Becoming a commercial real estate investor will take time and considerable effort. That said, the journey really does start by taking that first step.
But what is the first step? How can you start your journey with the understanding that you’re putting yourself in the best position to make a solid return on your investment?
Here are a few “first steps” you can take before you purchase a commercial property, such as a multifamily building, retail strip center, or office space.
1. Do your homework
There are a few key differences between commercial and residential investing – those who plan to purchase their first commercial property must understand these differences if they hope to see a strong return on their investment.
Perhaps most important is the issue of property valuation. While the value of a residential home is mostly derived from studying comparable properties in the area, a commercial property’s value is determined by the amount of income it generates. As a result, the tenants within a commercial property – their experience levels and business models – should be studied before making any type of purchase.
Since you’ll likely obtain a loan to help you purchase a property, it’s also important to understand how financing works in the commercial real estate world.
In their efforts to evaluate a property’s ability to generate income, lenders use calculations that may be new to you.
One prevalent metric within the commercial mortgage transaction process is the Debt Service Coverage Ratio (DSCR). This metric is calculated using the derived property Net Operating Income – the amount of net income after expenses – divided by the debt service (the principal and interest payments).
The objective for the lender is to determine how much they feel comfortable lending based on the amount of income the property generates.
Of course, lenders also review the borrowers themselves. Traditional lenders will want to see documentation such as tax returns, though this can present difficulty for certain investors.
Fortunately, reduced documentation loans do exist in today’s market. These carry a slightly higher interest rate, but they give investors more flexibility – a tradeoff many are more than willing to make.
Finally, you should also take time to become familiar with the various aspects of running a commercial property. The amount of maintenance and management involved can be substantial, so much so that many owners hire full-time property managers to run day-to-day operations.
If you’re not prepared to devote much time and effort to your commercial property, perhaps now is not the time to invest.
2. Start with the end in mind
Investors who only plan for the initial purchase of their commercial real estate property are setting themselves up for failure. That’s because one of the main keys of successful property ownership is a solid exit strategy.
What’s your ultimate objective? Are you looking to execute a fix-and-flip? Do you want to pass the property down to future generations?
Length of ownership is an important consideration because it impacts the type of financing you’ll want to secure as you purchase the property. Those with a long-term vision for their investment may want to minimize payments with a long-term financing solution – like a 30-year fixed rate loan.
On the other hand, “fix-and-flippers” may prefer a short-term loan that allows them to quickly transition to their next investment opportunity.
Thinking ahead will also help as you review potential purchases. For example, it could be a wise strategy to own a multifamily property in a growing sector. As the population increases, so does the demand for a unit in your building.
However, those looking to purchase certain property types, such as retail strip centers, should carefully review market trends to avoid owning a retail property in an economically distressed area. Investing in commercial real estate can be a rewarding experience, but those who wish to purchase a property must take several important steps to increase their chances of seeing a positive return.
The steps listed above are just the beginning. To learn more about the process – especially when it comes to the financing of commercial properties – reach out to one of our mortgage experts today.