What You Need to Know About Commercial Real Estate Investing as a Retail Investor
Are you looking to explore commercial real estate investing but worried about the high bar for entry? You may have tried your hand at residential real estate and are tempted by prospects of the more significant and more stable revenue streams often found in commercial real estate investments. If you think commercial real estate investing is only for those who already possess large amounts of investment capital, think again!
There are a few ways retail investors with some real estate investment experience can get a foothold in the world of commercial real estate. This article will explore how you can pool your investments in a real estate investment trust (REIT) or a private equity firm to see steady, predictable returns on your investments.
Before we get into how–let’s define some terms to help you understand how commercial real estate differs from residential real estate.
Commercial Real Estate Terms You Need to Know
If you have some experience in residential real estate, you might be aware of some of the valuation methods used by investors to compare similar properties. The most familiar method is the comparable sales method, and it relies on market factors to adjust the value of a residential property.
However, commercial real estate valuation methods do not focus on market factors but instead on projected income generated by the property.
Capitalization Rates and Net Operating Income (NOI)
Capitalization rates, or cap rates for short, is the most common method used to project the profitability of a commercial property. Cap rates in commercial real estate are determined by a simple equation that puts the NOI over the total purchase price. The NOI is an estimate of the annual income minus all the projected operating expenses. If you’re unfamiliar with these acronyms and definitions, you can find out more here: https://www.activedutypassiveincome.com/blog/rei-acronyms-explained/
Cap rates are used to compare the annual profit of similar commercial properties. They are not the be-all-end-all metric, but they are a valuable tool in the commercial real estate investor’s toolbox. If you are interested in commercial real estate, you need to become familiar with this valuation method, as it will be the first choice among investors when comparing similar properties.
How You Can Invest in Commercial Real Estate
Now that we have defined essential terms, we can look at how you can begin investing in the commercial real estate market. The following methods are the most commonly used by commercial real estate investment strategists.
Some are more hands-on regarding the amount of research, work, and time you must dedicate, while others are trusts or private equity firms that do much leg work. Options like these bring investors the closest to a passive income stream, but that phrase is misleading.
Usually, to be a direct investor, you and a handful of other investors get together to purchase a commercial property directly. You and your partners must create an LLC, and by doing so, you essentially found a small business whose function is to manage, market, and administrate a commercial property.
This method is the most time-consuming, involves the most risk, and is a full-time job of its own accord. It is the least “passive” of commercial investment options, as your LLC must find the commercial property, negotiate its purchase, market to tenants, draft leases, manage and maintain the property, etc. This method probably isn’t the way to go unless you want to be a dedicated commercial property owner.
Real Estate Investment Trusts (REITs)
If you do not have the capital to invest in commercial real estate as a direct investor, you can pool your capital in a REIT. REITs are companies that operate solely to invest, own, and operate commercial properties. There are umbrella REITs that handle many different types of commercial properties, and there are more industry-specific REITs that focus on restaurants or condominiums, for example.
REITs can be publicly or privately traded, meaning you can invest in them like stocks if they are public, but you need to be an accredited investor to trade in private REITs. Because these companies do practically all of the leg work — the research, development, and implementation of investment strategies — you’ll have no say in the choices and direction of the company.
Real Estate Mutual Funds
Real estate mutual funds are similar to REITs in purpose but differ drastically in function. They are similar in that both REITs and mutual funds pool investor money into real estate investments. However, the difference is in how they go about allocating their investors’ capital. Where REITs are companies that own, operate, and manage commercial properties directly, mutual funds invest in other companies that own, operate and manage commercial properties.
Investing in a mutual fund takes away the added step of researching REITs and other companies that directly manage property. Though this means less work for the investor, there is an added layer of separation between the investors and the commercial property, as they are investing in companies who exist solely to invest in other companies who own, operate, and manage commercial properties. If this sounds confusing, it’s ok!
Private Equity Firms
Private equity firms are another type of business structure that generates passive income for its investors. As far as investors are concerned, it is similar to a REIT but is always private, open only to accredited investors. Private equity firms differ in that some offer a unique structure — the individually syndicated deal.
This gives investors a say in the investment decisions. They have opportunities to invest in specific properties through the private equity firm. They have access to property information, including tenant information, and have a greater degree of control over which projects their money goes toward.
Options for Every Type of Investor
If the world of commercial real estate investing is new to you, it may seem overwhelming. However, the fact that there are so many different ways you can invest in commercial real estate means that there is an investment opportunity for every type of investor. Whether you are a casual retail investor or want to become a more serious investor, the commercial real estate world is big enough for all sorts of investors to get a piece!
About the Author
Veronica Baxter is a writer, investor, and legal assistant operating out of the greater Philadelphia area. She writes for First National Realty Partners, a New Jersey-based private equity firm.