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How commercial real estate investing works

by Jonathan Adams
real estate

Commercial real estate is an appealing investment class because of its consistent returns, passive income and growth potential. However, not all commercial investments are equally profitable. Moreover, commercial real estate investing comes with its own set of risks so it is necessary to be aware of the drawbacks in order to avoid mistakes and be prepared before making the purchase.

Commercial real estate investing usually requires higher levels of enterprise as well as capital, expertise and time as opposed to other real estate investment vehicles, which makes it more appropriate for high net-worth individuals.

Profit from commercial real estate investing is achieved through income and appreciation. While income is produced through the operation of the building, appreciation is the increase in the value of the property over time.

About commercial real estate

Commercial real estate is a broad term which includes various types of properties used to generate profit. It is typically leased out for business and retail purposes. Commercial real estate investors let the property to commercial tenants or businesses that occupy space in their properties in return for a rent. This real estate asset class is typically classified into five main categories which include industrial, office, retail, multifamily, and special purpose. Apart from these, there are many other property types such as self-storage, medical, elder care, land, hotel, malls, farmland, apartment buildings, warehouses, restaurants, and convenience stores.

Benefits of commercial real estate investing

Higher rental income: Due to the nature, size and potential of commercial real estate, investors should expect higher rental returns than residential properties. Usually, commercial properties have a better return on investment than single-family properties. While the average return on investment in case of commercial properties is six to twelve percent, it is between one and four percent for single-family properties. The occupancy levels at commercial properties are also high compared with the residential real estate as commercial properties tend to have more available units. Furthermore, commercial leases are usually longer than those in residential real estate which means more financial security to the investor.

Cash flow: The UK commercial property sector offers more investment stability compared with some of the other countries across the world due to its long lease duration advantages. There is more financial security as it offers a relatively consistent stream of income due to the long leases, which may be several years down the line. Apart from the lease, the number of units at commercial properties also plays a vital role for achieving potentially higher rental yields as the unit numbers at commercial properties are often higher than those at residential properties. This means the investor can achieve economies of scale and multiply the income streams much more quickly. Investors stand to gain even more due to the triple net lease, under which commercial tenants also pay the building’s real estate taxes, property insurance and maintenance costs.

Less competition: Another advantage of commercial real estate investing is relatively less competition as the sector is considered to be a bit difficult in terms of capital, risk, expertise, time and other associated resources. It is usually perceived as the prerogative of investors that are highly stable financially as it involves relatively high levels of investment. Add to these the component of risk, and it is easily a high-risk investment option. That is why the everyday investors usually do not consider commercial real estate investing as a viable option for investment and the sector is less saturated compared with some of the other real estate vehicles.

Many property investment specialists speak of the reliability in “bricks and mortar” investments such as commercial property. They argue that commercial property investment provides an income that other indirect investment asset classes struggle to yield.

In the UK, the responsibility for the maintenance and repair of the commercial property lies with the tenant as opposed to the residential sector wherein the landlord is responsible for carrying out the maintenance and repair at the property.

Appreciation and value addition

The next advantage of commercial real estate investing is the appreciation in the value of the property over the time the investor holds it. Although, the value of commercial property usually rises over time, there are pitfalls as well. Commercial property can also lose value and proven investment strategies may go wrong. This may be due to factors internal as well as external to the sector. Commercial property may experience fluctuations due to factors such as downturns in the wider economy. The value of commercial real estate is relative to the larger economy as a whole. However, commercial real estate is a hard asset that is also a scarce resource. It always has intrinsic value, and usually appreciates in value over time. The intrinsic value of a commercial property can be enhanced in a number of ways such as through renovations or making improvements to the property. This raises the ability of the property to earn more income. It may include a makeover to the property by adding the latest facilities and amenities such as appliances. Though these modifications will involve considerable expenses, they allow investors to charge higher rent, which means growth in the overall rental income from the commercial property. Another advantage of renovating a commercial property is that it can potentially enhance the price of the property in the future through ways independent of the market and other conditions.

Ways to invest in commercial property

There are many ways to invest in commercial property and investors should consider all the different routes before taking the first step into investment. These routes can be broadly classified into direct and indirect investment approaches. While the direct investment option involves the purchase of physical ‘bricks and mortar’ property assets, investing in Real Estate Investment Trusts or REITs, stocks and shares of companies that specialise in property and real estate, property index derivatives, trust companies or bonds of corporate property organisations form the indirect approach to commercial real estate investment.

Therefore, commercial real estate investing is indeed a viable option for those with deep pockets, though investors should carefully consider the time, category and place of investment for achieving the desired results.

Important
This article is for information purposes only.
Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.
There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.

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