We have all heard of the saying that 70% of the world’s millionaires are made through Real Estate. That’s true but majority of these millionaires are made investing in Commercial Real Estate versus Residential Real Estate. Commercial Real Estate however, seems to be very complex and out of reach for the masses.
Here are 5 tips to help you decode Commercial Real Estate Investing.
- Net Operating Income and Cap Rate : Transacting Commercial Real Estate is akin to transacting a business. It primarily deals in Net Income and Multiples. Net Operating Income is essentially the cash flow you expect to generate from the rents of a property. NOI is calculated by taking all reasonable revenues and subtracting all operating expenses (excluding capital improvements, mortgage payments, taxes and depreciation etc.). While Capitalization (Cap) Rate in its simplest definition is the cash on cash rate of return you expect to generate on the investment. For example. If a property produces $100,000 in annual Net Operating Income and you expect to make 10% (Cap rate) cash on cash return on the purchase, you would purchase the property for $1M.
- Actual NOI vs. Pro Forma NOI : It is imperative to watch out for this term. Commercial Real Estate Brokers are not bound by the same ethos as Residential Real Estate Brokers, so its a buyers beware world. Pro Forma NOI is an assumptive NOI. Most Real Estate Brokers will market a property based on an assumed NOI i.e. lets say a property is actually 75% occupied and actually produces a Net Income of $75,000. However, if it was 100% occupied, it could produce an income of $100,000 (pro forma), some brokers and sellers will market it based on a potential income of $100,000 hence inflating the selling price. As a buyer, it is prudent to understand the difference between Actual NOI and Pro Forma NOI.
- Yield Play vs. Value Play : These are the two primary method of determining which investing method you are pursuing. Yield Play is essentially buying a property primarily for the income or cash flow. In stocks investing, it is similar to buying a stock primarily for its dividend. You do not expect much appreciation from a Yield Play. While Value Play, is basically buying a property with a lot of room to grow its appreciation and cashflow. It is seeking a property that is underperforming in some ways and finding a way to get it to perform higher than it current state. In stocks investing, value play is similar to buying a growth stock.
- Direct & Indirect Investing : Direct investing means owning a stake or whole ownership in a Real Estate Asset. It is very expensive to invest directly in Commercial Real Estate even with financing in place. However, you have more control of your investments when you invest directly. Indirect Investing in Commercial Real Estate is becoming increasing popular. Methods such as Investing in Real Estate Investment Trust (REITs), Real Estate Focused Exchange Traded Funds (ETFs), Crowdfunding such as Fundrise, Peer Street, 1031 Crowdfunding etc., Private Equity Groups (usually reserved for people that falls under the Regulation D of the Securities and Exchange Commission (SEC) i.e. accredited investors, sophisticated investors, friends and family.)
- Consult a Professional Commercial Real Estate Broker: Ultimately, investing in Commercial Real Estate can be extremely lucrative, this is the reason why Real Estate has produced more millionaires than any other investment class in the world. However, it is also extremely risky. To invest in Commercial Real Estate, you will have to understand concepts such as : Due Diligence, Market Research, Inspections, Environmental Assessments, Appraisals, Tenant Mix, Land, Supply & Demand, Letters of Intent, Internal Rate of Return (IRR) etc. It is extremely advisable to always consult a professional, knowledgeable Real Estate broker with Integrity.
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