Owning and renting commercial properties as an investment can be more challenging than owning other types of rental real estate, however, it can also be one of the most lucrative investments if done correctly. Especially with household names like Starbucks and McDonalds as tenants. Below we take a deep dive into everything you need to know about commercial rental properties.
Table of contents
- Commercial Rental Property Definition
- Types of Commercial Properties
- Pros and Cons of Investing in Commercial Property?
- Commercial Rental Property News
- 4 Types of Commercial Tenants
- Types of Commercial Real Estate Ownership
- Managing Commercial Rental Properties
- Financing Commercial Real Estate
- Explore Other Types of Rental Real Estate
Commercial Rental Property Definition
Commercial real estate (CRE) is property (i.e. buildings and land) that is used solely for profit-generating business activities and often leased to commercial tenants for solely business purposes.
Types of Commercial Properties
Commercial real estate is a broad and common term, but within this asset class are several types of unique sub-classes that each have their own special characteristics. We explore the most common types of commercial properties below:
Buildings where administrative work usually takes place. These often include spaces for Medical Centers and Professional Services (Lawyers/Accountants).
Multifamily apartments are considered “Commercial” if they have five or more residential units and sometimes get into the 100’s of units.
Buildings where the property may have a combination of uses, such as retail, office and apartments.
Plots of land ranging in sizes from small to very large and also type depending on location such as agricultural outside of metropolitan cities, and infill land within urban cities..
Public facing storefronts such as shopping Centers, Malls (both indoor & outdoor), Neighborhood Plazas, Strip-Malls, and In-line retail in commercial corridors.
Often large buildings used for warehousing, manufacturing, and any other type of industrial economic use
These properties primarily serve travelers and include hotels, motels, lodges, cabins, hostels, and any other type of property for overnight stays.
Examples of special purpose properties include self storage, amusement parks, bowling alleys, parking lots, stadiums, theaters, zoos, and much more.
Pros and Cons of Investing in Commercial Property?
There are many factors to consider when determining whether or not to invest in rental real estate, specifically commercial rental properties. The following is a comprehensive list of the pros and cons you need to know before investing in commercial rental properties.
Pros of Commercial Investing
- Greater Income Potential – More units equal more opportunities to generate more revenue. Commercial properties also allow for alternative revenue sources such as advertising space (Billboards), rooftop cellular sites, parking lot rentals, vending & ATM machine rent, and more.
- Longer Tenancy – Commercial tenants normally sign multi-year leases ranging from 3-5 Years and sometimes have an “option” to add on additional years. This gives landlords greater long term predictability for property cash flow and stability.
- Less Maintenance Responsibilities – Most commercial leases require that tenants handle more maintenance responsibilities. A lease type called “Triple net – NNN” is the most ideal for Landlords, in which tenants are responsible for 100% of maintenance (with a few exceptions).
- Professional Relationships – Commercial tenants are generally business owners whose best interest is to keep the property welcoming and in good shape. These interests generally align with the owners, resulting in a well taken care of property.
- More Flexibility of Lease Terms – Since most businesses are unique, most commercial leases are tailored to each tenant. Maybe the tenant is a laundromat who uses a lot of water. In this case, you could write the lease so that this one tenant pays for the entire property’s water bill.
Cons of Commercial Investing
- Longer Vacancy Time – While apartment seekers are forever plentiful, renting a commercial space usually takes longer to find the perfect tenant. Depending on the market and property, this process can range from several months to several years.
- Greater Overhead Costs – Business tenants expect a professional interaction with their landlord. As such, there are additional costs to operate commercial properties such as a property management office, parking lot cleaning, admin personnel, licensing & permit fees, and more.
- Bigger Investment – The typical down payment to acquire a piece of commercial rental real estate is much greater than a standard home. The down payment for commercial properties can range from 20-50% and loan interest rates for commercial properties are usually higher than other rental property types.
- Professional Services – Since there is more at stake in commercial rentals, it is always best practice to avoid DIY (Do it Yourself) and use professionals. These can range from commercial real estate brokers for vacancy leasing, to licensed and bonded tradesmen for repairs.
- Greater Liability – Commercial rental real estate is generally intended for public use. With greater use of people regularly interacting with the property, also comes greater probability for someone to get hurt or damage the property (both intentionally or unintentionally).
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4 Types of Commercial Tenants
Not all commercial tenants are created equal. Most types of commercial tenants can be broken down into different categories. Commercial real estate landlords care about these categories because it is how they can make a preliminary assessment of a given tenant’s risk of defaulting on their lease obligations. Below we take a look at the 4 major types of commercial real estate tenants:
Mom and Pop Tenant
Small sole-proprietorship businesses. They are usually owned by a single individual and this is their sole location. Mom and pop tenants generally carry the most risk, but are sometimes the only option for a tenant in a non-prime location.
Privately owned, medium to small sized businesses. They are usually owned by a corporation and have several locations or a very established business. While they may not be a publicly traded company, non-credit tenant risks can be mitigated with case-by-case analyses of their financial history and business resiliency.
Large corporations who are rated as investment grade by credit rating agencies, due to their substantial size and financial stability. They are usually publicly traded companies and can be nationwide or regional to the area. Credit tenants are also sometimes referred to as “National Tenants”.
Either local, state, or federal government agencies. These are the lowest risk types of commercial tenants, since they are typically long-term leases and backed by the respective government agency. The only drawbacks to government tenants are that they generally have very specific space requirements and are inflexible to modifying certain lease languages.
Types of Commercial Real Estate Ownership
Since commercial real estate is treated as a business, legal ownership can take many different forms. The most common types of ownership structures for commercial properties are Sole Ownership, Partnerships, Joint Venture (JV) , Corporation, Limited Liability Company (LLC) , and Trusts. Choosing the right form of property ownership is extremely important for reasons such as liability protection, controlling tax liabilities, and staying on top of administrative requirements.
Managing Commercial Rental Properties
How to manage a commercial property depends a lot on the size and type of property. If you were to own a single-tenant retail building with a long term triple net (NNN) lease and are knowledgeable about commercial real estate best practices, then maybe self-managing could be an option. Conversely, if you own a 10-unit retail shopping center with a mix of national and local mom-and-pop tenants, then hiring a third-party management company might be a better option.
Financing Commercial Real Estate
Commercial rental property financing by far has a higher learning curve when compared to all other types of rental real estate loans. However, once understood and establishing an experienced track record, can unlock the greatest source of capital for a real estate investor. Commercial property loans place great scrutiny on the property, deal, and experience of the investor. As such, commercial lenders look at factors such as Loan to Value (LTV) ratio, which is how much equity the borrower has in the property, and Debt-Service Coverage Ratio (DSCR) which is the property’s ability to pay back the loan.