Even if you are inexperienced in commercial real estate, it is one of the most reliable investments you can make to build a significant net worth over time. However, you can lose your shirt if you don’t know what you’re doing.
I have had a successful career as a CRE professional, but I’ve also learned from my mistakes over the years. I’ve outlined five essential tips that will help you avoid the same critical errors and take advantage of the wealth-building potential of commercial real estate ownership.
4 ways commercial real estate can make you money
Many commercial real estate deals involve passive investors. As a passive investor, you don’t need a real estate license or law degree. The key is to have the highest level of confidence possible in the asset, the market, and the people you’re in business with. Always team up with a proven professional who knows the local market dynamics until you learn how to identify, structure and finance a deal on your own. You should also have a good real estate attorney to ensure your contracts are comprehensive and compliant, protecting you from any unpleasant surprises.
The average returns generated from smart, well-structured commercial real estate deals typically outpace every other investment class over time. There are four essential ways that commercial real estate generates monetary value and builds net worth:
- Cash flow: The cash flow of each property is calculated by the property’s rental revenue, minus operating and maintenance expenses (net operating income), capital expenditures and debt service payments.
- Debt paydown: Debt such as mortgages or private financing allows the buyer to invest less cash in the asset, which may enhance ROI. “Leveraged cash flow” reflects the property’s income as the debt service is being paid down. Once the debt is retired, the property generates unleveraged cash flow for a greater return over the ownership period.
- Asset appreciation: While cash flow can supply a stable return for investors, asset appreciation can also boost the value and income generated. Appreciation can be the result of market forces when local price valuations increase, or by an increase in the net operating income of the property, achieved by reducing expenses, expanding revenue opportunities on site, or both.
- Depreciation for tax purposes: The U.S. tax code provides depreciation tax credits while the actual market value of the asset may appreciate over time. This is why the wealthiest investors prefer commercial real estate as a tax shelter strategy.
What to do for a successful real estate investment
I transacted my first commercial real estate deal when I was 18 years old. But I had a partner and mentor without whom I would not have been successful. I’ve been hooked on CRE ever since. There is no other business than has the same power to impact net worth as profoundly or reliably over time.
In addition to working with partners you trust, here are five things I’ve identified that every new investor must do to be successful in commercial real estate investment and ownership:
1. Buy where demand is already strong — preferably close to home. I recommend properties that are no more than 30 minutes from a vibrant and growing employment base. Properties that are within a reasonably close distance to your home location are much easier to keep tabs on. Don’t rely on a property manager in another city to care about your investment as much as you do.
2. Make sure your team’s market knowledge is comprehensive and the due diligence is thorough. Due diligence on any particular property typically covers three categories: financial performance, existing leases and contracts, and the physical asset itself. Make sure your professional partner has impeccable knowledge about local trends for different commercial real estate asset types (Retail, Office, Industrial, Multifamily), how standards for each have changed with shifting demand, and how that demand is driving market behavior.
3. Don’t be dazzled by shiny objects. Expensive, Class A property can be costly to maintain. Sometimes there is more opportunity in non-shiny assets, such as industrial properties that require far less upkeep. Depending on the economic cycle, there may be more ROI (and lower risk) in the less attractive warehouse, workshop, distribution or storage property than in buildings with high-end interior design, materials and amenities.
4. Buy based on current performance and leasing rates, not projections. Don’t be swayed by optimistic pro forma numbers. Look only at income projections based on current market conditions, not the future. Nothing is guaranteed, but past and current market demand can provide a baseline to evaluate asset value and income potential.
5. Keep leverage low and cash reserves high. I prefer no more than 50% leverage but as much as 75% can be acceptable in the right market for the right property. I also recommend having enough cash in reserve for 12 months of debt service if cash flow is interrupted or delayed due to prolonged vacancies, governmental interventions or other reasons. Keep a separate cash reserve for routine as well as unexpected maintenance and repairs. Be prepared to cover damages, equipment failures, or costs related to extreme weather and other “unscheduled” events.
Location and local market dynamics will always be key factors in the success of any commercial real estate property and your investment in it. In the Triangle area of Raleigh, Durham and Chapel Hill, N.C., where our company is located, commercial real estate valuations have rebounded to surpass pre-pandemic levels and are expected to remain well insulated against any potential economic downturn.
Commercial real estate has two gears — fast forward and fast reverse. When done intelligently, there isn’t a more secure investment. A bad deal, however, can be financially devastating. Unless you’re an experienced CRE investor or developer, don’t do it alone. With the right partner, the right deal can change your life and create generational wealth for you and your family.