Once you decide to invest in commercial real estate, the next question becomes: how should I invest? Commercial real estate – like its residential counterpart – offers a variety of different strategies. Depending on your goals, experience, and unique situation, focusing on one particular strategy may make the most sense. Alternatively, some investors choose strategies on a deal-by-deal basis, determining what works best for a particular situation.
Regardless of which strategy you embrace, multiple commercial real estate investment strategies exist. As such, we’ll use this article to provide an overview, pros, and cons of four popular strategies. Specifically, we’ll cover the following topics:
- The Buy and Hold Strategy
- Traditional Development
- The Value-Add Strategy
- Owner-Occupied Buildings
- Final Thoughts
The Buy and Hold Strategy
As the name suggests, this strategy entails finding a stabilized property, purchasing it, and continuing its operations. That is, investors buy a successfully operating commercial property and hold it long-term.
A primary goal of this strategy is to minimize the work necessary to begin collecting income. These investors don’t want to deal with any renovation work or tenant placements. Instead, they buy a property that’s already effectively generating income to make an immediate return on their investment.
To pursue this strategy, investors need to first determine their target property type (e.g. multifamily/apartment, office, industrial, etc.). And, related to type, investors should consider the following factors when defining their target property:
- Desired level of involvement: Do you plan on managing the property’s day-to-day operations? If so, you’ll likely receive higher returns by minimizing your property management expenses. But, at the same, this means that: A) the building must be located in your area, and B) the time you put into managing this building can’t be used to focus on new investments.
- Overall investment objectives: What’s your overall investment objective for the deal? An investor looking to exit a deal on a five-year horizon will likely take a different approach to target properties compared to one looking to build a long-term commercial portfolio.
- Immediate profit paths: Due to the stabilized nature of these properties, investors immediately begin profiting in three ways. First, you collect cash flows from tenant rents. Second, loan amortization builds your equity in the property every month as you gradually pay down your loan principal. And, third, the long-term nature of these deals allows you to reap the benefits of property appreciation.
- Limited risks: When you buy a stabilized property, someone else (typically a real estate developer) has already assumed the majority of the deal’s risk. You already know that this deal successfully generates income at purchase. And, you can input those exact numbers – not rent projections – into your underwriting analysis.
- No rehab/construction requirements: Once again, this lets you begin generating income immediately. Rather than spend a period rehabbing a property, investors immediately begin collecting rents while not needing to oversee contractor work.
- Retail prices: When you buy a stabilized property, you’ll likely pay retail. Unlike a distressed property deal, investors typically won’t get any discounts on these purchases. This reality can make finding a deal that meets your financial objectives challenging. Rather, many of these properties function more like long-term bonds, providing stable – but lower – returns over the long run.
With this strategy, investors take a deal through its entire lifecycle: initial vision, planning and development, construction, and stabilization. Depending on your investment goals, you can either A) sell the stabilized property post-development, or B) continue to operate it yourself.
While this process can follow a variety of approaches, some common steps apply to every development:
- Initial vision: A development begins with a vision and “big picture” plan for the deal. What will the final property look like? How will the numbers work? Where will you develop the property? From this, investors can begin confirming their capital stack, that is, their combination of equity and debt to finance the deal.
- Formal development: This involves taking the steps to translate the above vision into reality. Architects, engineers, contractors, and zoning specialists will help confirm site selection and the detailed plan for that property. From these formal plans, developers complete detailed pro formas for the stabilized property. Armed with this information, investors secure financing to purchase the site and begin construction.
- Acquisition and construction: Typically with short-term commercial financing, developers acquire and begin construction on a property. During this phase, investors must supervise the actual construction of a property.
- Marketing and stabilization: Investors market to and sign leases with tenants to fully stabilize this property. Once meeting a certain occupancy level, developers can then secure long-term financing if planning on holding the property. Alternatively, they can sell the property to other investors at this point to exit the deal.
- Highest potential returns: Without a doubt, traditional development offers investors the largest return on investment in commercial real estate.
- Create your own vision: For investors with a clear vision, development allows them the most flexibility to plan and execute that vision. If you buy a stabilized property – or even one to renovate – you’re limited in ways to change that property. When you start with a patch of dirt, you can create a property to your exact specifications (albeit within zoning, financial, and structural limitations).
- Significant capital and experience requirements: This is not a strategy for novice investors. Developing a property requires a ton of experience. Investors need to have intimate knowledge of commercial financing, zoning regulations, construction, real estate legal restrictions, tenant marketing and placement, to name just a few. And, developments require major up-front investments. Before securing financing, investors need to pour tens of thousands of dollars (or more) into feasibility studies and designs.
- Risk: While offering the highest returns, traditional development also comes with the most risk. If you hit some obstacle and fail to complete a development, you’ll likely lose your entire initial investment – all the money you spent trying to make the deal happen.
