With the growing U.S. real estate market, it comes as no surprise that people would be intrigued by investing their money in real estate. According to a 2019 survey conducted by Bankrate, 28% of Americans prefer investing in real estate. Investing in real estate can come with a learning curve, but it can be a preferred alternative over investing in stocks or CD accounts. Let’s explore the main differences and what opportunities there are in investing in commercial real estate.
Benefits of Investing in Commercial Real Estate vs. Alternative Investment Options
Commercial real estate investing opportunities share some characteristics with other types of investment vehicles, but they differ significantly. Buying and leasing entire buildings or individual offices can be very profitable if done correctly but can yield poor returns if done incorrectly.
Mutual funds provide a convenient alternative to buying and selling stocks on your own. For those who don’t want to spend the time and effort making their own investment decisions, mutual funds may be an appealing option. On the other hand, though, mutual funds do not offer fixed guarantee returns and on top of that the individuals who pull out their money from mutual funds are taxed at the current income tax rate, just as they would their usual income.
Others may consider investing in the stock market. While this may seem like a better alternative due to their potential to maximize returns, stock investments may be taxed at a high rate when you sell them for a profit. In order to avoid this, you need to hold on to your stocks long enough for any profits to qualify as “long-term capital gains.” Additionally, stock prices can drop at any given moment, costing investors a lot of money.
Commercial real estate investments, unlike stocks or mutual funds, are tangible assets that can be sold at any time and provide significant tax advantages to investors over other types of holdings. Real estate investments frequently provide investors with a consistent cash flow. Real estate can generate relatively consistent revenues independent of market fluctuations, depending on the terms agreed upon with their tenants.
Factors to Consider
Capitalization Rate
Once a decision is made to invest in commercial real estate, you will need to be well-informed on the capitalization rate. Capitalization rate is the rate of return for your investments. It is calculated by a simple formula where the net operating income is divided by the property’s market value. This is an important metric to consider because it helps you determine an expected profit margin or return on your investment. When comparing this with the cost of borrowing (if any) you can determine whether a specific property will cost more money than it is actually bringing in. Using the cap rate formula provides investors with a quick overview of what their return could be. This ensures that they make the most informed decision possible when investing in real estate.
Triple-Net Leases vs. Gross Leases
Aside from informing yourself on what the capitalization rate is, it is also essential to know the differences between triple-net leases and gross-leases. Triple-net leases are a common leasing agreement that investors use when they lease out the whole or part of a property. When investors lease out the property, there is a monthly base fee for the agreed-upon space that the tenant is responsible for. In a triple-net lease agreement, the tenant is not only responsible for the monthly rent, but they would also be responsible for three of the major operating expenses which include property taxes, insurance, and common area maintenance. This lease type can be beneficial to a property owner financially and reduce exposure to cost fluctuations.
Gross leases are different from triple-net leases. Rather than handing over the responsibility to the tenant of paying the property’s operating expenses, the landlord handles that himself. The tenant is responsible for a monthly rental fee, which the landlord can use to cover operating expenses. It is possible for the landlord to include a clause in the lease that allows the monthly rent fee to fluctuate based on the operating expenses.
Single-Tenant vs. Multi-Tenant and Lease Terms
Another thing to consider when investing in commercial real estate is whether your building will be a single tenant building or a multi-tenant building and the lease terms. A single-tenant triple net leased building usually requires very little landlord responsibility. As a property owner of a single tenant leased asset with a long term lease in place (10 years or more), you are able to enjoy the potential returns for years without the hands-on management and hassles of other types of properties or investments.
Multi-tenant investment properties include properties such as retail shopping malls, apartment buildings, healthcare centers, or office centers. These locations will have a higher rental income but are more likely to have vacancies, affecting your monthly income. However, having multiple tenants means that the income for the vacancies may be made up by the tenants occupying the other spaces.
1031-Exchanges
Previously, we touched on the subject of tax benefits for real estate investors. One of those tax benefits is a 1031-exchange. The purpose of the 1031-exchange is to allow investors to sell their properties and buy new, similar properties that are for the same purpose, without having to pay federal and sometimes state taxes. This is beneficial to investors because, without a 1031 exchange, they would be responsible for paying taxes on the profits made from the sale of their property. A 1031-exchange can happen as many times as an investor would like, so long as the process meets the requirements. Therefore it is important to be well aware of what a 1031-exchange is and how it may benefit a real estate investor.
Real Estate Investment Opportunities
Let’s explore some of the real estate investment opportunities that may be of interest to you.
Four Types of Investment Approaches to Commercial Real Estate
Whether you are purchasing a building to lease as retail space, office space or to an industrial company, you may see terms such as Core, Core Plus, Value-Add and Opportunistic. These terms are often used to define the risk and return of a real estate investment. Risk and return factors can be impacted by both property specific attributes such as physical condition of the building, credit worthiness of tenants, lease terms and the amount of debt used to capitalize a project. Below we will explore three of these terms from the most conservative to the middle ground investment.
Core
Core properties are the most passive investments which require very little asset management and typically indicate the commercial property is leased to a long-term credit worthy tenant. These real estate investments are the most conservative, generating stable and consistent cash flows. Examples of core investments would be fully leased retail or office buildings located in a major city with creditworthy tenants on long term leases.
Core Plus
Core Plus investments require more involvement but leave room for income growth. These investments have a low to moderate risk with the ability to increase cash flows through improvements to either the property, management of the property or the tenant quality. These properties are similar to Core as they are typically in good condition and quality and have fairly strong occupancy rates. In a Core Plus investment, the cash flow is slightly less predictable because the upside requires some active investor participation. A 20-year-old industrial building that is well occupied but in need of minor upgrades is an example of a Core Plus investment.
Value-Add
Value-Add properties can include properties with low occupancy, management issues, and deferred maintenance. These investments are more moderate to high risk and typically have little to no cash flow at the time of acquisition. However, there is tremendous potential for upside to cash flow once physical and operational value has been added and expenses are reduced. Generally, these investors are willing to take on more risk and responsibility to achieve high returns in the form of appreciation and increased cash flow.
Final Thoughts
Investing in real estate doesn’t have to be a daunting process. Being informed of the foundational aspects of investing is sure to assist in the decision-making process when it comes to investing in real estate. There are plenty of different ways in which you can make an investment in the real estate market such as leasing or flipping residential homes, or leasing commercial buildings.
After doing your own research and being well-informed, you will be on your way to making a commercial real estate investment. Pinpoint is here to help support commercial real estate investment opportunities for all your commercial real estate Mississippi needs.