Examples of commercial real estate are:
- Office buildings
- Apartment buildings
- Mobile Home Park
Creative financing options are more available in the commercial market than residential. Commercial lenders are very familiar with seller financing and other creative terms. Typically, commercial sellers have more experience in real estate transactions and could be more open to seller financing or other creative terms.
The commercial real estate market is significantly larger than the residential market, allowing for a more diverse portfolio. Often investors get started with residential investing and move into the commercial space after gaining some experience. Commercial investing is often viewed as ‘next level’ investing and usually more passive income.
Commercial real estate is considered to “lag” behind the economy. It relies heavily on jobs to fuel the real estate market. Jobs come; first residential real estate is next, then often followed by opportunities in commercial real estate. Increasing employment is the key to any community’s growth. Commercial investing can provide secure, long-term income streams and steady capital growth.
Commercial real estate values and purchase prices can be based on the revenue the asset produces. When buying a commercial property, we are purchasing the income that the property produces. A common term in the commercial world is Capitalization Rate or cap rate as it is often referred to. The cap rate is the yield or ROI that property should return each year. The cap rate assumes you will have no mortgage. For example, if a seller says the building has a cap rate of 6, then the seller suggests you will gain a 6% annual return on your investment. Cap rate is often misunderstood, and you can easily calculate it yourself with the correct information.
Cap rate is Net Operating Income (NOI) divided by the Purchase Price. For example: if your NOI is $70,000 and the purchase price is $1,000,000, your Cap Rate is 7, and you could expect a 7% annual return on your investment before debt mortgage costs.
Is seven a reasonable cap rate? It implies cash flow coming from that purchase; however, it does not indicate the property’s condition, location, the strength of leases, and much more. Suppose you buy it at a seven-cap rate and need significant capital improvements that cost you money. In that case, your cap rate can quickly decrease. Just like a lower cap rate could indicate less cash flow, although if the asset is in good condition and needs no repairs, then it could be a maintenance-free or turn-key purchase.
“When you buy a property, you want the cap rate to drop so the property is worth more.”
Buying with a higher cap means more cash flow. A cap rate is a valuable tool, and there are many other considerations to account for.
There are some serious advantages to investing in commercial real estate. A significant advantage when you apply for financing the lender will be qualifying the loan based on the property’s performance. The lender gives considerable consideration to the income and expenses of the property and not your credit score and personal income. This is a significant advantage as, eventually, many lenders will ‘cap’ you on the number of residential mortgages they grant you. With commercial investing and the building’s performance being a key consideration for financing plus more creative financing opportunities, financing is a smoother process with more options available to both the commercial buyer and the commercial seller.