Maximizing Financial Returns | 5 Best Commercial Real Estate Investment Strategies
As with its residential counterpart, countless niches and investment strategies exist in the commercial real estate world. Property type, zoning, location, and industry are only some of the factors that can drive how an investor seeks return on investment.
As a new investor, it helps to understand some of these options and, more importantly, strategies that help maximize your financial returns.
In the following article, we outline five of the most effective commercial real estate strategies. Whether you’re a new investor or experienced one looking to branch into another niche, these are outstanding options.
Option 1: Traditional Development
Traditional development, that is, taking a project from initial idea through development, construction, and, ultimately, stabilized operations, offers the highest returns in commercial real estate.
However, with high returns come high risks. A failure to complete a development - due to any number of potential obstacles - could spell disaster for an investor. As such, it’s critical that any investor considering this approach is intimately familiar with the steps in properly analyzing a commercial real estate deal.
While various approaches exist to developing a property, here are the basic steps required in any deal:
Site identification and purchase: This step involves finding the actual “dirt,” that is, the land to be developed. This can either look like a from-the-ground-up project or overhaul of an existing property. Some of the considerations (though certainly not all) in finding a solid site are:
● Municipal zoning
● Opportunity zone availability
● Location
● Status of utilities
● Demographics
● Traffic levels
With the site identified, developers next need to actually purchase the site. While beyond the scope of this article, acquisition due diligence constitutes a key prerequisite to any commercial real estate purchase, and doing this properly can make or break a deal.
Drop us a note for assistance with the commercial real estate due diligence process.
Creating the vision: This step is where the initial vision for a property begins to actually take form, and it requires a solid team of subject-matter experts to properly execute. Specifically, most developers have a reliable team of the following professionals to work with throughout the development process:
● Architect
● Civil engineer
● Leasing/sales team
With input from this team, developers can complete the major elements of the development plan:
● Full development feasibility studies
● Site layout and land prep (e.g. razing of existing buildings, grading, utility connection, etc)
● Architectural design
● The marketing and sales strategy for stabilizing the property
Securing financing: With all real estate, financing is king, and it’s a fool’s errand to go too far into a potential project without confirming the financing plan. However, due to the high-risk nature of commercial real estate development, most lenders will need to see the products from the above step to approve a construction and development loan.
Furthermore, lenders will want to see a history of successful projects to provide assurances that a project won’t fail in the middle of the construction phase. This means that most lenders will also review the following:
● The developer’s operational team
● Additional equity partners in the deal
● The developer’s history of similar projects
Having all of the information organized to present to lenders will both A) increase the likelihood of financing approval, and B) set you up for success in the execution of the project.
Construction: As a developer, you may or may not also handle the construction directly, but regardless of involvement level, you’ll need to oversee the construction process.
This oversight includes, among other tasks:
● Selecting the right general contractor (assuming your development firm doesn’t also have a construction arm)
● Managing timelines
● Tracking costs and progress
● Submitting construction loan draw requests
The general contractor will handle the following, construction-specific tasks:
● Site preparation (grazing, utility installation, etc)
● Vertical construction (the actual building process)
● Interior and exterior finishes
Marketing and stabilization: To secure permanent financing, lenders require that the property be fully stabilized (though terms differ, this typically means at least 90 percent occupancy).
To hit this stabilization goal as quickly as possible - and therefore gain the benefits of a lower-rate, amortizing permanent loan - sales and marketing teams need to be working throughout the entire construction process.
Ideally, the developer’s team creates outstanding renditions and virtual-tour products, and units are pre-leased as early as possible. The sooner the team achieves stabilized levels, the sooner permanent financing applications can be finalized.
Option 2: Commercial BRRRR (a.k.a. Value-add Investing)
Investors typically think of this strategy in the context of single-family homes, but it works just as effectively for commercial real estate.
Also known as value-add investing, BRRRR stands for:
● Buy
● Renovate
● Rent
● Refinance
● Repeat
As the final “R” suggests, the beauty of this process is that it is a fully replicable investment strategy.
Buy: Unlike a turnkey property, the BRRRR model calls for purchasing an undervalued property.
It’s not uncommon for a commercial building owner to break a loan debt covenant, which necessitates a below-market sale as a distressed seller. Typically, though, the target properties for this strategy require significant work, which is why they’re listed below market.
Renovate: After purchasing the building, investors then renovate and add perceived value (hence, “value-add”) to both existing tenants and potential tenants.
