The Good and the Bad of Investing in Commercial Real Estate

Many residential real estate investors reach a point when they decide that transitioning to commercial real estate makes sense.  For a variety of reasons, this jump from residential to commercial real estate represents the next logical step in investors’ portfolios. 

In this article, I’ll outline the major advantages of investing in commercial real estate while also covering some of the associated drawbacks.  Specifically, I’ll dive into each of the following topics:

●      CRE Advantage #1: Flexible Financing Options

●      CRE Advantage #2: Passive Investment Opportunities

●      CRE Advantage #3: Potential for Economies of Scale

●      CRE Drawback #1: More Competition

●      CRE Drawback #2: Poor Management Risks

CRE Advantage #1: Flexible Financing Options

With residential real estate, investors have access to a fairly limited suite of financing options - typically just variations on a conventional, 30-year mortgage. 

With commercial real estate, investors have access to a far wider range of financing options, providing them significantly more flexibility in structuring deals. 

Between debt and equity financing options, investors can build their “capital structure” to maximize a deal’s returns while minimizing contributed capital.  Whereas residential lenders typically require the note holder on an investment property to contribute at least 20% of his or her own cash, commercial lenders allow for a more flexible equity structure.

The end result of this increased flexibility?  The primary investors in a commercial deal have the ability to 100% finance a project with a mix of equity (other investors’ money) and debt (financing from commercial lenders). 

Furthermore, from an administrative efficiency perspective, it’s far easier to finance one 50-unit commercial property than financing 50 one-unit single-family homes. 

Feel free to drop us a note if you need help analyzing commercial real estate financing options.  This analysis can seem challenging, and we’re happy to help!

CRE Advantage #2: Passive Investment Opportunities

Next, commercial real estate offers investors far more passive investment options than its residential counterpart.  And, as most investors get into real estate in the first place to earn more money while spending less time, these passive opportunities prove particularly appealing.  

I’ll dive more into this in the next section, but commercial properties frequently generate large enough NOI to justify on-site maintenance and management.  Conversely, single-family homes to quadplexes just don’t generate enough income to justify this expense. 

With stabilized real estate, in general, landlords far and away spend the most time A) dealing with maintenance requests, and B) marketing and leasing vacant spaces.  Consequently, the ability to pay for on-site maintenance and management - even if it cuts into NOI - drastically reduces the time investors need to commit to a commercial property. 

Furthermore, many commercial deals include triple-net lease structures, where the tenant is responsible for property operating expenses and maintenance, providing the opportunity for passive investment even without on-site support. 

CRE Advantage #3: Potential for Economies of Scale

Put simply, with commercial real estate, bigger is better, as larger deals provide investors the benefits of economies of scale. 

First, larger commercial properties require far more volume.  When investors outfit a duplex, it’s highly unlikely they’ll receive discounts on two of anything.  On the other hand, if you need to purchase 100 hot water heaters, you have tremendous leverage to demand per-unit discounts with vendors. 

Second, and referenced above, the income generated by a large apartment building may justify on-site maintenance and management.  If on-site management and maintenance payroll comes out to $50,000 per year, spreading that across a duplex translates to a per-unit expense of $25,000/unit - prohibitively high!

Conversely, spreading these same payroll costs across a 100-unit apartment building translates to $500/unit - still expensive, but far easier to justify in a property’s operating budget. 

Bottom line, on-site management and maintenance increases tenant satisfaction, decreases vacancy time, and limits (or eliminates) the time investors need to spend on the day-to-day operations of a property.  But, this expense can only be justified with the economies of scale commercial properties provide. 

CRE Drawback #1: More Competition

When new commercial investors look for properties, they typically look to buy and add-value to existing properties, as a full-spectrum commercial development requires significant experience.

 Due to their size and unique nature, far fewer commercial properties exist than residential homes.  As such, value-add investors face significant competition for a market’s commercial properties that A) are for sale, B) are within the deal’s price range, and C) have post-rehab projected NOIs to justify the investment.  

In other words, it’s tough to find commercial properties with numbers that make sense.  And, for the ones that do make sense, you’ll likely face a ton of competition. 

Local commercial real estate professionals can help you cut through the competition to identify ideal properties for your market and unique situation - need help finding reliable ones in your area? Drop us a note!

CRE Drawback #2: Poor Management Risks

While good management can increase the passive nature of a commercial property, bad property management can do just the opposite.  If you’re paying a property management company that fails to A) meet tenant needs, and B) quickly fill vacant properties, you end up paying for a service without receiving the associated benefit.

As such, commercial investors need to take particular care actually screening management companies (this becomes less of an issue with more experience and established relationships with management companies).  Here are some of the questions you need to ask, both of the company and its other clients:

●      How efficient is the company?  This will dictate the per-unit management expense.

●      How much experience does the company have?  An established - and successful - track record as commercial property managers generally means more reliability. 

●      Are they legally compliant?  Different states (and often municipalities) have different laws that property managers must follow - failing to comply with these standards can lead to significant fines and legal issues for owners.

In addition to answering these questions prior to signing a management contract, commercial real estate investors should also closely monitor the actual performance of any new management companies.  This supervision - at least in the initial stages of a relationship - will ensure that a commercial property management company successfully supports both tenant and owner needs, ultimately dictating the success of the property. 

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We recognize that, even after outlining the above information, tackling the challenges of transitioning from the residential to commercial real estate world can seem daunting.   

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!