Commercial Real Estate Investing Basics

Active commercial real estate investments

Active real estate investments are ones in which the investor manages the investment themselves. This typically means owning a portion of the investment and carrying a part or all of the risk and liability. While not always the case, active investing typically produces a higher return than passive investing. Active investments earn income in two ways:

  • cash flow from rental income and
  • appreciation, or adding value to the property.

How to buy and manage a CRE property yourself

If you actively invest in commercial real estate, you’re doing the work to find, fund, acquire, manage, and dispose of the property. While you may have funding partners, investors, a third-party management company, or a team of people helping you, you’re ultimately responsible for the success or failure of the investment.

Most active CRE investors choose a sector to specialize in. They might buy only multifamily homes or focus on office buildings. Before purchasing a commercial property, determine:

  • the type of CRE property you want to own,
  • the supply and demand of that CRE type in your real estate market, and
  • how to invest properly in that CRE sector.

Here’s how to get involved in active commercial real estate investing.

1. Evaluate investment opportunities

Once you’ve identified the sector you want to target and an ideal location, you’ll want to find investment opportunities to pursue. You can search for properties listed for sale with a commercial real estate broker on Loopnet, Crexi, Craigslist, or through your own direct mail campaign.

If the property is listed with a broker, they’ll typically send an offering memorandum (OM) that outlines the current performance of the property and its pro forma, or the potential income the property can produce when managed and leased optimally. While this information is useful, it’s up to you to confirm the estimates and current expenses.

Most offers are based on the net operating income (NOI) of the property and its cap rate.

  • The NOI is the income the property produces after accounting for all annual expenses before debt service.
  • The cap rate is the value of the property based on the income it produces, or the NOI. The higher the cap rate, the better the return. The lower the cap rate, the less of a deal you’re getting.

2. Submit a letter of intent (LOI)

If the investment looks promising, the next step is to submit a letter of intent (LOI). This is a one- or two-page document outlining:

  • what you intend to purchase, and
  • the terms of the purchase, including purchase price, down payment, inspection period, and other clauses or contingencies.

An LOI isn’t binding, but continues the due diligence process for the buyer and seller based on temporary terms. After the buyer continues their due diligence, they can enter into a formal contract. Have your attorney review any contract to ensure it outlines the necessary clauses and conditions and adequately protects both parties.

An LOI isn’t binding, but continues the due diligence process for the buyer and seller based on temporary terms. After the buyer continues their due diligence, they can enter into a formal contract. Have your attorney review any contract to ensure it outlines the necessary clauses and conditions and adequately protects both parties.

3. Secure funding

Immediately after the contract is executed, you should secure funding. There are a number of loan options available specific to commercial real estate:

  • Conventional loans: These require at least 20% of the purchase price as a down payment. There are both short- and long-term options, so you can get funding with a repayment term of anywhere from two to 30 years. There are fixed- and adjustable-rate mortgages — some short-term loans require balloon payments, as well.
  • Government loans: Small Business Administration (SBA7a) or Certified Development Company SBA504 loans are government-backed and offer loans of 15 to 25 years. Adjustable- and fixed-rate loans require as little as 10% down.
  • Syndication: You pool money from investors to purchase the property in cash, paying a preferred return, equity split, or combination of both.
  • Owner financing: The seller of the property carries financing at a specified rate and terms.

Most banks look at two factors when approving loans:

  • The loan-to-value (LTV) ratio, which is the loan you’re requesting in relation to the value of the property.
  • The annual income the property produces in relation to the annual debt service on the property. This is called the debt service coverage ratio (DSCR).

While the property is the most important factor in the loan, banks also review the investor’s business plan, creditworthiness, experience, and net worth to see if they’re qualified enough to repay the loan.

It’s not uncommon for CRE loans to require the investor to be a personal guarantor, assign a life insurance policy, or use other property, such as a primary residence as additional collateral.

4. Inspect and conduct due diligence

Like residential real estate, commercial real estate has an inspection period. This period can be negotiated to as little as 15 to 60 days and allows the buyer to conduct inspections and continue due diligence that may pertain to the property.

Buyers may commission a variety of reports:

  • Property inspection report
  • Phase I environmental survey¬†
  • Boundary survey

Most inspections are ordered by the lender directly. For this reason, you should pursue financing before ordering any surveys or inspections. This is also the period in which the buyer verifies information relating to the operation of the property, including deposits of income, rental rates, vacancy, prior tax returns, and so forth.

The buyer can renegotiate or cancel the contract, often without penalty, during the inspection period.

5. Close on the property and begin managing the investment

Once funding is secured and the inspection period has passed, the property will close with a title company or attorney. From there, it’s the investor’s job to manage the property. This can include:

  • overseeing or hiring an on-site manager,
  • hiring a third-party property management company,
  • using property management software to manage the rental units,
  • marketing on social media and advertising the property,
  • starting evictions on delinquent tenants,
  • making capital improvements, and
  • other responsibilities.

Owning a CRE property often requires substantial work and consistent monitoring. But it can result in a big payoff.

Commercial real estate and taxes

Income earned from commercial real estate is taxed differently based on the type of investment. Once you’ve determined the best method of investing in CRE for you, research how that investment is taxed and talk with a tax professional.

Take the first steps to invest in commercial real estate

Investing in commercial real estate doesn’t have to be intimidating, nor do you need hundreds of thousands of dollars to start. With the number of investment options available, you just need to determine which method of investing is right for you.

As with any investment, it’s imperative you conduct thorough due diligence and understand the risks and benefits before investing.

Source Article