Investing in Commercial Real Estate
Commercial real estate represents an exciting opportunity for many investors, offering higher appreciation, better returns, and greater tenant stability.
By Emily Southey | 14 minute read
Are you interested in investing in commercial real estate? You’ve come to the right place. We’ve put together the following guide to help you learn more about commercial real estate investing.
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What Is Commercial Real Estate?
Commercial real estate is a property used solely for business purposes. In other words, commercial properties are workspaces rather than living spaces. In most cases, commercial properties are purchased by investors and leased to tenants who want to use the property to conduct business. As there are many types of businesses, commercial real estate is a fairly broad term. Examples of commercial real estate properties include everything from shopping malls and warehouses to assembly plants, restaurants, hotels, and office buildings. Most investors make money from commercial real estate in one of two ways: leasing it out to commercial tenants or holding onto it, letting it appreciate, and reselling it. Commercial real estate is often divided into four classes distinguished by function. They are office space, industrial use, multi-family rental, and retail. From there, each category can be further broken down. For example, retail real estate may be categorized into hotels/resorts, restaurants, shopping centres/strip malls, and healthcare facilities.
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How Investors Make Money in Commercial Real Estate
Investing in commercial real estate can be incredibly lucrative, which makes it an attractive option for investors. Before purchasing a piece of commercial property, it’s important to understand the ways that investors make money from these properties. The most common method is by buying a property, letting it appreciate, and selling it at a higher price. However, depending on how involved you want to be, investors can also make money by renting it out to tenants and collecting rent. We break down the difference between direct and indirect commercial real estate investing below.
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Direct Investment
A direct investment in commercial real estate is one where the investor becomes the landlord. This form of investing is best suited to people who have extensive knowledge of the industry or have the money to hire a property management team to handle the property for them.
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Indirect Investment
An indirect investment in commercial real estate, also known as a passive investment, is when an investor indirectly invests in the market through a real estate investment trust (REIT) or an exchange-traded fund (ETF) that is centred on commercial property-related stocks. Another type of indirect investment is investing in stocks of companies that cater to the commercial real estate market, such as REALTORS® or banks.
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Types of Commercial Real Estate Investments
There are many types of commercial real estate investments. Understanding each is key to determining which one is right for you. From multi-family properties to offices and industrial spaces, the most common types of commercial properties are below.
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Multi-Family
Multi-family properties are a cross between residential and commercial real estate. While they primarily serve as residences, the investment opportunity is the main purpose behind the property type. Multi-family properties can be anything from low- and mid-rise apartment complexes to duplexes and multi-hundred condo towers.
“Most investors make money from commercial real estate in one of two ways: leasing it out to commercial tenants or holding onto it, letting it appreciate, and reselling it.”
Office
Office buildings are another popular type of commercial real estate. Office spaces are typically divided into three classes (Class A, Class B, and Class C) based on the property’s location and the market. Class A buildings are considered the best in terms of location and construction, while Class B properties are a step below (they might have high-quality construction but are located in a poorer location). Class C properties are those that are lacking in both construction and location. They might be dilapidated and in a less desirable neighbourhood.
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Retail
Retail spaces are those in which businesses sell goods to the public. Some of the most common examples of retail spaces are shopping centres and strip malls. Strip malls tend to contain smaller retail properties and may not have anchor tenants, like a big-box, department, or grocery store (for example, Walmart, Loblaws, or Home Depot). Strip malls may also contain a mix of retail stores, such as clothing stores, restaurants, dry cleaners, nail salons, and more. Conversely, shopping centres are usually larger (between 150,000 and 300,000 square feet in size), feature anchor stores, and may not have as wide an array of retail spaces.
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Industrial
Industrial properties within commercial real estate can vary considerably, depending on their specific uses. Industrial real estate may include everything from heavy manufacturing and light assembly to flex and bulk warehouses. The size and uses of each space may vary. Industrial properties can also vary quite a bit in size, depending on their specific uses. For example, while a heavy manufacturing facility may contain customized heavy machinery for manufacturing purposes, a light assembly facility could be used as an office space, for storage, or for product assembly. Meanwhile, a warehouse can be used to store a wide variety of goods.
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Hotels
Hotels are another type of commercial real estate investment. Hotels can be broken down into three categories: full-service hotels, limited-service hotels, and extended-stay hotels. Full-service hotels are usually in a downtown core or tourist areas (think Marriott or Four Seasons). Limited-service hotels are typically smaller, boutique properties that don’t provide as many amenities as full-service hotels, such as spas, room service, or on-site restaurants. Finally, extended-stay hotels are those intended for long-term stays. Therefore, they typically have larger rooms with kitchens and are aimed at guests staying for a minimum of one week.
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Mixed-Use
Mixed-use commercial real estate is a property that combines two or more of the property types listed above. One of the most common examples of mixed-use real estate is one that is a retail space on one floor, such as a restaurant, and an office or residence on the floors above it. You often see this in major cities. Most often, mixed-use properties feature some combination of office, retail, and residential/multi-family real estate.
