At The Investor's Edge, we deal primarily with residential real estate investors. But every once in a while, someone asks me about commercial real estate deals. More precisely, people tend to ask: how profitable is commercial real estate?
The profit on each commercial real estate deal will depend on the particular deal. If you can purchase and lease a commercial property on a triple net basis, it can be extremely profitable. But while commercial deals tend to offer the potential for higher returns, they require far more capital.
I’ll use this article to talk about a few different considerations for commercial real estate investments.
Before discussing commercial real estate, I want to outline the benefits of beginning with residential real estate. While commercial real estate can certainly provide outstanding returns, I typically advise against diving directly into it for the following two reasons:
If you decide you do want to pursue commercial real estate investing, you first need to decide what property type. With residential investing, only so much variety exists (e.g. single-family homes, townhouses, condos, etc.). With commercial real estate, investors face a much wider variety of options. And due to the major difference between each of these options, most investors choose to focus on a single one. It’s just too difficult to become experts in all commercial property types.
Each of the following broad property types includes numerous sub-categories. But, investors typically carve a niche focused on a single category from this list:
In addition to differences in physical layout, each of the above also includes tremendously different tenants. For instance, the needs of a hospital tenant will be completely different than a warehouse tenant. As commercial investors, you’ll need to intimately understand the tenant needs unique to your selected commercial property type.
Leases represent the next item to directly impact the profitability of commercial real estate. Commercial leases are significantly different than residential ones. Though subcategories exist, investors can use two broad types of commercial lease:
As a commercial investor, these explanations should make clear: how you structure your leases will directly impact a deal’s bottom line.
An inherent advantage exists to commercial leases, though. With residential leases, you typically sign renters to one- to two-year lease terms. With commercial leases, you’ll rarely see a lease term shorter than three years. Many leases include five-year and longer terms.
While finding a commercial tenant can be challenging, these longer terms mean you have more reliable cash flow once you do secure a tenant. I personally have owned commercial properties that have A) triple net leases, and B) five-year terms. With this outstanding setup, I basically have a five-year “don’t call me” relationship with my tenants. They pay me rent and they handle everything else. If an HVAC unit breaks, they handle it. When property taxes come due, they pay the bill. If you can structure a deal like this, commercial real estate can be extremely profitable.
But, for all its profit potential, commercial real estate also includes three major downsides:
Fortunately, a middle ground exists. If you’d like to benefit from commercial real estate profitability without dealing with the above downsides, you have options. Personally, I recommend beginning in commercial real estate as a limited partner, often referred to as a financial partner.
In this situation, you provide some cash to a commercial deal, and the general partner manages the daily operations. This provides two benefits. First, as an equity partner, you get a portion of the deal’s profits. Second, you can use this investment as a learning opportunity. You may only be a limited partner, but you should ask the general partner if you can shadow him or her during the entire process.
After a couple deals like this, you’ve gained two key items: 1) additional money from your portion of the profits, and 2) the experience necessary to begin investing in commercial real estate on your own.
If committed to commercial real estate investing, you can still use residential real estate to set yourself up for success. Both wholesaling and fix & flip strategies can provide you the cash necessary to get your start in the profitable commercial real estate world.
Learn how to make money flipping real estate with us by attending our next webinar.