Commercial Real Estate Investing
Welcome to the world of commercial real estate investing. Whether you are an experienced investor with a mature portfolio, or someone simply looking to understand what's involved and how it works, I think you will find this information a refreshingly uncomplicated discussion about the most essential basics.
The first thing we should distinguish is what commercial investment property is and what it is not. Keep in mind this definition depends on who you ask: the investor, the lender, the Realtor or an anonymous bystander. In general, commercial real estate is considered any real estate purchased for the purpose of commerce - that is the business of making and/or saving money. That can take many forms such as passive income, appreciation, tax savings or all of the above. This does not include the home in which you live, as that is not purchased for commerce. For the purposes of lending, single family homes or multi-family homes with four or less units are not considered commercial either. Some good general examples of commercial real estate are: office buildings, retail, warehouse spaces, and apartment buildings.
One of the things that separate commercial real estate from residential real estate is how it is valued. Our homes are valued based on the market: what similar homes in similar locations in similar condition are selling for. While that is one of the factors for commercial real estate, it is not the only one. In commercial we also typically take into account the following factors:
- The cost to build a similar building in a similar area
- Market comparables
- Income. An appraiser will typically focus on one or two of these areas over the others.
Let's now look at income, as this is one of the more important areas for an investor. First thing to look at is Net Operating Income, or NOI for short. This is easily calculated by taking all the income of the property as if it is 100% occupied, then subtract all the actual expenses such as vacancies, uncollected rents, utilities, management, repairs, maintenance, facilities upkeep, taxes and other assessments for example. What's left is your NOI.
Now that you have this figure, you can calculate what your capitalization rate is, or CAP Rate, for short. Simply put, your CAP rate is the ratio between the asking price (or purchase price) and the NOI. For example, if the property you're considering has $50,000 NOI and asking price is $500,000, your CAP rate is .10 or 10%. The higher the CAP Rate, the better the deal for the investor, or said another way, the greater the return on investment (ROI).
