Commercial real estate investment is like any other investment. You have an end goal – making more money than you spent. The processes, and setting your objectives, offer a great deal of latitude in how to turn your initial investing dollars into a solid profit potential. The essence of this is asking the right questions before you acquire the property, not only about the property and seller, but also about your objectives with it.
The risky way to make money on commercial real estate is to “flip” the property – to invest in one, do renovations, or bring in new long-term tenants, and then sell it for more than you paid for it. This requires a decent understanding of your local commercial real estate market, market timing dynamics, and a lot of research. In many cases, it’s best to start lining up the buyer before you line up the property to sell. Other times, it’s simply a matter of having a piece of property at the right place and right time when an investor comes through, or when a city is expanding.
The more conventional approach to commercial real estate investment is a “buy and hold” strategy. You buy the property, invest in improvements, and bring in tenants who bring a good revenue stream with them. A general rule of thumb is that the revenue stream should be at least 20% greater than the monthly costs of maintaining the property, including labor, periodic fixes for damages, expenses incurred in moving tenants in and out, plus any finance charges on your money and depreciation and wear and tear. (A good accountant can help you figure this out; it is entirely possible to run a property cash positive and lose money long term if you don’t understand this.)
Once your basic ownership strategy is in place, the next questions are about the property itself, and its neighborhood. First and foremost – are you buying a property that’s in a growth area? Is your local demographic young and adding jobs, or older? These both influence the decisions for buying commercial real estate properties.
What’s the property worth today? Don’t just take the listing price; take an average the selling prices of the six most similar properties in the six months to a year, weighing them for different neighborhoods and demographic areas. Combine this with the demographic questions above, and you’ll have a decent baseline for whether or not to do a buy-and-hold or a buy-and-flip strategy.
Before committing to the property, look into the repairs that need to be done. If you haven’t done property renovations before, take the time to run some preliminary back of the envelope quotes for time and money. Sinking a lot of money into repairing a property can make sense if it lands you an anchor store or two, in an area where the municipality is growing.
In a related vein, don’t forget to ask why the seller is unloading the property. In some cases, this will be obvious; a death in the family has resulted in the commercial property needing to be liquidated for the heirs. In other cases, it may have more to deal with tax issues and regulatory burdens.
Both the “fixer upper” question and the seller’s motivation question tie into the acquisition calculation: What can the property be acquired for? Does the property have accumulated equity that you have to handle, or existing tenants that are either elevating or deflating its asking price? All of these are factors to consider when looking at acquiring a property.
Finally, look at cash flow. When all other details are factored in, current cash flow and future cash flow are the keys to making a buy-and-hold strategy work, and it’s worth it to pay more for a property now with greater cash flow potential later, particularly if you’re planning on using your commercial real estate income stream as your retirement income, or seed money for other projects.