Land
Another commercial real estate investment, though it may not be the first one that comes to mind, is land. Purchasing land for commercial purposes can be a viable form of commercial real estate investing. The most common types of land are raw land (completely undeveloped) and vacant land (that has been developed but is now vacant). Another type of land is brownfield land, which is a piece of land that was previously used for industrial or commercial purposes and is now available for reuse. While it still has the potential for redevelopment, brownfield land usually features environmental impairments or is suspected of environmental contamination.
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Special Purpose
One final type of commercial real estate investment is special purpose properties. It is considered to be a miscellaneous category of commercial real estate and consists of extremely niche real estate projects, such as zoos, stadiums, bowling alleys, theme parks, and theatres.
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The Pros and Cons of Investing in Commercial Real Estate
Armed with a greater understanding of what commercial real estate investing is and what types of commercial properties are available, let’s move on to the pros and cons of commercial real estate investments.
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The Pros
One of the main pros associated with commercial real estate investing is income potential. Commercial properties tend to have a significant annual return that is higher than residential properties. Further, relationships with commercial tenants are typically easier to navigate than relationships with residential tenants. Business owners take pride in their businesses and are more likely to interact with the property owner in a professional and courteous manner. Further, since the appearance of the property reflects their business, commercial tenants (especially retail tenants) have a vested interest in maintaining their space. Plus, most businesses have limited hours of operation, which means you are less likely to get an emergency call in the middle of the night or outside traditional business hours. Another pro that comes with investing in commercial real estate is the flexibility of lease terms. There are fewer laws governing commercial real estate than there are surrounding residential real estate, which means you will have more power to negotiate advantageous lease terms.
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The Cons
Meanwhile, one of the drawbacks of owning a commercial property is the time commitment. If you own a commercial building with multiple tenants, managing it can be extremely time-consuming. With multiple tenants comes multiple leases, more maintenance issues, and increased public safety concerns. In this vein, depending on the number of tenants in your commercial building, professional help may no longer be an option but a requirement. While hiring a property management company to handle the day-to-day operation of the commercial property offers many benefits, it can also be costly, eating into your profit margin. Another con of commercial real estate is the upfront cost. Commercial real estate comes with a bigger initial investment than residential real estate, so you must have more capital to even consider investing in a commercial property.
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Tips for Investing in Commercial Real Estate
Follow these four tips for investing in commercial real estate put together by the experts at Wahi.
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1. Look for properties with multi-use zoning
Generally speaking, it’s a smart idea to find a property with multi-use zoning. Why? It will increase the market resale value, which can earn you more money on your investment. Buying a commercial property that is only zoned for manufacturing will not only limit your pool of buyers when it comes time to sell, but it will also limit your pool of potential tenants. Do yourself a favour and research the zoning restrictions for a commercial property before you buy. Make sure you could easily apply to change the zoning in the future if it isn’t already zoned for multi-use.
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2. Do not bite off more than you can chew
By this we mean, do not buy more commercial space than you can afford or that reflects the market. Buying too many commercial properties is a common temptation for real estate investors. However, doing so can lead to overspending, limiting your profit margin when you do sell. It can also make it more difficult to sell in the future as the larger the commercial building, the smaller the pool of potential buyers. The majority of businesses in Canada are small, which means they aren’t looking for huge office buildings, especially now that the pandemic has vastly increased the number of employees working from home. The general rule of thumb is this: If you purchase a property that is over 50,000 square feet, you should expect there to be a very small pool of buyers when it comes time to sell. Even in a strong market, selling larger commercial properties can be difficult.
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3. Purchase a sustainable property
Buying a commercial property with LEED (Leadership in Energy and Environmental Design) certification is a wise decision for many reasons. LEED-certified buildings are designed and built with sustainability in mind. Such properties consider and feature factors like human and environmental health, sustainable site development, water savings, energy efficiency, materials selection, and indoor environmental quality. Thus, purchasing commercial real estate with this type of certification is not only better for the planet but it can help your profit margins. As mentioned, these buildings tend to be more energy efficient, which keeps utility costs low. Further, improved air quality and design have been proven to improve employee productivity. If purchasing a LEED-certified property isn’t an option, you could also consider introducing sustainable or green initiatives to an existing building, such as upgrading the air quality system or adding solar panels to the roof. Ultimately, sustainability has plenty of benefits and is seen as the way of the future. Therefore, buying a green commercial property can significantly increase the property value.
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4. Consult with an experienced commercial REALTOR®
Our final tip for investing in commercial real estate is to work alongside an experienced commercial REALTOR®. Many investors make the mistake of trying to go it alone, but this can have serious consequences, such as overpaying for a property. When you work with a REALTOR®, you benefit from their knowledge, resources, and expertise. Find one who specializes in commercial real estate, and who can conduct a thorough comparative market analysis and help you find the right property to invest in. Experienced REALTORS® will assess the commercial real estate market on your behalf to determine what types of properties are in demand and where. They can also help you calculate the space needed to accommodate future growth.
