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Real Estate Education Center

What is Commercial Real Estate?

Commercial Real Estate is a broad categorization covering all properties purchased that are not used as primary residences. This term also encompasses both the property itself, natural resources and any buildings constructed on the land.

What kinds of properties can you buy and sell?
There is a very wide range of properties available in the commercial real estate market. Searching for the right commercial properties and figuring out what type is best for your investment needs is critical to your success as a commercial realestate investor. Some common types are:

Apartments - Small and medium multi-tenant residences make for a wonderful introductory investment. Each month, income is generated from rent, and the needs of your tenants equate with practical living. However, owning apartments can also be a challenge during periods of high turnover or tenant conflicts.

Office Buildings - These properties are typically leased by businesses, including corporations, and serve as their primary work environment. Offices yield the benefits of longer-term leases at favorable rates from high paying companies. However, this type of commercial property is more susceptible to market forces. When the economy is bad, vacancies rise when businesses are forced to close their doors and employees laid off.

Retail property - Owning a storefront can make a great business opportunity for an involved investor. Due to the variety of potential tenants (think supermarkets to single retail stores), the scale of facilities will vary widely. However, the potential for long-term leasing and the ability of clientele to raise the value of the overall retail complex is significant.

What types of people invest in commercial property?
Most commercial property investors have a significant amount of capital (100k+) and plan to invest over a long timeframe (5+ years). At this level the investments tend to be fairly stable cash flow generators with a decent chance at appreciation. More experienced investors are able to increase the total capital invested to billions and focus on much shorter timeframes. This represents a higher risk, but by becoming experts in repositioning property these experienced investors can generate a much greater amount of revenue (targeting 20%+ rather than 10%).

How much time does it take to invest?
We recommend dedicating a minimum of 10 hours of week to invest when you get started. This may seem high, but with the amount of capital you are putting at risk, it is best to ensure that you are paying attention to your investment. Also, there is great potential for you to improve the property you purchase to increase its sale value. As you become more experienced, many find that commercial realestate investing becomes a passion and a complete career. Alternatively, once you get the hang of the investment game and hold a few stable properties with great revenue the time required to maintain them will diminish over time (potentially less than 10 hours a month).

Partners You Need for a Successful Commercial Real Estate Deal

When approaching the world of commercial real estate, it is important that you remember that you are not alone! This world contains a great number of partners and allies essential to finding, formulating, and closing a great deal.

Commercial Real Estate Broker
These brokers are in the business of selling property. They do it for a living, and commonly have a great deal of experience and contacts across the commercial real estate world. This positions a broker to be a core ally in finding the right property for you. Not only do they know of several deals, but also they probably have many clients just like you and can help you better understand your needs as an investor.

Mortgage Brokers
A mortgage broker is your partner in finding financing for your real estate deal. There are several different ways to acquire the capital necessary to purchase a commercial property. A good mortgage broker can help you navigate this world and find the right loan for your financial needs. Additionally, many commercial mortgage brokers are very experienced in analyzing deals and may be able to help you validate deals before going in front of a loan officer.

In order to ensure that your rights are protected and that there are no legal surprises after the sale, retaining an attorney specializing in commercial real estate is a must. At the very least, you will need a title attorney to conduct a title inspection and draft the terms of your closing agreements. Additionally, a good commercial real estate attorney can help evaluate land use issues. Should a deal turn sour, a ligation specialist to advocate for your rights and ensure that you are protected is well worth it.

Insurance Agent
A commercial real estate insurance agent will help you insure many aspects of your investment against unforeseen circumstances. Commonly, you will want to insure your property against such events as fire or tenant damage. However, there are a variety of coverage options that your commercial insurance agent can offer, ranging from title fraud to lost income due to zoning changes.

Property Managers
Often, it is not the best use of your time to personally manage the day-to-day operations of your commercial property. A commercial property manager (or commercial property management company) will help maintain the basic operation of your property by collecting rent and performing maintenance. Additionally, a good property manager can help improve tenant relations and even help you increase occupancy with a well-staffed lease office. However, a bad manager can steal from you, alienate your residents, and even damage your property.

From time to time, you will need to make some capital investments to your commercial real estate. Most often, this will take the form of large repairs (roofing/parking lots/heating systems), which simply break down over time. Also, if you seek to increase the value or reposition your property, you will need to refurbish or even add on to the original structure. A good commercial property contractor can help you find and coordinate the wide range of construction workers and tradesmen needed to complete large scale development projects.

Escrow Agent
The commercial escrow agent is a neutral third party who simply holds the money in a commercial real estate transaction until the final agreement is signed and the property closes. The escrow agent is ideally a party who can be trusted to follow the escrow agreement to the letter with impartiality.

