How to Invest in Commercial Real Estate
Acquiring Commercial Property
What are ideal Properties?
Commercial bank-owned properties are available to people and businesses wishing to purchase real estate at affordable prices.
Real estate owned (REO) properties are owned by lenders, such as banks, following unsuccessful foreclosure sales that failed to result in the bank's obtaining an offer to buy the property for the outstanding loan amount.
The bank can legally repossess these properties. Usually the amount left owing on the loan is higher than the current market value of the property. However, the owner-bank is quite eager to sell these commercial properties to interested investors at excellent prices, and on very favorable terms.
Examples of Some Properties for Sale
Some examples of excellent commercial properties that are bank-owned, and available are:
- a new, 20,000-square-foot building located on a main thoroughfare
- a substantial, very impressive, 16,000-square-foot office building also on a main thoroughfare
- a beautiful building containing 24 offices and 13 restrooms, located next to a major highway
These examples and many more, show the caliber of real estate available in REO listings. The prices never have been better, so it's the right time to buy.
Properties such as these can be viewed through photographs on web sites of companies offering lender-owned real estate. Prospective buyers can qualify for purchase right on the Internet.
Advantages of Lender-Owned Commercial Real Estate
One of the greatest advantages in owning commercial property is the rate at which such property can be leased to responsible, established businesses. Unlike residential property, commercial real-estate is leased to motivated tenants who are in business to make a profit. This fact greatly benefits the commercial property owner by giving added security for dependable rental income.
Commercial property buyers are able to lease substantial square footage for extended periods of time to excellent businesses. Some leases can extend for 5 to 10 years in length. This is a major long-range benefit of owning commercial property.
A reputable real estate company, offering the bank-owned properties, can make agreeable purchase prices and financial arrangements available with a minimum of complexity for interested buyers of commercial REO properties. Investors can save a lot of time and energy by buying such property, already inspected and validated by a bank.
Because commercial property is customarily more valuable than residential, this factor works in favor of an investor-buyer due to the tremendous amount of capital investment saved by a discounted price in the high end of real estate figures representing tremendous economies of scale. Savings literally can be in the millions.
What are some additional advantages of buying REO real estate? The following are more of the practical benefits buyers can expect:
- liens are already removed, and taxes already paid
- lender-owned properties can be inspected, and are listed with professional real estate companies
- the owner bank itself generally offers financing on excellent terms
- title searches are often discounted by using the same title company used by the bank
- commercial REO property is typically in excellent condition
- in slow real estate markets, these properties are available at amazing discounts
With all these great benefits available, smart investors are looking to the best, local real estate companies for opportunities to view listings of commercial properties currently available in the community.
Although many investors would like to see a fifteen to twenty percent annual return rate on their investment, this may not be a reasonable expectation in a recession.
While there are great advantages to have rental money coming in, lots of commercial property owners today are finding it a safer bet to buy property that already has long-term tenants in place, rather than buying new commercial property with the risk of ending up with empty space due to difficulty finding tenants.
Rather than have vacant space in a property, it's better to reduce the rental price for the sake of having some income rather than none.
During recessionary times, the safest bet is to purchase moderately priced, smaller commercial properties rather than risk a large sum trying to buy a new luxury building without preexisting tenants.
But even a recession has its advantages. Since 2009 to the present (2012) there has been a buyer's market in the commercial real estate field. Purchase contracts should be available with provisions that favor the buyer, whereas before the recession, the seller would have the upper hand in inserting clauses sometimes dangerous to the buyer.
The key to wise commercial property buying is to generate a stream of income for the owner. This is true in all types of property, whether it's a condominium project, hotel, raw land zoned for commercial development, an office building, factory, mall, or industrial complex. But the stream of income must be offset by ongoing expenses and, in some cases by special maintenance costs that are unique to the type of property being purchased and its particular location.
The three figures to take into account when considering the purchase of commercial real estate are the selling price, the potential or actual income, and the ongoing or expected expenses.
Investors have a formula to determine the "cap rate" or "return on investment rate" of their property. It involves the same three figures that have to be taken into account when deciding whether to make the purchase. The higher the "cap rate," the better the transaction will be for the commercial real estate buyer.
For example, if a property is expected to generate $50,000 in annual income, minus $25,000 expenses, that will leave $25,000 remaining profit. Let's say the buyer paid $250,000 for that property.
The formula to figure "cap rate" would be Profit/Selling Price (that's Profit divided by Selling Price). In our example, it would be $25,000 divided by $250,000 = 10%. The cap rate (rate of return on the investment) is 10% per year.
The "cap rate" is like an ongoing dividend or an interest rate on a bond or CD. It's the reasonably expected investment return rate that a commercial buyer counts on receiving as a net income from the property.
In a healthy economy, cap rates of 15% to 20% are to be expected, but in a recession a more modest expectation would prevail.
These are some factors to consider, if someone wishes to enter the commercial property management field as an owner.
Having a separate management company oversee the property for you may be a good idea, but the added expense will reduce profits and, therefore, corresponding "cap rate" returns.
Since all real estate is unique, there will be many special and personal decisions to be made by an investor based on local factors, markets, and conditions. The adventure in becoming a commercial property owner is exciting and challenging.
How a Commercial Mortgage Works
Commercial real estate can secure a loan. Normally, the borrower will be a business rather than an individual. But the business borrowing the money must have good credit. The factors going into achieving that status are complicated and involve some analysis on the part of the lender.
A special type of commercial mortgage called "non-recourse" offers specific protections to the borrowing entity. If a default in payments occurs, the lender must take back only the property itself, and agrees not to sue the borrower business entity for any deficiency still owing after the value of the property is taken to apply toward the loan balance.
Many lenders, however, will avoid this type of transaction and ask the borrower to secure the loan further by guaranteeing it personally or on behalf of the business that obtains the loan.
Commercial mortgages are usually characterized by "balloon" payments that occur part way into the total payback period. For example, a commercial mortgage may be payable monthly over a 30-year period, but there will be a large payment due after 10 years. Often this balloon payment will be high enough to discourage further payments on the mortgage, resulting in the borrower's selling the property to pay off the mortgage.
The reason the "balloon" payment is fatal to the mortgage is that the monthly or annual payments that occur periodically are artificially depressed by making the overall term of the mortgage a high number of years, when in fact the "term" that really matters is the number of years until the "balloon" payment is due, which usually is the total amount of the outstanding balance due on the mortgage at that time. Therefore, the borrower enjoys low payments until the time the "balloon" payment comes due, which generally is so high that the commercial property must be sold, or a "refinancing" of the mortgage must take place with a whole new contract.
When a business seeks to acquire a commercial mortgage to purchase or improve property, the lender will sometimes look carefully at the "cash" that borrower has available to make mortgage payments, and often will look beyond the business entity to the credit ratings of the owners of the business. But the normal commercial mortgage is based on the value of the commercial property itself in most cases.
Because commercial mortgages involve risks and higher amounts of cash than personal or residential loans, the interest rates that are due and payable tend to be greater than those of the typical residential mortgage.
The federal government is interested in keeping the commercial mortgage industry economically sound and has agencies like Fannie Mae and Fannie Mac to assist in commercial mortgages. The commercial mortgage sector of the national economy is full of competitiveness and is considered a vital ingredient in America's financial security.