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If you’re new to the world of commercial real estate, you may be unsure how to get started.
Commercial real estate, or CRE, refers to property that is used exclusively for business purposes. You make money in CRE by selling it, holding it or leasing it to tenants for income-generating purposes. Local zoning laws determine which properties will be designated for commercial use and which will be residential spaces.
Tips for success in commercial real estate include determining your investment goals, developing a business plan and working with an experienced CRE broker. You’ll also want to familiarize yourself with the basic industry terminology. For example, it’s essential to know the different types of CRE available on the market. Other topics to learn include different methods for investing in CRE, key performance metrics and parameters for leasing commercial property.
- Types of Commercial Real Estate
- Investing in Commercial Real Estate
- CRE Performance Metrics
- Leasing Commercial Real Estate
Types of Commercial Real Estate
The four main categories of commercial real estate are office, industrial, retail and multi-family.
Office space refers to properties that are mainly used for corporate and professional workspaces. This category is subdivided into Class A, B and C properties.
- Class A office buildings feature a luxury, modern aesthetic and are located in high-demand areas. Most feature new or fully remodeled construction, state-of-the-art infrastructure, reliable service and desirable amenities.
- Class B properties are in good condition and feature quality construction. However, they lack the modern aesthetic and high-demand locations of Class A properties. They are an attractive option for those looking for a balance of quality and affordability.
- Class C buildings require significant renovation, offer few modern amenities and are typically located on the outskirts of a city or community. They can also be characterized by lower demand and a somewhat dated aesthetic appearance.
Properties for industrial use are designed for manufacturing, logistics and similar activities. They are heavily regulated by zoning laws and other policies. Examples include heavy manufacturing, light assembly, warehouses and other storage facilities and even oil refineries.
This category includes properties intended for purchasing goods and services by end consumers. All of the following are examples of retail facilities:
- Shopping centers and malls
- Restaurants and bars
- Hair salons and spas
- Department stores and clothing boutiques
- Gyms and sports centers
- Other establishments
It may sound counterintuitive to think of an apartment building as a commercial property, since people live there. Multi-family properties are a special type of commercial real estate owned by a landlord and rented to tenants exclusively for residential use. Besides apartments, other examples might include townhouses, condominiums, duplexes or even assisted living communities with dwelling space available for rent.
Investing in Commercial Real Estate
The two main options for investing in commercial real estate are direct and indirect investment.
Direct investment involves owning and/or managing a commercial property yourself. It is best to work with an experienced CRE firm to advise you on researching and purchasing the best property to meet your goals. The primary way to earn a return on your investment is to collect rent from commercial tenants, or from residential tenants in the case of a multi-family property.
It is highly recommended that you enlist the services of a professional property management company to assist with the responsibilities that come with ownership. Services include finding, managing and retaining tenants, as well as overseeing leases and financing. Property managers also coordinate basic upkeep and marketing for the property.
Indirect investment means holding securities or investment funds that own shares of commercial real estate. One popular example of indirect investment is real estate investment trusts, or REITs. A REIT is a publicly traded entity, similar to a publicly traded stock, which provides a feasible opportunity for more people to invest in commercial real estate.
CRE Performance Metrics
As with all investments, there are key metrics for measuring the performance of commercial real estate. They are useful for gauging profit potential and for tracking your investment over time.
The capitalization rate, also known as cap rate, measures the risk of buying a particular commercial property. It is the ratio of net revenue to current market value of the property. A higher cap rate indicates higher risk and a lower initial investment, while a low cap rate indicates a higher property value and lower risk. Cap rates will fluctuate over time in response to market conditions.
Internal Rate of Return
The internal rate of return, or IRR, projects the future value of an investment in today’s dollars. Unlike traditional measures like return on investment, IRR considers the time value of money and cash flow. It is an ideal tool for assessing the potential value of a property.
Cash on Cash Return
Cash on cash return (COC) measures the return on cash invested during a defined time period. It calculates the cash income earned in relation to the amount invested.
Sometimes referred to as cash yield on a property investment, COC is often used for investment properties that involve long-term debt borrowing. It is also used to project potential future cash flow.
Net Operating Income
Net operating income (NOI) assesses the profitability of a commercial property. It equals the sum of all revenue minus operating expenses. NOI is a pre-tax figure that excludes principal and interest payments on loans, capital expenditures, depreciation, amortization and income taxes.
Sources of revenue include rental payments and fees collected by the landlord. Operating expenses include the cost of running and maintaining the property. These may include insurance premiums, legal fees, repairs and janitorial services.
Leasing Commercial Real Estate
The most common CRE arrangement involves an investor or group of investors collecting rent from commercial tenants. Lease rates are typically quoted in terms of cost per square foot.
Types of Commercial Leases
Four main types of commercial property leases include:
- Single net lease: The tenant pays property tax in addition to rental costs.
- Double net lease: The tenant pays property taxes and insurance.
- Triple net lease (NNN): The tenant pays property taxes, insurance and maintenance.
- Gross lease: The tenant only pays rent. The landlord pays property tax, insurance and maintenance.
How to Determine Rent
Landlords calculate rent based on rentable square feet, which includes usable square feet and a percentage for common areas such as public restrooms, conference rooms, elevators, stairs and corridors.
Usable square feet refers to the entire space a business occupies, including storage and restrooms.
Monthly rent payments are determined by multiplying rentable square feet by the rental rate. Commercial tenants can expect to pay approximately 5% to 10% of gross sales per foot on rent. Sales per square foot is calculated by dividing gross sales by square feet.
A typical commercial lease term ranges from 1 to 10 years, with office and retail leases averaging 5 to 10 years. Choosing a longer leases often enables the tenant to lock in costs.
Besides rental payments, here are other costs tenants can expect to pay:
- Common area maintenance fees
- Percentage rent, which is the base rent plus a percent of sales to the landlord
- Security deposit
- Utility costs
Are you looking into commercial property investments? Not sure where to start? You’re in the right place! Get in touch with Commercial One Brokers today to learn about commercial investment opportunities in Branson, Missouri.