors have alarm monitoring services that notify the proper authorities in the event of any issues.
Residential real estate is covered by dozens of state and federal laws and regulations, like limits on security deposits and precise rules governing termination and eviction. Commercial real estate comes with far fewer laws, which generally results in much more flexibility in your leases for the rental property.
This also gives rise to more triple net leases. A triple net lease is an agreement on a property wherein the tenant is responsible for paying all of the expenses related to the property, including insurance, maintenance, and even real estate taxes. These are often folded into rent and utility payments. The only thing that you, as the owner, would be responsible for is paying the mortgage. Triple net leases usually have a lower monthly rent because the tenant is responsible for more of the ongoing expenses. Still, it can make things easier for you as the owner, while providing low-risk, steady, passive income.
Residential real estate is a vastly competitive market. That competition can drive prices up, which can make obtaining a residential property in the first place difficult. If you don’t act fast, another real estate investor or buyer will get that property before you even lift a finger.
By comparison, the commercial real estate market is much less competitive. There are just fewer investors in the field and less interest in general. That makes it easier to find the right investment opportunity and actually obtain that property. You can typically find better deals with commercial properties as well.
With residential properties, it can sometimes be challenging to find qualified tenants. They may not have a great credit score, or they may otherwise come with baggage that can make your experience as the property owner increasingly difficult.
For a commercial real estate investor, finding qualified tenants can be much easier. That’s not to say that every single potential tenant will be the perfect fit or that things will go smoothly every single time. However, commercial property tenants tend to comprise businesses, corporations, and other professional organizations. These tenants are more likely to respect the property and any rules involved, specifically because it can directly impact their own business profits. A retail tenant will naturally care about their store and storefront because any disorder or lack of maintenance will inevitably affect their own business. There is a natural alignment of interests between the property owner and the tenant. That just makes for a smoother, easier experience for everyone involved.
A commercial real estate investment will generally steadily appreciate year after year as long as you maintain your property and keep it up to date. The same can’t be said for a residential property.
Commercial real estate can come with its own difficulties, and many investors start with residential properties before moving up to commercial investments.
If you are ready to invest in commercial real estate, talk to our team of commercial real estate specialists at Berkshire Hathaway HomeServices California Properties. We can provide assistance and help you find the best commercial real estate deals in your area of choice.
Sources: Investopedia, IRS.gov, Investor Junkie
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