Commercial real estate has grown as a popular investment class within the last five years thanks to its consistent returns and high growth potential. While the residential real estate market has become quite volatile due to the global pandemic and housing shortage, commercial real estate has remained a more reliable investment. However, while commercial real estate, or CRE, has high-profit potential, not every commercial investment is created equal. Marc Jaffe, an Indianapolis investor, stresses that before investing in commercial real estate, would-be investors must first understand various facets of CRE investment and thoroughly research CRE best practices.
Have a Contingency Plan – Capital Reserve Fund
Any investment possesses a certain degree of risk. For this reason, many investors set up cost contingencies or additional funding to help with unexpected expenses such as renovations, management changes or rent raises. Indianapolis investor Marc Jaffe states that cost contingencies are crucial during periods of negative cash flow, specifically when an investor is improving their property and spending large amounts of cash on renovations. Within the commercial real estate industry, the standard contingency budget is between 5 to 15%; however, this budget may not be large enough depending on the asset and its performance. Investors can also set aside a capital reserve or replacement reserves fund. This type of fund has money set aside for unexpected expenses beyond capital improvements and is often created before a property nets any positive cash flow. The typical capital reserve fund will have between 3-5% of gross rent.
Research Key Commercial Real Estate Metrics
Net Operating Income (NOI): The net operating income or NOI of a property is calculated by subtracting operating expenses of the first year from the property’s first-year gross operating income.
Cap Rate: A cap or capitalization rate is used to calculate the value of an income-producing property such as a strip mall or office building. Cap rates estimate the net present value of future profits or cash flow and help investors recognize a potential property investment.
Internal Rate of Return (IRR): Internal rate of return or IRR estimates the interest an investor will earn on each dollar invested. The IRR calculation will estimate interest earned beyond net operating income and purchase price and provide investors with a prediction of long-term yield.
REITs and Fractional Ownership
Commercial realty will often require high initial investment costs. Although single investors can be the sole investor in a variety of commercial real estate projects, more often than not, investors prefer to invest in commercial real estate via REITs or through fractional ownership.
REITs: REITs or real estate investment trusts are quite similar to mutual funds. Fund managers will select desirable real estate assets and pool cash from a number of investors. The cash is then divided across multiple assets, and any returns are clubbed and distributed to investors based on their initial investment.
Fractional ownership allows investors to pool their investments and purchase a property far outside of any individual’s budget. Individual investors can purchase one or more fractions of an asset, allowing them to increase their portion of ownership over an asset. All returns and capital appreciation are paid back to investors in the ratio of their ownership.