- Ordinary income tax treatment: Unfortunately, the IRS generally treats developers as real estate dealers. This means that the bulk of a development deal’s profit will receive ordinary income tax treatment (as opposed to the more favorable long-term capital gains rate). A tax professional can help develop strategies to mitigate this reality, but developers still need to plan for this higher tax bill.
The Value-Add Strategy
This strategy entails buying an income-producing property, making some improvements (i.e. adding value), and continuing to operate it. Due to the popularity of the strategy in the residential investing world, many people refer to this as commercial BRRRR, meaning:
First, investors look for a property they can buy at a discount. This could be due to distressed nature, a prior owner who broke a debt covenant, or a variety of other causes. Investors then renovate the building, adding perceived value (hence, value-add). Common BRRRR improvements include:
- Updated lighting
- New interior and exterior paint
- New floors
- Improved common areas and signage
It’s also important to note that, with BRRRR improvements, investors generally don’t completely overhaul the building. Instead, the goal is to renovate to the point that the building appears new (or at least far newer than pre-renovation) while staying within a deal’s budget.
Once renovated, investors find, screen, and place quality tenants. This step enables the third “R” – refinance. Normally, BRRRR investors use short-term financing to purchase and rehab a property. Once they’ve conducted improvements and placed tenants, the property value should increase due to the associated increase in net operating income (NOI). Consequently, they can refinance the property into a long-term mortgage. If analyzed properly, this refinance will allow investors to recover their initial capital, leading to the final “R” – repeat. After recovering this initial capital investment, investors can roll it into another deal.
- Purchase discounts: As BRRRR investors seek distressed properties to purchase, they inherently only look for places at a steep discount. Yes, they will then need to pour money into rehab work, but, even with these costs, investors can typically get into these deals for less than buying a stabilized property at retail.
- Replicability: As stated, a properly analyzed BRRRR deal will allow investors to recover their initial capital when they refinance. This creates the potential for a replicable investment strategy. For example, say you raise an initial $200,000. With a buy and hold deal, that will provide a down payment for a single $1,000,000 deal. With BRRRR, that $200,000 can serve as the initial capital for deal after deal.
- Time and effort: Renovations take time, especially if you need to stagger them with current tenants (e.g. renovating a 100-unit apartment building). Additionally, investors need to pour effort into this strategy in supervising contractor work. For someone looking to invest with limited effort, this may not make sense.
- Value risks: Successfully repeating this strategy depends on the actual post-rehab value aligning with your projected value. If, after the renovation, the property appraises at far less than your initial estimate, you may struggle to recover your capital, derailing future investments. To prevent this outcome, investors should always take conservative underwriting approaches in estimating future values.
This strategy roughly parallels the residential real estate strategy of “house hacking,” where an owner lives in one room while leasing the others. On the commercial side, this means purchasing a building and having your business occupy a portion of it while leasing the remaining units to other tenants.
Your business could be a real estate one or something completely unrelated (e.g. you run a financial planning service and invest in real estate on the side). Regardless of the situation, this approach adjusts a real estate investor’s priorities. Rather than take an investment first, business second, owner-occupied buildings require a business first, investment second approach. That is, how can you align your business’s needs with real estate investing goals?
Normally, investors structure these property purchases as a separate legal entity (e.g. 123 Main Street, LLC). Then, your separate business signs a lease directly with this property entity. This structure provides a liability wall between your business and the property, and it facilitates the tax benefits of the deal.
- Favorable financing: Many lenders will provide advantageous commercial mortgage terms when you occupy a portion of that property (e.g. lower rates and longer terms).
- Control: When you serve as both landlord and tenant, you have total control over your business’s space. If you want to make any changes, you don’t need to negotiate with a separate landlord.
- Tax advantages: This system allows you to convert the tax deductions for your business’s rent expense into passive rental income offset by depreciation. In other words, you get a double tax advantage. You can always deduct business rent as a necessary operating expense. But, when you pay this rent to yourself (as a separate legal entity), it also becomes tax-advantaged passive income.
- Percentage occupied requirements: To qualify for advantageous owner-occupied financing, most lenders require that your business occupy a certain percentage of the building’s space, typically 50%. This limits your flexibility in designing the other rental units in a building.
- Mixing business with real estate environments: No business owner wants disgruntled tenants knocking on their door. When you co-locate your office with unrelated tenants, this could happen. But, by properly structuring the building’s operations with a third-party management company, you can avoid this situation.
More commercial real estate investment strategies exist than the ones described in this article. But, as common options, new investors should certainly familiarize themselves with these ones. Each strategy has its own unique considerations, pros, and cons. By having a solid grasp of each, you can make an informed decision about what strategy best supports your personal investment objectives.
If you’d like to discuss different commercial real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available real estate investment opportunities – and the associated strategies.