Saturday, December 24, 2011

Commercial Real Estate Investing: Complicated but Profitable!

According to a recent study in The Economist, residential property investment in developed countries amounted to $48 trillion, while commercial real estate investment (CREI) was 'only' $14 trillion. Though the number may be smaller, CREI is much more complex.

Real estate, unlike stocks or other investments, is always local - property is always somewhere, but somewhere specific. The actual investor may be far away, but the property has a location that forms part of its local market.

That affects how it's appraised, bought, used and sold. Unlike residential property...even though one in four homes are bought by investors...commercial property is usually intended to be used for a business purpose.

It may be a multi-dwelling apartment complex used as residences by others, but to the investor it's a commercial enterprise. As often, the commercial property is a multi-tenant commercial building on land zoned for that purpose. That introduces different considerations for valuing, financing, leasing, maintaining and a host of other tasks.

The commercial real estate investor has, usually, to invest a larger amount...requiring superior credit and incurring greater risk...and to estimate capitalization rate (cap rate) and Gross Rent Multiplier (GRM).

The cap rate is calculated by dividing a property's annual net operating income by its purchase price. Historically, good investments had a 10% cap rate, but the last few years has seen that decline to 8% corresponding to a greater risk and lower expected return. The GRM is arrived at by dividing the purchase price by the property's monthly gross operating income. These, along with consideration of assessed vs appraised value, and comparables, total income and replacement costs form the hard-fact base for estimating the worth of a deal.

Commercial real estate investment properties are at greater risk of unpredictable changes in general economic conditions. A building that enjoyed a 100% occupancy rate can quickly become only half full because of factors far outside the local market. Events in Asia or elsewhere around the globe can turn business conditions for some upside down overnight, whether the tenants are located in California or Barcelona.

Commercial property real estate investment requires increased knowledge of law, maintenance and finance. Zoning, leasing regulations, and other legal issues are more complex than for residential property. Where properties are rented, rather than just bought and sold — often the case with CREI — owners usually have to consider large electrical, air-conditioning and security systems, along with fire suppression, telephone and Internet facilities. Even plumbing is more complicated in commercial structures. Mortgages are more complicated and insurance is more costly.

The exception is the triple-net lease. In this arrangement the tenant is responsible for all the expense and arrangements for maintenance and repair as well as insurance.

But not to be gloomy, there are great potential rewards from CREI. The risks are greater, but often the return is as well — especially during good economic times. And the satisfaction of being part of sustaining and helping grow the dreams of other entrepreneurs is a great bonus for the commercial real estate investor.

And, after all, sometimes, "more complicated" means "more interesting".

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1:25 AM  

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