Frequently Asked Questions
What qualifies as “commercial real estate”?
Commercial real estate is defined as a property that is used exclusively for business purposes. The owner typically rents such a property to a company or individual who wants to use the space for commerce-related activities. Generally speaking, if the property isn’t a residential home or a space owned by the government (for example, a park or community centre), it is likely commercial real estate. Commercial real estate is a vital component of the economy, as it provides a space for the movement and sale of goods and services. Just as people rely on their homes for shelter, they rely on nearby businesses (housed inside commercial properties) for everyday life. Everything from a grocery store to a clothing store or warehouse is an example of commercial real estate. Overall, commercial real estate represents a massive industry and is distinct from residential real estate.
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What is the difference between commercial and residential real estate investment?
The key difference between commercial and residential real estate is the way the property is used. Residential real estate is for tenants to live in, and may include multi- or single-family homes, condominiums, apartments, townhouses, and more. Meanwhile, commercial real estate is property used for business purposes, such as warehouses, retail spaces, office buildings, hospitals, hotels, and assembly plants, to list a few. If a property is zoned residential, you can only legally find a residential tenant. Oppositely, if the property is zoned commercial, the tenant must be a company that is using the property to conduct business.
What are the advantages of commercial property?
There are plenty of advantages to investing in commercial real estate. First, the leasing rates are far higher than that of residential real estate. Therefore, buying a commercial property and renting it out can generate a significant amount of monthly cash, resulting in impressive returns. While industrial buildings typically have lower rents, they will still be higher than residential rents. Plus, they come with lower overhead costs. Another advantage of commercial real estate is that these properties usually have longer lease contracts with tenants, which means less turnover and a smaller risk of vacancy. It also results in a stable and reliable cash flow for the investor. Beyond monthly cash flow, commercial real estate investing typically offers the highest potential for capital appreciation, making it an extremely lucrative form of investing. As long as the property is maintained, up to date, and located in a desirable area, it is very likely to appreciate. Plus, as with any type of real estate investment, it instantly diversifies your portfolio, which increases the security of your financial portfolio.
Are there any disadvantages?
Yes, investing in commercial real estate does have some disadvantages. First, commercial real estate is highly regulated, and the rules and regulations that come with it are the main deterrents for most investors. The property taxes, maintenance obligations, and mechanics of purchasing are generally considered to be disadvantages. Another issue is the risk of tenant turnover (and subsequent tenant vacancies), especially in an unstable economy where businesses might be forced to close quickly, leaving a property vacant with little notice. If you find tenants, managing them can also be more complicated than managing residential tenants. For example, each commercial tenant may have specific needs, which can increase the cost of renovations. It is common for property owners to adapt each commercial space to accommodate the tenant’s specific industry or trade. However, this doesn’t come cheap and can be a problem if turnover rates are high and spaces require frequent refurbishment. Two final disadvantages of commercial real estate investments are that they tend to cost more than residential properties, which means investors must be prepared for significantly larger down payments and mortgage payments, and they typically move slower than residential properties, meaning when it comes time to sell, you could be waiting some time.
What should I do once I’ve found the right property?
Once you’ve found the right property, work with an experienced commercial REALTOR® to purchase the property. The process of buying a commercial investment property may also involve obtaining financing. When it comes to financing, some commercial investors choose to purchase the property with a group of other investors. If you go this route, make sure each member has a clear understanding of their obligations, rights, and responsibilities. Alternatively, if you purchase the commercial property as an individual, you might need to take out a commercial mortgage. Keep in mind that commercial mortgages often have higher interest rates and stricter criteria for approval.
After the property sale is complete, the next step is finding and maintaining tenants for your commercial property. It’s worth noting that negotiating with commercial tenants is often more complicated than with residential tenants, as it is in effect a business deal. That said, once you find a good tenant, commercial tenants tend to stay in place much longer than residential tenants. If you do not wish to manage the property day-to-day, research property management companies in your area that could take on these responsibilities.
What is passive investment in commercial real estate?
There are a few types of passive investments in commercial real estate. The first is to purchase a rental property and hire a property manager or management team to run it for you. This allows you to take a step back while the property manager deals with the day-to-day management of the property. In essence, you provide the money, they provide the time and effort.
Another, even more passive, option when it comes to commercial real estate investing is to purchase a commercial REIT (real estate investment trust). REITs function similarly to stocks or mutual funds. They can be purchased online, often through your bank or other financial institution, and can be bought and sold in a matter of minutes. REITs allow investors to diversify their portfolios and take advantage of all that real estate has to offer without actually purchasing or owning a property themselves. Therefore, investing in a REIT is the most passive form of real estate investing as the fund managers are the ones who purchase the properties and do all the work.
Emily Southey
Wahi Writer
