Commercial Real Estate: Is the risk worth the reward?
Asking “what is the best real estate investment?” is the wrong question. The right question is, “what is the best real estate investment for me?” There is no “best” type of real estate investment. You have to compare the pros and cons of each and decide what fits you. It all depends upon how much money and time you are willing and able to invest, how much you know about the property type, how much risk you are willing to take, and what your goals are. When you know all that you can choose the type (or types) of real estate that is right for you.
In this series we have looked at the pros and cons of investing in single- family houses, multifamily properties, and farmland. Now we will consider commercial property. It is a great investment…until it isn’t. A significant advantage is that commercial property has the highest cashflow of any real estate investment. The rents per square foot are much higher than for residential property. In addition, many commercial leases require that the landlord receives a percentage of the tenant’s income and that the tenant pays for much of the maintenance.
Commercial leases often require tenants to pay for repairs up to a certain dollar amount. Most commercial leases also assess tenants for their share of the costs of repairs to the roof, HVAC, and parking lot based upon the square footage of the space they rent.
Leases in multi-tenant properties usually include the “load factor.” In addition to paying to lease the space that the business uses, an additional charge is levied for common areas. For example, if a 100,000 square foot space is leased in a multi-tenant building with a 10,000 square foot lobby, the load factor is 10 percent, which means each tenant pays an additional 10 percent of the lease rate.
Commercial leases are longer than residential leases. It is not uncommon for commercial leases to run ten or more years with annual rent increases.
Because commercial real estate is rented to businesses rather than to individuals, they are subject to fewer government regulations than residential properties.
Commercial tenants normally deposit rent directly into the landlord’s bank account. For a landlord, there is nothing like knowing the rent will be in your account on the first of every month. Another plus is that commercial tenants do not call their landlords in the middle of the night, if ever.
A commercial property is more expensive than residential real estate, so the down payment will be significantly higher. Lenders require twenty, thirty or even more percent down and a higher interest rate than residential loans. In addition, the tax benefits of owning commercial real estate are not as good as residential (39 years of depreciation for commercial compared to 27.5 years for residential).
Everyone wants a place to live, but few want to rent commercial space. Since commercial leases are long-term, most tenants are locked into the space they rent, so the pool of potential tenants is small. Complicating this, the current demand for commercial property is among the weakest on record because so many people are working from home instead of going to the office. Many economists predict that some companies will permanently scale back their leased space in the future.
Still, commercial property is a great investment…until it isn’t. The cashflow is great until it stops. Although leases are long-term, when a tenant moves out it is not uncommon to wait a year or more before you find a tenant (it took me almost five years to find a new tenant for a commercial property). All the time it is vacant you are paying the mortgage, taxes, insurance, and maintenance. How’s that cashflow working for you now?
Also be aware that commercial properties do not appreciate as well as residential properties. And, if the building is open to the public, the landlord needs to carry a significant amount of liability insurance. Plus, the maintenance costs are high—much higher than a single-family house or multifamily.
Currently, many people are afraid to invest in commercial property. Defaults on commercial property loans in the most recent quarter are 9.6 percent, a record level*. Many analysts believe there will be an oversupply of vacant commercial properties for years, especially retail and hotels. If you have a strong stomach for risk, buying commercial real estate could be the best investment you’ve ever made. You have to weigh the risks and potential rewards and decide if and when what Warren Buffet said applies to commercial property: “Widespread fear is your friend as an investor because it serves up bargain purchases.”
* Source: Mortgage Bankers Association “Mortgage Delinquency Rates for Major Investor Groups, Q2 2020”
W. J. Mencarow is a real estate investor (including commercial) with over 35 years of experience. He offers a free e-course on real estate note investing at www.PaperSourceOnline.com