If you’ve been considering investing in commercial real estate, it’s important to know that there are some significant differences between a residential income property and a commercial income property.
We’ve previously written about how to identify a good residential income property and it is high time we talked about commercial income properties. Here’s our three cardinal rules on how to make sure it’s a wise investment.
Thou Shalt Have Deep Pockets
While commercial real estate can be more expensive than residential real estate, this rule is actually referring to vacancy rates.
With residential real estate, if you are having trouble finding a tenant, you can lower the price until you find someone to rent the home. After all, when a tenant is looking for a residential property where they can live, it is really just a question of how well the place fits their needs and budget. If it really fits their budget or is under it, they might consider revising what they “need” in the home.
For a commercial tenant, the space needs to work for their business. Cheaper rent is irrelevant if it doesn’t fit their requirements. Think about it from the perspective of the commercial tenant:
- If you run a store that relies on being visible and having decent traffic pass by via foot and car, then you can’t rent a 2nd floor space in an industrial plaza. Well, you can, but the landlord will have to rent it out again in a few months when you go out of business.
- If you need a restaurant location with a full kitchen, roof venting and space for up to 50 customers, the office space on the 12th floor of tower isn’t suitable, no matter how cheap the price per sf.
- If you operate a daycare, then finding a place that’s practically free to rent doesn’t matter if the space doesn’t (and can’t) meet the government regulations for childcare spaces.
It is for this reason that investors in commercial real estate need to be in a situation where the property becoming vacant in between tenants is not a dire situation. It is not unusual for commercial properties to see vacancy for months while they try to attract a tenant whose business fits the space. In some cases, we’ve seen vacancies of over a year. With high commercial property taxes and no rental income, you need to have reserve funds in place for such situations. If you require regular, consistent monthly income in order to cashflow the property, commercial investing may not be for you.
We recommend that investors have a reserve fund equal to one year’s expenses for the ownership and maintenance of each commercial property. You may not need it, but if you don’t have it when you do, you’ll be in a very tough spot.
Stick To What You Know
In residential real estate, we’re all experts by default. We all need to have a home to live in and we all understand the experience of living in a home.
In commercial real estate, it can be disastrous to end up buying a property where the end user is in a business you know nothing about.
- A vacant restaurant property can look like a great bargain but turn out to be impossible to rent to any savvy restauranteur due to problems with the layout, design, features and so forth.
- A low-priced industrial property with a stable history of great rental rates can be just about to hit a regulatory milestone where tenants can no longer operate in such facilities.
- A just vacated medical clinic might look like an easy place to rent out quickly, only the vacancy took place due to zoning violations and the building requires significant renovation for those business operations for which it is zoned.
Such problematic properties often appear to be great investments but result in high tenant turnover, rent payment issues and long vacancy periods before the whole cycle begins anew. If you don’t understand – at a deep level – the industry in which the tenants for the space operate, then you won’t notice the issues with the property.
We recommend that investors educate themselves thoroughly in the industry in which prospective tenants for the investment property work within – otherwise it is very easy to buy into a problem property.
The final area where commercial income properties differ significantly from residential investments is the specialized knowledge necessary to successfully conclude the transaction. While there are many different calibres of residential Realtors and lawyers, the fundamental nature of residential real estate is less complex than commercial real estate. In essence, we lump a wide range of properties and businesses under the term commercial, whereas residential is simply residences.
When you buy a residential income property and when you rent it to a tenant to live in, the processes are pretty straightforward and routine. Most home purchases are very similar and while different housing types (freehold vs condominiums for example) have different aspects, they follow a defined and common path. On the rental side, the paperwork is set out quite clearly, regardless of whether you use a Realtor (OREA’s Agreement to Lease) or go out on your own (the Ontario Standard Lease).
Purchasing a commercial property invariably involves unique considerations and an experienced lawyer is necessary to make sure the property is suitable for the described end use. Zoning, environmental assessments, taxes – commercial property has a whole host of other considerations that need to be reviewed by an experienced lawyer.
Similarly, the real estate agent you use to buy a commercial investment property needs to be well versed in both purchasing and renting out such spaces. While it is crucial to have a good understanding of the industry yourself, you need to align yourself with an agent who can put themselves fully in the shoes of prospective tenants to advise you on whether the space will be appealing to those businesses.
On the leasing side, commercial properties are again much more complex than renting out an income property for residential occupancy. With residential income properties, you look for a good credit score, good income and a stable history. With commercial income properties, you’re looking at more variables in the lease itself (graduated rental rates, base rent plus additional rent, signage and so on) as well as more challenges in predicting whether the tenant will be a good one or not.
When you’re a landlord signing a tenant to a commercial lease, you have to go beyond the basics to assess whether you believe that the business can succeed operating out of your property. The term “covenant” is often used as a short form for the strength of the tenant and the overall lease agreement.
A large, corporate client might have a very strong covenant where their word (the actual covenant in this case) to live up to the terms of the lease is considered reliable. A smaller tenant who is starting a new business and doesn’t have the track record to show would be considered to have a weak covenant. Basically, it is uncertain whether they can in fact live up to the terms of the lease, including paying rent and following through on their other obligations.
We recommend that you make sure to work with experienced lawyers and real estate agents who regularly do commercial transactions. While all lawyers and Realtors can handle residential and commercial transactions, it’s wise to involve professionals who do handle them regularly and who know the right questions to ask.
Commercial investment properties are complex and requires that the Realtors involved understand how businesses operate so they can assist their client in deciding if their property is the right fit for a particular tenant and their business.
If you follow our three rules and are well capitalized, invest in properties suitable for industries you understand and hire experienced partners, commercial real estate can be very lucrative. If it sounds like it might be a fit for you and you want to talk further, don’t hesitate to get in touch with us!