While the actual renovation work will vary from building to building, common BRRRR improvements include:
● New paint (interior and exterior)
● Updated lighting
● New floors
● Improved common areas and signage
This list certainly isn’t exhaustive. However, it’s important to note that, with a BRRRR renovation, investors don’t completely overhaul the building.
Rather, the purpose is to renovate to the point that the building appears new (or at least far newer than pre-renovation) while staying within the project budget, a critical requirement of the replicable nature of the BRRRR strategy.
Rent: With the building looking like new, investors need to find and screen quality commercial tenants.
Unlike residential leasing, which can be done quite effectively by non-professionals with the help of some free online software, the intricacies of commercial leasing make hiring a professional leasing company highly recommended.
The quality of these tenants - and the rents they pay - will drive a project’s net operating income (NOI) and, by extension, commercial valuation.
Refinance: This step is where buying under-valued properties and staying within the renovation budget becomes so crucial to BRRRR success.
Assuming the first two steps have been completed within budget and the rents drive the target NOI for the project, investors can refinance the project based on market cap rates (and the associated increased valuation) and pull all of their initial cash out of the investment!
However, unlike a commercial equivalent of a “fix-and-flip,” once you pull the cash out of a BRRRR deal, you still own an income-producing property.
Repeat: Here’s how the replicable nature of the BRRRR strategy comes together.
With the investor’s initial capital returned (and sometimes more, depending on the market and project quality), that money can now be reinvested in another BRRRR deal.
If you poll a group of real estate investors, the largest obstacle to most deals is raising the initial capital. With BRRRR, this obstacle becomes irrelevant after the first deal, as the initial investment for one project becomes the same for the next (and the next, and the next after that, etc).
Option 3: Long-term Buy and Hold
Certainly not a creative name, this strategy is self-explanatory: an investor buys a commercial property and holds it long-term.
The appeal to this strategy is that it can be applied to any type of commercial property, depending on the operational objectives of the investor.
Determine your target property type: This is where the investor’s operational objectives matter. Put simply, how involved do you plan on being in the day-to-day operations, and what’s the big picture goal for the property?
Here are some considerations:
● Investor involvement: This is a standard trade-off in real estate. If you’d like to manage the day-to-day operations of the business, you’ll likely receive higher returns on the project. However, involvement also means that A) the building needs to be in your geographic area, and B) the time you put into managing this building can’t be used to focus on new investments.
● Appetite for risk: If an investor’s looking to seriously build wealth, a riskier investment may make sense. However, if simply looking to generate cash-flow while maintaining wealth, investors should look for a more stabilized property with quality, long-term tenants in place.
● Overall objectives: What’s the overall goal in this project? An investor looking to sell on a 10-year horizon will likely take a different approach to target properties compared to one looking to build a commercial portfolio to be passed down in inheritance.
Analyze, or underwrite, the investment: The ability to cover expenses while generating cash flow is critical to the long-term buy and hold strategy.
As such, investors need to have an in-depth understanding of the commercial real estate underwriting process.
A failure to properly underwrite this deal could make the difference between a long-term, income-producing asset and the need to make an emergency sale at a loss.
Drop us a note for assistance with underwriting a commercial real estate deal.
Property operations: Returning to the target property type, this is where investor objectives matter.
Typically, investors do not want the headache of day-to-day involvement in a property’s operations, particularly investors seeking to continue building their portfolios.
To free yourself from these daily responsibilities (and continue focusing on new investments), hiring a quality property management company and, if necessary, a commercial leasing agent, is key.
This operational team should be confirmed during the underwriting and due diligence phases to ensure smooth operations immediately following purchase, as an effective management/leasing team will enable:
● Outstanding relations with tenants (current and future)
● Reduced vacancy rates (and, by extension, increased investor returns)
● Regular preventative maintenance to avoid unnecessary capital repairs
● Solid financial and operational reporting for investors (critical for access to credit in future investments)
Once the investor achieves this stabilized, hands-off status, he or she can then turn attention to new commercial real estate projects without the stress and headache of dealing with the daily operations of this property.
Option 4: Owner-occupied Buildings
In the residential real estate world, “house hacking” has become quite the trend. It essentially means the property owner lives in one unit (or room) of a house while tenants live in the other ones, so the rents cover the owner’s living expenses.
This is simply the commercial equivalent to this model. In this strategy, investors move their businesses into the target property (and maybe lease space to another couple tenants), and use these rents to pay the mortgage.
