Every March our inquiries about investing in commercial real estate increase and we always wondered why. Well we finally have a theory as to why. The release of the Forbes 500 list. Many on the list have attributed their wealth to commercial real estate investments. It seems fitting that the interest spikes in March and that most inquiries are directed towards, “how do I get started and how soon will I begin to make money?”
Commercial real estate can be a great wealth creator, but as with anything worthwhile, it is not as easy as it appears. The critical understanding needed to investing in commercial real estate is recognizing the value of the investment, which is typically based upon the income the property is, will, or can produce(ing). Basically, the characteristics of the investment will be determined by its cash flows. For example, if the income is steady then, traditionally the investment is steady. If the income increases, the investment value increases and if the income decreases, the investment value decreases. Although the foregoing is the basics in defining the investment, there are other parameters you should understand before you begin investing in commercial real estate. These parameters are about you, your investment tolerance, your time and resources, and your investment goals.
First, do you want to be Landlord? If yes, finish reading this section. If no, jump down two paragraphs. Okay, you want to be a Landlord. Now what type of Landlord do you want to be? Passive or active? There are risks and rewards to each. A passive Landlord will typically invest in NNN leased properties. These are properties that typically have leases in place and the Landlord primarily manages the accounting aspects on a month to month basis and prepares tax returns on a yearly basis. All maintenance issues are passed onto the Tenant. As you may guess, they have lower returns than if you were an active Landlord. An active Landlord is much more involved in the day to day operations and marketing of vacant space. Being an active Landlord is much more time consuming and requires much more understanding of the market, finances and building systems. At times, this is referred to as putting sweat equity into a property to enhance the cash flow it produces, thus creating value. The best Landlords usually employ professionals to execute specific needs, (i.e. hire qualified contractors for maintenance and repairs, engage brokers for marketing, hire property managers to manage the asset, etc.) As you might again guess, the returns are usually higher when you are an active Landlord, if they weren’t, why go through all of the troubles? Unlike the stock market, investing in properties as a Landlord is a non-liquid investment. Meaning, it takes time to sell property, and the timing needs to be carefully planned. The value (wealth creation) of these types of investments is produced by:
- Utilizing current cash flow to buy down the loan, thereby, raising your equity and enjoying a larger cash flow in the future
- Increasing tenant rent (if below market), or improving building to justify higher rent
- Repositioning building to attract higher credit tenants. Future investors will pay more for high- credit, less-risky tenants
Investment Trust Option
So you don’t want to be a Landlord, but still want to invest in commercial real estate. This is done very commonly through investment trusts, either private or public. Basically, you are relinquishing investment dollars to professional real estate managers to be the active Landlord. Typically, you invest into a property or a property fund with stated mandates on what type of investment strategy will be employed. In return, you will be given a return on your capital. Here you are relying on the fund or asset managers to create value and thus, you will share the value creation with them. The primary difference between private equity investments funds and public equity funds (REIT’s) are the liquidity aspects. With a REIT, you can trade your shares on the market daily; with private equity, you will need to be governed by the operating agreement of the fund and how they can become liquid.
As with anything, there is so much more to commercial real estate investing than meets the eye, but we hope we gave you a quick and broad overview. Stayed tuned for future blogs where we will write in more detail on; investment strategy, investment funds and the differences in commercial real estate investing and residential real estate investing.