13 Things You Must Know Before Investing in Commercial Properties

The commercial side of real estate can be an appealing proposition for any investor, as investing in commercial properties allows you to dip into a new pool of clients and grow your business interests. As with most investments, commercial real estate property investing comes with rewards and risks.  

For investors who have the money to risk, the rewards can be significant. However, taking a passive commercial real estate investing approach without considering all business aspects first can be a risky proposition. These tips should make your investment a more rewarding one.   

What Is Commercial Real Estate Investing? 

Unlike single-family homes, commercial property investment opportunities include retail buildings, office and industrial sites, apartments, warehouses, and mixed-use developments that may encompass a combination of office, apartment, and retail space.  

In other words, commercial properties are used primarily for business properties, while residential properties serve as private homes. Now that you understand the difference between the two, it’s time to learn how to know if a commercial property is a good investment for you.  

Level of Investment and Return 

Real estate investors often ask, “Is it better to invest in commercial or residential property?” In most cases, the answer to that question lies in the level of investment and rate of return you might expect.  

Compared to residential investing, one of the disadvantages of commercial property is that everything takes longer – like finding new tenants, build-outs, and renovations. Due diligence is measured in months and not merely days. But the leases are also longer and the rents heftier, often resulting in a higher return on investment.  

Other advantages of owning commercial real estate (CRE) include dealing with conscientious tenants and property appreciation. With commercial property investing, patience is the key.  

Not All Property Types Are the Same 

The five main CRE assets are industrial, office, retail, multi-family, and special purpose. Other types of commercial real estate investments include self-storage, medical, land, elder care, and hotel. Bear in mind that risk assessment is very different in the commercial sector compared to residential real estate and that it varies by property type. An important investing rule of thumb is to avoid failing businesses or business models altogether.  

That said, if your existing tenants include grocery stores, restaurants, or banks migrating online,  

you need to assume that they will default on their lease at some point. Prepare your insurance accordingly to ensure that you are covered when defaults happen.  

Know the Market Area and Supply & Demand 

Much like buying a home, location is vital to the success of running a commercial property. However, don’t be fooled by what your eyes may not see under the surface. In the world of CRE, a perfect location is more than just about traffic flow, community amenities, or distance from churches, schools, and hospitals. Instead, base your decision on considerations that include perceived supply and demand as the future unfolds.  

Consider Area Demographics and Trends 

While considering factors like supply and demand, finding the right types of commercial real estate assets and their corresponding locations should always depend on variables like: 

• Demographics 
• Household incomes 
• Security and crime statistics 

It’s also essential to understand the dynamics of the property you are choosing. For example, if you are looking for the best place to invest in commercial property – like retail – consider the immediate and long-term impacts of e-commerce on tenant and consumer demand. If you are looking at an office building, trends like remote work and telecommuting should influence your decision.   

Understand Market Cycles 

Since nothing lasts forever, CRE investors also need to understand the cyclical nature of the market they are investing in. Having a firm grasp of market fundamentals like competition, occupancy and vacancy rates, rents, along with legal implications such as tax laws, permits, and licenses, will allow you to weather economic downturns and enjoy higher yields through good markets and bad.  

In the end, being able to anticipate market cycles will enable you as an investor to fine-tune your commercial property investments and diversify your asset portfolio. 

Do Thorough Due Diligence  

Read any good commercial real estate investing books, and you will find that due diligence is one of the primary aspects of successful asset management. When compiling a practical due diligence checklist, be sure to include detailed records for all these categories: 

• Tenant information 
• Operating information 
• Building information (plans, reports, etc.) 
• Miscellaneous items (loan documents, licenses, approvals, permits, title survey, etc.) 

Have a Contingency and Capital Reserve Fund 

Uncertainty accompanies any investment, and commercial property is no exception. Regardless of all your planning and preparation, unforeseen factors will influence your yield one way or the other. One way to hedge this uncertainty is to account for cost contingencies.  

Cost contingencies are additional funds you set aside to cover unexpected expenses. Use those funds to help cover your debt service until the property is stabilized or during times when there is negative cash flow while you are making improvements to the property. In CRE, the standard contingency budget is usually 5% to 15%, but that amount may vary depending on the asset and whether it is performing according to expectations.  

You should also have a capital reserve fund, an account that has money set aside for long-term improvements or unexpected expenses above your initial capital improvements. Ranging anywhere from 3% to 5% of gross rents, this is money you set aside before netting any positive cash flow.  

Be Prepared for Setbacks and Extended Timelines 

Most new CRE investors set unrealistic timelines to build, renovate, fully lease, or reach market rents for their property. But renovations, new construction, changing management, and implementing new systems all take time. The first commercial real estate investing tip for dummies is accepting that there will almost always be setbacks that put you behind schedule.  

Assess Risk by Property Type 

Risk assessment is very different in CRE compared to residential and varies widely based on asset type. The yield of two residential properties next to one another may be quite similar, while the yields of two commercial buildings in the same location might fluctuate independently.  

Investing in apartment buildings in an area filled with vacant multi-family properties isn’t very smart. Before allocating your hard-earned bucks, know the potential risks for the different types of commercial real estate investments.  

Know the Time Frame for All City Approvals 

Another possible delay as a commercial investor is obtaining city permit approvals. Depending on the location of your property, it could take one month to several years to receive a building permit. Before investing in a commercial property, schedule a meeting with the local authorities to determine the required approvals. Those officials should include site planners, city council members, planning and zoning authorities, and others.  

Lease or Purchase? 

As a CRE investor, your two options are buying or leasing. The pluses and minuses of purchasing include: 

Pros 

• Equity in the property builds over time 
• Asset value appreciates over time 
• Potential for rental income 
• Tax breaks (interest, depreciation, and non-mortgage expenses) 
• Control of the property 

Cons 

• Upfront down payment  
• Must qualify for financing 
• Prepayment penalties on the loan 
• Liability insurance required  
• Potential for loss of capital or liquidity 

Capitalization Matters 

To be successful in CRE, you need capital and lots of it. Knowing how to invest in commercial real estate with little or no money requires the ability to find a patient source of capital. In addition to getting the best deal possible for your investment, capitalization is key when investing in commercial assets.  

Location is Still Key for Investing in CRE 

As we’ve seen, investing in CRE hinges on knowing everything you possibly can about a given location. If you want to know if now is the time to invest in commercial property in Chicago, Millennium Properties can help.  

At Millennium Properties, we are your premier partner to find, sell, and invest in Chicago-area commercial real estate. With headquarters in the Loop, we’re located in the heart of Chicago’s bustling commercial real estate marketplace. Since 1996, we’ve helped hundreds of business clients rent or purchase commercial properties in prime Chicago locations. If we can help you find a first-rate commercial real estate opportunity, contact us today.