Commercial Real Estate: Learn the basics of investing in commercial real estate and how you can use it as part of your portfolio.

In this article:

• Commercial Real Estate: A Good Deal
• Uncovering the Reality of Cash Flow: The Importance of Cash-on-Cash Return
• Balancing Investment Considerations: The Interplay of ROI, Cash-on-Cash, and Other Key Factors
• Understanding the Commercial Real Estate Individual Investor
• Maintaining Value: Assessing a Commercial Real Estate Property’s Value Through Appraisal
• FAQs
  • About the Author

Anyone who has been involved in real estate investment has heard that classic initiation of the real estate purchase, “Have I got a deal for you.” At one time or another, you’ve probably heard about deals that sounded good or bad for one of the parties. However, as you get more involved in real estate, you will see the truth in the saying, “There is a buyer for every property in America.”

Everybody has different reasons for buying and for selling. A property that one person wants to get off his hands might be exactly what someone else is looking for. Often, you hear from a seller that he was thrilled about his selling price. Perhaps, he had bought the building cheap many years ago and he was now getting old and wanted to retire. Or perhaps the building’s neighborhood and condition required too much money and management, and he just wants to walk away with what he perceives to be a fair price. Speaking to the buyer in the very same deal, you may hear that he sees the building as a great acquisition. He may feel that he can invest energy, time, and money into the property and eventually raise its income and value.

Commercial Real Estate: A Good Deal

A two-family house went up for sale in your neighborhood for $160,000. How would you go about deciding if it is a worthwhile investment? Naturally, the first thing you want to find out is the amount of profit that the building could bring you. Suppose your initial inquiries yield the following information:

According to the prevailing market, each apartment could be rented for $1,200 per month. Monthly payments for the mortgage (the loan for the acquisition of the building), come to $1,400. All other expenses for maintenance and repair of the building are estimated at $550 a month, bringing the total expenses to $1,950. With a total income of $2,400 a month, (2 apartments at $1,200), and expenses of $1,950, the Net Profit, or the Net Operating Income (NOI) is $450 a month. The Net Operating Income is the bottom line profit of a building and is calculated by subtracting all expenses from the gross effective income.

Four hundred and fifty dollars in your pocket every month certainly sounds good, but does it necessarily mean that it is a worthwhile investment? To find out, you must apply the Return on Investment. The ROI is the basic measure of a good investment. It measures the annual percentage of the original actual investment that returns to the buyer as profit. This number is the most reliable indicator of how profitable a deal is. The higher the ROI, the stronger your money is working for you.

Uncovering the Reality of Cash Flow: The Importance of Cash-on-Cash Return

Aside from being able to ascertain how strong an investment is, an investor wants to predict how much cash he can expect to get back from the deal and how quickly he will get it. For most investors, who do not have unlimited cash reserve, it is important to know how quickly cash will become available so that the money can be used for future deals. The ROI, which takes into account all net profits from a property including those not available as cash, cannot provide this information. For this information he needs to look at the cash-on-cash return. The cash-on-cash return is defined as the percent return on the buyer’s actual out-of-pocket costs, down payment plus closing costs, less the annual operating expenses, reserves, and annual debt service payments. Since the cash-on-cash considers all destinations of outgoing cash (such as reserves) as expenses, it is an accurate indicator of the cash that is actually available annually.

Once an investor decides on a cash-on-cash return that he is comfortable with, he can then use that percentage to weed out any deals that are not appropriate for his investment needs.

Balancing Investment Considerations: The Interplay of ROI, Cash-on-Cash, and Other Key Factors

The return that an investor usually seeks for a minimal-risk investment is 12% to 15% cash-on-cash. The cash-on-cash percentage and the ROI, however, are not the only factors that are taken into account in an investment. There are countless angles to take into account on each deal and different investors approach investments from different perspectives. Here are 4 of the most common factors which affect any investment.

• Safety of investment
• Development potential
• Financial instincts
• Location

Safety of Investment

The safer an investment is, the less return that an investor will demand to see for it. For example: If a six-family house became available next door to where he lived, although your calculations show only an 8.5% ROI, it could still be considered a good investment, since your familiarity with the area makes it a safer-than-average investment. Keep in mind that over time you can build up equity, meaning that the value of the building will likely increase, you would invest even without making your 12% to 15% goal. 

 Development Potential

A buyer may consider a property at a price of $1,100,000 and make the following calculation: “This building has an NOI of $72,967 and may only be worth $1,000,000. However, if I do certain improvements, upgrade these items, or extend the building, within a year it can be worth $1,500,000.” This buyer would be willing to overpay today with a price of $1,100,000 and then invest an additional $200,000 towards renovations since when all is said and done, he hopes to increase the NOI and thereby bring the overall worth of the property to $1,500,000. The $100,000 extra that he paid for the building, plus $200,000 in renovations will have been well worth it.

Financial Instincts

An investor may disregard the actual number of the ROI in his conviction that the building is worth more than the NOI indicates. He may be relying on his years of experience in the field, or he may know, based on owning other similar properties in the neighborhood, how much such a building will sell per square foot.

Location

A buyer may overpay because he is planning on using his purchase as an owner-occupied property and this location will give him a higher natural value. The same principle is illustrated by the sale of one-family homes where the price is based on location, not on the potential income that a given house could produce.

Understanding the Commercial Real Estate Individual Investor

The dominant factor that affects every deal, however, is the unique personality and situation of the investor. Everyone invests his money in different places based on his own perception of risk vs. reward. A deal that seems risky for one investor may seem reasonable to another. All investors have different budgets, circumstances, and outlooks. What an older investor might consider an undue risk might be considered by a younger investor to be a great opportunity.

As a broker, it is important to recognize with whom you are dealing. Knowing the individual client and his situation is the first requirement in representing his interests.

Maintaining Value: Assessing a Commercial Real Estate Property’s Value Through Appraisal

Despite projections for healthy profits, an experienced investor only goes through with a purchase if he is convinced that he can recoup the initial purchase price in the case that he has to sell the property. In order to assure this, the prospective buyer must have an appraisal (estimation of value) done on the property. The appraiser will tell him what the real value of the building is at the present and give an estimate of its future value. 

FAQs:

1. What is cash-on-cash return and how does it help an investor in property investment?The cash-on-cash return is a metric that measures the actual cash return on an investment property, taking into account the out-of-pocket costs, down payment, closing costs, and all annual expenses including operating expenses, reserves, and debt service payments. This metric provides the investor with an accurate indication of the annual cash available from the investment and helps the investor determine if the investment fits their target return.
2. How do the personality and situation of an investor affect their investment decisions? Every investor has a unique perception of risk vs. reward, and their investment decisions are influenced by their personal circumstances, budget, and outlook. As a broker, it is important to understand the individual investor and their situation to effectively represent their interests. Recognizing the client’s personality and situation is the first step in making informed investment recommendations and ensuring their success.
3. What are some minimal risk investment options in commercial real estate? There are several investment options in commercial real estate that offer low risk for investors. Some of these include:
   
   • Real Estate Investment Trusts (REITs): These are professionally managed portfolios of commercial properties that are bought and sold on the stock exchange.
   • Commercial Real Estate Funds: These are mutual funds that invest in commercial properties and offer low risk due to the diversification of assets.
   • Direct Real Estate Investment: Investing directly in commercial properties can also offer low risk if done correctly, by investing in stable, income-generating properties with strong tenant history and good cash flow.