During the inspection period, you will hire a wide variety of specialists to evaluate your potential commercial investment. These inspectors range from those who check on the structural integrity of a building to the environmental conditions of the land upon which it rests.

Maintenance Specialists
Many properties rely on systems to be in top form to continue operation. One common example is the HVAC specialist who is certified to maintain and repair heating or air conditioning units on your property.

It is important to think of each of these vendors as long-term partners in your commercial real estate investment career. Especially if you are investing in the same local market, you will be able to work with proven vendors time and again. As you build these relationships, each member of the commercial real estate "ecosystem" can become your ally by providing advice, trending information, and possibly helping you source deals through their other clients.

Ten Easy Steps to Purchasing a Commercial Real Estate Investment Property

Purchasing Commercial Real Estate in a Nutshell

  1. Determine Your Needs - figure out what's right for you!
  2. Read the Market - understand where and when to buy.
  3. Find a Property (and seller) - discover the right property for you.
  4. Perform Basic Valuation - figure out how much the property is worth.
  5. Put in a Starting Bid - make first contact with the seller.
  6. Submit your Letter of Intent - outline the formal terms of the purchase.
  7. Perform a Complete Valuation - use the hard numbers to revalue the property.
  8. Perform Due Diligence - do a deep dive to uncover any defects in the property.
  9. Close the Deal - sign the final sales agreement.
  10. Running your new Commercial Real Estate Investment - things to look for in your first few months as a commercial property owner.

Determine Your Needs
What timeframe are you looking to purchase in? How much capital can you access for the purchase, i.e. how much property can you afford? Are you planning to invest a lot of time working on the property? Are you looking for an income property or long-term appreciation?

Read the Market
Timing is one of the most critical aspects to the purchase of a commercial property. Since property location is fixed, it is highly susceptible to the ups and downs of the local economy. So, it is important to evaluate the status of the general locale, whether it be a county, city, or state. The economy will influence the overall availability of tenants, and therefore, the likelihood (or not) that your property will be occupied.

Find a Property (and Seller)
There are a wide variety of ways to find investors for your property. Here's where online commercial real estate multiple listing services such as cimls.com are useful. Just go online and browse properties in a desirable market (note: that this does not necessarily have to be where you reside). Other sources of sellers include:

  • Commercial Real Estate Brokers: most brokers are aware of a large number of properties and have good connections with current sellers.
  • Real Estate Clubs: most localities have regular meetings of other investors who are interested in the -commercial real estate market. Networking with this peer group can be both informative and lucrative.
  • Local Classified Ads: a simple way to find local properties that are potentially not listed anywhere else.

Perform Basic Valuation
There are two essential types of valuation to conduct.

1 - Absolute Value
A commercial property's absolute value is based upon the amount it is expected to appreciate, and the revenue it is expected to generate.

2 - Relative Value
The relative value is the going price for a property of a given type in a specific market. This is useful for comparison shopping, since the relative value of a property may often times be lower than the absolute value (this is a good indicator of a strong purchase).

For a complete primer to commercial real estate valuations, please see our other article: Commercial Real Estate Value 101.

Make Contact with the Seller or Commercial Broker
This is the starting point of negotiations. Both the initial timeline and price are initial guidelines set forth by the seller to begin the conversation - they are rarely the rule. Throughout the negotiation process, you will discover more about your respective motivations and a price that justifies a sale to both parties. The key piece of information to start your complete valuation is the Operating Statement. Ideally, you can collect 2-3 years of the most recent Operating Statements broken down by month. This will outline the property's revenue and expenses over time. Using this information, you can perform the initial valuation as well as look for trending in the numbers (has profit increased or decreased?).

Perform Complete Valuation
Using the operating expenses and other information gathered from the seller, a buyer may revaluate the initial pricing of the property. Additionally, this is the time where a buyer has the data to begin developing models around the expected revenue from the property. While only projections, these models serve as critical negotiating tools relating the time it takes to recoup your property investment as a critical part of the selling price.

It is also a good idea to run the final deal by your mortage broker and lender - they will often times ask good questions or poke holes in inconsistencies - the lender is on your side. If you fail, the lender fails - use your ally!

