Analyzing commercial real estate
Investing in real estate is a pretty safe way to grow your investment. The initial capital can be high, and real estate prices tend to increase. Even though you can see good returns soon, it relies on how well you maintain your investment. More and more millennials are looking to invest in commercial real estate. Only 50% prefer to invest in stocks.
Commercial real estate refers to apartment buildings, industrial, retail, warehouse, office, and other mixed-use buildings. Generally, commercial properties tend to be more complex than residential properties. And as such, calculating the potential returns can also be challenging.
One way to calculate the returns is by analyzing commercial real estate. Experts suggest looking at certain factors at both the micro and macro levels. This article takes you through the different defining factors. Every factor influences a different sector. And it also determines whether to invest in a commercial real estate deal.
- What is Commercial Real Estate Analysis?
- How to Analyze Commercial Real Estate Deals
- How do I Run Comps on Commercial Real Estate Deals?
- How Do You Determine if a Commercial Real Estate Property is a Good Investment?
- What is the 2% Rule in Real Estate?
- What is a Good Return on Investment for Commercial Property?
What is Commercial Real Estate Analysis?
Real estate analysis analyzes the current market value of properties compared to the property you are looking to invest in. It is a pivotal part of real estate transactions.
Commercial real estate analysis is a form of due diligence. It reveals the trends and helps industry experts predict the future. The analysis looks at various economic, socioeconomic, and demographic factors. This helps to arrive at a decision. Moreover, it also includes employment rates, housing vacancy, and cost of housing.
The result of the analysis helps reveal critical information such as
- Supply and demand
- Income-generating potential
What are the 4 Main Categories of Commercial Real Estate?
Commercial real estate is reserved for properties used for commercial and industrial purposes. It also serves as a residence for tenants (multifamily real estate) under a landlord.
The four main categories of commercial real estate include:
- Multi-family rental
- Office space
These categories can further be classified for zoning and licensing needs.
For example, office spaces can further be categorized as Class A, Class B, and Class C.
- Class A is the best of the lot with regards to space, location, age, aesthetics, and infrastructure.
- Class B is older and not priced as much as class A buildings. Therefore, developers target these for restoration purposes.
- Class C are old buildings over 20 years of age and in not-so preferred areas. They are in dire need of maintenance.
How to Analyze Commercial Real Estate Deals
More and more investors are looking to invest in commercial real estate deals. However, it can be challenging for even an expert, much less a novice. Hence, real estate professionals prefer to analyze a commercial real estate deal from micro and macro levels. For example, general market trends are one factor in the macro levels.
Some property-specific details have to be studied too. Each of these factors determines whether to buy or sell commercial real estate. And also on whether they invest in a primary market, secondary market, or tertiary market.
Assess Market Trends
Investors looking to invest in commercial real estate can learn about a deal in a few different ways. One way is to hunt for deals which a beginner can find challenging. Another common way is to look for partners who can bring the deals to your attention. In either case, the first step is to monitor the industry trends.
First, a commercial real estate investor will want to understand the market cycle. And where we are right now. Market cycles generally last around a decade. In any case, it is pretty risky to invest when the market is at its peak.
Where we are in the market cycle can affect your industrial real estate investments regardless of the location. Hence it pays to follow a local market when analyzing commercial real estate trends. The following questions can help you understand more about the local market trends:
- Is the population shrinking or increasing? If it’s the latter, why are people moving here?
- Who is the major employer in the area? What is the rate of unemployment? How diverse is the local economy?
- What is the average household income?
Conduct Commercial Property Analysis
Commercial property analysis is a comprehensive evaluation of various quantitative and qualitative variables. For example, you are ready to invest in a certain submarket based on positive market analysis. These factors help you identify the feasibility of the transaction.
The most important of these factors are the numbers from the property. It includes income, operating expenses, property taxes, insurance, and general maintenance. They help a prospective investor determine the return on investment.
Other quantitative factors investors may be interested in are:
- Age of the building
- Square footage
- Number of units
- Lot size
- Length of the current ownership
Remodeling is a significant factor investor may consider. That is assuming that buyers are ready to undertake any remodeling after the sale. Remodeling requires quite a significant capital but is a value add.
Investors also consider the property history of any asset. Investors will want to know:
- When was the property built?
- When were the major systems like HVAC and roof installed?
- How long has the current landlord owned the property?
Property patterns are pretty obvious. For example, consider that a business turns around more often. It is likely an indicator that it has often underperformed.
Performances can be gauged by factors like vacancy rates and current rate rentals. Property owners should realize that the ownership structure is a key part of history. And that it reflects the property’s performance and vacant rates.
Building and Lot Analysis
A buyer should conduct the building and zoning analysis before investing. This means identifying the current land and its size and configuration. Besides, you also need to know the local zoning ordinance to verify how the parcel will be zoned. It also tells you how many houses can be built on the estate.
Properties zoned for one particular use can be redeveloped for other uses. There will likely be what’s called the “entitlement process.” A prospective buyer seeks permission from the town to build a new structure. This could include obtaining specific variances or zoning reforms. It is often the case when the owners are constructing a structure other than the permitted one.
