At The Investor's Edge, we deal primarily with residential real estate investors. But every once in a while, someone asks me about commercial real estate deals. More precisely, people tend to ask: how profitable is commercial real estate?
The profit on each commercial real estate deal will depend on the particular deal. If you can purchase and lease a commercial property on a triple net basis, it can be extremely profitable. But while commercial deals tend to offer the potential for higher returns, they require far more capital.
I’ll use this article to talk about a few different considerations for commercial real estate investments.
Residential Real Estate vs Commercial Real Estate, Which One is Better?
Before discussing commercial real estate, I want to outline the benefits of beginning with residential real estate. While commercial real estate can certainly provide outstanding returns, I typically advise against diving directly into it for the following two reasons:
- Residential investing requires less money: While deals vary, as a rule, residential real estate investing requires far less money than commercial investing. This largely comes down to scale. A single-family home can only be so large. On the other hand, commercial properties tend to start at greater square footage and really face no limits in total size. This size difference means you’ll need far more initial capital to invest in commercial properties.
- Residential investing requires less experience: Even if you’ve never invested in single-family homes, you’ve likely lived in one. As a result, you know more about this property type than you realize, just by personal experience. Investing in office buildings, industrial properties, or other commercial buildings requires tremendous commercial experience. People don’t just inherently pick up this sort of commercial experience in their daily lives.
Commercial Property Types
If you decide you do want to pursue commercial real estate investing, you first need to decide what property type. With residential investing, only so much variety exists (e.g. single-family homes, townhouses, condos, etc.). With commercial real estate, investors face a much wider variety of options. And due to the major difference between each of these options, most investors choose to focus on a single one. It’s just too difficult to become experts in all commercial property types.
Each of the following broad property types includes numerous sub-categories. But, investors typically carve a niche focused on a single category from this list:
- Office space
- Hospitality (e.g. hotels)
In addition to differences in physical layout, each of the above also includes tremendously different tenants. For instance, the needs of a hospital tenant will be completely different than a warehouse tenant. As commercial investors, you’ll need to intimately understand the tenant needs unique to your selected commercial property type.
Commercial Lease Structures: Triple Net vs Gross
Leases represent the next item to directly impact the profitability of commercial real estate. Commercial leases are significantly different than residential ones. Though subcategories exist, investors can use two broad types of commercial lease:
- Triple net leases: With this lease structure, the landlord charges the tenant a base rent. Then the tenant pays directly the property’s “triple nets”—property tax, insurance, and operating expenses. This can be an outstanding set-up for investors. Basically, you sign a lease, collect rent, and the tenants take care of everything else. In terms of low-maintenance and high-return investments, these are great options for commercial investors.
- Full service, or gross, leases: With these leases, landlords charge tenants two fees: 1) base rent, and 2) operating expenses. So, rather than tenants paying these triple net expenses directly, the landlord pays them, and the tenants pay a portion to reimburse that amount. This poses a larger administrative burden for landlords, and this burden can cut into a deal’s profitability. But gross leases are great options for tenants, who only pay a single monthly payment.
As a commercial investor, these explanations should make clear: how you structure your leases will directly impact a deal’s bottom line.
Benefits of Commercial Real Estate Lease Terms
An inherent advantage exists to commercial leases, though. With residential leases, you typically sign renters to one- to two-year lease terms. With commercial leases, you’ll rarely see a lease term shorter than three years. Many leases include five-year and longer terms.
While finding a commercial tenant can be challenging, these longer terms mean you have more reliable cash flow once you do secure a tenant. I personally have owned commercial properties that have A) triple net leases, and B) five-year terms. With this outstanding setup, I basically have a five-year “don’t call me” relationship with my tenants. They pay me rent and they handle everything else. If an HVAC unit breaks, they handle it. When property taxes come due, they pay the bill. If you can structure a deal like this, commercial real estate can be extremely profitable.
Commercial Real Estate Downsides
But, for all its profit potential, commercial real estate also includes three major downsides:
- Cost: As discussed above, commercial properties simply cost far more than residential ones. It’s not uncommon for a commercial deal to require hundreds of thousands of dollars in upfront capital (if not more). This reality prevents most new investors from beginning with commercial real estate.
- Credit requirements: Commercial lenders require good credit history, especially for new investors. And, as a new investor, you’ll also likely need to personally guarantee a commercial loan. This puts you at significant risk. Even though you’ve structured a deal as an LLC, this personal guarantee means that you’ll be on the hook personally if a deal falls apart. In other words, a lender will be able to go after your home, your retirement accounts, and any other personal assets until you’ve satisfied the debt.
- Experience: Commercial real estate inherently includes far more complexity than residential. While you can jump right into commercial investing, you’ll likely make a ton of costly mistakes in the process. Successful commercial investing takes a ton of experience.
Commercial Real Estate Alternatives
Fortunately, a middle ground exists. If you’d like to benefit from commercial real estate profitability without dealing with the above downsides, you have options. Personally, I recommend beginning in commercial real estate as a limited partner, often referred to as a financial partner.
In this situation, you provide some cash to a commercial deal, and the general partner manages the daily operations. This provides two benefits. First, as an equity partner, you get a portion of the deal’s profits. Second, you can use this investment as a learning opportunity. You may only be a limited partner, but you should ask the general partner if you can shadow him or her during the entire process.
After a couple deals like this, you’ve gained two key items: 1) additional money from your portion of the profits, and 2) the experience necessary to begin investing in commercial real estate on your own.
If committed to commercial real estate investing, you can still use residential real estate to set yourself up for success. Both wholesaling and fix & flip strategies can provide you the cash necessary to get your start in the profitable commercial real estate world.
Learn how to make money flipping real estate with us by attending our next webinar.