“Why should I invest in Commercial Real Estate?,” someone recently asked me. With the well-publicized drop in residential prices in some areas of the country, it might seem prudent to be avoiding real estate right now. Fortunately, all real estate is local, and San Antonio has actually been showing appreciation in prices, even though sales volume has slowed to merely what it was in 2005. But commercial real estate is a different animal altogether:
First, commercial real estate is strictly property for businesses, i.e., retail centers, office buildings, warehouses, manufacturing sites, apartments, and land.
Second, there is less of it than homes. There are about 14,500 pieces of commercial property in San Antonio versus perhaps 300,000 homes.
Third, commercial real estate is either for the use of a business or for producing an investment return, as opposed to a house you and your family may live in.
So, why invest in this area? Some of the great fortunes in the U.S. have been based on real estate. Be it the King Ranch or Donald Trump, property investment can produce returns far in excess of the rate of inflation. Diversification is fundamental to good financial planning and that means splitting up your investable dollars into different sectors that will not act similarly. Investing in the stock market, where you can see the hour-by-hour and day-by-day gyrations of your portfolio can be stomach wrenching. Real estate trades hands infrequently, so the valuations are less subject to daily events and more governed by yearly trends of supply and demand. Putting a 5% to 15% portion of your investment portfolio in property is a very prudent thing to do. This will help stabilize your overall returns and real estate may often move in the opposite direction of the stock market. For instance, commercial real estate, as measured by the index of equity real estate investment trusts over the past 10 years, returned a total of 12.4% versus the SP-500 returns of just under 10%. Here are the basic ways you make money from investing in commercial real estate:
Income: Commercial investment properties will be leased to tenants, like businesses, and retail stores. These leases produce rental income for the owner which should create positive cash flow after the mortgage and expenses are paid. This may produce an income of 5% to 10% per year of the amount you invested.
Depreciation: Also called cost recovery, this tax write-off shelters some or all of your income from the expense of taxes. You write off the cost of the building and some of the building components, but not the land it sits on.
Equity build up: Because you can use your rental income produced by your tenants to pay your mortgage, then the part of your mortgage that is principal – but not interest expense – reduces the amount of your loan and thus builds up your equity in the property.
Appreciation: The property becomes worth more money 1) as the rent income goes up, 2) as the market puts a higher value on the rents and 3) as the land value goes up. Additionally, the value usually goes up somewhat in proportion to inflation so that property is a good hedge against inflation.
Leverage: When you borrow money to buy the property, you can control the entire property for a small percentage of the purchase price. Then because your mortgage is fixed, the appreciation in the equity portion of your investment is amplified. You can control more property for less money. For example, if you buy a property for $4, with $1 of your own and $3 you borrow, and the property goes up in value to $5, then you sell it, pay back the $3 you borrowed and keep the $2 left over. You have doubled your money when the property value went up only 25%. And the interest expense of the mortgage is tax deductible.
You may notice that these five elements of commercial investment form the acronym IDEAL coined by Certified Commercial Investment Members (CCIM), the experts in commercial real estate, a good way to remember it. This is not to say that commercial property investment is ideal, but it may be ideally suited to help you diversify your investments so that you are piece of mind or lack thereof is not tied to only one type of investment, like stocks, bonds, gold or oil wells. Spreading your investments into a well thought out variety of investments is a very smart thing to do and putting some of your hard earned money into commercial real estate investments can pay off for you. What are the three most important things in real estate?
Location It is crucial because that is the essential element of property-it doesn’t move, in Spanish it is “inmobiliaria”, the immovable.
Timing. A tract of land on north Loop 1604 in 1980 simply was a ranch or ranchette on the famous “death loop,” the two-lane farm-to-market road outside of town. Now, as time has progressed and the path of growth has overtaken it, Loop 1604 is a 6-lane expressway with office buildings, retail centers, and restaurants. But you can also find vacant tracts of land inside Loop 410 that have never been built on, growth has stopped in that area, maybe properties are declining and time has passed them by. Another example: Californians thought 15% per year appreciation was their birthright. Now they have seen that trend reversed. Like most things in life, timing is everything and real estate is no exception.
People. Every property is owned by someone, and after my many years in this business, every property has a story. People who own, buy, sell and use real estate are the real reason it has value or not. People are the true key to value.