Net Operating Income
NOI is derived when the gross profit is subtracted from the operating expenses. The operating expenses include all expenses necessary for maintaining a piece of property. It includes expenses such as taxes, insurance, utilities, and management. Besides, repairs and maintenance are also considered operating expenses. On the other hand, improvement and renovations are not. Therefore, calculating the NOI is an essential part of valuing the fair market value.
Monthly Cash Flow
NOI and cash flow are close enough that many use these terms for the other. Cash flow is the sum of all profits and losses generated by the asset. The net cash flow can be measured using the formula:
NIO – debt service payments, tenant improvements, lease commission, and capital expenditures.
Cash on Cash Return
Cash on Cash Return is the indicator of the property value. It is a measure that calculates the return on investment. Cash on cash return is measured using the below formula:
Annual Cash Flow(Pre-Tax)/ Total Investment x 100%
Most commercial real estate investors will look at properties that have a cash-on-cash return of 8%-12%.
In commercial real estate, “cap rates” refers to capitalization rates. It is a formula used for estimating the potential return for investing in a property. The cap is represented in percentages that range between 3% and 10%.
Caps generally have an inverse relationship with the property value. The more valuable the property is, the lower the cap rate. For example, buildings that generate more than $500,000 of NOI and cost tens of millions to buy can have a cap rate of 5%.
How do I Run Comps on Commercial Real Estate Deals?
Commercial real estate is evaluated on different terms than residential real estate. However, both of them consider the price and sales of comparable properties in the same area. In the case of commercial real estate, it is not everything.
Real estate professionals use a set of comparisons or comps to evaluate the property. The most common method is to compare the cap rate of similar properties. To calculate the cap rate, divide the sale price of the property by the net operating income.
The less common valuation methods include:
- Net Operating Income – Income the asset brings, including any loss, vacancy but before mortgage payments.
- Cash Flows – Profit after all the expenses are paid, including the mortgage.
- Cash on Cash Return – A measure of ROI calculated by dividing the capital with the annual cash flow.
- Gross Income – Cash flow before the expenses
The largest commercial listing website is Loopnet.com. It is owned by the commercial property database CoStar.com. This is also where you can locate commercial property leasing comps and listings. Commercial properties are not listed under marketplaces such as Zillow, Realtor, or Trulia.
How Do You Determine if a Commercial Real Estate Property is a Good Investment?
Investing in commercial real estate has several advantages and disadvantages. Many investors understand the benefits of such an investment. However, investors should do due diligence to verify if it is a good investment. Furthermore, it should also fit your financial goals and limitations.
Ask yourselves these questions:
- What is the monthly cash flow?
- If the cash flow is low, does that mean the property is not a good investment?
- The property has a good cash flow but with risks. Is it worth investing in?
Keep in mind that the answer will vary for each property, and so should your expectations. It is up to you to decide if the property meets your expectations and helps you reach financial goals. But, commercial real estate properties with a good cash flow are a good passive investment strategy.
A property is a value-add if it requires more work before being rented out or charged higher rent. A value-add asset should:
- Requires renovation
- Prolonged maintenance
- Need better curb appeal
Keep in mind that this is an active investment strategy. And until you do the value add, the cash flow will be lower. Once the renovations are complete, you can see a better cash flow or sale price. However, you will need to be on top of the team or rely on someone to complete it on time.
How long are you planning on holding on to the property? Here are some timelines expected for the investment strategies:
- Value add properties have a holding time of 1-3 years.
- Flipping strategy involves buying and selling within a year.
- Cash flow properties stay on hand until they generate the income required to invest in another property.
- Commercial properties in prime real estate areas are generally not sold or flipped. Therefore, there are chances that the market value will keep on increasing.
Here are some questions you may want to ask before deciding on the possible appreciation:
- What is the demand for land or space for new constructions in the locality?
- Is there a floating population of people moving in the area?
- Are the rental prices increasing?
What is the 2% Rule in Real Estate?
The 2% rule of real estate helps to identify profitable investment opportunities. In the real estate sector, investors use it to locate better investments. The 2% rule is generally a guideline and not always feasible. It is considered extreme by experts since it is not possible to adhere to.
The 2% rule is a good commercial property generates a monthly rent of 2% of the purchase price.
What is a Good Return on Investment for Commercial Property?
The ROI of a commercial property can range anywhere between 5% and 10%, much more than that of a residential property. The latter has an ROI of just 1%-3%. This is because the commercial real estates follow a lease agreement, not a rental. The lease agreement can run for years altogether, even as long as ten years.
Commercial real estate is those that are used for business or income-generating purposes. Investing in commercial property requires more finesse and significant capital from investors. The analysis and investment process is quite complex for commercial real estate. This discourages investors from analyzing commercial real estate deals.
The first few deals are the most challenging. However, it gets easy with time. Experienced investors will look into many deals before investing in one. Most deals require a commercial real estate broker and a real estate attorney on the table. Though the seller will have a team, having your team is in your best interests. You may also want to consult with a financial advisor to check if the investment is aligned with your financial goals.
Once you score the property, hire a property manager as the first order of things. The right property manager can make or break an investment.