Submit your Letter of Intent
Send out a Letter of Intent outlining your interest in purchasing the property and tentative terms of the purchase. This is the first formal bid in the process - essential to opening the way to give you the information necessary to fully evaluate a commercial property. Essential elements to the Letter of Intent include:

  • Location: formal address with the property name to ensure that there are no misunderstandings
  • Price: total sum you are willing to pay for this property
  • Purchase Date: the effective date at which the seller and buyer agree to sign the Purchase and Sale Agreement
  • Inspection Period: period during which you will evaluate all aspects of the property with the help of licensed professionals.
  • Deposit: sum of money to be held in escrow to validate your intent to purchase the property. This amount is usually around 3%, and is typically (but not always) refunded/credited back upon completion or dissolution of the sale
  • Access: confirm that you and your representatives (inspectors, etc.) will have the access needed to evaluable the property
  • Commission: outlines amount or percentage of commission to be paid by the respective parties

Once the terms of the Letter of Intent are agreed upon, the buyer will put down a deposit. At this time, the assumption is that if there are no surprises unearthed by the final investigation the deal will go though at the agreed upon price.

Perform Due Diligence
Previously, the pricing on the property is typically based upon the assumption that nothing else is wrong with the property. During due diligence, the buyer should be on the lookout for potential deal breaking issues with the property, or major issues which can be used to bargain down the asking price. It is the buyer's job to play detective here to make sure that every piece of the seller's story fits. Once the purchase closes, it will be very difficult to reverse - even in the case of major issues with the property.

Some key pieces of the commercial real estate investment property to evaluate include:

  • The Rent Roll: This is a full list of the current tenants, their lease terms, and lease term end dates. Take a look at all of the leasees and renters to evaluate their credit worthiness and overall quality - this will determine the initial risk of your cash flow. Additionally, if you plan to reposition the property (for example, transform a strip mall into a high end restaurant row) - this is where you can begin planning to transition your clientele.
  • Estoppel Letter: This letter, which is sent to all tenants, legally confirms their lease terms and payments.
  • Property Survey: Understand the exact perimeter of your plot of land.
  • Expenses and Capital Expenditures (for 2-3 years): This provides notice as to the conditions of the major aspects of the building and facilities. Recently replaced items (a.k.a. capital expenditures) should be in great condition. Watch for increasing expenses (i.e., HVAC repair bills). These indicate failing appliances, and good reasons to lower the bid price.
  • Environmental Reports (Phase I): Occasionally, commercial land may have special properties that restrict its use. This can range from hazardous chemicals to being inhabited by endangered species. And, while unusual, an unseen environmental hazard can render a property useless (and valueless).
  • Land Use/Zoning: It's always good to have a commercial real estate attorney double check the use laws regarding your property. These professionals may also be able to inform you of any upcoming changes in zoning.
  • Real Estate Tax and Insurance Bills for the previous three years: these items should validate the figures already given to you in the seller's operating expenses report for the last three years
  • Service Agreements: These agreements will serve as the starting place when the buyer staffs a new property by using existing vendors/property managers.
  • Title Evaluation: Believe it or not, the title to a property (proof of ownership) is often subject to fraud, liens, or other legal entrapments. It is essential to have a specialized Title Agent and Commercial Real Estate Attorney evaluate the property's title. Buyers should strongly consider purchasing title insurance from a commercial title agent, which will protect them from many common title issues.
  • Find a Management Company: This step is a non-essential, but it resolves a major risk (and may result in an ally) before fully committing to the deal.
  • Written Commitment for a Loan: Surprisingly, often a great deal is closed, but the buyer is unable to pay. To avoid this issue, buyers should run their due diligence and information though a Mortgage Broker and Loan Agent to ensure that they have a commitment for financing before the deal is closed.

Once a buyer has completed all of these items (and more!), he or she is ready to formally sign off on the inspection period. If there are any issues discovered during this process, the buyer has an opportunity to renegotiate the price or other terms of the deal. However, if no issues are found, the buyer can sign off on the inspection period, and the deposit becomes non-refundable - committing the buyer to the deal.

Close the Deal
At this point, the hard work is over. The buyer and seller will come together to draft the Purchase and Sale Agreement. This represents the formal commitment to purchase the property. It's best if both parties have the agreement reviewed by their respective attorneys. Before you close - check the latest profit and loss statements for up to date information to ensure that there are no unforeseen trends or sudden changes. If all is well, then the Purchase and Sale Agreement will be signed and the deal is officially closed.

Start Running your new Commercial Real Estate Investment
Now that the sale is over, the real work begins. Some action items for the new owner include:

  • Transferring utilities to the new owner (you!)
  • Sign up vendors/service providers for services such as maintenance, janitorial work, landscaping, and security - or have a management company do it for you.
  • After three months, you should have enough experience with the rhythm of the property to look for ways to cut expenses and increase revenue.
  • You can also start to reposition or upgrade your property in order to increase revenue or prepare it for resale.
  • Think about relisting your property. Pick an ideal price - if there is an eager buyer, it could be your turn to turn an early profit!