As mentioned before, investing in commercial real estate has various benefits and risks that you should be aware of before investing in real estate. Now that you understand these unique elements of the commercial real estate investment process, let's explore some best practices for investing. New investors in the commercial real estate sector often take on too much, too quickly, and feel like they're out of control.
What you should do
With all this in mind, if you're ready to invest in commercial real estate, there are a few important things you'll want to do before you make the investment.
Thorough due diligence
This is the most time-consuming task, but also the most rewarding, as it gives you valuable insight and knowledge about the property. To make sure you know everything, this process should be thorough. This means reviewing the property's current and past financial performance to understand what revenue you can expect. You should also conduct market research on the area where the property is located to get a better idea of potential customer levels and foot traffic potential.
Inspecting the physical condition of the property is also a must, to determine what issues need to be addressed before you take over the property and what work or repairs may be required in the future. Ideally, a professional inspection should be carried out during this process to document the property's condition and any objective recommendations.
Pay attention to value indicators
If you are serious about investing in commercial real estate, there are several value indicators you should pay attention to. These include details such as the selling price of the subject property and the selling prices of similar properties in the area. Similar buildings and properties in the vicinity should give you an accurate indication of the fair market value of the property.
You should also start by considering the gross rent multiplier, which will give you a rough guideline of the property's payback period, without factoring in other expenses like repairs, vacancy fees, insurance, property taxes, etc.
At the same time, you should also keep in mind what kind of cap rate you are expecting for each potential investment. These percentage values serve as a useful guide for many investors to identify the level of risk they are willing to accept and avoid buying properties that are above their tolerance threshold.
Choose the “right” industry
You can choose from office, industrial, retail and multi-family properties, but you need to choose the industry that best suits you. Each type of property has its own risks and benefits that you need to fully understand. What might be attractive to one investor in a retail property might be a headache for another, so you need to be absolutely sure that you are ready to take on all the responsibilities. You need to evaluate the pros and cons of each asset class and choose the one that best suits your needs as an investor and your capabilities as a landlord.
Something you can not do
Now that we’ve covered the important steps to take when investing in commercial real estate, let’s discuss the big pitfalls you want to avoid. These are some of the biggest mistakes made by new investors looking to get into this space.
Going Alone
One of the biggest mistakes many new investors make in commercial real estate is trying to do it all themselves. This type of real estate requires careful consideration and evaluation to make a solid investment decision, and that requires digging through a ton of information.
Successful commercial real estate investors hire a team of professionals to help them with a variety of tasks, including setting an overall strategy, conducting the necessary market research, sourcing viable properties, and even managing the property once acquired.
Focus solely on potential ROI
It's easy for new investors to get caught up in the potential returns they can make from real estate and lose sight of the full scope of responsibilities that come with real estate and what those income streams will actually look like. Focusing only on the potential return doesn't take into account the time value of money or even the timing of any regular cash flows that may occur. Plus, the longer an investor waits for potential returns, the harder it becomes to accurately predict what those returns will realistically look like.
Instead, you should focus on factors that provide more viable and realistic income expectations, such as regular cash flows, potential long-term property value appreciation, and internal rate of return.
Underestimating costs
Oftentimes, alongside placing too much emphasis on the potential return, many investors underestimate the overall costs they may face with their investment. These costs range from paying property taxes and insurance to the expense of making repairs and renovations, if necessary. Repairs and renovations, in particular, can quickly become a significant expense if not factored in from the start.
To avoid this, ideally you will identify repair issues during your due diligence and plan as best you can to avoid being surprised by the costs. However, sometimes other costs will suddenly come up that you will need to deal with, so you will need to factor repair costs into your budget. You can expect minor repairs to occur quite frequently during your ownership. You can also expect to deal with water leaks, electrical issues, infrastructure issues, and other unexpected issues at least once during your ownership, depending on the age and condition of the building.
financially unreasonable
The final pitfall to avoid is overinvesting. As with any investment, don't overinvest or put yourself in a risky position by putting more money into it than you can afford to lose. If you put all your money into one property, an emergency in that property or in another aspect of your life could have disastrous consequences.
Smart investors know how much risk they can take and try to balance risk with financial responsibility. This balance will be different for every investor, but the cardinal rule of never investing money you can't afford to lose is a great starting point. It's also important to remember that investing in real estate, especially commercial real estate, is a long-term investment strategy and should be treated as such. It usually offers lower returns but more stable returns. Those looking to make a lot of money in a short amount of time may be put off by the need for patience.