Investment: Commercial First?

I wanted to write about something that has been on my mind for a few months.  As I was speaking with my sister yesterday, I decided it was time.  She has just purchased her first property.  It isn’t a house.  It is a commercial building that she’s buying with a partner.  I think this is a very smart move for her.

When most buyers think about starting an investment portfolio, they typically think of residential property.  A rental house; a vacation house, etc. and when first time buyers think of owning real estate, they are usually thinking of buying a home to live in.

Not every buyer is equipped or ready to buy an investment first, but this will work for her for several reasons:

She’s not settled: While she’s happily enjoying her married time, she and her husband are not sure where they want to be.  They want the option to move around, to find the perfect spot to call home.  Owning a commercial investment property is much easier to manage from long distances, as commercial users are typically “easier” on the facility, and most often, they are long term tenants.

Because commercial tenants are establishing businesses, they typically want to stay and put effort into their spaces; meaning lease agreements are typically longer in duration for commercial property than residential.  Commercial tenants also create a symbiotic relationship with the facility.  A commercial tenant is likely to maintain the building because the cleanliness of the building and the repair status are directly related to the business and the image.

She wants to buy: Interest rates are still incredibly low!  Even though a purchaser will typically have a higher interest rate for a commercial property, currently that rate is still low historically speaking.  Even though she isn’t ready to purchase a home and “settle down”, she wants to get her foot in the door with a solid real estate investment at a low rate.  Banks do, however value commercial property differently than residential property (whether for investment or occupancy). Also, the down payment will typically be higher than a residential purchase.

She can make money: With the initial investment (initial dollars spent for the facility and repairs) at a low price, coupled with the great interest rate, her Capitalization Rate (cap rate) will be well above the 10% that the industry considers a reasonable rate.  For those of you that are scratching your heads: The cap rate is the ratio of the net operating income and the cost or value of the property.  Because current values are so low, many owners can afford to lower rents and fill commercial spaces which in turn generates greater income.

She is buying with a partner: While partnerships are not for everyone, this symbiotic relationship can work for many.  There are ways to ensure the partners are protected legally, and in title and I highly suggest anyone looking to form a partnership speak with their attorney and accountant.  The partnership means that each party spends less money on the up-front cost, leaving more liquid cash for the individual purchaser or meaning that the buyers can collectively purchase a property that is too expensive to buy alone.

The cons of owning commercial real estate can be substantial.  It is important to think about the negative implications of owning any real estate, but with commercial, sometimes those negatives can outweigh a buyer’s desire to search specifically for commercial investment.

Commercial investment is typically “riskier” than residential purchases in the eyes of lenders, and it is not common to have difficulty purchasing. It is always important to speak with a lender before you get too serious about your commercial venture.  Most often there is a higher interest rate and down payment.

There can be substantial costs even prior to closing; inspections, appraisal, licensing, attorney’s fees, and remodeling, among others.  Many buyers are unaware of the extra fees associated with a commercial investment, so it is important to speak with both your REALTOR and your accountant.

There can be liability; it is incredibly important to make sure that an owner is covered prior to purchase in any situation, and that point is still true with commercial.  A call to your insurance agent is a must.

What do you think?  Would you consider a commercial investment?  Do you own commercial property now?