7 Important Questions to Ask Before Investing in Commercial Real Estate

April 14, 2022

It’s common knowledge in the investing world that real estate is a great way to build wealth. Most people assume that means residential investing, flipping houses, and buying income-producing properties. Commercial real estate investing is often neglected in this equation, primarily because it seems like there is an overwhelming learning curve to gain expertise in the field. But if you’re willing to spend some time educating yourself on commercial investing, the rewards could far outweigh the time spent learning the commercial real estate ropes. If you’re ready to diversify your portfolio, here are seven questions to ask yourself before you get started.

1. Are You a Qualified Investor?

When you talk about commercial investments, you may hear the term “qualified investor.” In this case, you are qualified if your income for the most recent two years is over $200,000 and is targeted to be at least that much this year ($300,000 for a double-income household), or a net worth of at least $1 million, excluding the value of your primary residence. This is also referred to as being an “accredited” investor, and you document your accreditation with tax returns or investment statements. There are two reasons for requiring accreditation: high net worth investors can participate in bigger deals, and this can be a risky type of investing.

2. What Are Your Investment Goals?

One of the more daunting aspects of commercial real estate is the sheer variety of investment options. There are two fundamental types of commercial property: the ones that produce cash flow, and the ones that appreciate over time.Do you want to be a passive or active investor? What’s the asset class that interests you? Are you investing for retirement and estate planning, and are tax benefits a priority? Finally, what’s your risk tolerance?

3. Which Investment Type?

One of the things that novice real estate investors find a bit scary is that there are so many different opportunities and levels of participation. First, what’s the asset class that appeals to you? There are five types of commercial asset classes:

  • Residential
  • Office
  • Flex
  • Retail
  • Hospitality

Within these are layers of different kinds of properties. In office space, there are three classes of property—A,B, and C—and markets within those classes, primary, secondary, and tertiary. A new urban office tower is an example of a Class A primary investment, while an old strip mall in a less desirable part of town would be a Class C third-tier property.

Office space also includes medical parks, data centers and software storage facilities, schools, and public buildings. Retail space includes hotels, restaurants, and entertainment facilities, such as theaters and fitness centers.

If you are interested in industrial space, you can consider manufacturing, warehouses, and distribution buildings. Flexible industrial space features research and development, showrooms, and data centers, but occasionally will have some retail, such as a coffee shop or cafe.

Second, do you want to be an active or passive investor? Unless you want to be involved in the day to day operations of the buildings, a passive role is better for an investor. The only real options if you prefer an active role are in smaller multi-family investments.

4. What’s Your Timeline?

The next question is this: how long do you want to hold the investment?

The commercial real estate market is cyclical, meaning that every asset class has its ups and downs. When you’re investing commercially, you’ll typically buy shares in a Real Estate Investment Trust (REIT) or a private equity placement. You should plan on holding the investment for several years, especially as your investment could be raw land, or a proposed office or industrial park.

5. Where Is the Investment in Its Lifecycle?

Cycles in commercial real estate run in phases—recovery, expansion, over-supply, and recession. The typical cycle lasts about ten years. The cyclical nature of the business means that smart investors who buy in during slow times are going to see bigger profits when the recovery happens and rents rise again.

Since the internet has turned online shopping into such an economic behemoth, bricks and mortar retail properties have fallen, while industrial properties, particularly manufacturing and distribution, are on a high. Class A office space was considered a prime investment for years, but COVID-19 has made companies rethink how offices are used, and many of those buildings are currently underperforming. Shared and community workspaces, on the other hand, are in short supply and overperforming.

When you’re looking at commercial investments, find properties with a high sustained demand: an investment that has the potential to be attractive over a period of years. This type of investment will maintain yields, ensure an easy exit strategy, and demonstrate capital growth potential.

6. What’s Your Risk Tolerance?

Commercial property is unlike stocks and bonds in that it is a fairly illiquid investment.Some REITS trade on the market, but in general, commercial real estate is something you hold onto for the long haul, as discussed above.

What this means for your overall portfolio is that this cash is tied up for years. This is one of the reasons that so many commercial investments require an accreditation before you are invited in to invest—the risk could be high and you can’t easily sell the asset to reclaim cash.

When you do start seeing cash flow from your investment, you may also see asset appreciation from properties with a high return on investment (ROI).

If you prefer buying and selling with the click of a button, rather than committing to a years-long prospect, you can find some REITS that you can trade more easily than private placements.

7. What About the Tax Advantages?

Some investors get into commercial real estate for the tax advantages, which can be substantial.

If you own a commercial property, or even a percentage, depreciation is your biggest tax advantage. Even if the property generates cash flow, the K1 statement can easily show a loss. Here’s how this works.

The project sponsor can accelerate depreciation by implementing a “cost segregation study”, which effectively splits all the components of construction and operation, and allows you to depreciate them individually over a shorter period, usually 5 or 10 years instead of the standard 271/2 or 39 year periods. The magical result? The investment generates income and appreciates, but loses money on paper.

There are other tax advantages when you invest in commercial property. You can deduct a portion of mortgage interest, but you can also participate in 1031 exchange options.

After you have participated in commercial real estate investments with a buy-and-hold strategy, you can sell an asset and reinvest the proceeds in another commercial property, deferring having to pay capital gains on the profits. This is the strategy that investors use to generate wealth that they can pass on to their heirs.

Learn More About the Advantages of Commercial Investing

Learn More About the Advantages of Commercial Investing

If you’re ready to begin building wealth by adding commercial real estate to your investment portfolio, we are here to answer your questions and find the right investment for where you are in your portfolio and estate planning. Contact EXtrance today for more information on how we match investors to investments, and simplify the mysteries of commercial investing.