Here’s an overview of the key elements of the owner-occupied building strategy:
Aligning business and property: As you’ll be moving your own business into the target property, it’s critical to ensure that the property type and location actually support the needs of the business.
Investors may find the best deal in the world, but if the property doesn’t support the needs of the business, this model won’t work (though that may suggest pivoting to one of the other investment strategies from this article).
Put simply, this strategy re-prioritizes elements for the investor. Instead of investment first, business second, owner-occupied buildings call for a business first, investment second approach.
If your business isn’t making money, your property won’t be making money, either. However, as a hedge for this reality, many investors will include at least one other tenant in this strategy, as this will help offset building costs.
Financing considerations: If the investor’s occupancy meets certain criteria, owner-occupied financing may be an option. Though some lenders may have slightly lower requirements, most require owner businesses to occupy at least 50 percent of the property to qualify for owner-occupied financing.
Meeting these criteria can provide significant benefits to an investor.
As with all loans, terms on commercial real estate lending are driven by risk. Similar to a homeowner receiving significantly better terms on a primary home mortgage compared to an investment property, owner-occupancy of commercial property reduces the actuarial risk for lenders.
Consequently, investors using this strategy can expect to receive better interest rates and lower down payments than with a traditional commercial real estate loan.
Tax and entity considerations: Investors using this strategy should consider purchasing the property under a separate legal entity than their business, that is, purchase the building under its own LLC.
Next, your business leases the space directly from this property entity. By doing this, you provide a liability protection wall between your business assets and the building itself.
In addition to the liability protection, this set-up allows the business to deduct its rent payments as necessary business expenses. Those funds are passed on as rental income for the property entity, which is subsequently offset by the MACRS depreciation associated with the building, leaving more cash in your pocket.
As an added bonus, if investors ever decide to sell the business occupying the property, they still have a high-quality tenant in place for their property investment.
Option 5: The Land Bank Model
This final commercial real estate strategy also entails the most delayed returns and, therefore, should be used by patient investors with long-term planning horizons.
With land banking, you analyze a specific market and buy a piece of land you believe to be in the path of future development. Then, you wait.
In theory, this is a relatively hassle-free investment strategy. There’s no building maintenance or headache-inducing service calls - just property appreciation as the local development gets closer and closer to your land.
Eventually, you can either sell it for a solid return or, for a more active investment, partner with an experienced developer to build out the property.
Here are some considerations for investors thinking about the land bank strategy.
Land considerations: While the above seems like a surefire win (just buy, wait, and get rich, right?) a failure to properly analyze land prior to purchase can doom the deal.
First and foremost, investors need to have a solid understanding of how zoning works within the municipality. For example, land zoned for farming use either A) cannot be used for anything else, or B) needs to be rezoned via the required municipal-specific procedures to meet investor needs.
Investor due diligence requires both avoiding the first of these scenarios while having in-depth knowledge (or relationships with attorneys having this knowledge) to handle the rezoning application process of the second scenario.
You may have a perfect vision for commercial development on a piece of land, but if the zoning doesn’t align, the plan is dead on arrival.
Financing considerations: With this strategy, investors need to decide whether or not to finance or pay cash for the purchase. Both options have their pros and cons, and investors should consider their unique situations.
Paying cash has its benefits, as the land in this model does not produce any income.
On the other hand, there’s an opportunity cost to tying up too much cash in land. If investors can leverage a land purchase while gaining a solid return on the other funds, they may be able to both offset the land carrying costs while still generating cash flow.
But, the Great Recession demonstrated the clear risks of the leveraged option, with landowners needing to pay all loan, property tax, and other holding costs associated with the land while watching other income sources collapse.
Exit considerations: Land banking, though a more passive strategy than some of the others in this article, should not be viewed with a “set-it-and-forget-it” philosophy.
Rather, investors should maintain the appearance of the land with regular landscaping, trash pick-up, and squatter removal. By doing this, you increase the likelihood of potential purchasers seeing value in the land and making you an offer.
Additionally, if you have experience developing land (or just have a good vision for this particular plot), you can use the holding period to put together a proposed development plan. These plans could increase the perceived - and actual - value of the land by providing potential developers a pre-built vision.
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We recognize that, even after outlining the above options, entering the commercial real estate market can seem daunting to new investors.
That’s why we’re here to help. The Pocket Broker team lives and breathes commercial real estate, so drop us a note to see how we can help you achieve your unique objectives!